From 1927-2013, while beta produced an annual average premium of 8.1 percent, the small and value factors produced premiums of 3.1 and 4.9 percent, respectively. That large value premium went a long way to explaining the superior performance of the superstar investors from the value school of Graham and Dodd. So the anomaly of these superstar investors became less of one. But we aren’t done yet.
In 1997, Mark Carhart was the first to use momentum, together with the Fama-French factors, to explain mutual fund returns. This new momentum factor made a significant contribution to the explanatory power of the model.
And since then, the four-factor model has been the standard tool used to analyze and explain the performance of investment managers and investment strategies.
The Quality Factor
The latest contribution, one that helped further explain Buffett’s superior performance, was made by Robert Novy-Marx. His June 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors with new insights into the cross section of stocks returns.
Novy-Marx found that profitable firms generate significantly higher returns than unprofitable firms, despite having significantly higher valuation ratios (higher price-to-book ratios). Controlling for profitability dramatically increases the performance of value strategies, with the most profitable firms earning 0.31 percent per month higher average returns than the least profitable firms.
This idea has been extended to a quality factor that captures a broader set of stock quality characteristics. In particular, high-quality stocks that are profitable, stable, growing and have high payouts outperform low-quality stocks with the opposite characteristics. With this new insight, we have all the information we need to address the issue of the sources of Buffett’s outperformance.
As mentioned earlier, the “conventional wisdom” has always been that Buffett’s success is explained by his stock picking skills and his discipline—keeping his head while others are losing theirs.
However, the 2013 study “Buffett’s Alpha” by Andrea Frazzini and David Kabiller of AQR Capital Management, and Lasse Pedersen of New York University’s Copenhagen Business School, provides us with some very interesting and unconventional answers.
They found that in addition to benefiting from the use of cheap leverage provided by Berkshire’s insurance operations, Buffett bought stocks that are “safe”(have low beta and low volatility), “cheap” (value stocks with low price-to-book ratios), high-quality (meaning stocks that are profitable, stable, growing and with high payout ratios) and are large-caps.
The most interesting finding of the study was that the authors found that stocks with these characteristics—low risk, cheap and high quality—tend to perform well in general, not just the ones that Buffett buys.
Companies that are high quality have the following characteristics: low earnings volatility, high margins, high asset turnover (indicating efficiency), low financial leverage and low operating leverage (indicating a strong balance sheet and low macroeconomic risk), and low specific stock risk (volatility unexplained by macroeconomic activity). Companies with these characteristics have historically provided higher returns, especially in down markets.
In other words, it’s Buffett’s strategy that generated the “alpha,” not his stock selection skills. Once all the factors (beta, size, value, momentum, betting against beta (BAB), quality and leverage) are accounted for, a large part of Buffett’s performance is explained and his alpha is statistically insignificant.
It’s extremely important to understand that this finding doesn’t detract in any way from Buffett’s performance.