Warren Buffett is probably the most quoted person in the investing world. Most investors have sought his wisdom and looked to emulate his performance and investing style ever since his first rise to fame.
However, it would appear that while his style is easy to replicate, the sage of Omaha used one thing that many do not have access to, that is cheap sustainable leverage (and a solid unwavering conviction).
Buffett’s Alpha, is a research paper by Andrea Frazzini and David Kabiller at AQR Capital Management and Lasse H. Pedersen, also at AQR Capital Management and New York University, Copenhagen Business School. The paper tries to establish exactly how Buffett has gone about achieving his market beating returns over the past three or four decades and comes up with some interesting results.
While it is not possible for me to detail the whole paper here, I can briefly outline the findings.
Buffett has the highest Sharpe ratio of all U.S. mutual funds
The paper finds that studying data of all listed US stocks from 1926 to 2011, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) has the highest Sharpe ratio of all. Moreover, Buffett also has the highest Sharpe ratio of all US mutual funds that have been around for more than 30 years.
So how high is this Sharpe ratio? Well not as large as many would think, the Sharpe ratio of Berkshire Hathaway over the 30 year period studied is 0.76, almost double the market average. Adjusting for market exposure, Buffett’s Information ratio is even lower, 0.66. Both of these ratios are excellent but not, to quote the paper itself, ‘superhuman’.
Such high ratios reflect high average returns but also expose Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) to risk and significant losses and drawdowns.
Nonetheless, Buffett has been able to continue to achieve outstanding returns on his existing capital and how did he manage to do this? Through a method frequently disregarded by the man himself, leverage.
Buffett’s leverage ratio has averaged 1.6-to-1
The paper estimates that Buffett’s leverage ratio has averaged 1.6-to-1 during the past 30 years, boosting risk and excess return in that proportion. Sustaining a leverage ratio of 1.6:1 over several decades and through several significant periods of market turbulence has boosted Buffett’s returns when many other market participants have been forced into fire sales and write-downs. In addition, keeping this level of leverage for such a sustained period requires a great amount of skill and conviction.
Of course, this long-term leverage would not have been possible if Buffett had not had the financial power of Berkshire behind him. Berkshire’s financial power allowed Buffett to borrow for long periods at low rates, ultimately leading to improved returns over time.
That said, the key factor here is stock selection and this is exactly what the paper finds in conclusion. While Buffett’s returns have been amplified through leverage, stock selection has been key. Buying stocks at or around book value, which are well established within their own industries and have a wide ‘moat’ have given the best returns and allowed Berkshire to build large leveraged positions without the concern of collapse, insolvency or total loss.
Buffett likes returns that can be achieved by most ordinary investors
Indeed, using this methodology, along with the same level of leverage it is viable to suggest that Buffett like returns can be achieved by most ordinary investors. For example, if an investor purchased $100 of stock in The Coca-Cola Company (NYSE:KO) in 1988, at the same time as Buffett, using the same leverage ratio, they would now be sitting on gains of 2,664%. Over the same period, Berkshire Hathaway Inc. (NYSE:BRK.A) (NYSE:BRK.B) stock has returned 3,557%.