Blog Archives

Insurance is a big reason why Berkshire Hathaway’s risk-adjusted investment return has been able to beat every mutual fund since the year 1976.

We learn this according to a new research paper from New York University and AQR Capital Management, told by The Economist.

The insurance and reinsurance companies that are part of Berkshire Hathaway lend money to the Berkshire Hathaway parent company, and they actually provide more than one third of the company funding. Buffett is then able to use this leverage as a way to purchase large quantities of stocks as an investment.

“This would be an expensive strategy if the [insurance] company undercharged for the risks it was taking,” states The Economist.

“But thanks to the probability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

The insurance company also gives Warren Buffett a way to borrow money during both good times and bad times. “The long-term nature of the insurance funding has protected Mister Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market,” states the magazine.

“Without leverage… Mister Buffett’s return would have been unspectacular,” says The Economist.

By having the insurance company leverage available to him, Warren Buffett is able to tap into this resource and by stock shares in high-quality companies that are struggling and going through hard times. He did this with Coca-Cola during the 1980s, and he was also able to gobble up shares of General Electric during the most recent financial crisis, we also learned from The Economist.

The magazine quotes Warren Buffett as saying, “It’s far better to buy a wonderful company had a fair price then a fair company at a wonderful price.”

Buffett has also “steered largely clear of more volatile sectors, such as technology, where he cannot be sure that a company has a suitable advantage,” notes The Economist.

All in all, not everything touched by Warren Buffett turns to gold. Berkshire Hathaway is the biggest shareholder of Moody’s rating company, and they lost roughly $340 million when the stock plummeted 22% last week.

This drop happened because the government is considering suing Standard & Poor’s, a rival of Moody’s, because of ratings practices that they implemented prior to the financial crisis taking place.

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.

The name Warren Buffett has basically been synonymous with value investing for many years now. He was a disciple of the value investor extraordinaire Benjamin Graham, who is also known as the “Father of Value Investing.” Because of this, Mister Buffett has become the most widely known investor, likely due to his ability to determine the true value of securities, and then purchase them for much less than what they are actually worth. This is a core concept of value investing. Buffett has said that “Price is what you pay. Value is what you get.

Labeling Warren Buffett as strictly a “value investor” is definitely an oversimplification of what the man does. The truth is that his overall investing strategy has quite a few different factors involved.

Actually, in a recent paper, three individuals from AQR Capital Management recognized that the main driving force of Warren Buffett’s major success over the last few decades has not been value. “The standard academic factors that capture the market, size, value and momentum premia cannot explain Buffett’s performance so it has to date been a mystery,” write Lasse H Pedersen, David Kabiller and Andrea Frazzini.

Early in their study, they said that they “find 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.”

The group estimates that Warren Buffett applies about 1.6 to 1 leverage, and it is financed in part by the insurance float attained by Berkshire Hathaway. This group of individuals also recognized that Berkshire Hathaway’s public holdings between the years 1980 through 2011 averaged a beta of 0.77. This means that the stocks they purchased were quite a bit less volatile than the overall broader market.

It really isn’t all that surprising that Warren Buffett’s main catalyst to success was picking the safer stocks of high-quality companies. There is a Buffett style investment strategy that’s completely based on the way that Warren Buffett built his business. This strategy puts its major emphasis on quality companies, and this is even more important than specific value metrics. And these quality stocks also have a tendency to be a lot less volatile.

The overall Buffett style investing strategy requires that every company evaluated for purchase must have their earnings-per-share increase each year for at least a decade or more. Plus their annual earnings must provide them with the ability to pay off the entirety of their debt within a five-year span. The average ROI of each company must be 15% or more over the last decade as well. Every one of these signs are there to help you judge whether or not a business is of the highest quality.

It doesn’t really matter if you call it high-quality investing, value investing, high quality low beta investing or just low beta investing, the track record of Warren Buffett shows you in and of itself that this is an incredible approach that is definitely worth pursuing. So I recommend you do exactly that.