A few years ago, Andrea Frazzini and David Kabiller at AQR Capital Management, and Lasse H. Pedersen, also at AQR Capital Management, with New York University and Copenhagen Business School tried to answer this question in their research paper, "Buffett’s Alpha." The paper tried to establish exactly how Buffett has gone about achieving his market-beating returns over the past three or four decades.
Clearly, Buffett’s stock-picking skill and a great deal of luck have helped the Oracle of Omaha outperform, but according to the paper, there was one other major factor at work here.
“Well I came up with that a long, long time ago to describe the situation that – I was lucky. I was born in the United States. The odds were 30 or 40-to-1 against that. I had some lucky genes. I was born at the right time. If I’d been born thousands of years ago I’d be some animal’s lunch because I can’t run very fast or climb trees. So there’s so much chance in how we enter the world.” -- Warren Buffett speaking on Bloomberg.
According to the researchers, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial)’s ability to leverage its returns has been one of the main contributors to the conglomerate's growth over the years. The paper estimates that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Thanks to its high credit quality, Berkshire has been able to borrow at a low rate, further boosting its returns.
Buffett hasn’t borrowed in the traditional sense. Instead, he uses his insurance companies’ float to invest, providing a cheap source of capital. According to the paper, by using this route rather than issuing bonds, Berkshire’s borrowing costs from this source have averaged 2.2%, more than 3 percentage points below the average short-term financing cost of the American government over the same period.
Leverage combined with the ownership of high-quality, low volatility stocks is the reason why Berkshire is the size it is today.
Stock picking and borrowing
The Sharpe ratio of Berkshire Hathaway over the 30-year period studied is 0.76, almost double the market average. Adjusting for market exposure, Buffett’s Information ratio is even lower, 0.66. Both of these ratios are excellent but not, to quote the paper itself, "superhuman." However, when you combine the stock-picking skill with leverage, you have a powerful combination.
Buffett’s leverage ratio is estimated to have averaged 1.6-to-1 during the past 30 years, boosting risk and excess return in that proportion. Sustaining a leverage ratio of 1.6:1 over several decades and through several significant periods of market turbulence (combined with Buffett’s skill at value investing) has helped him smash the market, with a strategy that, at its core, is not too complex.
For example, using this methodology, along with the same level of leverage, it is viable to suggest that Buffett-like returns can be achieved by most ordinary investors. For example, if an investor purchased $100 of stock in The Coca-Cola Company in 1988, at the same time as Buffett, using the same leverage ratio through 2011, he would be sitting on gains of 2,664%. Over the same period, Berkshire Hathaway returned 3,557%.
The benefit of a float
I’m not advocating the use of leverage to invest in stocks, and I’m sure Buffett does not agree with this either. Still, it’s interesting to note that an extensive portion of Buffett’s returns have come as a result of cheap financing from his insurance businesses -- something most other investors don’t have access to. It goes to show that a simple strategy, combined with a little financial alchemy, can go a long way.
Here’s Buffett on the benefits of Berkshire’s float:
“Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most — though certainly not all — future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.
Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry's overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses.”
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Disclosure: The author owns no stock mentioned.
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