There are lots of good reasons to recognize that Warren Buffett is absolutely one of the best investors of his generation. As a matter of fact, his company Berkshire Hathaway has a higher Sharpe ratio (a way to measure risk-adjusted returns) than any other mutual fund or stock that’s historically capable of being tracked for 30 years or more. This is true even after you take a look at the four traditional factors (momentum, size, value and market), Berkshire Hathaway’s alpha is significant, and their returns are well above the traditional benchmark.
That’s why we must pose the question: What’s the source of Warren Buffett’s alpha? Most people using conventional wisdom have always believed that he is successful due to his ability to pick stocks, as well as his disciplined approach. But Andrea Frazzini and David Kabiller of AQR Capital Management, with the help of Lasse Pederson from the Copenhagen Business School and New York University, have come together to provide us with some answers that are both interesting yet unconventional. Let’s take a look at a summary of their findings right now:
- Between November of 1976 and all the way through December of 2011, Berkshire Hathaway had an annual investment return of 19% in excess of the rate of treasury bills, and they outperformed the overall stock market average with a combined return of 6.1%.
- Berkshire Hathaway’s stock portfolio was also riskier, and their total volatility was 24.9%. This is actually 58% higher than the overall market volatility of 15.8%.
- Between November of 1976 through December of 2011, Berkshire Hathaway’s Sharpe ratio was 0.76. This is almost twice the ratio of the overall general stock market which was 0.39.
- Even though their Sharpe ratio was so high, it does not reflect their average returns, and it does reflect the significant amount of risk that they have taken, and it also shows us the significant drawdowns that happened during certain periods between those years. As an example, during the time of July 1998 through February 2000, Berkshire Hathaway actually lost around 44% of its total market value. The overall stock market gained 32% at that time. There aren’t many fund managers who could survive a 76% loss of overall value. But the authors remind us that “Buffett’s impeccable reputation and unique structure as a corporation allowed him to stay the course and rebound as the Internet bubble burst.”
- Warren Buffett was able to easily boost his returns by using it’s leverage, and it was estimated at 1.6.
- Warren Buffett has chosen to stick with his strategy through thick and thin, and has been doing it for a really long time. That’s why he was able to survive some of the rougher periods which usually force other managers into a fire sale or a change in jobs.
- Buffett is known to buy safe, high-quality, cheap stocks (with low volatility and a low beta), but they are also growing, stable, profitable and have very high payout ratios. Another important factor is that they are large. And last but not least, they do not possess any exposure to the momentum factor.
The most interesting findings that this study provides us with is that the Berkshire Hathaway stocks with these characteristics – high-quality, low risk and cheap – will perform very well in a general sense. The high-quality companies, which also tend to have higher returns historically, particularly during the down markets, usually have the same characteristics as these:
- the earnings volatility is low
- they possess high margins
- they are efficient because they have a high asset turnover
- their operating and financial leverage is low – this is an indicator that they have low macroeconomic risk and a strong balance sheet
- they possess low specific stock risk – and you cannot explain their volatility by macroeconomic activity
So it’s easy to pinpoint that Warren Buffett’s overall strategy is what generated the alpha, and it really isn’t his stock selection skills at all. The authors of this information adjusted Warren Buffett’s overall performance for Betting Against Beta factor and the quality factor as well. The authors realized that once all of these factors (value, momentum, BAB, data, leverage, size and quality) are all accounted for, you can explain a large part of the performance of Warren Buffett’s choices.
In an effort to demonstrate the findings that they made, the authors created a stock portfolio that tracks a style of portfolio deemed Buffett worthy, and they noticed that it tracks just like the Berkshire Hathaway portfolio when you compare the two. They compare at a ratio of 75%, which basically shows us that the systematic portfolio created by the authors can explain about 57% of the variance of the Berkshire Hathaway stock portfolio.
I also want you to note that this finding doesn’t take anything away from Warren Buffett’s portfolio performance whatsoever. He was obviously the one who figured out this strategy way before the authors realized just what he was doing. As author Bill Bernstein points out, being the first, or among the first, to figure out a strategy that is capable of beating the market, is exactly what’s going to buy you yachts. That won’t happen for those people who copy the strategy after everybody already knows about it. Once that happens, all the low hanging fruit will already have been picked. It’s also important to note that these findings are at least capable of showing us why he’s been so successful over so many years. He was successful because of the strategy, and not because of his stock picking ability.
The genius that is Warren Buffett obviously recognized a long time ago that “these factors work, applying leverage without ever having a fire sale, and sticking to his principles,” said the authors. They also mention that Warren Buffett himself told us in his Berkshire Hathaway 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
The authors of this piece also considered “whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO.” As a way to address this, they decomposed Berkshire’s returns into a part due to investments in publicly traded stocks, as well as another part due to the private companies that are run within the Berkshire Hathaway structure. It’s their idea that the publicly traded stock returns are mainly driven by Warren Buffett’s skill to select stocks. But the private companies are so successful because of the managerial skills that Warren Buffett possesses. They also noted that the public companies were able to perform better, so it’s not necessarily his managerial style that is responsible for his overall alpha. They also found that the companies that Berkshire Hathaway owns do provide a steady source of low-cost financing, which provides him with great leverage to further pick stocks – 36% of the liabilities of Warren Buffett and Berkshire Hathaway are insurance float, and the average cost is well below the treasury bill rate.
Another major Warren Buffett advantage, even though it isn’t as important, is that: “Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment.” It’s good to note that accelerated depreciation basically mimics an interest-free loan.
There’s no doubt that the leverage of Berkshire Hathaway helps, and you should also note that it will boost the market’s excess return of 6.1% to about 10%. Once the authors take into account of all the style factors, the Berkshire Hathaway alpha of their public stock portfolio falls to a insignificant statistic of an annualized 0.1%. To put it another way, these factors just about completely explain the overall performance of Warren Buffett’s public portfolio. The bottom line shows us that we now can see Warren Buffett’s secret sauce, which is that he buys value stocks of high quality that are also safe, and he also applies low cost leverage.
I would also like to add that the average investor is not going to have access to the same low-cost leverage as Warren Buffett, but you can use some of the other factors that Warren Buffett applied to create his alpha. As an example, AQR Capital, Bridgeway and Dimensional Fund Advisors are three mutual fund providers that use the same strategies which apply a highly disciplined and a systematic approach to capturing a specific return on style premium. They are obviously not index funds, but their overall funds do fall under the general category of funds that are particularly low-cost, and also passively managed.