I recently came across the paper Buffett’s Alpha. It’s an award-winning, highly technical paper filled with math equations and other heavy financial modeling to understand how Warren Buffett, probably America’s greatest investor, was able to consistently significantly outperform the market for almost six decades with an overall 19% compound annual growth rate!

I read this long and technical paper so you don’t have to, and have summarized its findings below.

There are four things that helped Buffett with his edge:

• Investing style
• Finesse with leverage
• Minimal outside money
• Lucky to start in the 60s

Investing style

The paper uses the Carhart four-factor model to summarize Buffett’s investing style and explain where his alpha (stock market jargon for market outperformance) comes from.

The first Carhart factor, MKT, showed that Berkshire’s stock was less volatile than the rest of the market and significantly outperformed it, which we already know. The second factor, small-minus-big (SMB), showed that Berkshire tended to buy large stocks. The third factor, called the value factor (HML), showed that Berkshire tended to buy stocks that had a high book value relative to their market value. That is to say, Buffett bought cheap stocks. The final factor, the momentum factor (UMD), showed that Buffett is not a momentum investor and didn’t chase trends in his stock selection.

However, the paper states that these four standard factors actually don’t explain Buffett’s alpha. As such, it introduces two more factors to measure Berkshire’s performance by. First, the Betting Against Beta (BAB) factor which showed that Berkshire tended to buy low risk (low volatility) stocks. Second, the Quality Minus Junk (QMJ) factor, showed that Berkshire tended to buy companies that were profitable and growing. By controlling for just the BAB and QMJ factors, Berkshire’s public stock portfolio’s alpha is driven down to a statistically insignificant value.

Therefore, the main reason for Buffett’s success is his preference for low risk stocks that are profitable and growing.

Finesse with leverage

Buffett was able to obtain cheap leverage by buying insurance companies and using the insurance float as a sort of leverage. This was his genius. The insurance business model of charging insurance premium up front and paying out claims at a future date is essentially borrowing money from customers. When done properly, these loans are super cheap, significantly cheaper than the interest rates of the day.

Compound interest goes both ways, and an annual interest cost of 2% vs 5%, for example, makes a tremendous difference in the returns of a leveraged portfolio over time.

Even with cheap leverage, however, Buffett didn't really use a lot of it. According to the paper, about 1.6:1. This restrained use of leverage showed that Buffett was very careful and strategic with how he used it, and instead relied on consistent compound growth aided with just a little bit of borrowed money to achieve spectacular results.

Minimal outside money

Another stroke of genius from Buffett to achieve his long-running success is how he structured what is essentially his investment fund. Buffett closed off Berkshire from outside money very early on and more or less managed his own money throughout the decades. This might seem insignificant and perhaps even limited the amount of money Buffett could’ve made if he took on outside investments and charged a management and performance fee similar to modern hedge funds. However, even though Buffett stunted his short term income by avoiding outside money, this decision was key to Berkshire’s long term survival.

For example, from June 30th 1998 to February 29th, 2000, Berkshire lost 44% of its market value while the overall stock market gained 32%. If Berkshire had outside money, this would've probably killed the fund with an onslaught of redemptions from anxious outside investors.

Lucky to start in the 60s

Finally, it'd be remiss not to mention that even though Buffett employed significant skill in achieving such long-running success, he was also incredibly lucky to start investing in the time period that he did. This was a time period where access to information was low, thus increasing market inefficiencies and creating the underpriced companies that Buffett was able to invest in, and also the beginning of a multi-decade contraction of interest rates and expansion of the money supply by the Federal Reserve that is still ongoing today. In fact, just a few years after Buffett acquired Berkshire Hathaway, Nixon ended the gold standard, effectively giving a green light to the Federal Reserve to massively inflate the US dollar supply. This has unsurprisingly been a boon for the US stock market’s dollar-valuation.

If Buffett were to start investing today, it’s unlikely that he’d come even close to the performance he managed to achieve with Berkshire Hathaway since 1965. With the widespread availability of the Internet, and very accommodative central bank policies all over the world, markets are much more efficient and bloated. It’s incredibly hard to find the sort of deep value companies Buffett found in the 60s, 70s, and 80s to jumpstart Berkshire.

Thanks for reading

Hope you enjoyed this read and found it informative.