Beyond the Hype: Exactly How Warren Buffett Beats the Market

The story goes that Warren Buffett, not wanting to waste his time, would read a course's textbooks at the beginning of the semester, skip the classes, and pass the exams.

Whether the story's true or apocryphal doesn't matter. What matters is that a former colleague of mine, hearing the story, attempted the same strategy.

The results? Let's just say this guy was no Warren Buffett.

I share this anecdote because there's no end to the examples of self-defeating moves people justify in the name of Warren Buffett. In an effort to identify the moves that are worth following, here's what I believe are the five actions that explain exactly how Warren Buffett beats the market.

Action No. 1: Harnessing the power of a system
A well-conceived system is worth a thousand well-conceived tactics.

See the last two centuries of American capitalism as the most obvious example. You can insert your own list of gross political missteps, Wall Street greed, and corporate malfeasance that failed to stop the American economy's long-term progress.

Warren Buffett readily grasps the power of a good system.

You can see it in how he has structured his holding company, Berkshire Hathaway . Berkshire's structure allows Buffett to fund his company and stock purchases with the premiums from his insurance businesses. Since insurance companies get to hold their premiums until they have to pay out claims, Buffett gets to essentially borrow money for free and invest it in his market-beating ideas.

Which brings us to his system for finding his stock and company opportunities: It relies on learning about every publicly available company out there. He jokes about "starting with the A's," but the joke is reality. That was pretty much his method when he was getting up to speed decades ago reading those Moody's manuals, and it's his method today as he still reads annual report after annual report. For example, when he moved to co-purchase Heinz in 2013, he had already been following it for over 30 years, readying himself for an opportunity that may have never come. Even if the Heinz deal didn't happen, the studying would have contributed a better understanding of the deals that did.

As Berkshire Hathaway has gradually collected fully owned subsidiaries in just about every sector out there, Buffett's been able to supplement this knowledge of public companies with detailed, real-time operational data and access to expert managers from his own businesses. That combination can add context to just about any potential deal.

Speaking of the managers, his method for managing his 50-plus subsidiaries is a brilliant system. It's a system that has persuaded countless successful entrepreneurs not only to cede control of their babies to Buffett but also to stick around and run them. Buffett controls the macro-level purse strings (a.k.a. allocates capital) but allows the entrepreneurs and management teams to operate autonomously otherwise. You may argue correctly that they had that before -- though without the payout from a sale. What they didn't have is access to Berkshire Hathaway's money and its rock-solid credit rating (making borrowing cheaper). They also get the assurance that their companies will survive long after they're gone. If you don't think that's important to a founder, you haven't been paying attention to all the actions Buffett himself has taken to ensure Berkshire's health long after he's gone.

Buffett's "favorite holding period is forever" mantra plays well to assure sellers that he's in it for the long haul. It's also a reason he'll put up with mediocre returns from purchases that are past their primes (e.g., see his newspaper acquisitions).

This system of buying and holding indefinitely also has another huge advantage: tax efficiency. If you look at Berkshire's stock portfolio from its last annual report, you'll see it's sitting on over $60 billion in unrealized gains. The taxes on that would be enough to wipe out an entire year of Berkshire's profitability.

Every bit of these tax savings enhances Buffett's use of the greatest system we investors have: compounding returns.

Bottom line: Berkshire Hathaway's structure is a master course in systems thinking. And Buffett's systems were established early.

Action No. 2: Figuring out your system early and sticking to it
If you follow Buffett closely, you'll quickly notice how repetitive he is. In his interviews or at his annual meeting, you could often just substitute some recorded sound clips.

A "greedy when others are fearful" here, a "never lose money" there, and maybe a "naked when the tide goes out" for color.

This is a good thing.

The worst investors usually jump from system to system as conditions change; the best investors stick to a well-thought-out system throughout market cycles.

Buffett is clearly in the latter camp. You could see this discipline as he held onto an overpriced Coca-Cola but didn't buy hot tech stocks during the Internet bubble and when he held on to his banking stocks throughout the financial crisis. The advantages of sticking to the system outweighed the benefits of any tactical move.

Further, he figured it all out early. Do you still agree with your thinking 20 years ago? For the most part, Buffett does. Heck, some of his go-to quotes are more than a half century old!

One of the things he figured out early was to stick to high-quality companies. The next factor explains what he defines as "high-quality."

Action No. 3: Ignoring pie in the sky
When you boil it down, Buffett cares about two things in a company:

1. Has it proved that it can make efficient profits?

2. How confident can he be that it'll keep growing those profits efficiently (and significantly faster than inflation) in the long-term future?

Here's what that means from a practical standpoint. Buffett doesn't go after story stocks -- meaning that he doesn't trust a company's projections unless they're based on a track record. This practice helps ensure he doesn't have many losers weighing down his portfolio.

