Between 1976 and 2017, Warren Buffett’s Berkshire Hathaway delivered an average annual return of 18.6% over Treasury bill rates -- easily beating the stock market’s excess return of 7.5%. That is not just a good run for a few years or a decade. It’s an extraordinary record spanning four decades. On a risk-adjusted basis, Berkshire has outperformed any mutual fund or single stock that has a 40-year history. As a paper called “Buffett’s Alpha” puts it, “If you could travel back in time and pick one stock in 1976, Berkshire would be your pick.”
The purpose of that paper -- first drafted by Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen in 2013 and revised last month – isn’t to gush over Buffett’s record. It’s to ask how and why it was possible. Taking a hard, empirical look, it finds two big things that explain Buffett’s success.
One is that Buffett had unique access to cheap leverage, or borrowed capital, because his insurance companies could hold premiums collected upfront until claims needed to be paid out. That constitutes a form of cheap financing that isn’t available to most investors. The second element, which is widely accessible, lies in the kinds of stocks that Buffett chose to buy -- cheap, safe, and high-quality.
We know that buying cheap leads to better investment results – there is a mountain of evidence on this. But according to the paper, what really sets Buffett apart is his practice of buying “safety” and “quality.” Safety refers to stocks with relative price stability. But what about “quality?” What exactly is it? Quality can seem like a murky concept.
A 2013 paper called “Quality Minus Junk” (Asness, Frazzini, and Pederson) defined quality as something investors should be willing to pay a higher price for. It further characterized quality as having four dimensions. First is profitability, as measured by earnings, cash flows, margins or other metrics. Second is a record of growth. Third is safety – both in terms of stock price stability and fundamental factors like low debt or credit risk. And fourth is the profit that companies pay out (dividends), which is a measure of shareholder friendliness.
The paper found that when quality stocks are defined in this way, they do generate higher excess returns. They also command a higher price – though not as high as you would expect given their excess returns. That suggests that quality is “underpriced” by the market. And interestingly, quality is persistent -- meaning that the quality companies of today tend to remain quality firms five and ten years into the future.
Of course quality is in some ways the opposite of cheap – so how does quality work for value investors, who like cheap? Well, first, remember that quality might generally be underpriced by the market. And second, the paper suggests that combining quality considerations with value leads to better results than value alone.
Finally, keep in mind that the price of quality changes over time. The 2013 paper found that the price of quality reached its lowest level at the height of the dot-com boom in February 2000. It also was cheap before the 1987 crash and the 2008-2009 financial crisis. But after these events, the price of quality rose, reaching highs in late 1990, 2002, and early 2009. So perhaps the lesson here is to buy quality when it gets cheap during boom times -- not when everyone is rushing for the exits.