October 16, 2012

Recovering From The Great Recession & Buffett's Secret to Success

Two widely watched indicators just hit five-year extreme levels - and that's a positive for the economy.

Consumer sentiment hit a five-year high in the preliminary October reading, as measured by the University of Michigan-Thomson Reuters sentiment gauge. This gauge "covers how consumers view their personal finances as well as business and buying conditions," according to MarketWatch. Higher levels of sentiment could translate into higher consumer spending and help propel the economy.

And, the second indicator, housing foreclosure filings, hit a five-year low in September, according to RealtyTrac. Foreclosure filings include default notices, scheduled auctions, and bank repossessions. In September, there were 180,427 foreclosure filings. By contrast, that number was above 350,000 in mid-2009, so, yes, foreclosure filings have improved significantly over the past few years.

And, for good measure, let's throw in a third indicator - weekly jobless claims - which fell to their lowest level in more than four years for the week ending October 6, according to Bloomberg. Lower claims "may mean employers are seeing enough demand to maintain current staff, a necessary first step to bigger gains in hiring," according to Bloomberg.

While these three indicators look good, "Earnings pessimism among U.S. chief executive officers is climbing to levels last seen when the Standard & Poor's 500 Index was mired in bear markets," according to Bloomberg. In fact, analysts are now forecasting a 0.9 percent decline in corporate earnings for the just completed third quarter, according to Bloomberg.

Good news, bad news, what's an investor supposed to take from this? Well, like the movie by the same title, it's complicated. The economy continues to recover and rebalance from the Great Recession and this leads to some indicators looking good, others looking bad, and some looking just plain normal.

Data as of 10/12/12	1-Week	Y-T-D	1-Year	3-Year	5-Year	10-Year
Standard & Poor's 500 (Domestic Stocks)	-2.2%	13.6%	18.3%	9.9%	-1.8%	5.4%
DJ Global ex US (Foreign Stocks)	-1.8	7.8	4.6	0.1	-7.0	7.8
10-year Treasury Note (Yield Only)	1.7	N/A	2.2	3.4	4.7	3.8
Gold (per ounce)	-1.0	12.2	5.0	18.6	18.7	18.7
DJ-UBS Commodity Index	-0.6	4.4	0.6	3.7	-3.7	3.3
DJ Equity All REIT TR Index	-0.7	15.7	29.2	20.3	1.4	12.3

DO YOU WANT TO KNOW THE SECRET to Warren Buffett's remarkable investment success?

First, some background. Buffett partially owns a company called Berkshire Hathaway and he uses this as his vehicle for making investments in other companies. So, when people say Buffett is a great investor, they're looking at the performance of Berkshire Hathaway stock which, in turn, tends to reflect the performance of the companies Berkshire owns.

Further, a recent academic paper by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen, titled Buffett's Alpha, said, "Buffett's performance is outstanding as the best among all stocks and mutual funds that have existed for at least 30 years."

Now, here's the secret to Buffett's spectacular returns according to the paper's authors:

We find that the secret to Buffett's success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails.

Let's look at each of those components:

1. Cheap: defined as value stocks with low price-to-book ratios
2. Safe: defined as stocks with low beta and low volatility
3. High-quality: defined as stocks of companies that are profitable, stable, growing, and have high dividend payout ratios
4. Leverage: perhaps shockingly, the authors discovered that Berkshire magnified its returns by leveraging its capital by 60 percent financed partly using insurance float with a low financing rate

Source: Buffett's Alpha paper

This is not a buy or sell recommendation on Berkshire Hathaway stock, rather, it shows Buffett latched on to a good strategy early in his career, used leverage to magnify his returns, and stuck to the strategy even when it suffered large declines.

Now that we know "how" Buffett achieved his outstanding return (including the surprising leverage), does this in any way diminish his results? No. In fact, it's probably just the opposite. Buffett figured this strategy out more than 30 years ago and researchers are just now catching up with him!

Weekly Focus - Think About It...

"Research is to see what everybody else has seen, and to think what nobody else has thought."

—Albert Szent-Gyorgyi, Hungarian biochemist

Best regards,
Sean M. Dowling, CFP, EA
President, The Dowling Group Wealth Management

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