> Warren Buffett Blog: New Academic Paper explains Warren Buffett's investment Success

Thursday, December 19, 2013

New Academic Paper explains Warren Buffett's investment Success

Yes, of course we’d all like to know the secret of Warren Buffett’s incredible investment success at Berkshire Hathaway Berkshire Hathaway. For some it might be mere academic interest, for others a question of how to get some of that investment success. Fortunately, there’s a very good little academic paper that has just been published which explains what Buffett’s been doing. There isn’t anything magical, no trickery here. Nor is it, as some commentators would have it, simply that someone’s going to be the best investor and it’s just random chance that has led to Buffett being it. The real secret really is just that Buffett is a very good stock picker and that he’s been able to finance his investments at very low rates. Combine these two with a long period of time and that really is just about it.


Or, as we might say, Buffett has been doing exactly what he’s been telling everyone he’s been doing for the past 50 years.


The paper is here and the abstract is:



Berkshire Hathaway has realized a Sharpe ratio of 0.76, higher than any other stock or mutual fund with a history of more than 30 years, and Berkshire has a significant alpha to traditional risk factors. However, we find that the alpha becomes insignificant when controlling for exposures to Betting-Against-Beta and Quality-Minus-Junk factors. Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks. Decomposing Berkshires’ portfolio into ownership in publicly traded stocks versus wholly-owned private companies, we find that the former performs the best, suggesting that Buffett’s returns are more due to stock selection than to his effect on management. These results have broad implications for market efficiency and the implementability of academic factors.


If what makes Buffett and Berkshire Hathaway tick is one of the things that interest you then I recommend reading the whole paper. The particular part that interested me was the discussion of financing. I’ve been saying for some time now that part of Buffett’s success has been down to the fact that he is, at least in part, financing investments through the insurance float. And indeed he has been:



Finally, we consider whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO. Said differently, is Buffett mainly an investor or a manager? To address this, we decompose 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. We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performs the best, suggesting that Buffett’s skill is mostly in stock selection. Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.


Or in more detail from the paper:



Berkshire’s more anomalous cost of leverage, however, is due to its insurance float. Collecting insurance premia up front and later paying a diversified set of claims is like taking a “loan.” Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate. Hence, Buffett’s low-cost insurance and reinsurance business have given him a significant advantage in terms of unique access to cheap, term leverage. We estimate that 36% of Berkshire’s liabilities consist of insurance float on average.


This is a point that I have made before in a number of different pieces. With an insurance company there is always that float. That float is then invested into a variety of short and sometimes long term investments. So much so that in a truly competitive market for insurance we would expect an insurer to make a loss on the actual underwriting of the policies. The real profit from the business coming from the investment returns on that float.


This has a number of implications: for example, the ACA’s insistence that medical insurers pay out 80% of premiums in actual health care costs doesn’t really make much difference to anything. For there is that profit to be made from investing the float. We might also look at MF Global MF Global which, while not an insurance company had a similar cash flow position. The margins that speculators had to leave with the company on the futures and options the company handled for them were investable to the profit of the company. When short term interest rates plummeted as a result of the crisis and the subsequent QE the firm went looking for yield so as to enjoy that by now traditional income from investing the float. And it really was only the investment of the float that provided a profit, the basic ongoing business of clearing futures wasn’t going to feed everyone. As we know they took on too much risk in that search for yield and lost some part of that float and thus went bankrupt.


Reinsurance, the practice of writing insurance for insurance companies leaves the company with money for much longer periods of time. And yes, Berkshire Hathaway is heavy on reinsurance. And a company like MunichRe can best be viewed as a giant investment fund rather than an insurer at all. Certainly, it will be how well it invests the float which is the determinant of its profitability, not particularly the terms upon which it underwrites risk.


As the paper is at pains to point out, yes, Warren Buffett is indeed an excellent stock picker. But it is the combination of this, the leverage of being able to invest that insurance float and then the sheer length of time that he has been doing this which are the three things that add up to his total success.


Worth adding one more point that the paper doesn’t address. That Berkshire Hathaway is in large part an insurance company also explains the size of Buffett’s personal wealth. If, just as an example with numbers, $1 million were invested for 50 years at a 19% return annually then the end result would be some $6 billion. But if you were to use $1 million (I emphasise that this is just a made up number to use as an example) to purchase an insurance company which had a $10 million float upon which you then made that 19% return over 50 years then the personal fortune that would accrue would be $60 billion. And that is, in part, what Buffett has done. He’s been using his incredible stock picking and investment skills on the much larger amount of money within the company and thus providing significant leverage to his own initial investment.


It’s a very clever thing to have been doing all these years.