In May of 2012, members of the team at AQR Capital Management (one of the top hedge fund managers in the U.S.) released a 45-page paper entitled “Buffett’s Alpha.” AQR Founder Cliff Asness is a frequent contributor to CFA Institute publications. This paper, targeted towards the institutional investor community, seeks to deconstruct Berkshire Hathaway’s remarkable investment returns. According to Morningstar / YCharts, since January 1993, the Berkshire Hathaway Class A stock (ticker symbol “BRK.A”) has a total return of 1,960%, compared to the S&P 500’s return over the same period of 371%.
Takeaways from the Paper
The AQR paper includes a “rigorous empirical analysis” – its authors are hedge fund managers, after all. Instead of directing you to read the 45-page paper, Phlox seeks to add value for you by summarizing the paper here, and communicating to you how it informs our investment strategy. The main takeaways from the paper are the following:
Value: By their reference to “value,” the authors are referring to stocks that generally trade at prices reflecting a lower price to earnings (“P/E”) ratio. “Value” stocks tend to trade at lower P/E multiples, while “Growth” stocks tend to trade at higher multiples.
Low-Risk: The authors are referring to a definition of risk in financial markets widely utilized by academics and investment practitioners. Risk by this commonly accepted definition is volatility, or the measurement of variability in price. The two primary measures of volatility in financial markets are a) standard deviation—a measurability of the variability in the investment’s price itself), or b) beta—a measure of the degree to which investment returns deviate from those of a common market index such as the S&P 500.
By investing in low-risk stocks, Buffett generally favors low standard deviation, low-beta stocks.
Quality: Buffett invests in earnings quality, meaning companies that are profitable, stable, growing, and with high payout ratios. A stock with a high payout ratio pays meaningful cash dividends to investors.
The general public may not realize that Buffett was perhaps the world’s first hedge fund manager, utilizing leverage, or borrowed money, to amplify his investment returns. It’s important to note that Buffett utilizes debt in a very judicious and strategic fashion.
A significant portion of the debt utilized by Berkshire Hathaway is insurance company “float” whereby the company has the right to invest money that is set aside for the payment of future insurance claims. According to AQR, float represented 36% of Berkshire’s borrowing on average, since 1976.
Here are a few specifics on Buffett’s borrowing according to the AQR paper:
- Including the insurance float, Buffett’s ratio of loan to asset value is approximately 28% (or 1.4 times leverage as AQR explains it). I prefer to convert the 1.4 to “loan to value” for simplicity.
- Berkshire’s cost of float averaged only 2.2% since 1976, more than 3.0% below the average T-bill rate. In fact, Berkshire’s cost of float has been negative in recent years.
- Low financing rates: Berkshire maintains a AAA credit rating by the rating agency Standard and Poor’s, resulting in a very low cost of borrowing.
- Berkshire issued the first ever negative-coupon security in 2002, a senior note with a warrant.
- Berkshire sells derivatives, which serve as both a source of financing and as a source of revenue.
Berkshire stock has been far more volatile than the overall stock market. AQR calculates the volatility at 24.9%, higher than the market volatility of 15.8%. Since Berkshire borrows money to invest, it is logical that its stock would be more volatile than the market.
It sounds obvious, but at times, investors ignore a patently obvious basic tenet: buy quality investments. Why do we do this? Because we are reaching for something out of reach. We believe that the investment returns provided by quality companies are too low in comparison to other riskier opportunities. In an effort to earn a higher return, investors devote capital to low-quality investments. While Buffett is not infallible (he admits to his fair share of mistakes), he has enjoyed phenomenal success by staying disciplined and insisting upon quality investments. We must seek to maintain the same discipline.
Lessons for Phlox and Phlox Clients
1. We can learn a lot from Buffett, but we should not seek to fully replicate his strategy.
As stated in the paper, Buffett’s strategies result in higher investment returns, but also higher volatility, due to the use of leverage. Most investors do not have a stomach lined with iron as Buffett does. Such a gut is necessary in order to tolerate Buffett’s strategy. Phlox does not utilize borrowing/leverage in client portfolios.
2. Buffett understands the inherent value in his investments, so he does not allow market fluctuations to control his emotions.
With a few exceptions, nobody builds wealth by watching the market every minute of every day. Instead, we need to understand the inherent value in our investments. When the market is volatile, it is this understanding that helps us to avoid “buying high and selling low.” As the great investor Peter Lynch said, “it’s not a lottery ticket” (meaning the ownership of stocks). Quality stocks bought at reasonable prices are solid investments, not lottery tickets.
3. While Phlox does not advocate utilizing debt to buy stocks, Phlox does advocate judicious use of debt to buy a home.
Homes are where we live. They are where we raise our families and build our futures together. At a recent speech in Dallas, Buffett himself said that buying a home with a 30-year fixed rate mortgage is the single smartest investment a person can make. Note his reference to a 30-year fixed rate mortgage: he stipulates this type of financing because he knows that the phenomenon of inflation makes it a wise financial structure. Furthermore, mortgage interest is deductible for most tax payers, further lowering the cost of the debt.
4. Buffett creates wealth because he maintains high levels of liquidity
If I could give only one piece of advice from my study of Buffett and my work with many successful entrepreneurs, it is this: the 3 most important concepts in finance are 1) Liquidity, 2) Liquidity, and 3) Liquidity.
The reason Buffett is cool under pressure is because he has money in the bank and high-quality, liquid assets in the market that can be converted to cash when needed. He also has access to lines of credit and other forms of liquidity. When the storms roll in, Buffett is not looking for a loan. He has cash at the ready, and in fact, he’s looking to buy investments when others are in a state of panic.
5. Buy quality investments that pay cash dividends
Phlox favors a healthy allocation of U.S. blue chip stocks in client portfolios. These stable companies often pay cash dividends that increase on an annual basis. The dividends serve to increase investor liquidity and dampen the downside volatility in the stock.
Joe Martinez, CFA is the founder of Dallas-based Phlox Capital Management, an investment management and financial planning firm. You can read his commentary at www.phloxcapital.com.