Practical analysis for investment professionals
11 September 2012

Chasing Warren Buffett’s Alpha

Posted In: Equity Investments

From November 1976 to the end of 2011, Warren Buffett delivered an average annual return of 19% in excess of the Treasury bill rate, as measured by shares of his publicly traded conglomerate, Berkshire Hathaway (BRK.ABRK.B), versus a 6.1% average excess return for the stock market. In addition, Berkshire’s Sharpe ratio — a measure of return per unit of risk — is higher than all U.S. stocks that have been traded for more than 30 years from 1926 to 2011, as well as all U.S. mutual funds in existence for more than three decades.

So how does he do it?

If a newly published paper is any guide, the answer is pretty straightforward. According to “Buffett’s Alpha,” authored by AQR Capital Management‘s Andrea FrazziniDavid Kabiller, CFA, and Lasse Pedersen, who also teaches finance at the NYU Stern School of Business, Buffett buys low-risk, cheap, and high-quality stocks; he employs modest leverage to magnify returns; and he sticks to his investment discipline even during rough periods in the markets that would force investors with less conviction or capital “into a fire sale or a career shift,” as the authors put it.

Previous researchers analyzing Buffett’s returns using conventional size, value, and momentum factors haven’t been able to adequately explain his outperformance, the authors say, leaving admirers to conclude that Buffett’s magic is pure alpha. So they extend the analysis by testing Buffett’s impressive returns — as measured by Berkshire’s stock — against two factors that better reflect his folksy investing wisdom: One called “Betting Against Beta,” which represents safe, low-beta stocks, and another called “Quality Minus Junk,” which represents the stocks of high-quality companies that are profitable, growing, and paying dividends.

The results? “Controlling for these factors,” the authors write, “drives the alpha of Berkshire’s public stock portfolio down to a statistically insignificant annualized 0.1%, meaning that these factors almost completely explain the performance of Buffett’s public portfolio.” The factors also explain “a large part” of Berkshire’s overall stock return, the authors add, as well as Berkshire’s private portfolio, insofar as their alphas also become statistically insignificant.

As one commentator put it, “It’s some evidence that Buffett is doing what he says he’s doing.” But the takeaway is more nuanced. Buffett is in fact best known as a value investor par excellence, yet the authors’ findings suggest that his focus on safe, quality stocks “may in fact be at least as important” as his value bent in accounting for his consistent outperformance.

One of the most interesting aspects of the paper is its analysis of Buffett’s use of leverage. The authors deconstruct Berkshire’s balance sheet and find that on average the conglomerate is levered 1.6 to 1, which they describe as “non-trivial” and say at least partly explains why the volatility of its stock is high relative to the market — 24.9% versus 15.8% — despite investing in many relatively stable businesses. Still, they note that leverage alone does not account for Buffett’s stellar returns: Applying the same 1.6-to-1 leverage to the market yields an average excess return that is still nine percentage points below Buffett’s over the time span studied by the authors.

Of course, cheap financing doesn’t hurt. The authors note that Buffett benefited from Berkshire’s AAA rating from 1989 to 2009 and that he reaps the benefit of its cheap insurance float, which checks in at an estimated average annual cost of 2.2% — more than 3 percentage points below the average Treasury bill rate. The authors find that 36% of Berkshire’s liabilities, on average, consist of insurance float.

The paper also tackles a provocative question: Can Warren Buffett be reverse engineered? The authors take a stab at it by constructing a hypothetical “Buffett-style strategy” that is similarly leveraged and tracks Buffett’s market exposure and stock-selection themes — and find that it “performs comparably” to the real Berkshire Hathaway. (In fact, it outperforms, but the authors caution that the simulated strategy does not account for transaction and other costs, and also benefits from hindsight. The main takeaway, they assert, is the high covariation between the actual and simulated Buffett strategies.)

So why don’t investors just mirror Buffett’s trades? Blame hubris: As detailed in a separate academic paper published a few years ago, between 1980 and 2006 an investor could have achieved investment results similar to Buffett’s simply by following his trades as disclosed in public filings — yet the market seemed to underreact to such disclosures. The authors of the paper surmise that analysts and fund managers overestimate their own stock-picking skill or the “precision of their independent private information” and underweight the value of public disclosures, even Buffett’s.

