MarkHulbert

Bloomberg

Investors for years have been searching in vain for a formula to replicate Warren Buffett’s legendary returns over the past 50 years.

The wait could be over.

The study’s authors analyzed Buffett’s record since he acquired Berkshire Hathaway BRK.A, +1.10% BRK.B, +1.55%  in 1964. Their formula, which has more than a dozen individual components, comes in two major parts.

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The first is a “focus on cheap, safe, quality stocks,” defined as those that have exhibited below-average volatility and sport low ratios of price-to-book value — a measure of net worth. In addition, the researchers looked for stocks whose profits are growing at an above-average pace and that pay out a significant portion of their earnings as dividends.

The second part of the formula will raise eyebrows: It calls for investing in these stocks “on margin” — that is, borrowing money to buy more shares than could otherwise be purchased. To match Buffett’s long-term return, the researchers found, a portfolio would need to be 60% on margin — borrowing enough so that it owned $160 of “cheap, safe, quality stocks” for every $100 of portfolio value.

Andrea Frazzini, one of the study’s authors, a finance professor at New York University and a vice president at AQR, said the Berkshire portfolio has, on average, been leveraged to a similar extent through Buffett’s career.

It can be easy to overlook the extent of this leverage, since Buffett is able to borrow from other parts of his business. But that doesn’t mean the company isn’t still leveraged, Frazzini argues. According to its most recent annual report, for example, the total value of Berkshire’s holdings are double the company’s net worth, implying that its current leverage is about 2-to-1 — somewhat higher than its long-term average.

Employing margin can magnify profits, of course. It also increases potential losses when things go wrong. But note that the formula combines a heavy use of margin with stocks that tend to be much less risky than the market, so the net result can still be a portfolio that is no riskier than the market as a whole.

‘Margin call’ risks

To be sure, a heavily margined portfolio will always run the risk that, if its holdings fall enough, of getting a “margin call” — the need to come up with additional cash. Berkshire Hathaway has been able to sidestep that risk over the last 50 years. Despite a heavily reliance on leverage, its worst return in any calendar year was a loss of 9.6%. And its book value has been less volatile than the S&P 500 SPX, +1.26%  . Volatility is a common measure of a portfolio’s risk.

One factor that is conspicuous in its absence from the formula is anything to account for Buffett’s significant investments in privately owned companies. But that isn’t necessary, according to the researchers, because the public companies in which he has invested have outperformed the private ones.

This is somewhat surprising, given that Buffett has often trumpeted his abilities to pick good managers. Yet the researchers nevertheless find that his “returns are more due to stock selection than to his effect on management.” (A Berkshire Hathaway spokeswoman said that Buffett declined to be interviewed.)