A close look at Buffett is to understand factor-focused investing, Swedroe says.
If investors were asked, “Who do you think is the greatest investor of our generation?” an overwhelming majority would answer “Warren Buffett.” For decades, Buffett outperformed the market, as did others he called the “superstar investors of Graham and Doddsville.”
Their success could generally be attributed to the following:
- Using a broad theme of investing in “value stocks” and then identifying the best individual stocks to buy.
- While others panicked and sold during bear markets, they stayed disciplined, adhering to their strategy, avoiding “fire sales.”
Buffett’s performance, as well as the performance of the other superstars, presented a great challenge to the efficient markets hypothesis—if these superstar investors could persistently outperform, how could the market be efficient? To address this issue, we’ll take a brief walk through the history of modern financial thinking.
William Sharpe and John Lintner are typically given most of the credit for introducing the first formal asset pricing model, the capital asset pricing model (CAPM). The CAPM provided the first precise definition of risk and how it drives expected returns. It looks at returns through a “one-factor” lens, meaning the risk and return of a portfolio is determined only by its exposure to “beta.”
Beta is the measure of the equity-type risk of a stock, mutual fund or portfolio relative to the risk of the overall market. The CAPM was the finance world’s operating model for about 30 years. However, like all models, by definition they are flawed, or wrong. If they were perfectly correct they would be laws, like we have in physics. Over time, anomalies that violated the CAPM began to surface. Among the more prominent ones were:
- 1981: Rolf Banz’s “The Relationship Between Return and Market Value of Common Stocks” found that beta does not fully explain the higher average return of small stocks.
- 1983: Sanjoy Basu’s “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks,” found that the positive relationship between the earnings yield (earnings/price) and average return is left unexplained by beta.
- 1985: Barr Rosenberg, Kenneth Reid and Ronald Lanstein found a positive relationship between average stock return and the book-to-market ratio in their paper “Persuasive Evidence of Market Inefficiency.”
The 1992 paper “The Cross-Section of Expected Stock Returns” by Eugene Fama and Kenneth French basically summarized the anomalies in one place. The essential conclusions from the paper were that the CAPM only explained about two-thirds of the differences in returns of diversified portfolios, and that a better model could be built using more than just the one factor, beta.
The Fama-French Three-Factor Model
One year later, Fama and French published “Common Risk Factors in the Returns on Stocks and Bonds.” This paper proposed a new asset pricing model, called the Fama-French Three-Factor model. This model proposes that along with the market factor of beta, exposure to the factors of size and value explain the cross section of expected stock returns.
The authors demonstrated that we lived not in a one-factor world, but in a three-factor world. They showed that the risk and expected return of a portfolio is explained by not only its exposure to beta, but also by its exposure to two other factors: size (small stocks); and price (stocks with low relative prices, or value stocks). Numerous studies have confirmed that the three-factor model explains an overwhelming majority of the differences in returns of diversified portfolios.
In fact, the Fama-French model improved the explanatory power from about two-thirds of the differences in returns between diversified portfolios to more than 90 percent.
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.
After all, it took decades for modern financial theory to catch up with Buffett and discover his “secret sauce.” As my friend and fellow author Bill Bernstein points out, being the first, or among the first, to discover a strategy that beats the market is what buys you the yachts, not copying the strategy after it’s already well known and all the low-hanging fruit has been picked.
However, the findings do provide us with insight into why Buffett was so successful—it was strategy, not stock picking. Buffett’s genius thus appears to be in recognizing long ago that “these factors work, applying leverage without ever having to fire sale, and sticking to his principles.”
The authors noted it was Buffett himself who stated in Berkshire’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
The authors also considered “whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO.” To address this, they decomposed Berkshire’s returns into a part due to investments in publicly traded stocks and another part due to private companies run within Berkshire.
The idea is that the return of the public stocks is mainly driven by Buffett’s stock selection skill, whereas the private companies could also have a larger element of management skill. They found that the public companies performed better. So it’s not his skill as a manager that is responsible for his alpha.
However, they did find that the companies Berkshire owns provide a steady source of financing at a very low cost, allowing him to leverage his stock selection ability—36 percent of Buffett’s liabilities consist of insurance float with an average cost below the Treasury-bill rate.
Another advantage, though a less important one, is that: “Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment.” Accelerated depreciation acts just like an interest-free loan.
Once the authors accounted for all the style factors (market; size; value; momentum; betting against beta BAB; and quality) and the leverage, the alpha of Berkshire’s public stock portfolio drops to a statistically insignificant annualized 0.1 percent.
In other words, these factors almost completely explain the performance of Buffett’s public portfolio. The bottom line is that we now know that Buffett’s secret sauce is that he buys safe, high-quality, value stocks and applies low-cost leverage.
Finally, I would add that while you don’t have access to the type of low-cost leverage to which Buffett has access, you can access the other factors that created his “alpha.”
For example, Dimensional Fund Advisors, Bridgeway and AQR Capital are three of the leading providers of mutual funds that use strategies that involve a systematic and highly disciplined approach to capturing or harvesting a particular return or style premium. (Full disclosure: My firm Buckingham recommends Dimensional and Bridgeway funds in constructing client portfolios.)
While not index funds, the funds these three firms offer do fall under the broader category of what I would consider to be relatively low cost, passively managed funds.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.