Research - How Exactly Did Buffett Do It?
Summarizing the award winning paper Buffett's Alpha to provide insights on how Warren Buffett managed to be so successful for so long.
I recently came across the paper Buffett’s Alpha. It’s an award-winning, highly technical paper filled with math equations and other heavy financial modeling to understand how Warren Buffett, probably America’s greatest investor, was able to consistently significantly outperform the market for almost six decades.
I read this long and technical paper so you don’t have to, and have summarized its findings below.
Berkshire Hathaway is the public holding company Warren Buffett uses to conduct his investments. As of writing, the company’s market cap is $788B, making it the 7th largest company in the world. It wholly owns several private companies (e.g. GEICO) as well as a portfolio of public investments and other assets that Buffett and co. manages.
Berkshire was originally a textile manufacturing company. Buffett started buying the company’s shares in 1962 and eventually the CEO offered to buyback Buffett’s shares at an attractive price of $11.5 per share. Buffett agreed, but the CEO short-changed him at the last minute and offered $11.375 per share instead. In a fit of hurt pride, Buffett ignored the offer, bought more shares to take control of the company, and fired the CEO.
Under Buffett’s management, Berkshire transformed from a failing textile company to what it is today, and its market cap has grown annually by 19% since 1965 (compared to 9.7% for the S&P 500 with dividends included for the same period). In fact, according to the Buffett’s Alpha paper, Berkshire Hathaway’s stock is the best stock to own compared to any other stock or index fund that have lasted for more than 30 years.
How Did He Do It?
There’s been an ongoing debate among economists about the efficient market hypothesis; that is, whether the market fairly prices assets at all times, leaving no room to make excess profits by trying to get ahead of the market. The paper argues that even though some would attribute Buffett’s long running success to sheer luck, Buffett is actually a living counter example of said hypothesis.
The paper uses a few financial math models to show that Buffett didn’t just randomly come across his success. Rather, he picked a systematic way of investing that beat the market. I won’t dive into the technical complexities of the models but will share a high level summary of the paper’s findings on his system of investing and why it was so effective.
The paper uses the Carhart four-factor model to summarize Buffett’s investing style and explain where his alpha (stock market jargon for market outperformance) comes from.
The first Carhart factor, MKT, showed that Berkshire’s stock was less volatile than the rest of the market and significantly outperformed it, which we already know. The second factor, small-minus-big (SMB), showed that Berkshire tended to buy large stocks. The third factor, called the value factor (HML), showed that Berkshire tended to buy stocks that had a high book value relative to their market value. That is to say, Buffett bought cheap stocks. The final factor, the momentum factor (UMD), showed that Buffett is not a momentum investor and didn’t chase trends in his stock selection.
However, the paper states that these four standard factors actually don’t explain Buffett’s alpha. As such, it introduces two more factors to measure Berkshire’s performance by. First, the Betting Against Beta (BAB) factor which showed that Berkshire tended to buy low risk (low volatility) stocks. Second, the Quality Minus Junk (QMJ) factor, showed that Berkshire tended to buy companies that were profitable and growing.
The paper states that by controlling for just the BAB and QMJ factors, Berkshire’s public stock portfolio’s alpha is driven down to a statistically insignificant value.
Therefore, the main reason for Buffett’s success is his preference for low risk stocks that are profitable and growing.
Finesse with Leverage
It’s not satisfying when it’s said that Buffett was successful simply because of his preference for low risk and high quality. This seems like a simple criteria that anybody can apply to their own investing, but very few people can match Buffett’s long running market outperformance.
The paper highlights another key aspect of Buffett’s investing strategy that contributed to his wild success: his finesse with the use of leverage in his portfolio. Leverage is the borrowing of money to invest more and thus increase your returns (if you’re successful). Of course, it’s not all just upside, there’re costs as well. For one, the borrower needs to pay interest on the borrowed principle. Secondly, if an investor is leveraged up and the market pulls back, their total assets could be at risk of going below the borrowed money, and a lender can force the investor to fire-sale their entire portfolio at great loss to the investor to recoup the borrowed money. This is known as a margin call.
As such, one needs to use leverage carefully and strategically. It can bring you great fortune or take your fortune away. Buffett was remarkably skillful at employing leverage, which has greatly contributed to Berkshire’s significant market outperformance.
For one, Buffett doesn’t use a lot of leverage. The paper found that Berkshire’s average leverage is only 1.6-to-1. This is low compared to many modern funds that employ significant leverage (e.g. risk parity strategies that heavily lever up on bonds). This restrained use of leverage showed that Buffett was very careful and strategic with how he used it, and instead relied on consistent compound growth aided with just a little bit of borrowed money to achieve spectacular results.
