Summary
Warren Buffett is a legendary investor. Everyone knows that. But how has Buffett produced such extraordinary returns? And what usable lessons can be gathered from the performance of Berkshire Hathaway, Buffett’s famous holding company? Most students of stock market history consider Buffett a genius with a unique, magic touch. A deeper dive, however, reveals that Buffett’s success can be mostly explained by his steadfast commitment to the core investing principles he espouses. According to a white paper written by leading practitioners in the space, Buffett’s secret sauce can be primarily explained by:
- Consistent, significant exposure to value, quality, and low risk factors
- Prudent use of low-cost leverage
Decomposing Buffett’s Returns
The NBER white paper titled “Buffett’s Alpha” by Frazzini, Kabiller, and Pedersen (November 2013) provides a detailed empirical analysis of Warren Buffett’s remarkable investment performance. While there is much public speculation regarding the reasons behind Buffett’s success, this study rigorously breaks down the drivers of Berkshire Hathaway’s superior returns over a span of decades.
The study reveals that Buffett’s Berkshire Hathaway achieved a Sharpe ratio of 0.76 from 1976 through 2011, which is higher than any other stock or mutual fund that has a 30+ year track record, and nearly double that of the overall market. Buffett’s alpha relative to the U.S. stock market, however, becomes statistically insignificant once Berkshire’s portfolio is adjusted for factors including value, quality, and low risk. This analysis suggests that Buffett’s success is not due to luck or an unquantifiable genius or skill, but rather to a disciplined and unwavering commitment to these core investment principles, consistently applied over decades.
As you can see in Exhibit 1, Berkshire Hathaway’s excess returns can be primarily explained by consistent exposure to four powerful investment principles (i.e., factors). First, from 1976 through 2011, Buffett maintained a 0.95 regression exposure to the U.S. stock market. This is not surprising since Buffett is a long-only investor in U.S. stocks. In addition, however, Buffett averaged a 0.46 exposure to value, a 0.43 exposure to quality, and a 0.29 exposure to low risk, all measured against well-known definitions of these factors. Overall, 67% of Buffett’s excess returns above T-Bills are explained by these factor exposures that could potentially be replicated by any sophisticated and disciplined investment manager. Buffett is the most successful long-only investor of his generation, and his success is primarily attributable to his unwavering commitment to apply fundamental financial metrics and invest only in low-cost, high-quality, safe stocks.
Exhibit 1 – Buffett’s Exposure to Stock Market Factors, 1976-2011
Berkshire Hathaway Factor Exposures
Market
Value
Quality
Low Risk
0.95
0.46
0.43
0.29
Market 0.95
Value 0.46
Quality 0.43
Low Risk 0.29
Percent of excess return explained by above
67%
Percent of excess return explained by above: 67%
Understanding Buffett’s Use of Leverage
In addition to Buffett’s factor exposures described above, a second distinguishing feature of Buffett’s success is his access to low-cost leverage. A key source of this leverage is Berkshire’s insurance float through its insurance subsidiaries such as Geico, which is essentially interest-free borrowing. The authors estimate that 36% of Berkshire’s liabilities consist of insurance float, which has an average cost below the Treasury bill rate.
By using this low-cost insurance float to purchase additional equity investments, the authors estimate that Berkshire Hathaway operated with a leverage ratio of 1.6-to-1 from 1976 through 2011. This leverage magnifies Buffett’s returns but also adds proportional risk. By focusing on low-cost, high-quality, safe stocks, however, Buffett offsets much of the additional risk added by leverage. The strategy of buying value, quality, and low risk stocks, combined with low-cost leverage, explains most of Berkshire Hathaway’s outstanding performance.
Broader Implications for Long-Term, Factor-Based Investing
Buffett’s ability to outperform the market over decades implies that disciplined, risk-managed investment strategies that prioritize value, quality, and low risk, with prudent levels of leverage, could outperform the overall stock market for an indefinite period of time. Efficient market theory suggests that no one should be able to consistently beat the market over extended periods, but Buffett’s performance and those of other investors from Graham-and-Doddsville suggest otherwise. The authors ultimately conclude that Buffett’s success is not random but a reward for steadfast adherence to proven investment principles including value, quality, and low risk, combined with moderate use of low-cost leverage.
Conclusion
Warren Buffett’s extraordinary investment performance is not attributable to luck or stock-selection genius. Most of Buffett’s performance can be explained using a simple factor model that incorporates his self-described investment considerations of value, quality, and low risk while adding low-cost leverage in a controlled manner. His secret sauce lies in applying these principles consistently and in a disciplined manner over many decades. Even though Buffett’s results appear easy to replicate, few active investment managers share his emotional discipline and perpetual long-term focus. The most important insight from this paper may be that Berkshire Hathaway has effectively been a leveraged factor strategy for the past 50 years. There may be no need to find the “next Buffett” when Berkshire Hathaway’s investment strategy can be closely mimicked with a modestly leveraged factor model focused on value, quality, and low risk.
Link to white paper
To read this white paper in its entirety, follow the link below.