Warren Buffett is known as a value investor, but a recently released research paper has found that most of Buffett’s success over the long term is due not to value investing, but to his focus on high-quality companies.
The paper, “Betting Against Beta” (click here for a PDF copy), was authored by Andrea Frazzini of AQR, a quantitative fund manager, and Lasse Pedersen of AQR and New York University’s Stern business school, and was highlighted recently by the Financial Times’ James Mackintosh. “Value has helped, but accounts for only a couple of percentage points of outperformance each year, against the 15 points Berkshire has achieved” under Buffett, Mackintosh writes. “Instead, the genius of Buffett and Berkshire was to be boring. … More than half of the outperformance of Berkshire since 1976 is explained by its buying high-quality companies. For its portfolio holdings (ignoring the insurance company and other operating businesses) almost all its outperformance was down simply to the focus on high-quality stocks.”
There’s a second piece to the high-quality approach — Frazzini and Pederson found that Berkshire has produced exceptional returns by buying low-beta stocks, and applying leverage. What’s more, they “found this anomaly works in every market they tried,” Mackintosh writes. “In all cases, taking less risk leads to higher returns relative to the amount of risk taken. Equalise the risk — adding borrowing to the lower-risk approach — and investors can beat the market without any extra volatility.”
In their paper, Pederson and Frazzini say they find evidence that “since constrained investors bid up high-beta assets, high beta is associated with low alpha, as we find empirically for U.S. equities, 20 international equity markets, Treasury bonds, corporate bonds, and futures.” They also found evidence that a “betting-against-beta” (BAB) approach, which is long leveraged low-beta assets and short high-beta assets, “produces significant positive risk-adjusted returns”.
Mackintosh says ordinary investors should be cautious about using leverage. But, he adds, “They cannot expect to replicate Buffett’s returns, but they should be able to profit from his strategy by building a portfolio of high-quality companies, gaining a better return for the risk they are taking, even if they use less (or no) leverage.”