In a recent paper titled “Buffett’s Alpha”, its authors put it best when they wrote:
“…[T]he 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. ”
In summary, I highlight the sources of “Buffett Alpha’s” per hedge fund AQR and NYU researchers:
1. The combination of all of the following are sources of Buffett’s returns, where the sum is greater than the parts. Most too often focus on the first factor, but Buffett’s success cannot be replicated by merely focusing on the first factor.
- Conviction in investment strategy in the Graham and Dodd mold
- Financial cushion (wherewithal) to withstand rough periods and not be forced or panicked into selling
- Skill to operate with leverageand its inherent risk over many decades.Related to the third factor, I have also shared my layman’s explanation of Buffett’s use of leverage, which I call OPM or “Other People’s Money You Owe”. Buffett’s use of OPM is responsible for at least HALF of his returns:
[drizzle]2. Buffett’s investment strategy, especially with regards to stock selection, is grounded in the core investment principles of Graham and Dodd as laid out in Security Analysis (1934) and Intelligent Investor (1949):
(1) Safe stocks (low beta and low volatility)
(2) Cheap (value stocks with low P/B ratios)
(3) High-quality (stocks that are profitable, stable, growing and w/ high payout ratios; high dividend payout ratios typically denote stable, high current dividend income)
Stocks meeting the above criteria, which also meet the criteria used by Buffett, have done well in general. Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and leveraging safe stocks can largely explain Buffett’s performance.
3. Additional Key Points:
a. Buffett’s performance is outstanding as the best among all stocks and mutual funds that have existed for at least 30 years.
b. Sharpe ratio of 0.76 might be lower than many investors imagine. While optimistic asset managers often claim to be able to achieve Sharpe ratios above 1 or 2, long-term investors might do well by setting a realistic performance goal and bracing themselves for the tough periods that even Buffett experienced.
c. 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.
d. Stocks with characteristics favored by Buffett have done well in general, Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and leveraging safe stocks can largely explain Buffett’s performance.
I have some slightly different takes on a few items laid out in “Buffett’s Alpha”, but in my opinion, the analysis is pretty much spot on.
- By biggest point of contention is that I think that behaviorally, the presence of leverage FORCED or at least helped him adhere to the discipline and core principles of investing in more conservative, one might say, boring stocks over a long period of time, without selling, and having the stomach to weather the storms.
- Regardless, the most admirable aspect in my opinion, is that he stuck to his guns and his style and strategy, and did not become overly aggressive in his investments, when the cost or terms of his leverage were more friendly than at other times (i.e. when insurance profitably was higher than normal and the insurance market was extremely hard with high premiums). Most would have probably have gotten carried away and chased and strayed from his or her core investment principles. And when the insurance market softened, it would have been very difficult to switch gears and invest much more conservatively.
- Another area of oversight of the research paper “Buffett’s Alpha” is the significance of the following. The authors write,
“Empirically, Berkshire owns 63% private companies on average from 1980 to 2011 w/ remaining 37% invested in public stocks. Reliance on private holdings has been increasing steadily over time, from less than 20% in the early 1980’s to more than 80% in 2011.”
Why is this important? Because Berkshire’s privately owned companies like BNSF have less mark-to-market volatility than publicly traded stocks. What this enables is the ability to write premiums in insurance with more flexibility in volumes against a more stable asset base and equity cushion because privately owned companies are marked on the books at cost or a valuation that is updated much less frequently. This is a TREMENDOUS point that is overlooked.
Insurance regulators are able to become more comfortable with the premiums being written against the book value of private companies held by Berkshire Hathaway – because much of that valuation is static. This helped to control the costs of the insurance float even better, which in turn maximized the chances of ensuring underwriting profitability and minimizing the cost of capital of float leverage.
If you have two moving variables, insurance premium/liability levels vs. asset values, which are interconnected as the risk of one impacts the other, the fixing or increased stabilization of one of these variables enables you to control the risks of the other better.
- The authors go into “anomalous” cheap cost of capital from the insurance float, but the reality is most of the P&C insurance sector has historically been barely break-even or worse with regards to underwriting profitability, implying a more expensive cost of capital. They do not go into how he was able to achieve cheaper cost of “float” than the majority of the industry by approaching underwriting risk differently and unconventionally than most P&C insurance carriers.
- So, what did Buffett do differently than the rest of the P&C sector? I delve into it a little bit here:
(1) “managerial mindset that most insurers find impossible to replicate. Take a look at the facing page”
(2) “institutional imperative“
In that post, you can search for the phrases:
Source: AQR/NYU research, “Buffett’s Alpha”. (Please see below for summary.)
- Hedge fund AQR and NYU researchers have put out a great paper on this topic. I have summarized it below and also provided a link to the paper called:“Buffett’s Alpha”
By Frazzini, Kabiller and Pedersen
Working Paper Draft: November 21, 2013
- Please read and come to your own summary and interpretation, but my summary is here. Note: Any snapshots or images are from the paper itself, “Buffett’s Alpha”. Any verbatim quotes are accidental – please point any out to me.
- Some supporting and challenging opinions and analysis:
– Economist 2013:
– Economist 2014:
– Quora 2014:
– Seeking Alpha 2013:
–2014: The Oracle of Omaha, Looking a Bit Ordinary
– MarketWatch 2014:
My summary of “Buffett’s Alpha”:
1. Intro: The Secret Behind the Oracle’s Alpha
a. The overarching question – what’s the secret