What Warren actually does

Dear Gala,

There is a man in Omaha, a quiet city in the middle of America, who bought his first shares at eleven and has spent every year since thinking about what a business is worth. His name is Warren Buffett. I believe he is one of the savviest and wisest investors who ever lived, and his letters to his shareholders have taught me more than most of my degrees. So understand that everything that follows is written with admiration.

Sooner or later someone is going to bring up his name. One day you will explain that you keep your investments simple, that you own the whole market and stay away from clever ideas. And someone will answer: what about Buffett? He beat the market for fifty years, so it can be done. And if it can be done, you should try, or pay someone to try for you.

I want you to know what to say. There is a paper that answers the question. I will tell you what it says.

The record

First, the record is real. From the 1960s on, Berkshire Hathaway, the company he spent sixty years building, turned every dollar into thousands. In 2018 three researchers, Andrea Frazzini, David Kabiller and Lasse Pedersen, measured it properly and found that no American stock or fund that had been around long enough to compare had paid better for the risk it took. He is exactly as good as the legend says.

Safe and cheap

The same three researchers then took his record apart, the way you would take apart a watch, and their paper has one of the best titles in finance: Buffett’s Alpha. Here is what they found inside.

Buffett buys three kinds of things, and they are always the same three. Companies that are safe, meaning their business earns money in good years and bad. Companies that are cheap for what they earn and own. And companies of quality, meaning they grow, earn steadily, and hand the profits back. Soap, insurance, railways, banks, Coca-Cola. Nothing in the list is exotic and nothing in it is secret; Benjamin Graham, his teacher, was writing it down before Buffett was out of school.

There is a reason the boring ones pay so well, and Frazzini and Pedersen explained it in an earlier paper. Most people want a big win, and most people cannot borrow to get one. So they do the next best thing: they buy the wildest stocks they can find, the ones that can double in a year. So many people do this that the wild stocks end up expensive, and whoever overpays earns less. The quiet companies, the ones nobody brags about at dinner, get left behind cheap. Buffett does the reverse. He buys the quiet ones cheap, and uses borrowed money on the side to make the result big.

The borrowed part

Now the part of the watch nobody looks at. Buffett does borrow. Roughly speaking, for every dollar of his own there are about seventy borrowed cents next to it, and that leverage turns a good, steady strategy into a great record.

But look at where the borrowed money comes from. A large part of it is insurance. Berkshire’s insurance companies collect premiums today and pay claims years from now, and in between, Buffett invests the money. The researchers found this financing cost him less than what the American government itself was paying to borrow. And it has a property that matters more than the price: nobody can call it. There is no banker who can knock on a bad morning and demand it back. In the letter about 1929 and 2008 I told you that borrowed money is what turns a fall into a ruin, because the lender decides when you sell. Buffett found the one kind of borrowed money where that phone call cannot come.

So the machine has three parts. Boring, cheap, good companies. Borrowed money that is cheaper than the government’s and cannot be recalled. And decades of leaving it alone. When the researchers accounted for the first two, the magic in the record shrank to almost nothing. That sentence is easy to misread. It does not make him smaller. He worked out, thirty years before the professors, what was worth owning and how to pay for it, and then, and this is the part that filters out nearly everyone, he did it without interruption for fifty years.

1999

The interruption almost came, once, and it is my favorite part of the story. In the late nineties the market went mad for internet companies, and Buffett refused to buy any of them, because they failed his three tests. For that he was punished. In 1999 the crowd’s stocks roughly doubled while Berkshire fell, and the financial press wrote him off in print, by name, as an old man who no longer understood the world.

Think about what would happen to a fund manager in that position. His clients would read the paper, make the call, and pull the money, and he would be forced to sell his boring companies at the bottom to buy the exciting ones at the top, or lose the business. Buffett’s investors could sell his shares to some other buyer if they liked, but they could not take a dollar out of his hands. He did not have to answer the phone, so he did not have to move. Within two years the exciting stocks had collapsed and the old man was right again. Patience looks like a virtue. Up close it is a structure: he had arranged his affairs, decades earlier, so that no one on earth could make him sell.

What I do

I have watched the same law work in every market I have known. In stocks, whoever buys with borrowed money sells on the day the lender decides, and it is always a bad day. In real estate, the best buildings rarely changed hands between two patient owners; they went from someone whose loan came due in a bad year to someone who happened to have cash that year. And on the land it is the harvest: the farmer with a payment due at harvest sells at harvest, whatever the price that week, while the one who owes nothing stores the grain and waits for his price. The rule is the same in all three: whoever owes money can be forced to sell, and whoever owes nothing can wait.

So I copy the part of Buffett that can be copied. I own good companies at fair prices, mostly through the index, and I am content for the result to be boring. I keep the borrowed side of my life small, and on the rare occasions when debt makes sense, I size it so that no fall in the market can ever force me to sell. What cannot be copied, the insurance money, the fifty years, the temperament, I do not pretend to have. But the direction is available to anyone, and the direction is most of it.

With love,
Papá