Friday, February 14, 2014

14/2/2014: Buffett's Alpha Demystified... or not?

Warren Buffett is probably the most legendary of all investors and his Berkshire Hathaway, despite numerous statements by Buffett explaining his investment philosophy, is still shrouded in a veil of mystery and magic.

The more you wonder about Buffett's fantastic historical track record, the more you ask whether the returns he amassed are a matter of luck, skill, unique strategy or all of the above.

"Buffett’s Alpha" by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen (NBER Working Paper 19681, November 2013) shows that "looking at 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." In fact, for the period 1976-2011, Berkshire Hathaway realized Sharpe ratio stands at impressive 0.76, and "Berkshire has a significant alpha to traditional risk factors." According to the authors, "adjusting for the market exposure, Buffett’s information ratio is even lower, 0.66. This Sharpe ratio reflects high average returns, but also significant risk and periods of losses and significant drawdowns."

According to authors, this begs a question: "If his Sharpe ratio is very good but not super-human, then how did Buffett become among the richest in the world?"

The study looks at Buffett's performance and finds that "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. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion."

The conclusion is that "his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades."

But the above still leaves open a key question: "How does Buffett pick stocks to achieve this attractive return stream that can be leveraged?"

The authors "…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 profitable, stable, growing, and with high payout ratios).
This statistical finding is certainly consistent with Graham and Dodd (1934) and Buffett’s writings, e.g.: "Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down"  – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 2008."

Of course, such a strategy is not novel and Ben Graham's original factors for selection are very much in line with it, let alone more sophisticated screening factors. Everyone knows (whether they act on this knowledge or not is a different matter altogether) that low risk, cheap, and high quality stocks "tend to perform well in general, not just the ones that Buffett buys. Hence, perhaps these characteristics can explain Buffett’s investment? Or, is his performance driven by an idiosyncratic Buffett skill that cannot be quantified?"

The authors look at these questions as well. "The standard academic factors that capture the market, size, value, and momentum premia cannot explain Buffett’s performance so his success has to date been a mystery (Martin and Puthenpurackal (2008)). Given Buffett’s tendency to buy stocks with low return risk and low fundamental risk, we further adjust his performance for the Betting-Against-Beta (BAB) factor of Frazzini and Pedersen (2013) and the Quality Minus Junk (QMJ) factor of Asness, Frazzini, and Pedersen (2013)."

And then 'Eureka!': "We find that accounting for these factors explains a large part of Buffett's performance. In other words, accounting for 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… Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles. Perhaps this is what he means by his modest comment: "Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results." – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1994."

There is more to be asked about Warren Buffett's investment style and strategy. "…we consider whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO. Said differently, is Buffett mainly an investor or a manager?"

Authors oblige: "To address this, we decompose Berkshire’s returns into a part due to investments in publicly traded stocks and another part due to private companies run within Berkshire. The idea is that the return of the public stocks is mainly driven by Buffett’s stock selection skill, whereas the private companies could also have a larger element of management."

Another 'Eureka!' moment beckons: "We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performs the best, suggesting that Buffett’s skill is mostly in stock selection. Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.

So core conclusions on Buffett's genius: "In summary, we find that Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance. Buffett’s unique access to leverage is consistent with the idea that he can earn BAB returns driven by other investors’ leverage constraints. Further, both value and quality predict returns and both are needed to explain Buffett’s performance. Buffett’s performance appears not to be luck, but an expression that value and quality investing can be implemented in an actual portfolio (although, of course, not by all investors who must collectively hold the market)."

Awesome study!


Brian O' Hanlon said...

From the paper,

". . . his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades."

Buffett certainly does seem to understand a lot about how to use leverage. It does appear that a lot of investors out there exhibit an appetite for leveraged investment. And the conclusion to draw from it I think, is that appetite for riskier, leveraged investment and understanding of it, are not the same thing.

Indeed, we could also deduce that understanding without an appropriate appetite level for the same, is not the recipe for success either.

For me, the only person who really explained Warren Buffett's activities very well, was John Geanakoplos, the Yale professor.

But when Geanakoplos talks about Buffett, he concentrates more on telling about the opportunities that appear and become available to Buffett, once other investors have executed a strategy, . . often a successful one, . . . that worked maybe nine times out of ten, until it didn't work and failed.

Geanakoplos often tries to explain, the necessary function that a Buffett kind of investor (and that includes a far larger subset, than just one individual who happens to be famous), performs in financial markets.

It is actually like what happened in Ireland. Once the upper layer of risk hungry investors gets knocked out of the game, there needs to be some secondary pool of buyers, who possess a similarly large appetite for risk and using leverage in deals to exist. This under-layer of investors carry out a very important function, in liquidating all of the assets and investments made by the forerunners.

When you do not have that under-layer, it is very difficult to support the market at all. Because you may get left with a layer of investors much further down, who have very little use of leverage or appetite for risk, whatsoever.

The reason that I think that Buffett's strategy has been successful now over so many years, is not because of anything in particular that Buffett is actively doing at his particular level in the game. But rather, Buffett constantly manages to be successful, because of what is going on over his head, in the layer of very aggressive risk takers that each of the last several decades has produced in finance.

I mean, you go back to the 1980s, and the bond trading banks. In the 1990s, the hedge funds, and similarly in the 2000s, the investment banks displayed a gargantuan appetite for risk taking, or under-valuation of risk, if you like. And in each of these situations, the Buffett type of player seems to have been ideally placed to gain advantage, in the aftermath.

If memory serves me correctly, there were some entrepreneurs in finance, who found themselves being bailed out not once, but twice by Warren Buffett.

Brian O' Hanlon said...

Or put it another way, given the economic conditions throughout the globe in the past several decades have produced cycle after cycle of risk under-valuation, and the kinds of investment strategies arising out of those conditions,... it would perhaps be strange, given the kind of service that a Warren Buffett type of investor provides in the marketplace,... if Warren Buffett and others, were not kept extremely busy, decade after decade, and a simple consequence of that, expect to get paid for what they do.

On the other hand, if the last several decades had been very calm and uneventful, then things could get very quite for guys such as Buffett. But instead, you always hear of Buffetts name arising when there is some pinch point, some crisis, some kind of disaster that befalls the investor community at the most extreme risk-taking end of the spectrum.

To a certain extent, the last several decades have been defined and punctuated by crises of one form or another, and a need for investors to periodically run to some sort of 'safe haven' to mitigate their losses. And this leaves the field wide open, time after time, after time, for the Buffett kind of investor to go about their business in the 'clean up' phases.