A new research paper has unpicked the secrets of Warren Buffett’s extraordinary investment record, says Edward Croft
At times, the world of modern finance resembles a standoff at the OK Corral. On one side are the great money managers with their long history of outperformance. On the other are the academics trying to prove that their records are either lucky or systematically repeatable. In their sights has long been the biggest prize of all, Warren Buffett. But where many have failed, a recent research paper entitled “Buffet’s Alpha” appears to have hit the mark. Has the riddle of his stockpicking edge finally been deciphered?
The authors, Andrea Frazzini, David Kabiller and Lasse H Pedersen, began by breaking down the returns generated by Buffett’s investment vehicle, Berkshire Hathaway, into their constituent parts. By isolating the component specifically due to stock market investment, they aimed to discover exactly how, for 36 years, he had achieved compound returns of 19 per cent a year over and above the return from government bonds.
First, they learnt that Buffett has boosted his profits through the extensive use of borrowed money, or leverage. Effectively he has bought $60 of stocks using borrowed money for every $100 of his own, and was able to borrow extremely cheaply through Berkshire’s excellent credit rating and by using the cash available inside its insurance businesses as, effectively, an interest-free loan. Insurance companies take in money via premiums paid by customers. Until they have to pay it out in claims, they can use it to invest for their own profit. However, that only explained 10 percentage points of the annual 19 per cent excess return. What about the rest?
The traditional academic consensus is that, over the long run, just a few factors explain investment outperformance, specifically: size (“small caps beat large
caps”), value (“cheap stocks beat expensive stocks”) and momentum (“price leaders beat laggards”). Previous research had found that, while Buffett often showed a preference for value, he rarely bought small caps or momentum stocks. Academics found this puzzling. If they couldn’t mimic Buffett’s returns simply by picking cheap stocks (on a price to earnings or price to book value basis), his outperformance or “alpha” must be down to the one thing they couldn’t quantify—his skill at choosing individual stocks.
But the authors of “Buffett’s Alpha” had other ideas. Their previous studies had shown the significance of safety (“low volatility stocks beat high volatility stocks”) and quality (“profitable, dividend paying stocks beat speculative stocks”). By overweighting these factors along with Buffett’s known preference for cheapness, the authors were able to build portfolios that managed to do what previous researchers couldn’t—closely mimic Berkshire Hathaway’s returns relative to the risks they involved. They had discovered that “the general tendency of high quality, safe and cheap stocks to outperform can explain much of Buffett’s performance and controlling for these factors makes Buffett’s alpha statistically insignificant.”
Stop the press. Buffett never had an edge? The point they explicitly make is that his stock-picking record has been no better than the performance of high quality, safe, cheap stocks in general. The media likes to portray Buffett as a folksy, proverb-slinging, stock-picking super-investor, but that picture appears at odds with these statistical findings. Here Buffett is seen systematically pursuing an ostensibly replicable process. Rather than stock picking, his real genius “appears to be at least partly in recognising early on that these factors work, applying leverage without ever having to [have a] fire sale, and sticking to his principles.”
One of the most striking lessons from the paper is that, in recent years, Berkshire Hathaway has begun to underperform the model it follows. Perhaps because it has grown so large, it can no longer find enough suitable investment opportunities to accommodate all the cash it has available. But while Buffett may have been forced by his own success to deviate from this winning investment style, less constrained investors don’t have to. Most private investors may not be able to access the cheap leverage that Buffett used but it’s never been more straightforward to invest systematically in safe, cheap, high quality stocks through the use of low-cost exchange traded products or quantitative screening tools.
While there are no explicitly Buffett-esque Exchange Traded Funds, one recent listing uses a similar process, essentially promising to pay whatever return the companies included in its index collectively generate, backed up by a ream of research suggesting that investors may benefit from the impressive outperformance of safe, high quality, higher yielding stocks.
But as more investors pursue strategies that involve replicating an index, there are growing numbers of price distortions amongst individual stocks at the peripheries. Given their ability to invest more idiosyncratically and in smaller size, private investors are well placed to find them thanks to the growing choice of online stock screening tools, including Stockopedia, that are designed to help investors trawl the market using specific criteria such as Buffett’s.
Many might presume that recent success in modelling Buffett-style investment strategies dooms them to eventual failure as widespread adoption will mean they no longer have an edge. But investing in these kinds of stocks is just too unexciting for most investors’ gambling instincts. Perhaps it would be wise to reflect on a comment Buffett made in his 1994 Annual Report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”