Tuesday, June 24, 2014

Buffett's Alpha (again)

In their paper Buffett’s Alpha, Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen analyzed Buffett’s returns from 1976–2011 and decomposed them to identify the primary factors driving Buffett’s significant alpha. For regular followers of Buffett, the results should come as no surprise, but let’s dig in and discuss the three primary sources of Buffett’s alpha …

In summary, the authors regressed Buffett’s returns against factor exposures commonly known to influence returns. The three factors that showed as significant are forehead-slappingly obvious.
  • Value: Buffett has a tendency to favor low price-to-book value stocks.
  • Safe: He bets against beta in that he favors low beta stocks.
  • Quality: Finally, he favors quality companies (profitable, growing) over junky companies.
Which brings me to my take-home point: Investing is simple, but it is never easy. Warren Buffett (Trades, Portfolio) identified early on in his career the value investing tenets that would guide his investing career. He then had the audacity to apply those concepts year in and year out regardless of what was happening in the world around him.

Buffett’s worst years were at the height of the TMT bubble when the market saw his way of investing as out of date and not fit for this “new era” of investing. (Side note: Whenever something is said to be in a “new era” or of a “new paradigm,” do yourself a favor and short the ever-loving shit out of those securities—it’ll be like winning a rigged lottery because all those words really mean is “BUBBLE!” and bubbles always burst).

Despite this external pressure, Buffett stuck to his process and made an absolute killing in the tech wreck years that followed. Being a value investor often means you are taking a contrarian view by definition, which can be hard for humans. We are hardwired to take our social cues from the herd, so maintaining an opposite view requires determination and guts.

Do your homework better than the other person, stick to your process, and you too can tilt the odds in your favor.

[see also Buffett's Alpha]

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