There is at least one more very practical reason why investing like Buffett is harder than it may seem: Thanks to current U.S. Securities & Exchange Commission disclosure rules, he doesn’t always have to tell us what he owns.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Len Costa

Len Costa was head of communications and content strategy at CFA Institute, where he oversaw global social media, mobile products, and digital content strategy. He previously served as director of interactive media at the Institute for Private Investors (IPI), a peer networking organization for ultra-high-net-worth families and their advisers. Costa also wrote a private wealth column for the Financial Times and, prior to joining IPI, he held senior editorial positions at Institutional Investor and Worth magazines. His writing has also appeared in Forbes, Fortune, Slate, and The New York Times. Costa holds a BA from the University of Virginia, a diploma in French language from the Université de Paris, and a master’s degree in international affairs from Columbia University.

16 thoughts on “Chasing Warren Buffett’s Alpha”

  1. Andrew Arbenz says:

    Two additional points. First, Berkshire stock has benefited from everyone’s believing that Mr. Buffett is the world’s greatest investor (whether he is or not). Thus, his stock has a much higher P/E ratio than comparable companies and the rise of this P/E ratio has enhanced the stock returns mentioned above. Point two, I believe a major securities firm did an analysis of Buffett’s investment returns a few years ago and found that he hadn’t outperformed the index in 10-20 years.

    1. Dan Schaefer says:

      You are closer to the truth than the author of the story. Buffett looks at company stock as an option to buy the company. He buys shares below book value and if need be, he will exercise the option to buy the company and take it private. This puts him in a unique position to raid the board room if they don’t play by his rules. This influence on the board and going “all in” when the stock drops in value generates all his Alpha. Lets see if he buys over BYD in Hong Kong – another one of his excellent stock picks down 75% from his entry point.

    2. Value Investor says:

      This is factually incorrect. The quoted P/E of BRK is not reflective of all the earnings accruing to BRK (ignores look-through earnings of minority stakes). As widely known, BRK is better valued on a sum of the parts basis, of its substantial private investments, quoted investments and insurance operations (float). When you back out the implied P/E of its non-quoted investments, the ‘private’ business trades at a significant discount to the market (at c.10.x last time I looked). For a simple but powerful analysis see T2 Partners BRK presentation, updated monthly on their website.

    3. Joshua says:

      Contrary to your claims of the stock price outperforming due to expanding the P/E ratio, the Price to Book ratio has actually been contracting over the past 10-20 years, meaning that investors have been giving less and less of a premium to Berkshire’s book value. This may be due to the fact that Berkshire is getting closer and closer to being no longer managed by Buffett.

  2. Ashfaqur Amin says:

    What differentiates the not-so-successful investors and the successful investors is that successful investors know how to manipulate the system to their advantage. We all know that stock market is semi-efficient and those who recognise this fact and act on it tend to outperform the general market. I’ve once read in the Intelligent Investor by Ben Graham who many consider to be Buffett’s guru, that he once (as an investor in a company) put pressure on a company’s management to raise dividends…thus causing share price appreciation and he (Graham) came away with a little fortune.

    Then again, you cannot take anything away from Buffett because to take advantage of the opportunities in financial markets is no easy feat.

  3. Maverick says:

    i think is high alpha is primarily due to his stock picking abilities. he picks stocks which are relatively undervalued in the market and thus makes a small fortune when others come to know of it. Its the Buffets reputation more than anything else that has been giving him returns. off course he has a record to prove that he deserves that reputation. I am not going to comment if he or others manipulate the market but when small timers come to know of his intentions or investments they make a beeline for whatever he is buying into. This coupled with leverage and low interest rates Berkshire enjoy all team up and give him a grand return on his investments. Small timers with their inherent habit of over reacting and non reaction are not able to mimic the moves of warren buffet and as rightly said he is not required by law to tell us what he owns or has his money into.

  4. Mohit Gupta says:

    I have read few articles on Mr. Warren Buffett’s investing strategy which may help throw some light on how he generated such returns. I came to know that Mr.Buffett focuses on return on equity (ROE) rather than on earnings per share. Mostly people understand that ROE can be distorted by leverage (a debt-to-equity ratio) and therefore is theoretically inferior to some degree to the return-on-capital. Return-on-capital is more like return on assets (ROA) or return on capital employed (ROCE). He seeks to estimate a company’s intrinsic value and call this process as BOND MATHS. He looks at what he calls owner’s earnings which cash flow available to shareholders or free cash flow to equity (FCFE). We can state it as, net income + D&A – CAPX – (change in W/C).He takes into consideration the future owner’s earnings and then discount them back to present.

