Price is what you pay, value is what you get


“Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results”, Warren Buffet, Annual Report 1994

This truly modest statement comes from a man that is widely regarded as one of the most successful investors of all time; a gifted person that accumulated a wealth of $70bln from zero, giving 2/3s of it to charity and only a small portion of it to his children famously quoting that he leaves them enough money to do something but not too much to do nothing.
Just to give you an idea, Warren Buffet’s Berkshire Hathaway enjoys the highest sharp ratio (return/risk) than any stock or mutual fund with a history of more than 30 years. His track record has been under serious study from several market practitioners as well as prominent academics.

So can such a statement be true ? Can investing be simple?
Buffett’s investment approach originates from Graham and Dodd, Columbia business School professors and fathers of value investing who published their original ideas in the famous book “Securities Analysis” (1934).
Recent studies on his investment style show that he buys cheap, safe and high quality stocks with a constant degree of leverage. More specifically:

Cheap stocks (e.g. value stocks with low price-to-book ratios)
Safe stocks (e.g. Low beta or low volatility stocks)
Quality (e.g. Stocks with profitable, stable, growth and high payout ratios)
Some degree of leverage: Buffett’s Berkshire Hathaway uses a leverage of around 1.6xtimes (i.e. for 100 capital, 160 is invested)
As simple as this sounds such a strategy has outperformed for so many years!

Buffet’s strategy works because it is based on a market anomaly that is most probably due to leverage. In theory, we expect a rational investor to request higher levels of returns for more risky investments. Contrary to common belief this does not seem to be always the case!
In real life, low risk investments seem to outperform high risk ones (in comparative terms) simply because many investors cannot leverage their portfolio and as such low-risk investing becomes unattractive. Many real world investors such as individuals, pension funds and mutual funds cannot use leverage (or they don’t want to) and will overweight risky investments which leads to overpricing of these securities. In other words, investors prefer to allocate funds on high risk stocks/investments while low risk investments remain unattended. This leads to the relevant overpricing of risk assets and underpricing of less risky ones. This phenomenon is also called betting-against-beta.

So Buffett’s strategy is to buy cheap and quality stocks while betting-against-beta using leverage of around 1.6 times.

Finally, I leave this post with the best Buffett’s quotes in this link. If I had to choose only one, it would be this:
“Price is what you pay. Value is what you get”