It has become an annual tradition in my household. I sit down on a Saturday morning once a year, and read Warren Buffett's annual letter to Berkshire Hathaway (BRK.A, BRK.B) shareholders. I view Buffett as the greatest investor of our lifetime. He transformed a failing northern textiles company into one of the great companies in American history.
Whenever I read this letter, however, I am reminded of a 2013 paper that I read on how Buffett generated his tremendous long-run outperformance. That year, Andrea Frazzini, David Kabiller, and Lasse Pedersen, each affiliated with hedge fund AQR Capital Management, published "Buffett's Alpha", which deconstructed the return profile of Berkshire Hathaway. From their analysis, the authors found: "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."
That is a powerful statement. In a set-up to their attention-grabbing assertion, the authors demonstrated that of all stocks that traded for more than 30 years between 1926 and 2011, Berkshire Hathaway had the highest Sharpe Ratio. Buffett also magnified these risk-adjusted excess returns through the deployment of leverage estimated by the authors to be at a level of 1.6 to 1 on average. The leverage came both in the form of borrowings, which benefited from Berkshire Hathaway's very high quality credit rating, and through float from his insurance subsidiaries. In this year's annual letter, Buffett again dedicated a section to the merits of the float from his property and casualty business that he has used to invest in high quality stock investments and operating companies.
To demonstrate that Buffett's tremendous performance was a function of this tendency to buy low risk stocks and employ conservative levels of investment leverage, the authors created tracking portfolios to mimic Buffett's market exposure and active stock-selection themes, leveraged to the same active risk as Berkshire Hathaway. The Buffett-tracking portfolio performed comparably to the best-in-class performance of Berkshire Hathaway, demonstrating that Buffett is less a sage stock picker than a principled practitioner who has long understood the Low Volatility Anomaly and who had an investment vehicle that allowed him to avoid costly liquidations in times of stress. The average beta of his public stock holdings was just 0.77 over this period.
Low Volatility investing is one of my "5 Ways to Beat the Market", buy-and-hold strategies that have beat the S&P 500 (NYSEARCA:SPY) over long time intervals. Levering low volatility investments has been a key to Buffett's long-run success. In fact, if you levered the S&P 500 Low Volatility Index up to the same variability of returns as Berkshire Hathaway since 1991, you would have roughly equaled the performance of the famed investor.
The Levered Low Volatility Index solves for the leverage needed to equate to Berkshire Hathaway's above average volatility, a function of that company's embedded leverage. The level I solved for 1.645x is close to the 1.6x leverage that the "Buffett's Alpha" authors estimated in their study. The assumed financing cost was 1ml + 0.5%.
While levering low volatility stocks seemingly explains much of Buffett's market outperformance over the past quarter-century, his performance is still tremendous. Even if investors understood this key to market-beating returns, they would still need to have the financial wherewithal to hold through market drawdowns, including the -37% performance for the strategy in 2008. While the PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA:SPLV) replicates this index, it does so with a 25 bp expense ratio that is not factored into the gross index returns above, furthering Berkshire's small outperformance.
While data on the S&P 500 Low Volatility Index dates to only 1991, Buffett has been deploying this strategy since the 1960s. When I looked at other low volatility datasets that stretched back further, I could not replicate the Oracle of Omaha's performance through levering the low volatility index. (The AQR study only stretched back to the mid-1970s). Buffett earned much higher returns in the earlier years as Berkshire Hathaway grew.
Can market participants expect Berkshire Hathaway to outpace levered low volatility for the next quarter-century? Given that the company is run by the octogenarian Buffett and his nonagenarian partner, Charlie Munger, certainly we will see a management change at the company. While Berkshire has a cadre of well-heeled executives who have demonstrated tremendous acumen at Berkshire's operating units, continuing to generate market-beating returns at a company with a $420B market capitalization will be increasingly difficult. In recent years, the company has had difficulty investing the cash thrown off by its strong operating businesses and that excess liquidity creates a headwind to a company that wants to utilize low cost operating leverage.
In "A Strategy That Sells Itself", I illustrated that low volatility small cap stocks have generated tremendous long-run outperformance. The dataset that I used in that piece does go back to the mid-1960s, and levering those stocks would have produced alpha relative to Berkshire Hathaway, the single best performing investment over that time period. That illustrates the challenge for Berkshire. There are market-beating returns available by applying its ability to leverage low risk companies to smaller capitalization companies with higher expected returns. Unfortunately for Buffett, those acquisitions no longer move the needle given how the company's tremendous success has swelled its size.
In a time when even the newly installed chief executive of the United States questions the state of the American system, I love that Buffett spent portions of his letter extolling the virtues of his homeland and its free market systems that have nurtured his success. I also greatly enjoyed the anecdote on the bet that the S&P 500 would outperform a fund of hedge funds. Long-time readers know that I believe low-cost passive strategies that capture structural alpha are strong choices for individual investors.
At the end of the day, though, the greatest lessons I have learned from Buffett is the merits of applying low cost investment leverage to high quality businesses and taking a very long-run, methodical approach to building wealth. I hope this article again illustrated that fact to Seeking Alpha readers.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.
Disclosure: I am/we are long SPLV, SPY.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.