In 2018, three researchers from AQR Capital set out to see if they could determine the reasons for Warren Buffett (Trades, Portfolio)'s excess performance over the past four decades. The researchers, Andrea Frazzini, David Kabiller CFA and Lasse Heje Pedersen, compiled their findings in a research paper titled Buffett's Alpha.
One of the primary takeaways from this report is the fact that approximately 70% of Buffett's market-beating performance since the late 1970s has been thanks to leverage. The authors of the study estimate that on average, Buffett's leverage has been around 1.7 to 1, a level of leverage they call "non-trivial."
They go on to report that the two primary methods of leverage Buffett and Berkshire Hathaway have used is debt and the insurance float. Now, calling insurance float "leverage" is a bit misleading, because it is not what most people would consider to be leverage. Most investors consider leverage to be borrowing, whereas float does not involve borrowing money directly. Still, the level of borrowing is considerable.
Buffett explained how the float worked in his 2010 letter to Berkshire Hathaway shareholders:
"Insurers receive premiums upfront and pay claims later...
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money -- and, better yet, get paid for holding it...
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."
The authors of Buffett's Alpha calculate that this insurance float hasn't been entirely interest-free, but the cost of this float has been trivial. In fact, the authors calculate that the average annual cost of Berkshire's insurance float has been 1.72%, around 3 percentage points below the average T-Bill rate.
By making the most of this super cheap debt, Warren Buffett (Trades, Portfolio) has been able to achieve market-beating returns. The authors of the study try to determine what percentage of Buffett's returns are attributable to leverage and how much to stock picking. They conclude that by applying a 1.7 to 1 leverage ratio to the market between 1976 and 2017 would have generated an average annual return of 12.7% compared to Berkshire's average annual return of 18.6%.
These findings tell us three things. First of all, with access to leverage any investor can achieve Buffett-like returns over the long-term. Second, Buffett's investment success is not 100% due to stock picking, and third, at least some of Buffett's excess returns are due to stop picking.
The authors of the study then go on to try and find what kind of stocks Buffett likes to own in his portfolio. The answer to this question is relatively simple. He likes companies that are profitable, growing steadily and trading at an attractive price. After reaching this conclusion, the authors of the paper summarize, "Buffett’s returns appear to be neither luck nor magic but, rather, a reward for leveraging cheap, safe, high-quality stocks."
This is an interesting conclusion, but I think it also leaves out an important factor -- Buffett's staying power. The data might show Buffett's performance can be replicated by picking a basket of cheap, high-quality stocks and leverage in the portfolio, but it does not show how critical Buffett's long-term outlook and resistance to volatility has been over the past five decades. Many investors would have sold or bailed out in one of the market's many swings -- particularly if they had been borrowing money. That's something to factor in if you think it is easy to replicate the Oracle of Omaha's performance.
Disclosure: The author owns shares in Berkshire Hathaway.
