Sunday, September 30, 2012

Buffett's secret

Low beta + leverage. The leverage is obtained cheaply via Berkshire's insurance and reinsurance business. But I wonder whether low beta investing practiced algorithmically (i.e., without Buffet's stock picking skill, just taking a representative sample of low beta companies, or using some simple selection method) would work. I haven't yet read the AQR paper below and wonder how they adjust for "quality factors". Can I do that too?
Buffet's Alpha

Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha become statistically insignificant when controlling for exposures to Betting-Against-Beta and quality factors. We estimate that Berkshire’s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and stable sources of financing. Berkshire’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks. We find that Berkshire’s portfolio of publicly-traded stocks outperform private companies, suggesting that Buffett’s returns are more due to stock selection than to a direct effect on management.
More from the Economist.
Economist: ... Yet the underappreciated element of Berkshire’s leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

A further advantage has been the stability of Berkshire’s funding. As many property developers have discovered in the past, relying on borrowed money to enhance returns can be fatal when lenders lose confidence. But the long-term nature of the insurance funding has protected Mr Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market.

These two factors—the low-beta nature of the portfolio and leverage—pretty much explain all of Mr Buffett’s superior returns, the authors find. Of course, that is quite a different thing from saying that such a long-term performance could be easily replicated. As the authors admit, Mr Buffett recognised these principles, and started applying them, half a century before they wrote their paper.
See also If you're so smart, why aren't you rich?


David Coughlin said...

What makes me curious is, did he say to himself, "Being vertical is an advantage," or did he say, "I'm taking a vertical position; oh hey, that worked out nicely."

Richard Seiter said...

Good question. I wonder if he was just thinking something like: "Where can I find a stable, low-cost source of funds?"

LondonYoung said...

Read this article, think about it, and read it again ... it was written in 1977 ...

Ken Condon said...

Great piece. Thanks for the link. And it was written before the fed ratcheted interest rates through the roof to put the squeeze on inflation. I remember that vividly-the wailing and gnashing of teeth- and the subsequent stock bull market that followed. I wonder of Buffets 12% “rule" applies from 1977 until now. I need to crunch some numbers ;)

Ken Condon said...

OK-I’ll bite. What’s your take on the current zero to nagative interest rates?

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