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?

Buffet on Goldman

Great minds think alike ;-)

NYTimes: ... Mr. Buffett said that he feels little sympathy for the firms the S.E.C. says were hurt by Goldman’s purported lack of adequate disclosure. Of one firm, ABN Amro, Mr. Buffett said: “It’s hard for me to get terribly sympathetic when a bank makes a dumb credit bet.”

What Mr. Buffett thinks about Goldman is something the investment community has been buzzing over for days. Berkshire has invested $5 billion in Goldman preferred shares, and Mr. Buffett is notoriously skeptical of Wall Street mores. One of the low points of Mr. Buffett’s investing career is stepping in at Salomon Brothers when the firm was embroiled in a trading scandal: he had to temporarily assume Salomon’s chairmanship and apologize to Congress.

In the case of Goldman, however, Mr. Buffett and his chief lieutenant, Charles Munger, made it clear they’re on the firm’s side. Goldman and Berkshire have a long history, with Mr. Buffett relying on Goldman as his longtime investment bank. (He’s famously said that Byron D. Trott, a longtime Goldman banker who left to start his own shop, is one of the few Wall Street bankers he trusts.)

According to DealBook’s Andrew Ross Sorkin, who’s one of three panelists asking questions at the meeting, Mr. Buffett essentially took Goldman’s defense that everyone involved in the now-infamous Abacus deal was a sophisticated investor fully capable of evaluating the risks in the subprime mortgage investment. Instead of needing to be told that a hedge fund manager who suggested which bonds should form the underpinnings of the Abacus collateralized debt obligation was also short the bonds, the investors should have relied on their own due diligence, Mr. Buffett said.

“If I have to care who is on the other side of the trade, I shouldn’t be insuring bonds,” he said.

Mr. Buffett added an implicit rebuke of a line of questioning raised by several senators during this week’s Goldman hearings. An investment bank could very well be short the securities Berkshire is buying, and a buyer like Berkshire should be perfectly aware of that in any case.

Mr. Munger added that were he on the S.E.C., he would not have voted to press charges.

That isn’t to say that Mr. Buffett and Mr. Munger think Goldman is blameless here. Mr. Munger suggested that there’s a difference between breaking the law and behaving unethically — and that simply following the former shouldn’t be the basis of a business’ conduct.

If you're so smart, why aren't you rich?

Does being smart help you become rich?

Folksy Warren Buffett once said that an investor with IQ of 150 should sell 30 points to someone else, as anything above 120 is unnecessary.

Consider the following simple model (we can call it the "Igon Model" in honor of Malcolm Gladwell):

Igon Model: IQ correlates positively with wealth, but the effect goes away for IQ > 120. IQ above 120 provides no advantage, relative to IQ=120, for acquiring wealth.

Were this model to be true, one would expect with overwhelming probability to find that the vast majority of rich people have IQ around 120, but not much higher. This is because IQ is normally distributed: as you go further out the tail the population decreases exponentially. To be specific, IQ = 120 corresponds to the 90th percentile, whereas IQ = 135 is 99th percentile (i.e., only 1 in 10 people with IQ > 120 have IQ > 135) and IQ = 145 is 99.9th percentile (i.e., only 1 in 100 people with IQ > 120 have IQ > 145).

Now let's look at the 2009 Forbes list of richest people in the world:

1 William Gates III 53 40.0 United States
2 Warren Buffett 78 37.0 United States
3 Carlos Slim Helu 69 35.0 Mexico

If the Igon Model were correct, we would not expect to find this list dominated by people with IQ much higher than 120. But in fact we do. Note these three made their money in different ways: Gates founded a software company, Buffett is primarily an investor, and Carlos Slim is an oligarch ;-)

Bill Gates scored 1580 on the pre-1995 SAT. His IQ is clearly >> 145 and possibly as high as 160 or so.

Warren Buffett graduated high school at 16 ranked in the top 5 percent of his class despite devoting substantial effort to entrepreneurial activities. Most people who know him well refer to him as brilliant, that folksy quote above notwithstanding. I would suggest the evidence is strong that his IQ is above 135, perhaps higher than 145.

Carlos Slim studied engineering and taught linear programming while still an undergraduate at UNAM, the top university in Mexico. He reportedly discovered the use of compound interest at age 10. I would suggest his IQ is also at least 135.

So it would appear that the three richest men in the world all have IQs that are higher than 90 percent or even 99 percent of the > 120 IQ population. (Relative to the general population they are all likely in the 99th or even 99.9th percentile.) The probability of this happening in the Igon Model is less than 1 in 1000.

[Here's a basketball analogy: the analogous Igon Model for basketball would say height over 6ft2 (90th percentile) doesn't increase likelihood of success in basketball. Suppose we find the 3 top players in the world are 7ft (Shaq/Gates), 6ft8 (LeBron/Buffett) and 6ft6 (Kobe/Slim). That strongly disfavors the model, as a random draw of 3 people from the set of people over 6ft2 in height has almost zero probability of producing the 3 heights we found.]

