Investing Like Warren Buffett

Here it is, the secret to investing like Warren Buffett. What does it mean? Basically it says that, all other things being equal, the stocks of more profitable firms should outperform the stocks of less profitable firms. The profitability factor is the Warren Buffett factor.

To put this in context, what are factors? If you’re familiar with the Morningstar equity style box, you get the basic idea. The style box plots two factors, 1) size, and 2) value. Over the past few years, research has identified several other factors, including profitability and momentum. More about momentum and other factors in another blog. After adjusting for size and value, nearly all of Warren Buffett’s out-performance can be explained by profitability, (some call it, more loosely, quality.)

Thanks to Larry Swedroe for his insights on this topic. I was privileged to hear him speak about this at a recent meeting of the National Association of Personal Financial Advisors. His book on this topic is “The Incredible Shrinking Alpha.”

Can you take this secret and invest like Warren Buffet? Yes and no. The retail investor has several choices of efficient investment vehicles rigorously investing in the equity, size and value factors but fewer choices for investing in the profitability factor. Some explicitly invest in a quality factor but definitions of quality vary enough that it’s difficult to compare one investment to another. My personal preference for investing in the profitability factor is the products of Dimensional Fund Advisors (DFA). DFA uses profitability as a screening factor in several of their funds and has two new funds--one international and one domestic—focusing on profitability. There are other investment products marketed as “smart beta” that may or may not include profitability. More later about “smart beta,” another topic for a future blog post.

Of course, a big complication is that the secret is no longer secret. It may be that even Warren Buffett may not be able to invest like Warren Buffett in the future. Nevertheless, investing for profitability is likely to be persistently available as other investors make investments in growth companies that are not very profitable now but are expected to be in the future.

References: The profitability factor appears in a paper by Robert Novy-Marx published in 2012, “The Other Side of Value: The Gross Profitability Premium.” If you’re seriously interested in understanding the leading equation, this is the source. In their paper “Buffett’s Alpha,” Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen, made the connection of profitability to Warren Buffett.