Andrea Frazzini, David Kabiller and Lasse H Pedersen unpick Warren Buffett’s business model and find a low-beta quality portfolio leveraged with an insurance float and derivatives
Much has been said and written about Warren Buffett and his investment style, but little rigorous empirical analysis has been done to try to explain his performance. Traditional factors have fallen short in accounting for his long-term success, leaving the extraordinary returns of his company, Berkshire Hathaway, as something of a mystery.
By almost any measure, Berkshire’s performance is impressive. Between November 1976, when our data sample starts, and the end of 2011, Berkshire realised an average annual return of 19.0% in excess of the T-Bill rate, significantly outperforming the average excess return of the general stock market (proxied by the Center for Research in Securities Prices US value-weighted market index) of 6.1%. However, achieving these kinds of return requires more than astute stock picking. Buffett also had to assume – and expertly manage – a meaningful amount of risk. And he did.
Between 1976 and 2011, Berkshire’s Sharpe ratio exceeded that of all other US stocks that have traded for at least three decades, at least as far back as 1926. It also beat the Sharpe ratios of every US mutual fund that has existed for more than 30 years. Yet, even though Berkshire’s Sharpe ratio of 0.76 is nearly double that of the overall US stock market, it may be lower than many investors imagine. That is, it reflects the company’s high average returns, but it also shows that its investment approach is not without significant risk and periods of substantial drawdowns.
If his Sharpe ratio is very good but not unachievably good, how did Buffett become one of the most successful investors in the world? To examine this question, we used Berkshire’s public filings to analyse the company’s investment strategies, presenting our findings in a recent paper titled ‘Buffett’s Alpha’.
A large part of Buffett’s success is, of course, his legendary skill at recognising stocks that are ‘cheap’ – that is, with low price-to-book ratios. But he also goes further, buying stocks that are not only cheap but ‘high-quality’ (profitable, stable, growing and with high payout ratios) and ‘safe’ (with low beta and low volatility). His recent deal to buy the HJ Heinz Co is a good example: it has a very low beta of around 0.4 and is profitable and stable because people buy ketchup during both recessions and booms.
Once he has selected these cheap, quality, low-beta stocks, Buffett magnifies their returns with the judicious use of leverage, which he finances with below-market-cost capital from a balance sheet that includes a sizable float from Berkshire’s insurance holdings. He has managed to ride out rough periods that might have forced other leveraged investors into a fire sale or a career shift. For example, during the run-up of the tech bubble — from July 1998 through February 2000 — Berkshire lost 44% of its market value even as the overall stock market gained 32%. Buffett’s impeccable reputation and unique structure as a corporation allowed him to weather this 76 percentage-point shortfall and eventually rebound after the bubble burst.
It is interesting to consider how much leverage Buffett uses, the sources of leverage, and their terms and costs. To fill in these gaps, we collected all of Berkshire’s balance sheets, annual reports and Form 13F fillings with the US Securities and Exchange Commission, and extracted enough data to analyse his strategy. We were able to gain insights into Berkshire’s privately held companies by comparing data on all of Berkshire (the sum of its private and public holdings) with just the public part. Together, this information allowed us to analyse Berkshire Hathaway’s balance sheet.
Based on numbers disclosed by the company in those public filings, we estimate that
Buffett applies a leverage of about 1.6-1, on average. This is a non-trivial use of leverage, and can help explain why Berkshire realises a high volatility despite investing in a diversified set of relatively stable businesses. It can also explain why Berkshire’s actual risk and returns exceed those of an unleveraged portfolio that replicates the company’s holdings.
In addition to considering the magnitude of Buffett’s leverage, it is interesting to consider its sources, terms and costs. Berkshire enjoyed a AAA-rating from 1989 to 2009, allowing it to borrow at relatively low rates. For example, the company issued the first-ever negative-coupon security in 2002, a senior note with a warrant.
Berkshire’s more unusual source of leverage, however, is its insurance float. Collecting insurance premiums up front and paying claims later is like taking a loan. Figure 2 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than three percentage points below the average T-bill rate. Thus, 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. Berkshire reported $28bn of such deferred tax liabilities in 2011. Accelerating depreciation is similar to an interest-free loan in the sense that Berkshire enjoys a tax saving earlier than it otherwise would have and the dollar amount of the tax when it is paid in the future does not accrue interest.
Berkshire’s remaining liabilities include accounts payable and derivative contract liabilities. It has sold a number of such contracts, including index options on several major equity indices and credit default obligations (CDOs). This may serve as a source of both financing and revenue as such derivatives tend to be expensive. Investors who are unable or unwilling to use leverage directly will pay a premium for instruments that embed leverage, such as option contracts.
As one test of our findings, we built a systematic, Buffett-style hypothetical portfolio using traditional factors such as ‘value’ and the new ones – ‘safe’ and ‘high quality’ – to pick stocks and applied leverage using low-cost capital. Our hypothetical portfolio uses only stock information that was available to any investor, so it does not benefit from knowing how individual stocks will perform. We found that the Buffett-style portfolio performed comparably to Berkshire Hathaway.
Finally, our analysis considers whether Buffett’s success as an investor is due to his skill as an investor or his skill as a manager of the companies he buys. To address this, we separate Berkshire’s returns on investments in publicly traded stocks from those in private companies run within Berkshire. The idea is that the return of the public stocks is mainly driven by Buffett’s skill as an investor, whereas the private companies would have a larger element of management.
We find that both contribute to Berkshire’s performance, but the portfolio of public stocks performed better, suggesting that Buffett’s skill has been mostly in investing. If this is so, then why does he rely heavily on private companies, including insurance and reinsurance businesses? One reason is the access to the insurance float; another is that private companies give him access to asset-based borrowing at attractive fees and duration.
This deeper understanding of how Buffett invests and the ability to build Buffett-like portfolios may benefit investors, but in no way do our findings discount his skill. After all, he decided to invest based on these principles half a century ago. He and his companies have shown tremendous skill in underwriting risk, structuring additional leverage and investing in cheap, stable and high-quality companies. Finally, his financing terms, portfolio construction and investment conviction has enabled him to stick to his principles and continue operating at high risk even after experiencing ups and downs that caused many other investors to rethink and retreat from their original strategies.
Andrea Frazzini is a vice-president, David Kabiller is a founding principal and Lasse H Pedersen is a managing director at AQR Capital Management