Just over two years ago I wrote a post called Berkshire Hathaway Analysis. I don't think I could have come up with a more boring title if I tried.
That post has been sticking-in-my-side for some time now, and finally I had some headspace to go back and re-consider it. I started the initial post by asking just why so many smart people in finance don't know or admit to what impact leverage has had on Berkshire.
Well, as discussed in that post, some researchers attempted to answer that very question in a superb paper called Buffett's Alpha. Tim Ferriss would be proud of the attempt to decompose just how a world-class performer has achieved his remarkable success. Until now I actually can't think of any other article that I have read that quantitatively decomposes his returns - every article focusses on his stock picks, witty comments, insightful and extremely written letters and him as a person.
There has long been a general consensus that Buffett has an X factor about his ability to synthesise information, develop insight and translate that into outstanding stock picks. After reading the article a number of times, I concluded that he does have an X factor, however not specifically as a traditional stock picker (e.g. a fund manager) but as a strategist: he developed a simple yet very powerful system at an early stage and had the stomach to see it through.
The research paper covers the period 1976 - 2011 and notes the excess return (over the T-bill rate) of the S&P500 was 6.1% v Berkshire 19.0%. The S&P500 (like all stock market indexes) have the privilege of a 0% tax rate, yet Berkshire is a tax-paying entity and therefore the pre-tax return is likely higher, however the paper does not split out tax (this would be a very difficult exercise).
The paper decomposes Berkshire's performance into a few different quantitative components.
Firstly leverage. The S&P500 is un-leveraged whereas Berkshire uses leverage. The paper estimates leverage to have averaged around 1.6:1 or a gearing ratio of a bit less than 40% based simply on assets and liabilities on the balance sheet over time. That's pretty significant, and the researchers estimate the index return would jump from 6.1% to around 10% if it was leveraged on a similar ratio.
So that still leaves around 9% excess return to account for. The next component is a quantitative screen for stocks based on value and quality. i.e. they were looking to decompose the Buffett stock picking X factor into a repeatable formula based on value metrics (P/B,CF,E etc) and quality (ROE, margin etc). What they found is that controlling for these quantitative metrics almost entirely removed the 9% excess.
That's pretty interesting.
The real magic seems to be the combination of leverage with relatively safe instruments such as cheap, quality stocks. A high beta portfolio does not work particularly well with leverage. This magic itself has a few ingredients. One is time. It's outstanding that Buffett thought of this idea at a relatively young age and had the stomach to stick with it over good times and bad and just let compound interest work its wonder.
The next is conditioning his fellow shareholders to think along his lines and not revolt during periods when it appears not to be working (e.g. the dot com era) therefore creating true 'permanent capital' - the holy grail of funds management. Never does he need to worry about fast money coming nor scared money leaving. I'm absolutely willing to bet that plenty of other good fund managers could achieve similar returns if they used a bit of leverage and had truly permanent capital.
The other ingredient is cheap debt. It is widely known that he invests the float of his insurance businesses. Most insurance companies lose money on their float however Buffett and his managers have often managed to actually make money on the float meaning they have had a negative cost of capital.
In the follow-up to this post I will delve into Buffett's performance a little more deeply and discuss how us ordinary investors can implement these ideas and delve into Buffett's performance
Kristian
The research paper covers the period 1976 - 2011 and notes the excess return (over the T-bill rate) of the S&P500 was 6.1% v Berkshire 19.0%. The S&P500 (like all stock market indexes) have the privilege of a 0% tax rate, yet Berkshire is a tax-paying entity and therefore the pre-tax return is likely higher, however the paper does not split out tax (this would be a very difficult exercise).
The paper decomposes Berkshire's performance into a few different quantitative components.
Firstly leverage. The S&P500 is un-leveraged whereas Berkshire uses leverage. The paper estimates leverage to have averaged around 1.6:1 or a gearing ratio of a bit less than 40% based simply on assets and liabilities on the balance sheet over time. That's pretty significant, and the researchers estimate the index return would jump from 6.1% to around 10% if it was leveraged on a similar ratio.
So that still leaves around 9% excess return to account for. The next component is a quantitative screen for stocks based on value and quality. i.e. they were looking to decompose the Buffett stock picking X factor into a repeatable formula based on value metrics (P/B,CF,E etc) and quality (ROE, margin etc). What they found is that controlling for these quantitative metrics almost entirely removed the 9% excess.
That's pretty interesting.
The real magic seems to be the combination of leverage with relatively safe instruments such as cheap, quality stocks. A high beta portfolio does not work particularly well with leverage. This magic itself has a few ingredients. One is time. It's outstanding that Buffett thought of this idea at a relatively young age and had the stomach to stick with it over good times and bad and just let compound interest work its wonder.
The next is conditioning his fellow shareholders to think along his lines and not revolt during periods when it appears not to be working (e.g. the dot com era) therefore creating true 'permanent capital' - the holy grail of funds management. Never does he need to worry about fast money coming nor scared money leaving. I'm absolutely willing to bet that plenty of other good fund managers could achieve similar returns if they used a bit of leverage and had truly permanent capital.
The other ingredient is cheap debt. It is widely known that he invests the float of his insurance businesses. Most insurance companies lose money on their float however Buffett and his managers have often managed to actually make money on the float meaning they have had a negative cost of capital.
In the follow-up to this post I will delve into Buffett's performance a little more deeply and discuss how us ordinary investors can implement these ideas and delve into Buffett's performance
Kristian
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