A recent report by Yale University researchers argues that there are two reasons why Warren Buffett outperforms the market. In Part 1 of our analysis of the Yale paper, we looked at whether the use of the insurance premiums received by Berkshire to fund investments constituted a leverage sufficient to detract from Buffett’s legendary reputation.
In this article, we look at the conclusion by the Yale researchers that Berkshire’s stock price has a high beta returning excess profits but with higher than normal risk, and that Buffett’s success relies on his ability to choose safe quality stocks with low Beta ratings, bought cheaply.
If you read the Yale report, you need to know what some of the terms mean.
An Alpha characteristic is given to mutual and investment funds and is said to measure performance on a risk adjusted basis. A positive Alpha rating signifies that the fund has outperformed its benchmark measure by 1 per cent, so the higher the positive Alpha number, the better the performance. Negative numbers means that the fund has underperformed.
Beta indicates the volatility of a stock in comparison to the rest of the market. The price of the shares in a company with a Beta of 1 moves up or down generally in line with the market. The price of shares with a Beta of less than 1 move up and down at a lesser rate than the market. The price of shares with a Beta greater than 1 fluctuates more widely than the market does. So you would expect to see greater fluctuations in the share price of a stock with a Beta of 1.2 than you would in one with a Beta of .8. The Beta is also said to be an indication of the risk that attaches to a stock. If this is so, and Beta is some kind of measure of risk, it is not the type of risk envisaged by value investors. For example, the current beta rating for Coca Cola is .50. (Beta values for individual stocks are available free from ADVFN).
The Sharpe Ratio measures risk adjusted performance. To find the Sharpe ratio of an investment portfolio fund, you take away a specified risk-free rate (say the long term rate for US Treasury bonds) from the rate of return for the portfolio and divide the answer by the standard deviation of the portfolio returns. The higher the ratio, the better the portfolio has performed on a risk-afjusted basis.
Berkshire Hathaway’s performance
The Yale Report concludes statistically and mathematically that Berkshire Hathaway has a Sharpe Ratio of .76 over the period of time examined. This is much more than that of the overall stock market but the researchers are surprised that it is not higher, having regard to Buffett’s reputation. They put this down to leverage which we discussed in Part 1.
If his Sharpe Ratio is very good but not unachievably good, then how did Buffett become of the the most successful investors in the world? The answer is that Buffett has boosted his returns with leverage and ….stuck to a good strategy for a very long time.
As we said in Part 1, we do not think that the use of premiums by Berkshire has the importance that the researchers give it. Sure, it gives Buffett an advantage over ordinary investors but other big investors with the same advantage – other insurers, banks – do not invest as successfully as Buffett. To their credit, the Yale researchers acknowledge that Buffett has contributed to his success by astute stock picking.
The Buffett stock picks
The report examines mathematically the public company stocks bought by Buffett and concludes that these stocks are generally stocks of high quality bought at low prices. This would come as no surprise to students of Buffett and are consistent with the Benjamin Graham approach: if you can place a value on a stock and buy it at less than its intrinsic value, this is an investment and everything else is speculation. They are also consistent with what we think are Buffett’s general investment principles.
The report also concludes that these stocks are low beta stocks and the Tables provided as addenda to the report gives Berkshire’s stocks an overall rating of .67. Again, we would think that this is consistent with the Buffett strategy of buying good performing businesses rather than buying on hope and future-gazing.
Curiously, the beta rating of Berkshire itself is quite high, leading the report to conclude that it is a stock that fluctuates in wider arcs than the market and thus bears a higher degree of risk. We would think some of the high beta rating for Berkshire stems from the period of the Dot.com Boom, when Berkshire’s stock price languished while the stock market went crazy over techno-stocks. Then when the Dot.com Boom collapsed, the reverse happened. In any event the type of risk posed by a high beta is not the type of risk that either Benjamin Graham or Warren Buffett considers.
Benjamin Graham and beta risk
Benjamin Graham invested in an era when beta theory was just developing but was aware that people could misinterpret what type of risk that beta measures. In a paper written by Bruce Grantier, Benjamin Graham is quoted in the following words.
Beta is a more or less useful measure of past price fluctuations of common stocks. What bother me is that authorities now equate the beta idea with the concept of risk. Price variability yes; risk no. Real investment risk is measured not by the percent that a stock might decline in price in relation to the general market in a given period but by the danger of a loss of quality and earnings power through economic changes or deterioration in management.
