Invisible Hand

Warren Buffett, Market Efficiency and the Disappearance of Alpha

Invisible Hand

Given Warren Buffett's standing as one of America's most prominent dealmakers, it's not uncommon for some investors to think they can load up on shares of Berkshire Hathaway to fortify their portfolios.

The problem, though, is that placing such oversized bets on a single stock -- even if it's the company which Buffett leads -- can inject a lot more risk into an otherwise globally diversified portfolio of index funds. 

This begs a rather fundamental question: Has Berkshire Hathaway sufficiently rewarded investors over time for accepting a higher level of risk?

Any in-depth analysis of Buffett's performance needs to consider his ability to produce 'alpha.' This is a word used in finance to express how much excess return a manager makes relative to a comparative benchmark.

Of course, Buffett isn't a mutual fund manager. Instead, he sits in the position of overseeing a business conglomerate that also happens to own equity positions in several blue-chip companies.

Since Berkshire Hathaway is not a mutual fund, its share price reflects the market's estimate of the value added by Buffett's Rolodex, his capital allocation abilities and his company's acquisition prowess. This means any degree to which Buffett can add value in the future is already incorporated into today's price of Berkshire Hathaway.

As a result, IFA's wealth advisors like to warn investors that most of this Buffett-led company's oversized alpha happened long ago. 

Along these lines, we've compiled alpha data for Berkshire Hathaway and the Russell 1000 Value Index from 1981 through 2019, the largest data set available to us for calculating such statistics. 

Figure 1 below is a chart showing Buffett's ability to produce alpha for investors in Berkshire Hathaway over the initial 19 years (1981-1999) studied. The t-stat of the stock's alpha during this period was 2.55. That's notable since any such t-stat greater than 2.00 provides us with 97.5% confidence this period of outperformance exhibited some degree of skill, not just pure luck. (At the bottom of this report, we show what goes into calculating the t-stat.) 

Figure 1

By contrast, consider the next 20 years (2000-2019). As depicted below in Figure 2, Buffett's alpha produced a t-stat of 0.81. Not only does that reveal a big drop from his earlier days heading Berkshire Hathaway, it also raises a major red flag. Namely, that is: If this period is used as an indicator of Buffett's performance going forward, it'd take a minimum track record of 123 years for an investor to have confidence that generating positive alpha was attributable to skill, not luck. 

Figure 2

In Figure 3, notice how such a significant later period of lagging performance is obfuscated by Buffett's earlier days running the company. Viewing this entire 39-year period indicates that almost his entire alpha occurred in the initial 19 years. 

Figure 3

It's also worth pointing out that we're not alone in coming to such a conclusion. Indeed, many other researchers have found much the same when analyzing Warren Buffett's performance record over time.

One of the most heavily cited (Frazzini, Kabiller and Pedersen) academic works was last revised in 2019.1 It attributed Berkshire's returns to the use of leverage combined with a focus on cheap yet safe stocks of high earnings quality. In fact, one of Berkshire's primary sources of capital cited by the authors was the "float" from its insurance operations, which refers to the difference between premiums collected and claims paid.

Combined with Berkshire's ability to issue AAA-rated debt, these researchers found that Buffett has used such flexibility to operate the company with a low cost of capital.

Investors shouldn't be surprised by such findings. Leading market research continues to find that generating alpha on a consistent and longer-term basis is an unsustainable investment strategy. Even in those cases where it has been identified, tactical alpha opportunities have proved to be fleeting, at best.

In one of his frequently mentioned series of letters to investors published by Berkshire Hathaway, Buffett himself observed:

"The bad news is that Berkshire's long-term gains – measured by percentages, not by dollars – cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won't be great."2

At IFA, our investment strategy echoes Buffett's repeated endorsements of index funds as the best way for most investors to accomplish their investment goals over time. 

Below is a calculator to determine the t-stat. Don't trust an alpha or average return without one.


Footnotes:

1) "Buffett's Alpha," by Andrea Frazzini, David Kabiller and Lasse Pedersen, Jan. 10, 2019 (latest revision).  

2.) Berkshire Hathaway, Warren's Letter, Feb. 22, 2020. 


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