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Hi! Welcome to the #AskDrWealth series! I'm Alvin, the founder of Dr Wealth And, of course Warren Buffett is the world's most famous investor and lot of people want to emulate his investing style, There are many books written about Warren Buffett and everyone seems to have a version of how he actually invests.
Warren Buffett has never really stated very explicitly, although he does reveal some of his thought processes in his annual letters. A few years ago, a group of researchers started to break down Warren Buffett's investing source of alpha, and they termed this paper, "Buffett's Alpha". It was written by this group of people, Frazzini, Kabiller and Pedersen.
It's a handful remember right but that's the purpose of this video, I'm gonna explain to you the gist of the research itself. So there are scientific ways, or through data, they are able to break down, what kind of characteristics of stocks does Warren Buffett buy and essentially they discovered that there are two main kind of factors that Warren Buffett stocks tend to exhibit certain characteristics.
One, is they tend to have low beta. So, 'low beta'. What it essentially means is that the stock prices movement doesn't really correlate to the broader index. So, for example Warren Buffett even when he buys the US stocks right, they may not correlate so much to the S&P 500 index. In that sense okay?
So they tend to find that they are not so correlated, and you can also say in other ways, that they tend to be 'low volatility' stocks. That means they don't fluctuate so much. So they are very stable stocks that Warren Buffett choose. The second one is that they tend to be of higher quality. That means they are very profitable and they have growth elements in them.
that means the profits grow over time. So these two kind of characteristics are pretty much what most people understand. Especially the second one, 'High Quality Stocks' right? The first one maybe less so, okay? In terms of the correlation to the index. The more important thing is that, if let's say Warren Buffett buy this kind of high-quality, stable stocks...
which also mean that these prices of the stocks that he own, may not go up a lot. Because they fluctuate lesser right okay? What they found on top of these two characteristics, is that Warren Buffett is levered. He has a leveraged portfolio He actually lever around 1.6 times of his portfolio value! So imagine that his wealth without that leverage, would grow according to like what this white line hypothetically say, but if let's say he levered this portfolio by taking financing and buying bigger portion of the stocks by 1.6 times, it'll probably follow a much higher but of course, more volatile path of the wealth-growing phase.
So which means Leverage is a very key factor to Warren Buffett's wealth. How does he get the leverage? You know that in history, he buy some of these insurance companies, like one of them the most famous one, is Geico. So, insurance company, they sell policies and they collect premiums from their consumers, from the customers.
And these premiums are cash. Which means these insurance companies gather a lot of cash every month. And what do they do with this money? They either go and invest or they lend it out, buy bonds, and that's how they generate returns for their customers. Once in a while, they have to pay out certain amount to those people who claim insurance.
But, most of the time, these insurance company has a lot of money. What Warren Buffett did was that he borrowed money against this float of the insurance company and, what's more amazing is that, he borrowed an interest rate that is lower than the Treasury bill of the United States government! Which means, Warren Buffett has been borrowing money, cheaper than a triple-A US government!
Which means people see, or Geico companies, insurance companies see Warren Buffett as more creditworthy than the US government. In essence right? So, these are some of the key elements and by being able to borrow at a very cheap rate, the cost of capital is very low for him. Which means the spread of the investment returns from the stock, and the fee that he needs to pay in terms of the interest rate is low, the spread is going to be very large for him.
That's how some of these key elements resulted him to reach great success, when it comes to building his own wealth through investing. Which we believe that most people, would not be able to borrow at this kind of rates, as a retail guy. So which means, some of the Warren Buffett strategies or characteristic that he have is very unique to him, and it may not be so worthwhile, for an individual to really copy what he does.
So I hope that by using this study by itself, 'Buffett's Alpha', you can actually go and download the paper and read in more detail. It actually breaks down how Warren Buffett achieve his success. Put it in context and see whether you are also in the same situation to adopt this kind of things, which I believe most people are not in this situation.
Thank you for watching! I hope, it has been an enlightening session for you guys.
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