Warren Buffett and beta risk
Whatever risk beta measures is not the risk Buffett measures. Aberrations like the Dot.com and other boom-busts aside, it is probably valid to say that mathematically you can calculate a pattern of fluctuations for a particular stock and compare it to the stock market as a whole. It follows that this model can generally predict that a specific stock is more likely to rise proportionately higher than the market and conversely fall to a greater degree than the market.
The risk attached to such a pattern is, as Graham believes, a price risk. So too with Buffett if you accept his often stated view that you invest in a company on the basis of its value as a business and not on the basis that the price of its shares will be higher on the stock market next week, next month or next year. He has famously said on several occasions that if the stock market closed for a year or ten years it would not bother him. Risk to him then is not a variation of price or price dependent. The risk he takes is whether the business of the company will continue to make profits over the long term. A beta rating is not an expression of the worth of a business. Rather it is an expression of the degree of Mr Market’s bipolarism.
We doubt whether Buffett even considers the beta value of a stock when deciding to buy. The only relevance to him would be that a stock with a high beta might give him a good chance to buy in when it hit its downward point, assuming that the company otherwise warrants buying on his investment principles. In his 1993 letter to shareholders, Buffett explained his attitude to beta measurement in these words.
In stating this opinion, we define risk, using dictionary terms, as “the possibility of loss or injury.”
Academics, however, like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks – that is, their volatility as compared to that of a large universe of stocks. Employing data bases and statistical skills, these academics compute with precision the ”beta” of a stock – its relative volatility in the past – and then build arcane investment and capital-allocation theories around this calculation. In their hunger for a single statistic to measure risk, however, they forget a fundamental principle: It is better to be approximately right than precisely wrong.
For owners of a business – and that’s the way we think of shareholders – the academics’ definition of risk is far off the mark, so much so that it produces absurdities. For example, under beta-based theory, a stock that has dropped very sharply compared to the market – as had Washington Post when we bought it in 1973 - becomes “riskier” at the lower price than it was at the higher price. Would that description have then made any sense to someone who was offered the entire company at a vastly-reduced price?
In fact, the true investor welcomes volatility. Ben Graham explained why in Chapter 8 of The Intelligent Investor. There he introduced “Mr. Market,” an obliging fellow who shows up every day to either buy from you or sell to you, whichever you wish. The more manic-depressive this chap is, the greater the opportunities available to the investor. That’s true because a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses. It is impossible to see how the availability of such prices can be thought of as increasing the hazards for an investor who is totally free to either ignore the market or exploit its folly.
In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company’s name. What he treasures is the price history of its stock. In contrast, we’ll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company’s business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two. We don’t need a daily quote on our 100% position in See’s or H. H. Brown to validate our well-being. Why, then, should we need a quote on our 7% interest in Coke?
In our opinion, the real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will, over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake. Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful.
Risk for Buffett is really that a company in which he invests may not be as good a business as he thought it would be. Beta risk is a price risk.
Value investing and modern market theory
The Grantier Paper contains a good discussion of possible flaws in modern market theory and is worth reading. We would also add that this type of mathematical analysis is generally viewed with cynicism by value investors. As we said in Part 1 of this post, Benjamin Graham is somewhat disdainful about complex mathematical analysis in finding value stocks. As he said in The Intelligent Investor:
Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give speculation the deceptive guise of investment.
Both Charlie Munger and Warren Buffett hold similar views. Munger told the last annual meeting of Berkshire Hathaway shareholders that:
Some of the worst business decisions I’ve ever seen are those with future projections and discounts back. It seems like the higher mathematics with more false precision should help you but it doesn’t. They teach that in business schools because, well, they’ve got to do something.
Buffett, at the same meeting, said that some of modern investment theory is just ‘false and nutty’ and doubted the worth of complex calculations as to value:
If you need to use a computer or a calculator to make the calculation, you shouldn’t buy it.
We think these astute investors are correct in their scepticism about complex mathematical theories to identify investment opportunities but we have to confess that, even in the simple mathematical calculations that we need in value investing, we resort to a financial calculator. Buffett can do these things in his head or with pad and paper: we need the Texas Instruments B-35 Solar Calculator.
Read the Report
We think that the Yale Report, despite our reservations, is well worth reading, because it statistically examines the Berkshire investments and strategies.