Sunday, September 02, 2012

Buffett's Alpha

While much has been said and written about Warren Buffett and his investment style, there has been little rigorous empirical analysis that explains his performance. Every investor has a view on how Buffett has done it, but we seek the answer via a thorough empirical analysis in light of some of the latest research on the drivers of stock market returns.

Buffett’s record is remarkable in many ways, but just how spectacular has the performance of Berkshire Hathaway been compared to other stocks or mutual funds? Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Berkshire has a higher Sharpe ratio than all U.S. mutual funds that have been around formore than 30 years.

We find that the Sharpe ratio of Berkshire Hathaway is 0.76 over the period 1976-2011. While nearly double the Sharpe ratio of the overall stock market, this is lower than many investors imagine. Adjusting for the market exposure, Berkshire’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.

If his Sharpe ratio is very good but not unachievably good, then how did Buffett become one of the most successful investors in the world? The answer is that Buffett has boosted his returns with 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. Thus, his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and its risk over multiple decades.

This leaves the key question: How does Buffett pick stocks to achieve a relatively attractive return stream that can be leveraged? We identify several 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 [are] profitable, stable, growing, and with high payout ratios). This statistical finding is certainly with 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.

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