Several articles (I,II,III,IV) have recently discussed the source of Warren Buffett's alpha and strategies designed to reproduce his success. To briefly summarize, an academic study by Pedersen and coworkers concluded that Buffett's success was largely the result of three factors:
- Buying the highest quality, lowest risk stocks at good prices (the beta of Buffett's average holding was calculated to be approximately 0.7)
- Leveraging these holdings (Buffett's average leverage was calculated to be 1.6:1)
- Maintaining this strategy through bull and bear markets for a period of fifty years (Berkshire is considerably more volatile than the underlying stocks it holds - large drawdowns of up to 50% did not deter Buffett from his strategy, some of which occurred while the S&P 500 was rising)
Figure 1 is an excerpt from Pedersen's article and shows the remarkable result of Buffett's investing strategy. The green line comprises a theoretical portfolio of Buffett-like stocks that the authors selected through picking the most undervalued low-beta stocks on the market with equivalent use of leverage. The blue line is the performance of Berkshire Hathaway (BRK.A), while the line in red is the S&P 500 with 1.6:1 leverage. Notice that both Berkshire and a Buffett style portfolio had very significant drawdowns before the end of the dot-com bull market.
Just because a strategy works exceedingly well for fifty years does not mean it works well every single year, even during a raging bull market. The source of this underperformance is the extent to which overvalued tech stocks were attracting money away from value stocks at the time. Over time Berkshire realized a return 19.0% in excess of the risk-free rate, compared with the market's average excess return of 6.1%. By the late 1990s Berkshire's outperformance relative to the market slowed, likely because Berkshire had become so large that suitable investment opportunities were no longer available.
Nassim Taleb, the author of The Black Swan, paints a much more subdued picture of the risk inherent to the stock market. He consistently advocates an approach toward investing that is referred to as a barbell strategy. Because tail risk can cause such drastic drawdowns in equities, Taleb recommends the use of options to create a 'bipolar' portfolio of which the major portion is invested in risk-free bonds, while the risk-taking portion is leveraged through the use of options to comprise all of the risk and volatility of the portfolio. In a bear market, such a strategy will experience a large loss of capital on the risk-taking portion, however, because risk assets only comprise 10-15% of the total the strategy will substantially outperform during a black-swan event such as the 2008 financial crisis (Figure 2).
Figure 2: Taleb's Barbell Approach to Investing
The interesting aspect of these two strategies is that while thinking about Buffett, it became apparent that you could use Taleb's strategy to replicate Buffett's approach to the stock market. To create such a portfolio, one would select high quality undervalued, low beta stocks and then use 10-15% of your portfolio to purchase slightly in the money call options with the remaining portion invested in a secure bond ETF, such as PIMCO's Total Return Fund ETF (BOND).
One undervalued Buffett-type stock that fits this approach nicely is Johnson and Johnson (JNJ). The company appears to be deeply undervalued relative to its cash flow, has a beta of 0.54, has remarkably cheap call options and appears to be in the midst of a turnaround. If you had a hypothetical ten thousand dollar portfolio how could one create a Buffett/Taleb strategy? You would buy 2 Jan-2014 $70 call option contracts giving an exposure equivalent to 200 shares of Johnson and Johnson (1.48 to 1 leverage). This option trades for $5.10, thus a bid of $5 is likely to be filled in short order. At a cost of one thousand dollars you would realize upside comparable to holding 200 shares of J&J. The other nine thousand dollars would then be used to purchase low risk bonds.
The advantage of this strategy is that if we experience a bear market, the maximum drawdown you could suffer would be 10%, however, if the bull-market continues the strategy is likely to generate Buffett-like returns.
However, just as one stock does not make a portfolio, neither does a single call option. In order to diversify in the event that Johnson and Johnson underperforms you will need to find additional companies that fit the criteria mentioned above. In order to identify additional ideas for application of this strategy I applied the following filters:
- I screened stocks held by the Powershares Buyback Achievers ETF (PKW) and eliminated those with a beta above 0.85 (It is preferable to select stocks that are actively repurchasing shares - since options do not collect dividends).
- The resulting list was searched for companies having the highest Y-Charts value scores.
- Stocks were further screened in an intuitive manner. I rejected companies with either unstable cash flow or a poor history of shareholder returns. Each stock listed below has returned a minimum of 20% since 2007, with most returning in excess of 60% over a time that the market has not advanced overall.
Stocks that passed these tests and represent interesting ideas for implementation of this strategy are: The Chubb Corp. (CB), General Mills (GIS), International Business Machines (IBM), McDonald's Corp. (MCD), McKesson (MCK), Target (TGT), The Traveler's Companies (TRV) and Exxon Mobil (XOM).
Generally, you will need to put more than 10% in options in order to generate a reasonable break-even price, in that regard Johnson and Johnson is unique as slightly in the money calls are incredibly cheap. For other stocks, you can set the option closer to the money or even out of the money, but this comes at the expense of a higher break-even price relative to where the stock is trading. I do not view the strategy as desirable if the stock must advance more than 1% simply to break even on the trade.
For example, Exxon requires that you pay $1325 for a Jan 77.5 call in order to get a break-even price of 90.90 or 1% above where the stock is presently trading. Thus, a leveraged position is less desirable as you will have 23% risk exposure to achieve 1.6:1 leverage. In this respect, simultaneously achieving Buffett leverage and Taleb risk-aversion requires cheap call prices that are only available for J&J at the present time. For most of the issues mentioned, you must have 15% invested in risk assets to generate an unlevered position.
Conclusions and Limitations of the Strategy:
The above strategy is a general method for limiting risk without sacrificing return. In my view, if you can replicate 1.6:1 leverage while risking 10% of your capital (as is the case presently for J&J) you are likely to generate very good Buffett-like returns on a diversified number of different positions. However, there are a number of disadvantages to consider as well. While the strategy can realize long-term capital gains, you will have to turn over the portfolio once a year, forcing you to pay taxes on these gains. For example, early this year you could have bought options set to expire on the 18th of January 2014. You could then close the position just over one year hence and incur long-term capital gains tax rates, however, you could not compound your winnings absent of taxes. By opening new positions just a few days early the cycle could repeat year after year. This would double market exposure for several days, but allow long-term tax rates to apply.
Another disadvantage is that many of the stocks mentioned pay a superior dividend yield to the coupon yield on a diversified fund of bonds. Thus, the income you receive will be less when implementing this strategy. For example, using a 90% portfolio to invest in bonds will generate a 2% annual return vs. buying J&J stock which pays an annual 3.3% dividend yield.
If in any given year many of your positions expire worthless it is probable that the S&P 500 is in a bear market. Thus, while you would have to dip into your 'risk-free' holdings to initiate new positions you could be happy that you only lost 10% (or perhaps 15%) of your investment, while others had likely lost a good deal more.
At this stage of our present bull market, I expect this strategy is a very sound one, particularly for large cap low beta blue chips, such as the ones recommended above. Historically, the largest cap stocks tend to outperform during the late stages of a bull market. Using this method to craft a diversified portfolio of 10-15 stocks should be able to capture any remaining upside in this bull market while limiting risk if the bull is nearly over.
Additional disclosure: The above article should not be considered a solicitation to buy securities or options derived from them. Please conduct your own due diligence and carefully consider risk vs. reward before taking a long-position in any stock or option. The long position above for JNJ refers to Jan-2014 calls on the underlying stock.