Warren Buffett’s Alpha Research Review by Sure Dividend
Warren Buffett is worth over $70 billion at the time of this writing. He is arguably the greatest investor of all time. What if his success were due to simple investing choices and rational capital allocation rather than preternatural stock picking powers?
“Buffett's returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks.”
– From Buffett's Alpha
In the paper 'Buffett's Alpha' by Frazzini, Kabiller, and Pedersen, they argue that Warren Buffett's results come from investing in cheap high quality businesses and using low-cost leverage to boost returns. You may remember the names Frazzini and Pedersen from their ‘Quality Minus Junk’ paper that was recently analyzed on Sure Dividend. Frazzini, Kabiller, and Pedersen identified 4 repeatable (well, mostly) strategies that explain virtually all of Warren Buffett’s performance. These 4 strategies are below:
- Invest in low beta stocks
- Invest in high quality stocks
- Invest in cheap stocks
- Use low-cost leverage
Invest In Low Beta Stocks
Beta measures how sensitive a stock is to moves in the overall market. High beta stocks tend to have bigger gains during bull markets and bigger losses during bear markets. The 'Buffett's Alpha' study shows that Warren Buffett invests disproportionately in low beta stocks.
The 10 lowest beta stocks in the S&P 500 are listed below:
- Newmont Mining (NEM): Beta of -0.22
- Pepper/Snapple (DPS): Beta of 0.01
- Consolidated Edison (ED): Beta of 0.14
- Southern Company: Beta of 0.14
- General Mills (GIS): Beta of 0.17
- Duke Energy (DUK): Beta of 0 .18
- Kimberly-Clark (KMB): Beta of 0.20
- American Tower (AMT): Beta of 0.20
- PPL Corporation (PPL): Beta of 0.22
- Stericylce (SRCL): Beta of 0.23
- Wisconsin Energy (WEC): Beta of 0.23
Of the 10 lowest beta stocks in the S&P 500, 5 are utilities and 3 are consumer goods companies. A quick glance at Warren Buffett’s portfolio will show that he typically does not invest in utility companies. Warren Buffett has historically heavily in consumer goods stocks, however.
Low beta and low volatility are closely linked. While they are not exactly the same, most low beta stocks are low volatility stocks, and most low volatility stocks are low beta stocks. I believe both low beta and low volatility to by signs of a high quality business. Low volatility stocks tend to have stable operations and reliable cash flows.
Invest in High Quality Stocks
As mentioned above, I believe low beta and low volatility to be a sign of high quality. Other signals that a stock is ‘high quality’ is a long history of profitability and growth. The authors of Buffett's Alpha consider high payout ratios a signal of high quality as well.
What academics would call the ‘high quality phenomenon’ really isn’t much of a phenomenon at all. Businesses that exhibit consistent growth and profitability while rewarding shareholders should generate more wealth than those that don’t. It is really a very simple concept that is fuzzy to analyze quantitatively due to the somewhat vague nature of what ‘quality’ really means. The Dividend Aristocrats Index is an excellent place to look for high quality businesses.
Invest in Cheap Stocks
“Price is what you pay, value is what you get”
– Warren Buffett
Buying high quality/low beta stocks trading at absurd valuations is not a good idea. The 'Buffett's Alpha' study found that Warren Buffett has invested in high quality stocks that tend to be value stocks as well. Stocks with low P/E ratios tend to be value stocks, although value cannot be perfectly and easily defined. A stock may have a low P/E ratio and not be value (if it had large one time earnings, for instance). All told, metrics like P/E, PEG, PE 10, P/B, EBIT/EV and EBITDA/EV paint a good picture of when a stock is ‘on sale’, especially when combined with historical average valuation levels.
Use Low-Cost Leverage
The final lesson from the 'Buffett's Alpha' paper is to use cheap leverage to boost returns. The authors of the study found that Warren Buffett has leveraged his investments somewhere between 1.4x and 1.6x.
He didn’t go out and use margin on his trading account. Warren Buffett’s margin comes from a mix of low cost corporate debt , derivative instruments, and insurance float. His insurance float comes at very low financing costs. In fact, from 1976 to 2011, Berkshire Hathaway’s insurance float cost was negative 60% of the time. This means he was actually getting paid to use leverage. Obviously, individual investors cannot recreate this.
What individual investors can recreate is using low-cost, non-callable debt to boost returns. Margin accounts are not good, because you can be forced to liquidate your holdings during market downturns. Berkshire Hathaway’s highest yielding corporate debt has a coupon of 5.4%. If you could issue debt at this rate or below and invest it in high quality businesses trading at fair or better prices, you will likely recreate (at least in part) Warren Buffett’s phenomenal returns.
Using debt is risky. I would not personally advice people to take on debt for investments unless they are very sure and very comfortable in their ability to purchase high quality businesses at fair or better prices and have demonstrated this ability for at least 3 years. In this unique case, a reasonable (around 1.5x) amount of leverage may make sense to boost returns.
The 'Buffett's Alpha' paper is an excellent and interesting read. My review does not truly do it justice. I recommend interested investors read the study for themselves (link is at end of this article).
I do believe the study is missing one of Warren Buffett’s most important investing wisdoms, however. The study does not discuss (at least in any depth) Warren Buffett’s penchant for buying and holding for long-periods of time. The recreated Buffett strategy in the article rebalances monthly, something that would reduce performance significantly by causing excess portfolio turnover. Keeping your investing fees low is critical. Practicing buy and hold investing on high quality stocks with attractive entry prices gives you value and lets you participate in the secure growth of high quality businesses while simultaneously minimizing investing fees paid to Wall Street.
- Buffett's Alpha by Frazzini, Kabiller, and Pedersen
- Buffett's Alpha Revisited by Ploutos on Seeking Alpha
- Quality Minus Junk Research Review on Sure Dividend