(By Edward Croft) At times the world of modern finance resembles a standoff at the OK Corral. On the one side stand aloof the esteemed fund managers of the era with their long records of out-performance. On the other the academics and quants who wish to shoot them down by 'proving' that their excess profits can be explained away as either lucky or systematically repeatable. In their sights has always been the biggest scalp of all, Warren Buffett, and where many have failed a recent research paper titled 'Buffett's Alpha' looks to have finally shot him down. Essentially the paper finds that Buffett may not have had an 'edge' after all.
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The esteemed researchers looked at Buffett's investment vehicle, Berkshire Hathaway (BRK), and broke out the performance related solely to publicly traded companies. They then ran some mathematical regressions over the data to figure out what 'factors' could explain the portfolio's out-performance.
All geared up... Firstly, they found that Buffett's equity portfolio performance benefited from his ability to access cheap borrowed money. Basically he was investing $160 into stocks for every $100 he owned. How? Well Berkshire always had a great credit rating which helped, but it also owned insurance businesses which benefit by taking in premiums from customers often years before having to pay out claims. Effectively this 'float' acts as an ongoing interest free loan which Buffett can then invest back into stocks.
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...and boring... But what of his stock picking prowess? Buffett has made 19% annually for a zillion years and the market plus the leverage could only explain 10% of that - where did the rest come from? Well it's very simple.
There are a few standard factors that academics use to explain the majority of stock market out-performance. The ones normally mentioned are the following: small caps beat big caps (size), cheap stocks beat expensive stocks (value) and recently rising stocks beat recently falling (momentum). But they found that while Buffett did have a preference for cheap stocks, he had little exposure to small caps or momentum. Previous studies had found the same, suggesting that Buffett's extra profits were due to some unexplainable 'alpha'.
But this set of quants decided to try out a couple of more modern factors to see if they could explain his performance: the propensity for lower volatility stocks to beat higher volatility stocks (i.e. safe beats exciting ) and the tendency for high quality stocks to beat low quality stocks (with quality defined as profitable, stable, dividend paying stocks).
They worked a treat. By appropriately over-weighting the factors for cheapness, safety and quality they could build portfolios that mimicked Buffett's un-leveraged stock portfolio returns, or even beat them (see below).
'Accounting for the general tendency of high-quality, safe and cheap stocks to outperform can explain much of Buffett's performance and controlling for these factors makes Buffett's alpha statistically insignificant.
Why this matters Now, is this really new? Didn't we all already know that Buffett likes to invest in high quality, safe and cheap stocks? Yes, but in the context these findings have rather profound implications.
It suggests that Buffett's investment style can be replicated by algorithms investing in completely different companies to the ones Buffett would pick, but which share the characteristics of those he would pick. When something is easily modeled like this, it can be treated as just another asset class - something you or I can eventually easily invest in systematically. Hush, hush, but Buffett's style could even be marketed as just another ETF. Sure there's no guarantee that the future will be like the past, but this is an enticing prospect for many investors nonetheless.
Now I went out on Twitter yesterday to blab about this and was met with quite a few protests which I felt were rather misplaced. Sure the argument 'its easy with hindsight' has some merit and to give the authors some credit they do admit that Buffett "started doing it half a century before we wrote this paper", but some may be missing the point that maybe we over-credit Buffett's ability as a stock picker. We all hold up Buffett as a 'genius' but it turns out you can systematically build portfolios that can offer the same kind of return profile without being a folksy, gun-slinging 'alpha male' stock-picker. And of course perhaps this should come as no surprise as the Oracle himself has been saying it for decades.
'Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results'.
Will Robo-Buffett profits persist? Of course for anyone who has been paying attention to what we've been writing this year, this kind of result should come as no surprise. Soc Gen's research into 'Quality Income' stocks almost completely mirrors the findings in this paper. They are describing the same kind of stocks. High quality, dividend paying mid to large caps. These stocks are fundamentally extremely boring to most investors.
While the smart, long term, quantitative money will doubtless be putting billions to work investing in these kinds of strategies (and the authors do work at $50bn quant hedge fund AQR Capital), I seriously doubt that this 'anomaly' will disappear very soon. The fact is that the majority of professional investors are so worried about receiving their Christmas bonuses that they fight tooth and claw to beat their peers from year to year, not over the three to five year periods that see these strategies win.
Until, 90% of the fund management industry is replaced by robots, the great news is that these opportunities will possibly persist - which is precisely why individuals can take advantage of them. If you are interested in finding safe high quality stocks, a couple of our tracked strategies that highlight them include our model of Richard Beddard's Nifty Thrifty and the SocGen-esque Quality Income - both of which have outperformed year to date - and we also list several Buffett-esque strategies too. Of course past performance is no indication of future returns, and for all I know the greatest investor for the next 30 years might be investing in the opposite kind of stocks… volatile, unprofitable and expensive… but I wouldn't bet on it.