Buffett\'s_Alpha_-_Frazzini,_Kabiller_and_Pedersen

Buffett’s Alpha 1 Buffett’s Alpha Andrea Frazzini, David Kabiller, and Lasse H. Pedersen * First Draft: May 3, 2012 This draft: August 29, 2012 Comments Welcome Abstract 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. * Andrea Frazzini and David Kabiller are at AQR Capital Management, Two Greenwich Plaza, Greenwich, CT 06830, e-mail: andrea.frazzini@aqr.com; web: http://www.econ.yale.edu/~af227/ . Lasse H. Pedersen is at New York University, Copenhagen Business School, AQR Capital Management, CEPR, FRIC, and NBER, 44 West Fourth Street, NY 10012-1126; e-mail: lpederse@stern.nyu.edu; web: http://www.stern.nyu.edu/~lpederse/. We thank Cliff Asness, Aaron Brown, John Howard, Ronen Israel, Sarah Jiang and Scott Richardson for helpful comments and discussions. We are grateful to Nigel Dally for providing us with historical 10-K filings. Buffett’s Alpha 2 1. Introduction: The Secret Behind the Oracle’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. 1 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 30 years, 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 for more 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 2 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 1 Based on the original insights of Black (1972) and Black, Jensen, and Scholes (1972), Frazzini and Pedersen (2010) show that leverage and margin requirements change equilibrium risk premia. They show that investors without binding leverage constraints can profit from Betting Against Beta (BAB), buying low-risk assets and shorting risky assets. Frazzini and Pedersen (2012) extend this finding to derivatives with embedded leverage, Asness, Frazzini, and Pedersen (2012a) to the risk-return relation across asset classes, and Asness, Frazzini, and Pedersen (2012b) to fundamental measures of risk denoted quality. 2 The Information ratio is defined as the intercept in a regression of monthly excess returns divided by the standard deviation of the residuals. The explanatory variable in the regression is the monthly excess returns of the CRSP value-weighted market portfolio. Sharpe ratios and information ratios are annualized. Buffett’s Alpha 3 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. Stocks with these characteristics – low risk, cheap, and high quality – tend to perform well in general, not just the ones that Buffett buys. Our analysis seeks to determine if Hathaway’s investment success is truly idiosyncratic or “alpha”, or if it can be explained simply by these characteristics. The standard academic factors that capture the market, size, value, and momentum premia cannot explain Buffett’s performance so it has to date been a mystery (Martin and Puthenpurackal (2008)). Given Buffett’s tendency to buy stocks with low return risk and low fundamental risk, we further adjust his performance for the Betting-Against-Beta (BAB) factor of Frazzini and Pedersen (2010) and the quality factor of Asness, Frazzini, and Pedersen (2012b). We find that accounting for these factors explains a large part of Buffett's performance. In other words, 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. 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. Perhaps this is what he means by his modest comment: Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1994. It cannot be emphasized enough that explaining Buffett’s performance with the benefit of hindsight does not diminish his outstanding accomplishment. He decided to invest based on these principles half a century ago! He found a way to apply leverage. Finally, he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies. Finally, we consider whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO. Said differently, is Buffett mainly an investor or a manager? To address this, we decompose Berkshire’s returns into a part due to Buffett’s Alpha 4 investments in publicly traded stocks and another part due to private companies run within Berkshire. The idea is that the return of the public stocks is mainly driven by Buffett’s stock selection skill, whereas the private companies could also have a larger element of management. We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performed better, suggesting that Buffett’s skill is mostly in stock selection. Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate. In summary, we find that Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance. 2. Data Sources We use stock return data from the CRSP database, balance sheet data from the Compustat/XpressFeed database as well as hand-collected annual reports, holdings data for Berkshire Hathaway from Thomson Financial Institutional (13F) Holding Database (based on Berkshire’s SEC filings), the size and cost of the insurance float from hand- collected comments in Berkshire Hathaway’s annual reports, and mutual fund data from the CRSP Mutual Fund Database. We also use factor returns from Ken French’s website, from Frazzini and Pedersen (2010), and Asness, Frazzini, and Pedersen (2012b). We describe our data sources and data filters in more detail in Appendix B. 3. Buffett’s Track Record Buffett’s track record is clearly outstanding. A dollar invested in Berkshire Hathaway in November 1976 (when our data sample starts) would have been worth more than $1500 at the end of 2011. Over this time, Berkshire realized an average annual return of 19.0% in excess of the T-Bill rate, significantly outperforming the general stock market’s average excess return of 6.1%. Berkshire stock also entailed more risk, realizing a volatility of 24.9%, higher than the market volatility of 15.8%. However, Berskhire’s excess return was high even relative to its risk, earning a Sharpe ratio of 19.0%/24.9% = 0.76, nearly twice the market’s Sharpe ratio of 0.39. Berkshire realized a market beta of only 0.7, an important point that we will discuss in more detail when we analyze the types of stocks that Buffett buys. Adjusting Berkshire’s performance for market exposure, we compute its Information ratio to be 0.66. Buffett’s Alpha 5 These performance measures reflect Buffett’s impressive returns, but also that Berkshire has been associated with some risk. Berkshire has had a number of down years and drawdown periods. For example, from June 30, 1998 to February 29, 2000, Berkshire lost 44% of its market value while the overall stock market gained 32%. While many fund managers might have had trouble surviving a 76% shortfall, Buffett’s impeccable reputation and unique structure as a corporation allowed him to stay the course and rebound as the internet bubble burst. To put Buffett’s performance in perspective, we compare Berkshire’s Sharpe and Information ratios to those of all other U.S. common stocks. If Buffett is more of a stock picker than a manager, an even better reference group than other stocks might be the universe of actively managed mutual funds, so Table 1 compares Berkshire to both of these groups. Berkshire is in the top 3% among all mutual funds and top 7% among all stocks. However, the stocks or mutual funds with the highest Sharpe ratios are often ones that have only existed for short time and had a good run, which is associated with a large degree of randomness. To minimize the effect of randomness, Table 1 also compares Berkshire to all stocks or mutual funds with at least a 10-year or 30-year history. Berkshire’s performance is truly outstanding seen in this perspective. Among all stocks with at least a 30-year history from 1926 to 2011, Berkshire has realized the highest Sharpe ratio and Information ratio. If you could travel back in time and pick one stock in 1976, Berkshire would be your pick. Figures 1 and 2 also illustrate how Berkshire lies in the very best tail of the performance distribution of mutual funds and stocks that have survived at least 30 years. 4. Berkshire’s Leverage Berkshire’s large returns come both from a high Sharpe ratio and an ability to leverage performance to achieve large returns at higher risk. Berkshire uses leverage to magnify returns, but how much leverage is used? Further, what are the sources of leverage, their terms, and costs? To answer these questions, we study Berkshire Hathaway’s balance sheet, which can be summarized as follows: Buffett’s Alpha 6 Stylized Balance Sheet of Berkshire Hathaway Assets Liabilities and shareholders’ equity Publicly traded equities Liabilities Privately held companies Equity Cash Total assets Total liabilities We can compute Bershire’s leverage (L) as follows: This measure of leverage is computed each month as Berkshire’s total assets ( ) less the cash that it owns ( ), relative to Berkshire’s equity value ( ). We would like to compute the leverage using market values (which we indicate with the superscript MV in our notation), but for some variables we only observe book values (indicated with superscript BV) so we proceed as follows. We observe the market value of Berkshire’s equity as the stock price multiplied by the shares outstanding and the cash holdings from Berkshire’s consolidated balance sheet (see Appendix A). Further, the balance sheet also tells us the book value of the total assets ( ) and the book value of equity ( ), which allows us to estimate the market value of the total asset ( ) as Based on this method, we estimate Berkshire’s average leverage to be 1.6-to-1. This indicates a non-trivial use of leverage. This magnitude of leverage can help explain why Berkshire realizes a high volatility despite investing in a number of relatively stable businesses. By focusing on total assets to equity, we capture all kinds of liabilities and, as we discuss further