Buffet's Alpha, from the CFAI's Financial Analyst Journal

[EricSchleien]

https://www.cfapubs.org/doi/full/10.2469/faj.v74.n4.3

[Cigarbutt]

This is a follow-up and update from previous work that had sparked interesting debates a while back including here:

http://www.cornerofberkshireandfairfax.ca/forum/berkshire-hathaway/buffets-alpha/msg83746/#msg83746

 

IMO, there are significant flaws (both conceptual (volatility, risk measures etc) and common sense) but some parts are helpful ie a) concerning the cost of float earlier on when interest rates were higher and when stocks, in general perhaps, were a better deal and b) how the long-term performance is truly outstanding.

 

In the last 20 years at least, Mr. Buffett has not used (apart from limited opportunity time periods and only to a limited degree) float as leverage. Some of the larger and growing cash balance has been related to a growing relative dislike of bonds with cash and fixed income remaining in overall balance with the float liabilities. Interesting to note though that BRK's returns have also gravitated to the market in the last 20 years and, in this respect and forgetting size, the authors may have a point concerning leverage.

 

I get that the underlying motivation of the authors is to come up with some kind of model or a statistical factors equation that would reproduce past results and that would prospectively continue to outperform.

 

For those interested in a career in basketball, people who studied Micheal Jordan have come up with 21 steps on how to become like him:

https://www.incomediary.com/how-to-be-like-mike-20-life-lessons-from-michael-jordan

The mathematical model is coming soon.

[compounding]

Attempting to reduce someone like Buffett or Jordan into a few clean causal relationships (that anyone can replicate) or a how-to-guide is so naive I almost find it offensive. This can only be the result of the thinking of someone who has no practical connection to reality, or perhaps someone who just does it because they like the subjects so much that they would rather spend their free time thinking about it instead of playing bridge or something of the sort.

[DooDiligence]

This is a follow-up and update from previous work that had sparked interesting debates a while back including here:

http://www.cornerofberkshireandfairfax.ca/forum/berkshire-hathaway/buffets-alpha/msg83746/#msg83746

 

IMO, there are significant flaws (both conceptual (volatility, risk measures etc) and common sense) but some parts are helpful ie a) concerning the cost of float earlier on when interest rates were higher and when stocks, in general perhaps, were a better deal and b) how the long-term performance is truly outstanding.

 

In the last 20 years at least, Mr. Buffett has not used (apart from limited opportunity time periods and only to a limited degree) float as leverage. Some of the larger and growing cash balance has been related to a growing relative dislike of bonds with cash and fixed income remaining in overall balance with the float liabilities. Interesting to note though that BRK's returns have also gravitated to the market in the last 20 years and, in this respect and forgetting size, the authors may have a point concerning leverage.

 

I get that the underlying motivation of the authors is to come up with some kind of model or a statistical factors equation that would reproduce past results and that would prospectively continue to outperform.

 

For those interested in a career in basketball, people who studied Micheal Jordan have come up with 21 steps on how to become like him:

https://www.incomediary.com/how-to-be-like-mike-20-life-lessons-from-michael-jordan

The mathematical model is coming soon.

 

I'm studying Beethoven's 32 variations because they're making me do it.

 

I will never reproduce his performance  ;D

[nickenumbers]

For those interested in a career in basketball, people who studied Micheal Jordan have come up with 21 steps on how to become like him:

https://www.incomediary.com/how-to-be-like-mike-20-life-lessons-from-michael-jordan

The mathematical model is coming soon.

 

Cigarbutt, the Michael Jordan link is got me laughing so hard, I am going to S..t myself.  Forget this investing stuff.  Now that basketball has been made simple in 20 EASY steps, I am going to start working on those.

 

It will be a Cinch.  Look for a 5 foot 6, finance guy playing for the NBA Washington Wizards in about 12 months.

 

PS- Step 4 is practice, but there is no step to tell me how to Slam Dunk or Alley-oop.  Maybe I will Google the 4 easy steps to Alley-oop in just 30 days..    ;)

[DooDiligence]

For those interested in a career in basketball, people who studied Micheal Jordan have come up with 21 steps on how to become like him:

https://www.incomediary.com/how-to-be-like-mike-20-life-lessons-from-michael-jordan

The mathematical model is coming soon.

 

Cigarbutt, the Michael Jordan link is got me laughing so hard, I am going to S..t myself.  Forget this investing stuff.  Now that basketball has been made simple in 20 EASY steps, I am going to start working on those.

