In my graduate program at the University of Maryland, I was asked to give a presentation on and lead my class in a discussion of Buffett’s Alpha, a journal article written by Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen. I decided to summarize the paper (and similar papers) in this blog post so those outside of my financial economics course could benefit. Be sure to check out the resources below for more information on the articles I surveyed.
Warren Buffett is known as the Oracle of Omaha for a reason. “Berkshire realized an average annual return of 19.0% in excess of the T-Bill rate, significantly outperforming the general stock market’s average excess return of 6.1%”[i] from 1976 to 2011. From the period of 1970-2009, his company had a Sharpe Ratio of 0.76 almost double that of the overall stock market. Efficient Market Hypothesis skeptics have used his success as evidence of the theory’s real world applicability. Andrea Frazzini and Lasse H. Pedersen (with David Kabiller and Clifford S. Asness) have written three academic articles on Buffett’s success and I attempt to summarize their arguments here. The titles of their papers are Buffett’s Alpha, Betting Against Beta, and Quality Minus Junk. In one sentence, Buffett’s Alpha summarizes Frazzini, Pedersen, and Kabiller’s proposal, “The secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails.” Specifically, I plan on talking about Berkshire Hathaway’s leverage advantage, the Betting-Against-Beta factor, and the Quality-Minus-Junk factor discussed in these articles.
Buffett’s Alpha and Betting Against Beta claim leverage is one key to Buffett’s long-term success. So, how does Warren Buffett use leverage to finance assets? From 1989 to 2009, Berkshire Hathaway’s debt was rated AAA allowing him to quickly acquire funds. Additionally, Berkshire Hathaway benefits from the insurance and reinsurance business. Buffet uses the insurance float to acquire cheap leverage. The authors estimate “average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate.” Both high ratings and utilization of the insurance float have given Berkshire Hathaway easy access to leverage. The authors claim Buffett’s average leverage to be 1.6-to-1. This high leverage position could be used to explain the high volatility in Berkshire Hathaway, which between 1976 and 2011 “realized a volatility of 24.9%, higher than the market volatility of 15.8%.” But Buffett’s returns have been excessive when volatility (and risk) is accounted for. Overall, Buffet’s leverage has increased his returns and because he was able to weather negative return scenarios, he has come out on top.
Betting-Against-Beta is a factor that Frazzini, Pedersen, and Kabiller developed in Betting Against Beta. Beta represents risk and determines how high an asset will go when the market goes up and how low the asset will go when the market goes down.[ii] It measures the response a security’s return is to the market return and Berkshire Hathaway “realized a market beta of only 0.7.” The Capital Asset Pricing Model (CAPM) suggests people invest in a portfolio with the “highest expected excess return per unit of risk (Sharpe ratio) and leverage or de-leverage this portfolio to suit their risk preferences.”[iii] But many individuals and mutual funds are limited on their leverage abilities. Instead they attempt to get excess returns by tilting their portfolio toward high-beta assets, overpricing high-beta assets in the process. This leads unconstrained investors (like Buffett and LBOs) to short high-beta assets and long low-beta assets (levering them up). The authors called this the Betting-Against-Beta factor and built a portfolio to test the premise. Their BAB portfolio was “a portfolio that holds low-beta assets, leveraged to a beta of one, and that shorts high-beta assets, de-leveraged to a beta of one.” They tested this BAB portfolio with US and international equity markets as well as US treasury markets. The authors concluded this BAB portfolio delivered high average returns and a high alpha. Purchasing low-beta stocks and leveraging them up seemed to be profitable. Buffett’s taste for companies with betas below one and betting against beta is another explanation for his excess returns.
Asness, Frazzini, and Pedersen define quality as, “stocks that are safe, profitable, growing, and well managed.”[iv] To summarize Quality Minus Junk, “A quality-minus-junk (QMJ) factor that goes long high-quality stocks and shorts low-quality stocks earns significant risk-adjusted returns in the U.S.” The key here is “significant risk-adjusted returns”. The authors claim that the price difference between low quality and high quality stocks isn’t great enough for the low quality stocks to be purchased at a discount. They say, “[We] cannot tie the returns of quality to risk.” Buffett’s returns mimic this QMJ factor as it tilts towards going long on high quality stocks and shorts low quality.
Buffett’s success can’t be simply summarized in a few sentences, but according to Asness, Frazzini, Kabiller, and Pedersen, easy access to leverage, betting against beta, and a tilt toward high quality stocks have been contributing factors for the Oracle of Omaha. Buffett uses “leverage combined with a focus on cheap, safe, quality stocks.” The last thing I leave you with is this quote from the man himself, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”[v]
· Quality Minus Junk - Asness, C., A. Frazzini, and L. H. Pedersen (2013)
· Betting Against Beta - Frazzini, A. and L. H. Pedersen (2013)
· Buffett’s Alpha - Frazzini, A., Kabiller, D., Pedersen, L. H. (2012)
· Lectures by Professor David Hillier, Associate Principal at the University of Strathclyde
· Summary of “Buffett’s Alpha” – Columbia Business School (2014)
· The Secrets of Buffett’s Success – Buttonwood in The Economist (2012)
· Warren Buffett’s Alpha: How Warren Buffett Became the World’s Greatest Investor – Life on the Buyside
· h/t Gautam Rao for editing
[i] Frazzini, A., Kabiller, D., Pedersen, L. H., 2012. Buffett's Alpha. AQR Capital Management and New York University, Greenwich, CT and New York, NY.
[ii] Professor David Hillier; Associate Principal at the University of Strathclyde
[iii] Frazzini, A. and L. H. Pedersen (2013), “Betting Against Beta”, Journal of Financial Economics
[iv] Asness, C., A. Frazzini, and L. H. Pedersen (2013), “Quality Minus Junk”, AQR Capital Management, New York University.
[v] Warren Buffett, Berkshire Hathaway Inc., Annual Report, 2008.