  5. Mohit Gupta says:

    i dont know whether he manipulates the market, but investors do follow him when they come to know about his investment decisions. Stock markets are semi-efficient and any person like that of Mr.Buffett reputation can reap high returns outperforming the market…..

  6. Abhishek Bhatnagar says:

    It is always said that if an investment decreases in price, it automatically becomes less risky and inversely more valuable. Warren Buffett usually invest in low risk,low priced securities and since he is being followed by many investor’s round the world ,he is able to dominate the share price of the security.Thus,generating an ultimate alpha….

  7. Manish Raghuwanshi says:

    Truly said, his portfolio in part benefits from his cult of being the “Investment Oracle”. But we also have to consider the fact that he invest in exceptionally good business. So, weather the investment by managers in the companies he owns, after the disclosure by SEC is purely bcoz of his cult or because of the value that they sensed at the same time or before is difficult to scrutinize.
    About the discussion revolving around Alpha, I have two Scenarios:
    Firstly, its through buying the “Fair” Company @ some discount to Intrinsic value , say @ discount of 33% to book value; thus creating a “margin of safety” of atleast 33% (its here when he can with high conviction put the capital ) and henceforth, can generate a cool return of 50 % by the time company reaches to its Book value. Now , such opportunities comes very rarely, may be only during the occasions of heavy selling or slowdown and the rapid recovery that follows. So, basically he loads his gun during the period of “fear and greed” and creates “ALPHA”. The Salad Oil Scandal and his investment n AMEX is testimony to this style of investing.
    This explains the authors reasoning behind Buffett’s buying low-risk, cheap, and high-quality stocks.
    Moving further, the author’s analysis of the main contributors to buffets portfolio returns from “betting against Beta” and ”Quality minus junk” lies in his the fact that he wants companies with consistent performance rather than cyclical or companies with high beta/leverage or fluctuating annual returns(although he never cares for quarterly results). This explains his investments in Wal-Mart, wells-fargo and others where he can have near term revenue visibility and assured consistence performance.
    He likes buying good business when they are beaten down.(although value investor like me never let those businesses to come down as warren is not only the one who is patiently waiting for fair price of such business).After the Charlie’s advice of buying such business at fair price rather than waiting for good price(i.e.,33% discount or more),he seems to have started focusing on purchasing good business even at high book values.IBM purchase seems to explain this.
    Secondly,adding High beta stocks(high risk) to generate higher sharpe ratio makes sense; however more sense it does makes to him to add low beta stocks(low risk) and use leverage to increase the holdings of those stocks in his portfolio to generate higher sharpe ratio. His leverage comes from” Insurance float” which is very cheap as compared to T-bill and “negative coupon Bonds” that he can issue to investors which again is one of its own kind. Clearly, its Unique.
    So This Unique Tool in part helps him to create alpha along with the rest part from his Low beta and High quality stock picking ability.

  8. Max Rudolph says:

    I am surprised that, in the peer reviewed article, the authors do not defend the use of variance (their term – volatility) and the Sharpe ratio that require Berkshire’s returns to be normally distributed for these statistics to be valid. I would not be surprised if a simple graph of the data would be very eye-opening, especially if compared with the comparable market data.

    I would also expect the key result of this paper to be the death of CAPM and beta. To so blandly use a factor, Betting against Beta, as if the academic arguments Buffett and Munger have lambasted for decades were unreasonable, now that is news. Of course they both of them recognized this before Markowitz’ original paper! Perhaps they should receive a Nobel Prize 🙂

  9. Steve Marcum says:

    I think that academic studies like this fall victim to availability bias.

    Imagine a study trying to quantify the reasons for Michael Jordan’s success. It might conclude that his success is due to his relative arm length, height, strength, endurance, vision, hand-eye coordination, and the number of hours he practiced as a child. They could probably work the numbers in a way that concludes all other reasons are “statistically insignificant.” I’m sure these factors played huge roles. But the conclusion that other factors are “statistically insignificant” is ludicrous.

    That’s the same way I feel about the conclusion in this study: it’s ludicrous.

    When I read these types of articles, I can’t help but think of the phrase made popular by Mark Twain: “There are three kinds of lies: lies, damned lies, and statistics.”

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