More than 40,000 people undertook the pilgrimage to Nebraska to attend Berkshire’s Hathaway’s AGM on May 2nd. They had good reason to listen to the insights of Chairman, Warren Buffett, considered by many to be the greatest investor of modern times. Berkshire Hathaway, the company he founded almost fifty years ago, has delivered to shareholders compound annual growth in returns of over 20 per cent over this time, handsomely beating the S&P500.
Some have taken Mr Buffett’s stellar track record as compelling evidence that active management can deliver consistently high returns over the long run. Others attribute his success to luck; by chance, a small handful of funds will inevitably beat the benchmark over an extended period.
Researchers at AQR Capital, a US based hedge fund, have recently sought to understand the reasons for Berkshire Hathaway’s strong performance. In their working paper, Buffett’s Alpha, Andrea Frazinni and his co-authors attribute the strong returns not to luck, but to reward for leveraged exposure to safe, quality stocks that are cheap.
Modern portfolio theory says that a stocks’ beta dictates its expected future returns. This means that a high beta stock should yield high expected returns because it is very sensitive to fluctuations in the economic cycle. For instance, mining firms, building material stocks and discretionary retailers are considered to have high betas since their profitability is largely tied to the fortunes of the economy. According to theory, these sectors should yield higher returns than low beta or defensive sectors such as healthcare, consumer staples and telecommunications.
Investors with a strong risk appetite can juice up their portfolio returns by choosing to invest in predominantly high beta stocks. Alternatively, leverage can also play an important role by allowing investors to amplify their returns. Investors wanting to take on more risk can borrow and use the proceeds to gear up their exposure to the market. Many retail investors engaged in this type of behaviour through margin lending for instance, during the credit boom in the lead up to 2008.
Contrary to theory, the overwhelming evidence compiled over the past three decades - led by Nobel prize winning economist Eugene Fama - has shown that high beta stocks have yielded worse returns than low beta stocks. Moreover, the assumption surrounding leverage comes unstuck in the real world. Despite the rapid growth of hedge funds in recent decades, the lion's share of financial assets is still managed by institutional investors who are subject to leverage constraints; their mandates typically prevent them from borrowing or short-selling.
Betting against beta
In an environment where most institutional funds are subject to borrowing constraints, the obvious way to beat one’s peers is to gravitate towards high beta or risky stocks, especially those with supposedly strong growth prospects that easily capture investors’ imagination. But crucially, these stocks become over-bought and expensive, and many fail to deliver on analysts' wildly optimistic growth expectations, which underpin their poor future returns. Some high profile examples that fit this picture in Australia recently include: Woolworths, REA Group and Navitas.
Accounting for the tendency for high quality, defensive and cheap stocks to out-perform accounts for much of Mr Buffett’s performance over time. Mr Buffett clearly identified many years ago that the ability and willingness to borrow heavily and bet against beta would yield remarkably strong returns. The authors conclude that that the Sage of Omaha’s performance is not attributable to luck or chance, but rather the successful implementation of exposure to value and quality factors that have yielded strong returns over time.
Applying Buffett's Investing Principles to Australia
I have developed a number of screens for the ASX200 that represents proxies for Mr Buffett’s three preferred attributes: quality, safety and value. Stocks need to attain a score better than the median across each of the categories to get into the long portfolio. Three stocks that meet the criteria include: CSR, Echo Entertainment Group and IAG. The full text report contains a full list of the thirteen stocks in the long portfolio and how they score across the quality, safety and value screens.
Conversely, the short portfolio is composed of stocks that fail to meet the threshold across each of the three screens. Three stocks in the short portfolio include: Oil Search, Premier Investment and Caltex. The full text report contains a full list of the eleven stocks in the short portfolio.