Is Buffett Just Lucky? - Part II

A follow up to this recent post.

Is Buffett Just Lucky?

This recent paper attempts to better understand what's behind Buffett's success through empirical analysis.

Here is an excerpt from the conclusion section:

"In essence, we find that the secret to Buffett's success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails. Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett's performance.

Buffett has become the focal point of the intense debate about market efficiency among academics, practitioners, and in the media (see, e.g., Malkiel (2012)). The most recent Nobel prize has reignited this debate and, as a prototypical example, Forbes writes 'In the real world of investments, however, there are obvious arguments against the EMH. There are investors who have beaten the market – Warren Buffett.' The efficient-market counter argument is that Buffett may just have been lucky. Our findings suggest that Buffett's success is not luck or chance, but reward for a successful implementation of exposure to factors that have historically produced high returns.

At the same time, Buffett's success shows that the high returns of these academic factors are not just 'paper returns', but these returns could be realized in the real world after transaction costs and funding costs, at least by Warren Buffett. Hence, to the extent that value and quality factors challenge the efficient market hypothesis, the actual returns of Warren Buffett strengthen this evidence."

Let's consider further the leverage Buffett uses that is mentioned above. The kind of stable leverage -- mostly in the form of insurance float -- employed by Buffett is tough for most to replicate.

Some think all leverage is bad leverage. Yet, when leverage is in the right proportion, is cheap, and stable in nature, it can work very well.

Stable means that sources of funding won't dry up when the going gets tough. Funding can't be highly dependent on short-term creditors who'll cut credit lines when there are signs of trouble.

That just makes a difficult situation untenable. A big source of the financial stress -- along with too much leverage -- for some financial institutions during the crisis five years ago or so.

This Morningstar article by Sam Lee explains it very well:

The poster boy for leverage done right is none other than Warren Buffett. Yes, the man who said, "A long, long time ago a friend said to me about leverage, 'If you're smart you don't need it, and if you're dumb you got no business using it.' " He makes extensive use of a special kind of leverage, the prepaid premiums, or "float,"...

Lee also adds:

Float can never be called away at the whim of a nervous counterparty. Even better, the timing of the payouts is unrelated to market conditions, so Berkshire doesn't have to stump up a mountain of cash just as the markets are going to hell in a handbasket.

So, unfortunately, this is the one important aspect of what Buffett does that most investors can't realistically make happen. This point is well made later in the same Morningstar article. Most leverage available to investors is often not only too costly to make sense but, more importantly, is also not stable enough during the tough times even if used in moderation. In other words, the requirement to post collateral at the worst possible time must be avoided.

Margin, for example, simply doesn't cut it as a stable source of funding. Very short-term financing -- in pretty much all its forms -- that's employed to fund the purchase of longer term assets just doesn't cut it. That sort of funding is likely to become scarce just when it is needed most (maybe during the next financial crisis). It only seems to work really well until it suddenly doesn't. The result being forced sales of assets at (or nearly at) just the wrong time.

Buffett's leverage, in contrast, is set up such that doesn't need to worry about a counterparty who requires the posting of collateral at the worst possible time (i.e. a margin call).*

He also knows that the eventual payouts are usually far removed from current market conditions.
(e.g. Consider the put options Buffett has previously written on indexes. These options generally expired far into the future (a decade plus). Little collateral was required. They also could only be exercised upon expiration. These may seem to be minor differences, but it means that what is happening to the market near-term matters little as far as cash needs go. The potential payouts aren't connected to the current market environment. A big advantage.)

As I mentioned in the prior post, the deals Buffett made during the financial crisis understandably get lots of attention. This leads, I think, to the incorrect conclusion that outperformance is primarily the result of his unique position.**

There's no doubt that the modest leverage Buffett uses -- mostly in the form of insurance float which provides cheap and, crucially, stable funding -- plays an important role. Yet, as I've already said, I think it's a mistake to conclude this alone or mostly is the driver of his results. From earlier in the paper:

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

Also, that leverage is only put to work in moderation is hardly unimportant factor.***

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

Naturally, the way that Buffett invests takes not a small amount of discipline. The leverage advantage aside, many aspects of the approach can be learned. Well, at least they can if the ideas are treated with deserved respect and with enough hard work.

This doesn't suggest his incredible results over the decades can be matched by many, but it just might help someone who takes it seriously to avoid taking on more risk for less reward (and maybe avoid paying a whole lot of frictional costs for the privilege).

I'm sure that some will think it necessary to continue waiting for sufficient empirical evidence. Debate and disagreement that moves the world closer to what's reasonably true is a healthy thing. On the other hand, resistance to ideas with greater merit because it's at odds with a preferred but flawed theory, for whatever reason, is not.

When something that seems to work in the real world conflicts with an established theory, it's a useful habit to give it serious consideration.

For those who still choose to completely ignore Buffett's way of thinking, all I can do is wish best of luck with their own investments.

Doing better than the market as a while long-term is never going to be easy. Most market participants will not. That doesn't logically lead to the conclusion that the markets are efficient.

In fact, these two seemingly conflicting things can coexist just fine.

Adam

* At least not a large amount of collateral in proportion to total resources.
** Well, a little quick math will reveal that, 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. From earlier in the paper: "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."
*** 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.
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Is Buffett Just Lucky? - Part II
Is Buffett Just Lucky? - Part II
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