Warren Buffett has said that he would most like to be remembered as a teacher. In my case, he has succeeded. That is how I regard him. Much of what I think I know about investing has come from Buffett. He has a unique way to encapsulate ideas that are sensible and clear, and I have learned a lot from him.
Buffett's success as an investor has often befuddled academics. Is he the luckiest man in the world? Nassim Nicholas Taleb, in saying that he would choose George Soros over Buffett as an investor, has said,
I am not saying Buffett isn't as good as Soros. I am saying that the probability Soros's returns come from randomness is much smaller because he did almost everything: he bought currencies, he sold currencies, he did arbitrages. He made a lot more decisions. Buffett followed a strategy to buy companies that had a certain earnings profile, and it worked for him. There is a lot more luck involved in this strategy. [Source: Better Lucky than Smart : The Urban Legend of Warren Buffet ]
But a new academic study does make it sound like skill has had a lot to do with Buffett's success as an investor. The study is entitled "Buffett's Alpha," by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen (2013). They state that:
The standard academic factors that capture the market, size, value, and momentum premia cannot explain Buffett's performance so it has to date been a mystery.
The authors then go on to demystify it. I would suggest that anyone who has simply listened to what Buffett has been saying for years would not have found his success a mystery, but now it has the imprimatur of academic rigor.
First off, just how well has Buffett done? The record is truly remarkable. Buffett has produced better returns than any other stock or mutual fund that has been around for 30 years. (In the rest of this article, all quotes are from "Buffett's Alpha.")
Buffett's track record is clearly outstanding. A dollar invested in Berkshire Hathaway (BRK.A, BRK.B) in November 1976 (when our data sample starts) would have been worth more than $1500 at the end of 2011. Over this time period, Berkshire realized an average annual return of 19.0% in excess of the T-Bill rate, significantly outperforming the general stock market's average excess return of 6.1%.[q]
Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years.
Buffett is in the top 3% among all mutual funds and top 7% among all stocks. However, the stocks or mutual funds with the highest Sharpe ratios are often ones that have only existed for a short time periods and had a good run, which is associated with a large degree of randomness….Among all stocks with at least a 30-year history from 1926 to 2011, Berkshire has realized the highest Sharpe ratio….If you could travel back in time and pick one stock in 1976, Berkshire would be your pick.
The authors state their insights into the sources of Buffett's success at the outset of the paper:
Buffett's returns can…largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks.
Buffett's Sharpe ratio is surprisingly small: 0.76 over the period of the study (1976-2011). That is almost twice the Sharpe ratio of the market as a whole, but, as the authors surmise, most investors would probably think it was much larger.
What it reflects, according to the study, is "…high average returns, but also significant risk and periods of losses and significant drawdowns." Indeed, BRK lost 44% in market value during the dot.com bubble.
The following may be the key passage in the study:
How does Buffett pick stocks to achieve this attractive return stream that can be leveraged? We identify several general features of his portfolio: He buys stocks that are "safe" (with low beta and low volatility), "cheap" (i.e., value stocks with low price-to-book ratios), and high-quality (meaning stocks that [are] profitable, stable, growing, and with high payout ratios).
Here are the reasons that I think this passage is so important:
(1) It states that Buffett picks stocks. While this might seem obvious to most of us, there is a cadre of academics and advisors that will not acknowledge that his success comes (at least partly) from stock selection. I know this sounds strange to the average investor, but some in the industry are so immersed in the idea that you can't beat the market by picking stocks that they will search for any other reason to explain excess returns. The authors of this study, to their credit, simply acknowledge that Buffett picks stocks, then go on to examine what kinds of stocks he has picked.
(2) It indicates the factors that the authors found contribute to Buffett's stock-picking success. He has looked for stocks that are:
- Safe, meaning stocks with low beta and low volatility
- Cheap, meaning they have low P/B ratios
- High quality, meaning the companies are profitable, stable, growing, and have high payout ratios (!)
I usually write about dividend growth investing. Most of the people who read my articles or those of most other dividend growth investors will not find any of those characteristics to be surprising, except perhaps including a high payout ratio as a characteristic of high quality. The paper goes into great detail on the contribution of those factors to Buffett's stock-picking success.
Buffett's total performance is not all explained by his stock picking. Other factors include these:
- Leverage. The authors found a leverage ratio of 1.6. I thought a couple of their notions on leverage were stretched, as for example when they portray the tax deductions for accelerated depreciation as being like an interest-free loan from the government. No matter. Buffett's outperformance is so huge that leverage does not come close to accounting for it. "If one applies 1.6-to-1 leverage to the market, that would magnify the market's average excess return to be about 10%, still falling far short of Berkshire's 19% average excess return."
- Risk. Berkshire stock also entailed more risk, displaying a volatility of about 25 percent, compared to the market's volatility of about 16 percent. Utilizing risk in this fashion as a factor in explaining returns is standard in the academic community. Under Modern Portfolio Theory, risk and returns are correlated. I personally do not make this direct association (preferring concepts like Ben Graham's margin of safety instead), but it is customary in studies such as this one. Also, please note that the volatility of Berkshire's stock does not necessarily match the volatility of his stock holdings, which as the study states are generally less volatile than the market. Since Berkshire is publicly traded itself, its price goes through Mr. Market's meat-grinder separately from the value of what Buffett owns. I think that is why every Letter to Shareholders compares Berkshire's book value (rather than its stock price) to the S&P 500.