The most amazing aspect of Buffett’s use of leverage is where he gets the borrowed money from. When a company or fund needs money, most of the time they borrow from a bank. Buffett very adeptly recognized early on that the business model of insurance companies (i.e. charging insurance premium up front and paying out claims at a future date) is essentially borrowing money from customers. When executed correctly, these “loans” can come with a much lower interest rate than is made available by banks to even the highest of quality of companies.
The story goes that Buffett took an interest in the insurance business very early on in his financial career. In 1951, he took a train to Washington D.C. and knocked on the door of GEICO’s headquarters until a janitor admitted him in, and then met Lorimer Davidson, GEICO’s vice president at the time. Buffett was charming and intelligent enough to somehow get Davidson to take hours out of his day to discuss the insurance business with Buffett.
Buffett applied this intimate knowledge of the insurance business when he acquired Berkshire and started acquiring insurance companies. The most famous acquisition is probably GEICO. Everyone has seen ads of the quirky talking lizard trying to sell you car insurance: “If you want to save 15% or more in car insurance, you switch to GEICO, it’s what you do”. In fact, it was just announced a few days ago that Berkshire is buying insurer giant Alleghany for $11.6 billion. Insurance companies form a significant portion of Berkshire’s private company portfolio.
With insurance companies under his belt, Buffett had access to incredibly cheap leverage and used that to his advantage. Compound interest goes both ways, and an annual interest cost of 2% vs 5%, for example, makes a tremendous difference in the returns of a leveraged portfolio over time.
Another stroke of genius from Buffett to achieve his long-running success is how he structured what is essentially his investment fund. Buffett closed off Berkshire from outside money very early on and more or less managed his own money throughout the decades. This might seem insignificant and perhaps even limited the amount of money Buffett could’ve made if he took on outside investments and charged a management and performance fee similar to modern hedge funds. However, even though Buffett stunted his short term income by avoiding outside money, this decision was key to Berkshire’s long term survival.
Berkshire might have had an overall 19% compound annual growth rate (CAGR) since 1965 but this is its average growth rate; there were certainly volatile years in between. For example, from June 30th 1998 to February 29th, 2000, Berkshire lost 44% of its market value while the overall stock market gained 32%.
If Berkshire managed outside money, this could’ve been a death-knell for the fund, as outside money can be incredibly finicky on down years and pull out. This could result in a bank run type situation where investors try to be the first to flee to avoid a fire sale of Berkshire’s assets and see their investment further fall in value.
Buffett’s longstanding decision to close off Berkshire to outside money allowed the company be much more resilient, being able to endure hard times in order to rebound spectacularly when conditions were favorable again.
Lucky to Start in the 60s
It’d be remiss not to mention that even though Buffett employed significant skill in achieving such long-running success, he was also incredibly lucky to start investing in the time period that he did. This was a time period where access to information was low, thus increasing market inefficiencies and creating the underpriced companies that Buffett was able to invest in, and also the beginning of a multi-decade contraction of interest rates and expansion of the money supply by the Federal Reserve that is still ongoing today. In fact, just a few years after Buffett acquired Berkshire Hathaway, Nixon ended the gold standard, effectively giving a green light to the Federal Reserve to massively inflate the US dollar supply. This has unsurprisingly been a boon for the US stock market’s dollar-valuation.
If Buffett were to start investing today, it’s unlikely that he’d come even close to the performance he managed to achieve with Berkshire Hathaway since 1965. With the widespread availability of the Internet, and very accommodative central bank policies all over the world, markets are much more efficient and bloated. It’s incredibly hard to find the sort of deep value companies Buffett found in the 60s, 70s, and 80s to jumpstart Berkshire.
It’s hard to imagine attributing Buffet’s multi-decade 19% CAGR completely to luck as some economists that subscribe to the efficient market hypothesis would like to do. Buffett was certainly lucky in the process, but it’s clear, as the Buffett’s Alpha paper concluded, that Buffett skillfully employed a system for investing that identified market inefficiencies, with a little help from cleverly acquired cheap leverage, to achieve long-running significant market outperformance.
Although markets are arguably a lot harder to navigate today than when Buffett started in the 60’s, his investment principles of buying cheap, high quality stocks while smartly and carefully applying leverage still deserves an unwavering spot near the top of the modern investor’s handbook.