Friday, December 13, 2013

Is Buffett Just Lucky?

Well, a recent paper* answers the above question with a resounding no.

"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..."

At first glance, this would seem to qualify as one of the least surprising conclusions in history.

Yet, for adherents to efficient markets and related ideas, somehow it is not.

"While much has been said and written about Warren Buffett and his investment style, there has been little rigorous empirical analysis that explains his performance. Every investor has a view on how Buffett has done it, but we seek the answer via a thorough empirical analysis..." 

In fact, some still think it may just be luck:

"Buffett's success has become the focal point of the debate on market efficiency that continues to be at the heart of financial economics. Efficient market academics suggest that his success may simply be luck, the happy winner of a coin-flipping contest as articulated by Michael Jensen at a famous 1984 conference at Columbia Business School celebrating the 50th anniversary of the book by Graham and Dodd (1934). Tests of this argument via a statistical analysis of the extremity of Buffett's performance cannot fully resolve the issue. Instead, Buffett countered at the conference that it is no coincidence that many of the winners in the stock market come from the same intellectual village, 'Graham-and-Doddsville' (Buffett (1984))."

Some context is in order. Back in 1984, Columbia Business School arranged a conference to celebrate the 50th Anniversary of the influential book Security Analysis by Benjamin Graham and David Dodd.

At least in part, the celebation essentially became a contest between competing schools of thought with Warren Buffett representing one side and Michael Jensen, a University of Rochester professor, representing the other.

Jensen made the case for the efficient markets view of the world.

In fact, Jensen did argue that an apparent outperformance like Buffett's might be the result of pure luck.

"If I survey a field of untalented analysts all of whom are doing nothing but flipping coins, I expect to see some who have tossed two heads in a row and even some who have tossed 10..." - Michael Jensen

Buffett, in his now well-known speech at the conference, made the case for Graham and Dodd and against efficient markets. The speech became the basis of this article published later that same year.
(The article remains well-worth reading in its entirety.)

The Superinvestors of Graham-and-Doddsville

For those, like myself, who are convinced that...umm...Buffett just might be onto something (considering the track record over more than half a century), it at first all seems more than just a little bit amazing that there'd still be doubt there is real skill involved.

Skills that, at least in part even if with varying degrees of success, can be learned and applied.

It's only when certain aspects of human nature are taken into account that what is surprising at first glance becomes much less so.

"When you hatch a theory, you don't easily let go..." - Robert Shiller in this CNBC Interview

That's true even for theories that are influential yet also the highly flawed variety. In any case, I'm of the view that this question about Buffett's capabilities was answered a very long time ago.
(I know this will come as a shock to those who might read this blog from time to time).

More from the paper...

"We show that Buffett's performance can be largely explained by exposures to value, low-risk, and quality factors. This finding is consistent with the idea that investors from Graham-and-Doddsville follow similar strategies to achieve similar results and inconsistent with stocks being chosen based on coin flips. Hence, Buffett's success appears not to be luck. Rather, Buffett personalizes the success of value and quality investment, providing out-of-sample evidence on the ideas of Graham and Dodd (1934). The fact that both aspects of Graham and Dodd (1934) investing – value and quality – predict returns is consistent with their hypothesis of limited market efficiency. However, one might wonder whether such factor returns can be achieved by any real life investor after transaction costs and funding costs? The answer appears to be a clear 'yes' based on Buffett's performance and our decomposition of it."

Well, it may be achievable in the real world but those that go to the other extreme (i.e. assume investing effectively is easy to do well versus impossible to do well as some efficient market adherents seem to believe) will likely end up with disappointing results. Naturally, intelligence matters to an extent. Yet the importance of that alone sometimes gets overestimated. Among other things, investing well requires the right combination of knowledge, skills, temperament, hard work, discipline, patience and an awareness of psychological factors.

It also requires a realistic appraisal of one's own limits.

If it was just about I.Q., then the disaster at Long-Term Capital Management (LTCM) should probably not have happened.

The paper points out that Buffett's performance was "very good but not super-human," so "how did Buffett become among the richest in the world? The answer is that Buffett has boosted his returns by using leverage, and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift."

For those who think that Buffett's ability to negotiate special deals on private transactions is the key driver of returns consider this:

"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."

The lucrative deals he made during the financial crisis understandably get lots of attention but this leads, I think, to the incorrect conclusion that Buffett's results are primarily the result of the unique perch from which he now sits. Well, while those deals are surely good for shareholders, they just aren't big enough relative to the all other assets to really drive increases to intrinsic value.**

Now, the modest leverage Buffett uses -- mostly in the form of insurance float which provides cheap and, crucially, stable funding -- plays an important role. Yet it would also be a mistake to conclude it alone is the dominant driver of his long-term outperformance:

"...Buffett's leverage can partly explain how he outperforms the market, but only partly."

The fact that the leverage is employed in moderation is also an important element here. The paper estimates Buffett's leverage at ~ 1.6-to-1, so we aren't exactly talking about extreme leverage.
(During the financial crisis some large financial institutions employed extreme leverage -- easily 25-to-1 and even much worse with an appropriate consideration for what, in many cases, was off-balance-sheet -- while often relying too much on short-term funding sources.)

So the leverage Buffett uses is cheap, stable, and moderate. He keeps lots of cash on hand. All these things matter.

The strongest adherents to efficient markets essentially believe that, when it comes to publicly-traded equities, participants should not be able to systematically profit from market inefficiencies.

"In summary, if one had applied leverage to a portfolio of safe, high-quality, value stocks consistently over this time period, then one would have achieved a remarkable return, as did Buffett. Of course, he started doing it half a century before we wrote this paper!"

For some, Buffett's argument nearly 30 years ago was very persuasive while others still, to this day, don't think sufficient evidence exists.***

This recent paper certainly attempts to remedy this.

More in a follow up.

Adam

* By AQR Capital Management's Andrea Frazzini and David Kabiller along with NYU professor Lasse Pedersen. 
** Of course, those deals have been a good thing for shareholders. That doesn't logically mean that they are the key driver of overall investment results. Do some quick math and it becomes pretty obvious that those deals, at least relative to the size of all the investments he is responsible for, do not really move the needle in terms of increasing intrinsic value.
*** From this Morningstar article: "There are two ways to validate an economic or financial theory: wait 100 years and collect new data, or look at a fresh new data set, such as another time period or different markets. It can take decades before someone's held accountable for a bunk theory." This gives a huge advantage to the promoter of a questionable financial theory. Those trying to achieve a good balance between risk and reward in the real world can't afford to wait for undeniable proof based upon unbiased data. In the meantime, someone with impressive academic credentials can continue promoting their ideas knowing that, not only is it not easy to obtain sufficient data, that most data can be made to say just about whatever one wants with a tweak or two. Some theories may be mostly about getting published and looking brilliant among academic peers. Whether it happens to reveal anything useful in the real world a secondary consideration. With or without this recent paper, I happen to think that Buffett's approach is built upon sound investment principles. I also think that are well worth learning and putting to use within one's own inevitably unique set of capabilities and limits.
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