Buffett’s Alpha

[Guest hellsten]

http://www.econ.yale.edu/~af227/pdf/Buffett%27s%20Alpha%20-%20Frazzini,%20Kabiller%20and%20Pedersen.pdf

 

In essence, we find that the secret to Buffett’s success is his preference for cheap,

safe, high-quality stocks combined with his consistent use of leverage to magnify returns

while surviving the inevitable large absolute and relative drawdowns this entails. Indeed,

we find that stocks with the characteristics favored by Buffett have done well in general,

that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a

low financing rate, and that leveraging safe stocks can largely explain Buffett’s

performance.

 

I don't agree with the following at all:

 

Berkshire stock also entailed more risk, realizing a volatility of 24.9%, higher than

the market volatility of 15.8%.

 

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%.

[mhdousa]

Anything that defines risk as volatility isn't worth wasting any time on.

[eclecticvalue]

Is the leverage the paper talks about is the float he uses from insurance companies?

[LC]

Is the leverage the paper talks about is the float he uses from insurance companies?

Yes

[Guest hellsten]

Is the leverage the paper talks about is the float he uses from insurance companies?

 

AFAIK, it is the float and the AAA-rated debt.

[writser]

Anything that defines risk as volatility isn't worth wasting any time on.

 

Agreed. This paper is a bit too academic for my tastes.

[Guest rimm_never_sleeps]

let me guess this was written by a PHD? brk has always been underleveraged. he usually has $20b undeployed at a given time these days.

[ExpectedValue]

let me guess this was written by a PHD? brk has always been underleveraged. he usually has $20b undeployed at a given time these days.

 

I think your point is irrelevant. There's actually more than one study (I read one by the guy who helped Einhorn start up his reinsurer), which points to the fact that a significant amount of Buffett's good investment results came from the "structural alpha" generated from the insurance operations. E.g.: low/0 cost leverage without the ability to be pulled during market declines.

 

He still outperforms, even without it, but you can definitely see that a big chunk of the results came from being able to lever up returns.

 

[Guest rimm_never_sleeps]

how do the PHDs explain the performance of the Buffett partnership and his personal account? in many ways buffett has to invest more conservatively in berkshire. he has said the worst thing he could do to his friends and family who hold the shares is to lose money.

[eclecticvalue]

At least the academics know the leverage comes from the insurance float. I just looked into the paper and it is confirmed. I should have done it in the first place.

 

Now your seeing people like Einhorn and Steven Cohen are trying to copycat Buffett. Too bad Sardar hasn't been able to get one yet.

 

 

[ExpectedValue]

how do the PHDs explain the performance of the Buffett partnership and his personal account? in many ways buffett has to invest more conservatively in berkshire. he has said the worst thing he could do to his friends and family who hold the shares is to lose money.

 

What does it matter?

 

The academics wrote the paper discussing the investment results for Berkshire Hathaway. The results and drivers of those results are pretty simple to decompose. You had his great investing skills, amplified by his access to leverage, which allowed him to really grow book.

[twacowfca]

I got a chuckle out of some of the superficial aspects of the paper.  For example, the authors point out that the volatility of Warren's returns is higher than the market's volatility.

 

However, most of BRK's vol is up vol!  :).  And a large part of his down volatility occurred when he sat out the Internet Bubble!  BRK's low point in 2000 occurred almost exactly to the day when the Nasdaq peaked.

 

Ziemba has modified the Sharpe ratio to eliminate its bias toward a normal distribution for volatility.  With that modification, the extra vol in BRK's returns disappears!  In fact,  Warren has had one of the lowest volatilities of fund managers who have shown consistent alpha if vol is measured by Ziemba's modification of the Sharpe ratio to eliminate the distortion of up volatility.  :)

[Rabbitisrich]

There are a few issues that cloud the analysis, though I don't know to what extent. For example, the Buffett portfolio is assembled from the 13f-hr, then treated as constant weights between reports. So if a company outperforms the rest of the portfolio, the excess weighting may be treated as "sold", and then "repurchased" when it shows up at a different weight in the next 13f.

