Mr Buffett: Is it plausible to try and copy-cat the world’s greatest Investor?!

 

Introduction

After watching the documentary ‘Warren Buffett: The world’s greatest money maker’ one gets an empowering sense they too could replicate the success of the ‘Oracle of Oklahoma’. This feeling came about due to the sheer simplicity in which he explains his investment strategy; in the documentary he states he follows the three criterion for all investments he makes:

·        Investment Philosophy

·        Security Selection

·        Psychology of Investing

 

I decided to investigate this in more detail to determine why, if it is so simple, others have struggled so much to replicate his success.

 

It is evident from the documentary that Buffett disagrees with the concept of debt financing; arguing “borrowed money has no place in the investor’s tool kit”. He highlights the dangers of highly leveraged firms, explaining that no-one can predict what is going to happen in markets. This is the first major lesson I learned:

 

1.      He doesn’t borrow to invest

 

Instead of amassing capital from bank loans he, rather intelligently, uses the float from the premiums his insurance business customers pay to invest. This is worth around $77 billion and carries an extremely simple but important advantage over traditional debt finance: It allows Berkshire to borrow at a cost averaging 2.2% (Worstall, 2013). The fact this figure is more than three percentage points below the average short-term financing cost of the American Government over the same period means Buffett is able to borrow at a rate which is below the market, therefore if his stocks make only market returns he will still outperform the market.

 

Even before Buffett acquired enough capital to implement this technique with his insurance business, he followed the same principal when making investments in small to medium sized businesses. This is the second lesson I derived from Mr Buffett:

 

2.      Use Profits to fund Operations

 

This is interlinked with the first lesson, but also carries extreme significance. He suggests that if he believes profit from one business could be put to better use, then this should be done. This point surprised me, as it reveals he does not agree with the idea that an optimum capital structure should be pursued. He is implying that trying to lower the WACC is risky because any slight changes to the WACC impact a manager’s decisions dramatically. This is the basis for arguments against Kraus and Litzenberger’s trade-off theory.

 

 

Although it may not be feasible for the vast majority of investors to imitate Buffett’s investing technique due to the enormous float generated from his insurance business, we can still learn some lessons from the ‘Oracle of Oklahoma’.

-          Use profits to fund operations

-          Sell off parts of the business if you think you could reinvest it better

 

Worstall, T. (2013). Explaining The Secret Of Warren Buffett's Success: Double Leverage. Forbes.com. Retrieved 15 April 2016, from http://www.forbes.com/sites/timworstall/2013/02/08/explaining-the-secret-of-warren-buffetts-success-double-leverage/#7d94b8767ba9