Buffett’s Alpha: Updated White PaperVW Staff
Buffett’s Alpha Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen* First Draft: May 3, 2012 This draft: November 21, 2013
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 light of some the latest research on the drivers of returns.
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).2 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)). How can Buffett’s argument be tested? Ex post selecting successful investors who are informally classified to belong to Graham-and-Doddsville is subject to biases. We rigorously examine this argument using a different strategy. 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.
Buffett’s record is remarkable in many ways, but just how spectacular has the performance of Berkshire Hathaway been compared to other stocks or mutual funds? Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years.
See Full PDF of Buffett’s Alpha here or here Buffett's Alpha – Frazzini, Kabiller and Pedersen (1)