How Buffett did it

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Good morning. April’s ISM services survey, out yesterday, came in well above expectations, and showed that services are still firmly in expansion. At a high level, it added to the evidence that the US economy is robust. But bad signs were hiding below the surface: the prices paid index way overshot expectations, while employment contracted for the second month in a row. That smells a little bit like stagflation. Email me: [email protected].

Buffett and Berkshire

Warren Buffett announced his plan to step down as Berkshire Hathaway’s CEO after an absolutely vintage period for the stock’s performance:

But Berkshire has always had multiyear periods of excellent performance, alternating with years of mediocre or market-trailing performance. The miracle is beating the index, on average, by a few percentage points a year over many decades. That, and the magic of compounding, is how you become one of the richest men in the world. So let us consider (as many have before) where that extra point or three of performance a year comes from.

The clearest and most convincing account of this I have ever read comes from Andrea Frazzini, David Kabiller and Lasse Heje Pedersen of AQR Capital Management. In their paper Buffett’s Alpha they argue it comes down to doing three things. Buy high-quality, low-risk businesses at reasonable prices; use a fair amount of leverage to amplify those returns, managing the leverage carefully so you don’t go out of business; and stay in the game for a long time:

Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors . . . [and] 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. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion. Thus, his many accomplishments include having the conviction, wherewithal and skill to operate with leverage and significant risk over a number of decades.

That’s a great summary, but there are some subtleties that are worth exploring.

It is one thing to talk airily of “quality” stocks — those, in short, with high profitability — but it is another to identify individual companies that are and will remain profitable. It’s not a matter of just picking a basket of stocks off a spreadsheet that have high returns on equity, low volatility and reasonable valuations. Companies don’t come with labels that say “will be steady and profitable though thick and thin”. There is more skill to what Buffett does than an analysis of “factors” might seem to suggest. 

I put this point to one of the authors of the paper, Andrea Frazzini. He agreed, but made the point that high corporate profitability tends to persist through time, so that while it is not easy to pick out “quality” stocks, it is not impossible. “In the paper we looked at profitability, operating leverage, macroeconomic sensitivity. Some of these characteristics persist for a long period of time . . . Buffett had some spectacular stock picks, but if you pick companies with similar amounts of quality/profitability, and used the same amount of leverage as he did, you would have results in the same ballpark.”

If the formula is as simple as quality plus leverage, why are there not more Buffetts? “He has been doing it for longer,” Frazzini says, “even before these ideas [about ‘factors’] were in the academic research. You need a lot of patience, and he has superhuman patience. It’s a small edge, but one that builds up over time.”

In addition to being patient, you have to be in business. That is, the leverage you are using has to not render you insolvent. There are two aspects to this.

The first is Berkshire’s famous self-financing business structure. Its insurance operations generate premiums that are, in effect, low-cost financing for Berkshire’s investment business. But the financing is not just low-cost — its long-term. What sinks many investors who use leverage is a margin call from a lender. Insurance customers don’t make margin calls. This advantage is hard to reproduce. Lots of other investors have tried to generate cheap investable capital by acquiring or owning an insurance company. Indeed, huge private equity house/asset managers such as Apollo have adopted the strategy. But no one can match the scale of Berkshire’s insurance arm, which Buffett has built with great skill over time. No other investor, in short, is as good at insurance.

But the other aspect is just as important. It is that Buffett’s investors have absolute trust in him, and do not put meaningful pressure on him — by selling or otherwise rebelling — even when his performance is average or worse. His image as the wise old man of finance, and of Berkshire as the shining example of American shareholder capitalism, brings stability to the company and the stock that has a huge value. Much is made of how Berkshire beats the S&P while having a beta (relative volatility) below 1. But a big part of the reason that Berkshire’s beta is low is because of Buffett’s reputation, which he has cultivated with immense care and intelligence, rather than any financial characteristic of the business itself.

My colleagues Eric Platt, Oliver Ralph, and I did a long interview with Buffett in Omaha in 2019. I came away thinking that his genius of public relations was as great as his genius for investment. The way he answered hard questions, bent the conversation in his intended direction, and projected goodwill and integrity — I have never seen anything remotely in the same league from any other business leader, and I’ve interviewed plenty. Buffett is a flawless performer. It is interesting to reflect on how much this may have helped Berkshire secure favourable deals and defuse potential crises over the decades.

In sum, I think Buffett’s achievements are a bit misunderstood. Too much emphasis is put on him being the greatest stock picker, or business picker, of all time. But there are plenty of other great stock pickers (and Buffett has had his share of terrible picks, including some of his largest investments). Buffett’s unique achievement is building a business structure and a reputation that have allowed him to invest in ways others, however clever, simply cannot.

More comments on Buffett and Berkshire in days to come.  

One good read

The madman’s brother.

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