 

It will be a Cinch.  Look for a 5 foot 6, finance guy playing for the NBA Washington Wizards in about 12 months.

 

PS- Step 4 is practice, but there is no step to tell me how to Slam Dunk or Alley-oop.  Maybe I will Google the 4 easy steps to Alley-oop in just 30 days..    ;)

 

Earl Boykins was 5' 5" & signed to the NBA’s Washington Wizards in 2009. He subsequently went on to play with the Milwaukee Bucks and the Houston Rockets.

 

https://en.wikipedia.org/wiki/Earl_Boykins

[Graham Osborn]

Our innovation for this study was to also control for the factors betting against beta, BAB, described in Frazzini and Pedersen (2014) and quality, QMJ, of Asness, Frazzini, and Pedersen (forthcoming 2018). 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 QMJ factor reflects a tendency to buy high-quality companies—that is, companies that are profitable, growing, and safe and have high payout.8

 

Table 4 reveals that Berkshire Hathaway loads significantly on the BAB and QMJ factors, indicating 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 0.3%. That is, these factors almost completely explain the performance of Buffett’s public portfolio. Hence, a significant part of the secret behind Buffett’s success is the strategy of buying safe, high-quality, value stocks. These factors also explain a large part of Berkshire’s overall stock return and of the private part in that their alphas become statistically insignificant when BAB and QJM are controlled for. The point estimate of Berkshire’s alpha, however, drops only by about half.

 

Herein lies the problem.  It might be true that, in retrospect, you can define the price action (eg "beta") and fundamental action (eg "quality") with meaningful precision.  But portfolios aren't built in retrospect.  The "alpha" comes from the ability to predict which companies will manifest such qualities in the future.

 

It's easy to construct models that explain the past.  It's much harder to construct models that predict the future. 

 

It is interesting to note that Berkshire roughly equaled the S&P500 return over the past 10 years.  You could say that Berkshire underperformed after backing out leverage - but that would overlook that many of the S&P500 businesses have huge amounts of leverage which is far more callable and expensive than Berkshire's is.  On the other hand, Berkshire has meaningfully underperformed the Nasdaq over the same period, and that has more to do with the superior quality of the Nasdaq businesses vs Berkshire's.  I don't think anyone would debate that Google is a better business than BNSF.  Sounds to me like Buffett should fire Ted and Todd and put Berkshire's portfolio in an index fund (obviously not at present levels though).

[Cigarbutt]

...

It's easy to construct models that explain the past.  It's much harder to construct models that predict the future. 

 

It is interesting to note that Berkshire roughly equaled the S&P500 return over the past 10 years.  You could say that Berkshire underperformed after backing out leverage - but that would overlook that many of the S&P500 businesses have huge amounts of leverage which is far more callable and expensive than Berkshire's is.  On the other hand, Berkshire has meaningfully underperformed the Nasdaq over the same period, and that has more to do with the superior quality of the Nasdaq businesses vs Berkshire's.  I don't think anyone would debate that Google is a better business than BNSF.  Sounds to me like Buffett should fire Ted and Todd and put Berkshire's portfolio in an index fund (obviously not at present levels though).

Interesting indeed.

 

If you look at corporate debt to GDP as a proxy for overall leverage and graphically superimpose with float reserves on cash and fixed income held at BRK as a proxy for the use of float leverage, it results in a very interesting perspective. In the last 20 years, the corporate leverage has been cyclical just like BRK's leverage of float but the peaks at BRK are lagging chronologically behind overall corporate leverage peaks. The message here seems to be that Mr. Buffett has deployed float (only to a limited degree compared to the early years) when other corporate players were deleveraging.

 

Statisticians and quantitative-oriented investors may want to work on this data which could result in a very high correlation ratio etc with a lag adjustment by 2 or 3 quarters for instance and this may suggest what Mr. Buffett may do under certain circumstances. But it seems that what motivates Mr. Buffett is not primarily what others are doing, it is what he thinks is the approriate thing to do, a stance that will always be difficult to capture with a mathematical model.

 

From the 2018 annual report:

"Nevertheless, I like our own prospects. Berkshire’s unrivaled financial strength allows us far more flexibility in investing our float than that generally available to P/C companies. The many alternatives available to us are always an advantage and occasionally offer major opportunities. When other insurers are constrained, our choices expand."

 

I would conclude that the use of float as leverage at BRK will continue to be proportional to the extent of opportunities available.