Case Study: A Quantitative Analysis Of Warren Buffett’s Returns by Steven De Klerck
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With impressive returns over numerous decades, the name Warren Buffett keeps firing one’s imagination. In 2013, AQR Capital Management published the study “Buffett’s Alpha” in which the historical returns of Warren Buffett’s investment vehicle Berkshire Hathaway are subjected to a quantitative analysis. This quantitative analysis allowes to depart from the often anecdotal and qualitative contemplations regarding Warren Buffett’s investment strategy.
The study can be split up into three parts. In a first step, the researchers document and discuss the returns of Buffett’s vehicle Berkshire Hathaway over the past decades. Subsequently, they analyze the various components underlying the returns of Berkshire in order to acquire a better insight in the way how Buffett managed to realize these returns. Finally, the researchers try to set up a Buffett strategy.
Over the 1976-2011 period, Berkshire Hathaway realized an average annual excess return of 19.0 percent, a significant outperformance compared to an average annual excess return of 6.1 percent for the S&P500. At the same time, the volatility of the Berkshire stock was significantly higher compared to the market: 24.9 percent versus 15.8 percent. These figures render Berkshire into the best performing stock of all US stocks with a track-record of more than 30 years over the period 1926-2011. However, after 2001 the realized excess return shows a sharp decrease. Over the period 1976-2000, the average annual excess return was 26.5 percent; after 2001, we notice a drop towards 3.3 percent. Berkshire keeps on getting larger, and so the number of investable opportunities is definitely getting smaller.
Despite strong long term returns, the Berkshire stock has also seen difficult periods. Over the period June 1998 – February 2000, for example, the stock price of Berkshire dropped with 44 percent; the stock market however increased with 32 percent, resulting in an underperformance of 76 percent. In “Valuations And Stock Returns: Looking Back on The Dot Com Period”, I have referred to an underperformance of 42 percent for small cap value stocks versus large cap growth stocks, also during the Internet period. There, the following question was raised: being an investor, how do you cope with an underperformance of 42 percent on an annual basis? In both cases, investors do need a quantitative framework in order to perform a rational analysis and to successfully survive these and similar periods of underperformance. When there is no such grip, stocks will become “psychological dynamite” (Graham, 1949) for most investors.
After having mapped Berkshire’s performances, the researchers analyze the components of the returns underlying Berkshire’s stock. On the one hand, Berkshire invests in both public and private companies. On the other hand, Berkshire uses debt financing in order to finance these investments. The researchers estimate that Berkshire, through leverage, manages to realize returns which are 1.4 to 1.6 times higher than the returns of the direct investments in the public and private companies. Consequently, by means of an investment in Berkshire investors enjoy returns of 1.4 to 1.6 times higher than the returns that they could realize when investing directly in the companies in which Warren Buffett invests.
Subsequently, the researchers raise the question in what kind of companies Warren Buffett invests. Hence, they examine to what extent the returns of Berkshire correlate with the returns of specific long-short portfolios (value, quality, volatility and momentum). The value portfolio, for example, is long in value stocks and short in growth stocks. Value stocks are those with the highest book-to-market (or the lowest price-to-book) ratio; growth stocks are those with the lowest book-to-market (or the highest price-to-book) ratio. It should be noted that the computations underlying the high quality-low quality portfolios are comprehensive and those underlying the low volatility-high volatility portfolios are quite complex.
Based on this exercise, the researchers document that the returns of Berkshire closely connect with the returns of the value-growth portfolios, the high quality-low quality portfolios and the low volatility-high volatility portfolios. The researchers formulate their conclusions in the following way:
A significant part of the secret behind Buffett’s success is the fact that he buys safe, high quality value stocks.
This conclusion tightly fits in with the leading topic throughout the literature in the field of value investing and fundamental analysis, viz. the finding that financial statement information about the fundamentals (profitability, solvency and liquidity) of companies can be used in order to establish more attractive value portfolios. Otherwise said, investors can use the same investment style as the one used by Warren Buffett by holding a portfolio consisting of cheap, quality companies.