Who is the greatest stock picker of all time?

Many investors knee-jerk reaction is Warren Buffett.

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Understandable response, but is that the answer? Maybe not…

So who is the greatest investor of all time?

A few years ago, I asked this question of a mentor and friend. His answer surprised me. Without a moment’s hesitation, he replied that it was Peter Lynch. Our conversation went something like this…

Me: Lynch, what about Buffett? Surely his results over such a long period of time speak for themselves?

Friend: Buffett  isn’t a stock picker, his success is largely due to factor bets such as value and quality. Lynch, on the other hand, was a genuine stock picker.

Me: What makes you say that?

Friend:  He performed well, even when experiencing outflows. Buffett never had to manage outflows.(1) Also, the magnitude of his out-performance was so large that it’s statistically unlikely that his performance was due to luck.

Buffett versus Lynch: Some Background

I’ve thought about Buffett vs. Lynch question several times over the years. So it was with great enthusiasm that I read a recent AQR paper: Superstar Investors.(2) Dan Villalon and Jordan Brooks compare the performance of 4 super investors:

We will consider the results of AQR’s paper shortly. But first, it might be helpful to learn a little more about Peter Lynch and how his investment approach differed from that of Warren Buffett.

One thing that stood out about Lynch was his flexibility. Lynch wasn’t value, he wasn’t growth, he wasn’t size and he wasn’t quality. Instead, he was all of those things at the same time. For example, in his book, One Up on Wall Street, (3) Lynch describes the way he categorizes stocks into different kinds of opportunities:

  • Slow Growers – aging companies growing slightly faster than GDP. Usually bought for their dividends and buybacks.
  • Stalwarts – large quality companies that are profitable and are growing slightly faster than slow growers.
  • Cyclicals – A company whose sales and profits rise and fall in a regular if not completely predictable fashion.
  • Fast Growers – Small, aggressive new enterprises growing at 20-25% per year.
  • Turnarounds – Battered bruised and possibly in or facing bankruptcy. The performance of these stocks is largely uncorrelated with the broad market.
  • Asset Plays –A company that’s sitting on something valuable that the market has overlooked, for example real estate.

This was very unusual. I can confidently say – as a professional portfolio manager that has invested with hundreds of fund managers – that almost nobody invests like this. Fund managers usually stick to a style (e.g. large cap growth), a particular valuation methodology (e.g. free cash flow to firm, forecast over 10 years with a terminal value) or a type of company (e.g. profitably companies with reinvestment opportunities at fair prices). In other words, each manager has one philosophy/opportunity/method that they stick with.(4)

But a rigid process is not a panacea: this approach might create blind spots and/or constrain their ability to identify the best investments. A strong philosophical bent helps on the fundraising front because most clients and consultants want managers to avoid “style drift.” Lynch was different. Lynch was often labeled a growth manager, and yet, only 3 of the 6 categories above have anything to do with revenue or earnings growth.

Not only was Lynch unique among fund managers, his eclectic approach was quite different to Buffett’s. The Oracle of Omaha has focused primarily on opportunities within his “circle of competence.”  The outline of this “circle” can be roughly drawn around the following sectors:

  • Banking
  • Insurance
  • Media
  • Consumer non-durables

Buffett also holds relatively few, concentrated positions. This is in stark contrast to Lynch, who owned approximately 1,400 stocks at the time he wrote One Up on Wall Street!

Lynch was a true all-rounder, comfortable investing in all sorts of opportunities.  Meanwhile, Buffett’s investment process has gradually migrated over time through 3 stages:

  • Early – Graham and Dodd net-nets, deep value (“cigar butts”) and merger arbitrage.
  • Middle – great companies (i.e. an enduring “moat “) at reasonable prices (the influence of Charlie Munger).
  • Late – Private investments, special one-off deals and securities.

The Buffett style migration appears to have been driven by 4 factors:

  • Changes in market conditions. By the 1970s, there were fewer net-nets available in the market.
  • The influence of Charlie Munger. Munger helped Buffett to appreciate that, “time is the friend of a wonderful business.”
  • Size. Managing increasing amounts of money meant that Buffett had to shift his investment process away from “cigar butts” and merger arbitrage and focus instead on companies with a “moat” and buying whole companies.
  • Reputation. Buffett’s reputation ensures that he has access to opportunities that few can match.

For readers wanting to learn more about the evolution of Warren Buffett’s investment strategy over time, I suggest two excellent books Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor by Jeremy Miller and Inside the Investments of Warren Buffett: Twenty Cases by Yefei Lu.(5)

Buffett Versus Lynch: The Evidence

Let’s return to the AQR Superstar Investors paper. The focus of the paper is to examine the investment performance of 4 superstar investors to see how much of their performance can be explained by to systematic exposure to one or more factors.

Warren Buffett Factor Analysis

Warren Buffett’s investment performance during his tenure at Berkshire Hathaway is nothing short of legendary, beating the market by over 10% per year from January 1977 through to May 2016. Risk-adjusted returns are also impressive with a Sharpe ratio of 0.74 and an information ratio of 0.49.

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Buffett Or Lynch

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

But it seems that the majority of Buffett’s phenomenal performance can be explained by exposures to several factors.

AQR explains:

We find that this alpha becomes statistically insignificant when controlling for some of the investment styles Buffett describes in his writings.

The “Buffett Factors” can be described below:

  • Market: the U.S. equity market factor from Kenneth French’s data library
  • Value: the HML factor from Kenneth French’s data library
  • Low-Risk: the “Betting-Against-Beta” (BAB) factor10 from AQR’s data library
  • Quality: the “Quality-Minus-Junk” (QMJ) factor11 from AQR’s data library

Buffett Or Lynch

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Of the 10.6% out-performance achieved by Buffett, 7% can be explained by the factors listed above, leaving an “alpha” of 3.6%. Furthermore, the t-statistic for this alpha is not statistically significant. Buffett’s portfolio reflects a cheap-stock portfolio with quality and low-beta characteristics.(6)

Does this mean that Buffett has no skill? Far from it! As the executive summary to the AQR paper points out:

Though our results may seem compelling, we have the clear benefit of hindsight. Any “alpha” that comes out of

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