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Many colors of value [ClearOnMoney]
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Commentary

Many colors of value

27 Aug 2012 by Jim Fickett.

Among those known as “value investors”, different individuals choose widely different strategies. In particular, while a core part of value investing is often seen to be “buy low, sell high”, which takes advantage of volatility, Buffett's strategy seems to have included, as an essential component, the selection of particularly stable, un-volatile stocks.

Today the Aleph Blog pointed to an interesting recent academic paper analyzing Warren Buffett's strategy: Buffett’s Alpha, by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen.

The first main result in this paper is that, in a simple quantifiable sense, Buffett outperformed every stock and every mutual fund over the last 30 years. The measure used is the Sharpe Ratio:

The Sharpe ratio is calculated by subtracting the risk-free rate - such as that of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.

Frazzini et al. report,

Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years

Many, many people have anecdotal or personal interpretations of Buffett's strategy. The meat of this paper is in trying to analytically decompose Buffett's strategy into simpler pieces, in a quantifiable way. So the authors do a regression of Buffett's returns against a number of simpler, well-defined strategies. They find that only two of the component strategies matter – low volatility and quality, and that Buffett's extraordinary performance is thus likely to be due mainly to leveraging (with insurance float) the cash flows of solid, steady businesses.

Since Buffett’s alpha cannot be explained by standard factors studied by academics, his success has to date been considered a sign of unique skill or as “alpha”.

Our innovation is to also control for the Betting Against Beta (BAB) factor of Frazzini and Pedersen (2010) as well as the quality factor (QMJ, “quality minus junk”) of Asness, Frazzini, and Pedersen (2012b). A loading on the BAB factor reflects a tendency to buy safe (i.e., low-beta) stocks while shying away from risky (i.e., high-beta) stocks. Similarly, a loading on the quality QMJ factor reflects a tendency to buy high-quality companies, that is, companies that are profitable, growing, and paying out dividends (see Asness, Frazzini, and Pedersen (2012b) for details).

We see that Berkshire loads significantly on the BAB and QMJ factors, reflecting that Buffett likes to buy safe, high-quality stocks. Controlling for these factors drives the alpha of Berkshire’s public stock portfolio down to a statistically insignificant annualized 0.1%, meaning that these factors almost completely explain the performance of Buffett’s public portfolio. Thus, a significant part of the secret behind Buffett’s success is the fact that he buys safe, high-quality, value stocks.

To then make the point conclusively, the authors show that if one could go back 30 years and leverage a portfolio of safe, high-quality stocks, one could duplicate Buffett's results:

To illustrate this point in a different way, we create a portfolio that tracks Buffett’s market exposure and active stock-selection themes, leveraged to the same active risk as Berkshire. We find that this systematic Buffett-style portfolio performs comparably to Berkshire Hathaway. Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles.

Anyone who reads a few of Berkshire Hathaway's annual reports knows that Buffett defines value more in terms of strong cash flows than in terms of bargain prices. But it came as a surprise to me that explicitly avoiding volatility seems to be a significant component of Buffett's strategy.