In his recent article, Wall Street Journal columnist Jason Zweig noted that Berkshire Hathaway’s stock had under-performed the S&P 500 Index over the 10 years ending in 2017, 7.7% versus 8.5%.
Zweig ascribed this underperformance to the large size of Berkshire Hathaway’s portfolio. “Too much money” is a long-known problem for active managers, as they are challenged to find attractive opportunities in which to deploy their larger portfolios.
While size can become a problem for active managers, in his recent article Buffett’s Secret Sauce Loses Flavor, Larry Swedroe suggests that a number of other factors may be at work. Larry reviews the evidence that a handful of “factors” or characteristics of securities, including value, size, quality, and momentum largely explain portfolio performance. He then considers the contribution of the factors to Buffett's longer-term and more recent results.
The conventional wisdom has always been that Buffett’s success is explained by his stock-picking skills and his discipline—keeping his head while others are losing theirs. However, the 2013 study “Buffett’s Alpha” found that, in addition to benefiting from the use of cheap leverage provided by Berkshire Hathaway’s insurance operations, Buffett bought stocks that are “safe” (meaning stocks that have low beta and low volatility), “cheap” (value stocks with low price-to-book ratios), high-quality (meaning stocks that are profitable, stable, growing and with high payout ratios) and large.
The most interesting finding of the study was that stocks with these characteristics—low risk, cheap and high quality—tend to perform well in general, not just the ones that Buffett buys.
In other words, it’s Buffett’s strategy that generated “alpha,” not his stock selection skills. The authors found that once all the factors (beta, size, value, momentum, BAB and quality) and leverage are accounted for, a large part of Buffett's performance is explained and his alpha is statistically insignificant.
It’s extremely important to understand this finding doesn’t detract in any way from Buffett’s performance. After all, it took decades for modern financial theory to catch up with Buffett and discover his “secret sauce.”
Buffett’s genius, as Frazzini, Kabiller and Pedersen observe, thus appears to be in recognizing long ago that “these factors work, applying leverage without ever having a fire sale, and sticking to his principles.” The authors noted that Buffett himself stated in Berkshire Hathaway’s 1994 annual report: “Ben Graham taught me 45 years ago that, in investing, it is not necessary to do extraordinary things to get extraordinary results.”
To more properly analyze Buffett’s performance, we compared the returns from Berkshire Hathaway to those of the Vanguard 500 Index Fund and DFA’s Large Value Fund.
The reason for doing so is that Buffett’s investment strategy has always been a value strategy, and the under-performance noted by Zweig might just be a result of the fact that the value premium was negative over the period 2008 through 2017 (-0.7%).
BRK.A’s under-performance relative to the S&P 500 over the last 10 years is virtually fully explained by the negative performance of the value factor over that period. This under-performance is not unusual—since 1927, value has had a negative premium in 14% of 10-year periods, not much different than the 10% figure for a negative market beta premium.
That said, when we compare the performance of Berkshire to that of the Large Value Fund, and whether looking at the 10- or 20-year period, there is little-to-no evidence of stock selection skill.
Again, none of this is meant to take anything away from the decades of out-performance Buffett delivered prior to the periods we examined. After all, he discovered the “secret sauce” that could outperform the market well before the academics did. However, those days appear to be gone.