 

The authors also try to look past tax effects by comparing a pre-tax stylized portfolio to the "Buffett" portfolio mentioned above. Yet, taxes and fees are a large part of portfolio management. It's a comparison of a tax-efficient portfolio strategy to a tax-free strategy, before taxes.

 

These issues aren't really criticisms of the study, but they complicate the authors' conclusions. What is the turnover on the stylized portfolios? Does size affect tahe monthly rebalancing as the portfolio grows?

 

 

[jb85]

let me guess this was written by a PHD? brk has always been underleveraged. he usually has $20b undeployed at a given time these days.

 

I think your point is irrelevant. There's actually more than one study (I read one by the guy who helped Einhorn start up his reinsurer), which points to the fact that a significant amount of Buffett's good investment results came from the "structural alpha" generated from the insurance operations. E.g.: low/0 cost leverage without the ability to be pulled during market declines.

 

He still outperforms, even without it, but you can definitely see that a big chunk of the results came from being able to lever up returns.

 

I seem to recall Buffet himself saying that about 7% of the 20% annual returns came from float.  I've looked for the quote but can't seem to find it.  It would be interesting if someone went back through his stock purchases and calculated the returns without leverage.  if my recollection about the 7% is correct, then he averaged about 13% since taking over Berkshire.

[twacowfca]

let me guess this was written by a PHD? brk has always been underleveraged. he usually has $20b undeployed at a given time these days.

 

I think your point is irrelevant. There's actually more than one study (I read one by the guy who helped Einhorn start up his reinsurer), which points to the fact that a significant amount of Buffett's good investment results came from the "structural alpha" generated from the insurance operations. E.g.: low/0 cost leverage without the ability to be pulled during market declines.

 

He still outperforms, even without it, but you can definitely see that a big chunk of the results came from being able to lever up returns.

 

I seem to recall Buffet himself saying that about 7% of the 20% annual returns came from float.  I've looked for the quote but can't seem to find it.  It would be interesting if someone went back through his stock purchases and calculated the returns without leverage.  if my recollection about the 7% is correct, then he averaged about 13% since taking over Berkshire.

 

It's not just the float, but the opportunistic way he used it.  He shifted almost all of his float into stocks in 1973 1974 when the companies he bought were priced by Mr. Market at less than one third what a private buyer would have paid for them.  Two or three years later, the gains from that float, in a sense, allowed him to help recapitalize Geico, an investment that compounded more than 30%/annum.

[Guest rimm_never_sleeps]

exactly. every insurance company has float. most of them can't even earn their cost of capital. he created massive shareholder value from it. excuse me. I mean Alpha.

[giofranchi]

let me guess this was written by a PHD? brk has always been underleveraged. he usually has $20b undeployed at a given time these days.

 

I think your point is irrelevant. There's actually more than one study (I read one by the guy who helped Einhorn start up his reinsurer), which points to the fact that a significant amount of Buffett's good investment results came from the "structural alpha" generated from the insurance operations. E.g.: low/0 cost leverage without the ability to be pulled during market declines.

 

He still outperforms, even without it, but you can definitely see that a big chunk of the results came from being able to lever up returns.

 

TariqAli,

of course you are right! But rimm_never_sleeps has a point too! If you let your investments grow many times your capital, and you put to risk all your funds, without holding much cash, even Mr. Buffett could get killed. I think he knows and never let that happen. I agree with rimm_never_sleeps, when he writes that BRK has always been underleveraged... if compared to other insurance/reinsurance companies.

I have already posted the chart in attachment, but you mentioned GreenlightRe, so I will do it again: please, notice how underleveraged GLRE looks to be, if compared to other similar companies.

 

giofranchi

Insurer-Reinsurer_Leverage.pdf