God is a Capitalist

Wednesday, December 11, 2013

Buffet the Great

Authors of a new paper, "Buffett’s Alpha", Andrea Frazzini and David Kabiller at AQR Capital Management crown Warren Buffett one of the best investors ever. I welcome this after decades of having to endure the worship of Keynes as the greatest investor. Keynes achieved his reputation, after years of failure, by investing in gold mining stocks during the time in which he used his political influence and notoriety to convince the US and UK to abandon the gold standard. Keynes succeeding through insider trading. Buffett did it the old fashioned way.

Here are excerpts from the paper:
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...

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...
We identify several general features of his portfolio: He buys stocks that are “safe” (with low beta and low volatility), “cheap” (i.e., value stocks with low price-to-book ratios), and high-quality (meaning stocks that profitable, stable, growing, and with high payout ratios).

Of course, Buffett's success defies gravity, or at least the Efficient Market Hypothesis (EMH). Warren Buffett got to the heart of the problem with the EMH at a 1984 conference at the Columbia Business School held to honor the 50th anniversary of Benjamin Graham’s Security Analysis. Finance professor Michael Jensen, a defender of EMH, told the audience that investors such as Buffett who beat the market were just lucky. The EMH did not assert that no one could get lucky; only that they couldn’t get lucky consistently.
“If I survey a field of untalented analysts, all of whom are doing nothing but flipping coins,” Jensen said, “I expect to see some who have tossed two heads in a row and even some who have tossed ten heads in a row.”[1] 
 In other words, clusters of success can happen in randomly generated events, as statisticians know.

Buffett spoke next and presented his own analogy. A whole nation would participate in coin flipping with everyone staking a dollar on the first flip. After 200 rounds of flipping, 215 millionaires would emerge. Professors of the EMH would retort that coin-flipping orangutans would have achieved the same result. However, Buffett added this:

“If you found that 40 came from a particular zoo in Omaha, you could be pretty sure you were on to something. So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read…I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small village that could be called Graham-and-Doddsville.”[2]

[1] Roger Lowenstein, Buffett: The Making of an American Capitalist (New York: Main Street Books, 1996), 317, in Justin Fox, The Myth, 212.
[2] Lowenstein, Buffett , 212-213.

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