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Apologies if this has already been posted.

I recently came across this academic paper - http://www.econ.yale.edu/~af227/pdf/Buffett%27s%20Alpha%20-%... which purports to explain Buffett's outperformance. I found it quite interesting because all the recent academic findings the authors used (the betting against beta and quality factors) were long since informally discussed in Buffet's annual letters!
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The authors of this paper were honest/generous in giving full credit to Buffett, who acted on these principles decades prior to their academic studies:

It cannot be emphasized enough that explaining Buffett’s performance with the benefit of hindsight does not diminish his outstanding accomplishment. He decided to invest based on these principles half a century ago! He found a way to apply leverage. Finally, he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies.
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On the other-hand my portfolio performance of 58.4% compounded 1992-1994 <Audited> is explained by superior company investment selection.


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Is that for the entire three year period, or from the end of 1992 to the start of 1994?

Joe
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Indeed. I had no intention of implying otherwise and regret if it appeared otherwise. It is still interesting, however, that it took so long for these points developed so early by Buffett to be analyzed by academics.
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Thanks for posting the link!
The paper has several cringe-worthy statements. Overall, it stinks of professorial smugness.

1. I don't think Buffett pays attention to P/B if the company has dependable earnings, e.g. Coke. Strike one for Buffett buying "cheap" stocks as asserted by authors.

2. Their overall attitude is as if free insurance float falls from the sky witout effort, there is no mention of Buffett's (or Jain's or GEICO's) intelligent underwriting.

3. Their use of the word "leverage" is intriguing. They don't consider total leverage (operating * financial), but only financial leverage (assets/equity at market value.) If the operating companies have a lower beta, then Buffett is justified in using higher "leverage" because the overall risk is still very low. Secondly, as pointed out many times by Mungofitch, this so-called leverage is through the use of uncallable debt. Thirdly, even after all that, the (financial) leverage is only 60% D/E, and in fact even lower (40%) when you only consider actual debt + float. This is not very high even for a primarily operational company, let alone a mixture like Berkshire.

4. They focus on irrelevant factors. Accelerated depreciation, seriously, who cares? You can't live on that for 35 years (1976-2011) that the authors looked at. Almost every asset will depreciate fully in that time and the shield from early years will be balanced by the later years.

5. Instead of admitting that Buffett's success cannot be explained by Fama-French + momentum model, they make an odious addition to the model:
"Our innovation is to also control for the Betting Against Beta (BAB) factor of Frazzini and Pedersen (2010) as well as the quality factor (QMJ, “quality minus junk”) of Asness, Frazzini, and Pedersen (2012b). A loading on the BAB factor reflects a tendency to buy safe (i.e., low-beta) stocks while shying away from risky (i.e., high-beta) stocks. Similarly, a loading on the quality QMJ factor reflects a tendency to buy high-quality companies, that is, companies that are profitable, growing, and paying out dividends (see Asness, Frazzini, and Pedersen (2012b) for details)." If you use CAPM, be a man and admit that the theory presupposes that low-beta stocks are also low-expected-return stocks. If their actual returns are better than high-beta stocks, the original theory was wrong! Don't prop it up with BAB and QMJ as if BAB and QMJ can be identified ex-ante. They can't.

The last part of the paper is where they slice and dice the risk and present a strategy of "how to be Bufefett". Color me skeptic. Maybe I will come back in 20 years and audit their results. Surely these academics will eat their own cooking by investing their entire net worth in their strategy, like Buffett did.
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5. Instead of admitting that Buffett's success cannot be explained by Fama-French + momentum model, they make an odious addition to the model:
"Our innovation is to also control for the Betting Against Beta (BAB) factor of Frazzini and Pedersen (2010) as well as the quality factor (QMJ, “quality minus junk”) of Asness, Frazzini, and Pedersen (2012b). A loading on the BAB factor reflects a tendency to buy safe (i.e., low-beta) stocks while shying away from risky (i.e., high-beta) stocks. Similarly, a loading on the quality QMJ factor reflects a tendency to buy high-quality companies, that is, companies that are profitable, growing, and paying out dividends (see Asness, Frazzini, and Pedersen (2012b) for details)." If you use CAPM, be a man and admit that the theory presupposes that low-beta stocks are also low-expected-return stocks. If their actual returns are better than high-beta stocks, the original theory was wrong! Don't prop it up with BAB and QMJ as if BAB and QMJ can be identified ex-ante. They can't.

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To be fair to the authors, they recently showed that low beta stocks actually return more than high beta stocks and have constructed a "betting against beta" factor to "explain" the result (they have no really good argument as to why this is, in fact, the case). Hence, they are not using the CAPM. In other words, they have an adequate enough understanding of the phenomenon to put a name on it but are still far from actually explaining it in a reasonable and convincing manner.

P.S. How do you get the italics on the original post when you reply? <quote> tags don't seem to achieve that.
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<quote> tags don't seem to achieve that.
Use i (for italic) in the tag.
Or b (for bold).

http://www.fool.com/help/index.htm?display=community02#Styli...
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