Note to angry Gladwell egalitarians: don't take this analysis too seriously :-) It's really an example of "Igon analysis" in the spirit of MG!

There are many factors aside from intelligence that impact success in business or investing. See here for a discussion by money manager and investment theorist William Bernstein, which is very similar to what Buffett has said on various occasions. If you carefully study biographies of the three men listed above, what really stands out (aside from high mental ability) is their determination, drive and fascination with material success beginning at a young age. See also: success vs ability and creators and rulers.

What about the broader population? It's well established that graduates of elite universities earn more than graduates of less selective schools. But, interestingly, controlling for SAT score (IQ) largely eliminates the differential. I wonder why? (See also here for UT Austin data on earnings variation with SAT and major.)

Carlos Slim in the New Yorker

There's a great profile of Carlos Slim in the New Yorker this week. Slim is one of the richest men in the world and recently took a big stake in the financially troubled New York Times. Unfortunately, the online version is subscriber only. Here is a brief summary of the article (excerpts from the summary below).

There are a lot of similarities between Slim and Warren Buffet: early interest in investing and business, modest lifestyle, patriotic nationalism, humility, even a Graham and Dodd value style of investing in distressed assets. Slim taught linear programming while still an engineering student at UNAM (Autonomous National University of Mexico) and discovered compound interest at age 10. (He learned that at a 10 percent annual rate of return his money would double in 7 years, not 10 :-)

Near the end of the article the writer describes a meeting between Slim and one of his most visible critics, Denise Dresser, a Princeton-trained academic (Instituto Tecnológico Autónomo de México) and political analyst. I suspect a look through Dresser's work might be of interest for those who want to disentangle the political economy of Mexico.

... The foundation of his empire is Telmex, the telecommunications company, which he acquired in 1990, and the cell-phone business, América Móvil, which is now the third-largest company in Latin America. Although Slim has often been described as a merciless predator, he has never been caught in one of the scandals that periodically spill onto the front pages of Mexican newspapers. His nationalism, humility, and relatively modest personal habits stand as a kind of rebuke to the image that Mexicans typically have of their oligarchs. Tells about Slim’s father, Khalil, who emigrated to Mexico from Lebanon and became a successful merchant. Describes Slim’s childhood and his early interest in numbers and money. He invested from a youthful age and abandoned engineering to go into business. Discusses Slim’s visit to the 1964 World’s Fair and its influence on his interest in technology. Writer gives a brief history of the Times’s recent economic difficulties and considers why Slim would be interested in the paper. Also tells about David Geffen’s bid for the Times. Writer chronicles the growth of Slim’s business holdings from the mid-sixties to his acquisition of Telmex. Slim has often used recessions as an opportunity to buy businesses at reduced prices. Writer interviews Randall Stephenson [current AT&T CEO], who worked for Slim in the nineties. “He’s probably the most intelligent businessman I’ve met,” Stephenson says. ...

Buffet and LTCM

Interesting tidbit for students of the LTCM meltdown, as relayed by Wharton professor Jeremy Siegel.

Apologies to people who believe in efficient markets and similar orthodoxy ;-)

Long Term Capital Management

One student asked about Berkshire’s role in the Long-Term Capital Management (LTCM) crisis that rocked the financial markets in 1998. It was obvious that Warren wished that he had been able to buy LTCM’s positions when the Fed forced a resolution of the crisis that was crippling the government bond market.

The LTCM crisis was a ready-made example of Warren’s philosophy of buying firms when the economics was right, yet fear ruled the markets. He noted that “off-the-run” (non-benchmark) government bonds were selling to yield 30 basis points more than the “on-the-run” (benchmark) bonds that were maturing just six months later. He rightly claimed that this made no sense economically.

LTCM had taken a huge leveraged position in these bonds when the spreads were much smaller, but didn’t have the collateral to hold on to it when the spread widened. Buffett quoted John Maynard Keynes, who wrote in 1931 that “The market can stay irrational longer than you can stay solvent.” As the spread widened, Keynes’ dictum became devastatingly relevant for LTCM. But Berkshire, with its huge cash hoard, could withstand the pressure of even more market irrationality before the spread eventually returned to normal.

Unfortunately, Warren was never able to consummate the deal. He had been invited by Bill Gates to vacation in Alaska when the crisis broke and it was hard to negotiate such a deal on a cell phone. Eventually the banks holding the collateral made a deal with LTCM and Berkshire didn’t have a chance to top their offer.

Warren is philosophical about the loss of this opportunity, noting it was the most expensive vacation he ever took. “Bill Gates cost me about $3 billion,” he shrugged. But that incident certainly has not soured their friendship and didn’t prevent him from giving the Bill and Melinda Gates Foundation the lion’s share of his wealth.