To be clear, we're not suggesting that the principles of long-term, value investing are worthless.
But a recent study concludes that Buffett's win-streak is about much more than savvy stock-picking.
According to AQR Capital Management's Andrea Frazzini and David Kabiller and NYU's Lasse Pedersen, Buffett's returns are driven by a combination of investing in low-beta stocks and employing low-cost leverage.
In other words, he bets on stocks with low, yet stable returns, and he amplifies those returns by betting with cheap borrowed money.
That second part is key because not everyone has access to the type of cheap financing one can get when one is a billionaire backed by a multi-billion dollar corporation betting on hundreds of millions of dollars worth of stocks.
"We estimate that Berkshire’s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and stable sources of financing," write the authors in their paper, "Buffett's Alpha."
They identify four reasons why Buffett's leverage costs are so low (emphasis ours):
In addition to considering the magnitude of Buffett’s leverage, it is also interesting to consider his sources of leverage including their terms and costs. Berkshire’s debt has benefitted from being highly rated, enjoying a AAA rating from 1989 to 2009. As an illustration of the low financing rates enjoyed by Buffett, Berkshire issued the first ever negative-coupon security in 2002, a senior note with a warrant.
Berkshire’s more anomalous cost of leverage, however, is due to its insurance float. Collecting insurance premiums up front and later paying a diversified set of claims is like taking a “loan.” Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate. Hence, Buffett’s low-cost insurance and reinsurance businesses have given him a significant advantage in terms of unique access to cheap, term leverage. We estimate that 36% of Berkshire’s liabilities consist of insurance float on average.
Based on the balance sheet data, Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment as provided for under the IRS rules. E.g., Berkshire reports $28 Billion of such deferred tax liabilities in 2011 (page 49 of the Annual Report). Accelerating depreciation is similar to an interest-free loan in the sense that (i) Berkshire enjoys a tax saving earlier than it otherwise would have, and (ii) the dollar amount of the tax when it is paid in the future is the same as the earlier savings (i.e. the tax liability does not accrue interest or compound).
Berkshire’s remaining liabilities include accounts payable and derivative contract liabilities. Indeed, Berkshire has sold a number of derivative contracts, including writing index option contracts on several major equity indices, notably put options, and credit default obligations (see, e.g., the 2011 Annual Report)...Hence, Berkshire’s sale of derivatives may both serve as a source of financing and as a source of revenue as such derivatives tend to be expensive (Frazzini and Pedersen (2012)). Frazzini and Pedersen (2012) show that investors that are either unable or unwilling to use leverage will pay a premium for instruments that embed the leverage, such as option contracts and levered ETFs. Hence, Buffett can profit by supplying this embedded leverage as he has a unique access to stable and cheap financing.
This is not intended to discredit Buffett's accomplishments. Indeed, this is an extremely sophisticated and smart strategy.
But the bottom line is that the average investor cannot replicate Buffett's strategy.
Download the paper at Yale.edu.
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