The most famous example is his avoidance of tech stocks. That's because there are few tech stocks that have a long-term track record of efficient profits. As for the ones that do have good track records, it's hard to project their future profits because disruption is so high in that space. We saw him make an exception with IBM, which has shown an ability to innovate over decades and has altered its business model so that it is more a service provider than a tech innovator.

What really confuses people, though, is that Buffett's seemingly simple system can't be predicted easily with screens of simple metrics such as the P/E ratio. Even now that the companies he can choose from are limited to the largest elephants, his purchases continue to come as a shock.

Many analysts ascribe precise figures around "margin of safety" (e.g., "Stock X is 40% undervalued!"), but Buffett's math is simultaneously less precise and more artful.

Here's the part that's missing from many analysts' equations. When analysts do a discounted cash flow calculation, they generally look out for five to 10 years and then assume a company can grow by somewhere near the rate of inflation.

Great companies beat inflation for a lot longer than 10 years. Understanding that nuance is a big deal. That's why Buffett could buy shares of Coca-Cola 100 years into its life and still make a killing.

How much of a killing? It's worth over 10 times what Buffett paid for it. He can say the same thing about his "boring" investments in Procter & Gamble and American Express. 

By avoiding pie-in-the-sky situations, he rarely goes hungry and frequently ends up with pie in a tall building. Not bad for a guy whom many growth investors pooh-pooh.

The next action also deals with heights.

Action No. 4: Hitching a ride on giants while ignoring the ants
Buffett has a great desire to be loved. As an awkward young man, he went so far as to conduct his own secret behavioral tests on people based on the principles of a Dale Carnegie course he took. Once he verified that the principles worked, he mastered them. You see it in how he refuses to "criticize, condemn, or complain," how he uses "praise and honest appreciation," and how he "talks in terms of the other person's interests."

Buffett took this weakness and made it a strength by relying on the advice of the giant in the space.

He has taken a similar "standing on the shoulders of giants" approach to investing. He's commented that his investing style is 85% Benjamin Graham (i.e., value investing) and 15% Philip Fisher (i.e., growth investing). You can also add in his business partner, Charlie Munger -- a brilliant investor in his own right who has no qualms about speaking his mind to anyone, Buffett included.

Those three are Buffett's largest investing influences, but Buffett seeks knowledge from great minds everywhere. As Munger has noted about Buffett: "Half of all the time that he spends is just sitting ... and reading, and a big chunk of the rest of the time is spent talking ... with highly gifted people."

As Buffett himself said, "By the age of 10, I'd read every book in the Omaha Public Library with the word 'finance' in the title -- some twice."

The end result is a giant standing on the shoulders of other giants.

While Buffett wants to win friends and influence people socially, he doesn't have that need for approval when it comes to his investing judgment. His work with the giants helps give him the unshakeable confidence that allows him to ignore criticism from the ants who are fearful when he is greedy.

Which gets us to the factor that Buffett says is his most important key to success.

Action No. 5: Focusing
According to his biographer, Alice Schroeder, Buffett has "focus like you have never seen on anybody else."

What this means is he's strategic in how he spends his time, he says "no" to a lot of things, and he doesn't have much of a work/life balance.

Remember that most of his time is spent improving his knowledge base via reading and talking to other wise people. That limits the amount of time he can spend managing his sprawling conglomerate empire, talking to the press, and socializing with friends and family.

We know the decentralized system he's set up helps him stay high-level in how he manages Berkshire Hathaway. He reads summary reports and talks to managers when they request it, but otherwise he mostly focuses on the big-picture strategy and capital allocation.

As for his public appearances, it seems that Buffett is always in the news. But he gets that exposure through a few high-impact public utterances a year: his annual meeting and shareholder letter, plus a CNBC appearance here and a New York Times article there. We Buffett followers then amplify the message.

Committing so much time and mental energy to honing his craft comes at the expense of family and non-work-related friends. The anecdote about his sneaking out of social engagements at his own house to read more annual reports is the one that sticks with me.

If 10,000 focused hours is the price of mastery, Buffett's well past the 100,000 hours for hyper-mastery.

Putting it all together
Beyond his highly above-average intelligence and his highly above-average emotional equanimity, we can put together exactly how Warren Buffett beats the market. He started obsessing on making money since before he was 10 and has kept it up into his 80s. He sped up his learning curve by figuring out who the trustable experts were and learning from them -- all the while surrounding himself with fellow high-caliber learners. He has made sure to make the most of his work by quickly establishing and sticking to well-thought-out systems. And finally, he focuses in a way that makes lasers jealous.

To put it into cliches, Buffett works remarkably hard and he works remarkably smart. It's not sexy, but it's true. Any explanation of Buffett's success that doesn't acknowledge those two things is either wrong or a misleading shortcut.

As my colleague should have realized, if Buffett was skipping classes, he was doing it to read more books.