- Wholly owned companies. "Berkshire owns 63% private companies on average from 1980 to 2011, the remaining 37% being invested in public stocks. Berkshire's reliance on private companies has been increasing steadily over time, from less than 20% in the early1980s to more than 80% in 2011." Interestingly, the study found that BRK's wholly owned companies have not contributed as much to BRK's outperformance as Buffett's investments in public companies. I suspect that many people would have thought that it was the other way around. "Buffett's skill comes mostly from his ability to pick stocks, and not necessarily his value added as a manager [of BRK's wholly owned companies]."
- Persistence. The authors properly point out that Buffett has stuck to his guns through "rough periods where others might have been forced into a fire sale or a career shift." Indeed, BRK's 44% loss in value during the 1998-2000 period coincided with a time when the overall market gained 32%.
I was surprised that no mention was made of the contribution to Buffett's success of reinvesting profits and compounding. Compounding is finance's equivalent of money going viral. It is well-known that Buffett prefers businesses that supply him loads of cash, which then becomes the raw material for further investments that generate even more cash: This is the snowball effect.
Berkshire pays no dividends, so all the incoming cash is available for reinvestment. Perhaps the authors consider reinvesting to be just a part of Buffett's business model, present to some degree in any successful business. Nevertheless, a complete explanation of his success ought to cover the importance of the relentless reinvestments of profits, since that is at the very core of what Buffett does. I suspect that the reason it goes unmentioned is that it is not the sort of "factor" that is typically used to explain investment returns.
The authors devoted a lot the study to seeing if they could replicate Buffett's results by following his strategy. The short answer is yes. They constructed "Buffett style" portfolios, applied 1.6 leverage to them, and found that they were able to replicate his results within reasonable degrees of variation. There are detailed descriptions in the paper of how the authors built their Buffett-like portfolios, and I will not attempt to explain them here except for the following brief summary.
Academic factor analysis of returns now recognizes four "standard" factors that contribute to or determine returns. The first three come from the work of Ken French and Eugene Fama and are known collectively as the Fama-French three factor model. The factors are size, value, and beta. Studies have shown that these three factors explain over 90% of a diversified portfolio's returns. The fourth recognized factor is momentum. (A fifth factor, gross profitability, is of recent origin and was not used in the Buffett study. Other factors that operate crosswise to the standard factors - such as dividends - are ignored.) The characteristics of a portfolio can be described by how much that it loads on the recognized factors.
The authors found that Buffett under-loads on the size factor (since he invests primarily in large-cap stocks), overloads on value, and pays no attention to momentum. Although the paper did not study it, we can presume that he pays great attention to profitability. And as mentioned above, Buffett magnifies results via leverage and reinvestments.
In discussing their factor-based Buffett-style portfolios, there was a slight tone of if you account for these factors, Buffett added nothing else, since we can replicate his results. I took this as just the way academic studies about factor analysis are written, but I can see where some readers could use that approach to minimize the importance of Buffett's stock picking (or indeed anything idiosyncratic that he or any investor does outside of employing the recognized factors).
The authors seem to want to distance themselves from such an interpretation, however, because in a couple of spots in the paper, we find tributes such as this:
However, it cannot be emphasized enough that explaining Buffett's performance with the benefit of hindsight does not diminish his outstanding accomplishment. He decided to invest based on these principles half a century ago! He found a way to apply leverage. Finally, he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies.
I read the paper from the perspective of an individual investor, and I found it all quite encouraging for several reasons:
The stocks you pick can have a great deal to do with your results. As a self-directed investor, you are not consigned to the returns from index funds or their close cousin, passively managed funds. I doubt that Buffett ever purchased an index fund in his life. The common refrain that most of your returns are determined by asset allocation is true if you select your investments only by asset class and invest only in funds. If you invest outside those paradigms, the factors affecting your returns are different.
Sticking to a sound strategy works. Obviously, staying with a strategy during bad market conditions can be hard. Indeed, it may be the most difficult part of investing for individuals. At times it may be difficult to distinguish between sticking with a sound strategy and hard-headedness. Nonetheless, individuals are not subject to quarterly comparisons to benchmarks, other funds, inflows and outflows, and other forms of pressure that fund managers must contend with. Most of their pressure is self-induced, with influences from the investment industry and the media. All things considered, the opportunity to stay with a sound strategy is probably easier for individuals than fund managers.
Sound stock selection is based on sensible factors. There cannot be anything surprising in factors like safety, value, quality, and profitability when it comes to stock selection for long-term investors.
Individuals have access to leverage too. While most individuals don't have access to anything like Buffett's huge insurance float, if tax deductions count as leverage for Buffett, then deferred taxes (such as in an IRA) count as leverage for individuals. Compounding can take place for a long time in tax-deferred accounts, unencumbered by taxes along the way.