below, Berkshire’s financing arises from a variety of types of liabilities. The two main liabilities are debt and insurance float and, if we instead compute leverage Buffett’s Alpha 7 as then we estimate an average leverage of 1.4-to-1. As another expression of Buffett’s use of leverage, Berkshire’s stock price is significantly more volatile than the portfolio of publicly traded stocks that it owns as we describe in Section 5, Table 2. In fact, Berkshire’s 25% stock volatility is 1.4 times higher than the 17% volatility of the portfolio of public stocks, corresponding to a leverage of 1.4 assuming that Berkshire’s private assets have similar volatility and ignoring diversification effects. This leverage number is similar to the leverage computed based on the balance sheet variables. The magnitude of Buffett’s leverage can partly explain how he outperforms the market, but only partly. If one applies 1.6-to-1 leverage to the market, that would magnify the market’s average excess return to be about 10%, still falling far short of Berkshire’s 19% average excess return. In addition to considering the magnitude of Buffett’s leverage, it is also interesting to consider his sources of leverage including their terms and costs. Berkshire’s debt has benefitted from being highly rated, enjoying a AAA rating from 1989 to 2009. As an illustration of the low financing rates enjoyed by Buffett, Berkshire issued the first ever negative-coupon security in 2002, a senior note with a warrant. 3 Berkshire’s more anomalous cost of leverage, however, is due to its insurance float. Collecting insurance premiums up front and later paying a diversified set of claims is like taking a “loan.” Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate. Hence, Buffett’s low-cost insurance and reinsurance businesses have given him a significant advantage in terms of unique access to cheap, term leverage. We estimate that 36% of Berkshire’s liabilities consist of insurance float on average. Based on the balance sheet data, Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment as provided for under the IRS rules. E.g., Berkshire reports $28 Billion of such deferred tax liabilities in 2011 (page 49 of the Annual Report). Accelerating depreciation is similar to an interest-free loan in the sense that (i) Berkshire enjoys a tax saving earlier than it otherwise would have, and (ii) the dollar amount of the tax when it is paid in the future is the same as the earlier savings (i.e. the tax liability does not accrue interest or compound). Berkshire’s remaining liabilities include accounts payable and derivative contract liabilities. Indeed, Berkshire has sold a number of derivative contracts, including writing index option contracts on several major equity indices, notably put options, and credit default obligations (see, e.g., the 2011 Annual Report). Berkshire states: 3 See http://www.berkshirehathaway.com/news/may2202.html Buffett’s Alpha 8 We received the premiums on these contracts in full at the contract inception dates … With limited exceptions, our equity index put option and credit default contracts contain no collateral posting requirements with respect to changes in either the fair value or intrinsic value of the contracts and/or a downgrade of Berkshire’s credit ratings. – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 2011. Hence, Berkshire’s sale of derivatives may both serve as a source of financing and as a source of revenue as such derivatives tend to be expensive (Frazzini and Pedersen (2012)). Frazzini and Pedersen (2012) show that investors that are either unable or unwilling to use leverage will pay a premium for instruments that embed the leverage, such as option contracts and levered ETFs. Hence, Buffett can profit by supplying this embedded leverage as he has a unique access to stable and cheap financing. 5. Decomposing Berkshire: Public Stocks vs. Private Companies Berkshire Hathaway stock return can be decomposed into the performance of the publicly traded companies that it owns, the performance of the privately held companies that it owns, and the leverage it uses. The performance of the publicly traded companies is a measure of Buffett’s stock selection ability whereas the performance of the privately held companies additionally captures his success as a manager. To evaluate Buffett’s pure stock selection ability, we collect the portfolio of publicly held companies using Berkshire’s 13F filings to the Securities and Exchange Commission, and we construct a monthly times series of the market value of all Berkshire’s public stocks ( ) as well as the monthly return on this mimicking portfolio ( ). Specifically, at the end of each calendar quarter, we collect Berkshire’s common stock holdings from its 13F filing and compute portfolio monthly returns, weighted by Berk