"Buffett's Alpha" Paper from Andrea Frazzini, David Kabiller and Lasse H. Pederson
Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha become insignificant when controlling for exposures to Betting-Against-Beta and quality factors. We estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks. Decomposing Berkshires’ returns into a portfolio of publicly traded stocks versus private companies, we find that the former performs the best, suggesting that Buffett’s returns are more due to stock selection than to a direct effect on management.
The report found that of all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, 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.
The report went on to find Buffett had a 0.76 sharpe ratio over the period of 1976 to 2011. Adjusting for the market exposure, Buffett’s information ratio is even lower: 0.66. They go on to call his sharpe ratio very good but not “super-human.”
So if the ratio is not the result of Warren’s exuberant wealth, what is? The answer is that Buffett has boosted his returns by using leverage, and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift. They estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.
The report identified three general features found in most of Berkshire holdings and attribute them to most of his success.
1. “Safe Stocks” (Measured academically, by low beta and low volatility)
2. “Cheap Stocks” (Low P/B and Normalized P/E ratios)
3. “High Quality” (Profitable, stable, growing companies with high payout ratios to shareholders)
Based on the factors listed above Buffett’s alpha is statistically insignificant when quantified relative to a simulation portfolio adjusted for Betting-Against-Beta and Quality Minus Junk factors.
The report was seeking an answer to the question is Buffett mainly an investor or manager? They found, after breaking down Buffett’s returns by private and public ownership, that both contributed to his returns but his public stock portfolio performed the best. The genius of his ability seems to come from recognizing early on that these factors work, explicitly or implicitly, and then applying comfortable leverage to the business model. Most important is sticking to his gut and following his principles through thick and thin.
This is what Buffett may have indirectly been referring to with the quotes,
“ I am a better investor because I am a businessman and a better businessman because I am an investor.”
“Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
One would ask, why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? A very obvious reason may be that this capital structure provides a steady source of financing to Berkshire and other businesses within it, allowing Buffett to leverage his stock selection ability. The report found that about 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate. Yes, below the T-Bill rate. Profitable insurance underwriting leads to negative borrowing rates, thus Berkshire is being paid to borrow.
Over the sample period of the study (1976 to 2011) they had found $1 invested in Berkshire in 1976 would have become $1,500 by 2011, or an average annual return of 19% higher than the T-Bill rate. Although, with higher returns, comes higher exposure to risks (measured by volatility) and Berkshire entailed considerably more risk than the market. Berkshire realized a volatility of 24.9%, higher than the market volatility of 15.8%. However, Berkshire’s excess return was high even relative to its risk, earning a Sharpe ratio of 19.0%/24.9% = 0.76, nearly twice the market’s Sharpe ratio of 0.39.
Full Report (with Math Calculations)
About the author:
"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain