Value maven Buffett a closet leverage buff

Warren Buffett might be a value investing legend, but a new analysis of his investment approach suggests that Berkshire Hathaway Inc.'s chairman and CEO could be more accurately called a savvy connoisseur of risk.

In an unpublished paper, “Buffett's Alpha,” AQR Capital Management veterans Andrea Frazzini, David Kabiller and Lasse H. Pedersen argue that Mr. Buffett's success over the past half century is the result of a sophisticated application of leverage to a portfolio of quality, low-beta stocks.

Mr. Kabiller is a founding principal of AQR and head of client strategies. Mr. Pedersen is a principal and global asset allocation team member. Mr. Frazzini is a vice president with AQR's global stock selection group.

The authors count themselves among the legions of admirers of Mr. Buffett's skill as an investor — exemplified by the fact that over the more than 30-year period covered by AQR's empirical analysis, the stock of Mr. Buffett's holding company has enjoyed the highest risk-adjusted returns of any listed company.

Still, the most popular views offered up to account for Mr. Buffett's success — such as his ability to make long-term investments in undervalued companies — fall short in explaining that investment skill, Mr. Kabiller said in a recent interview with him and his co-authors.

Although the “value investor” label suggests a conservative investment approach, AQR's analysis shows Mr. Buffett hasn't shied from taking on considerable risk to garner exceptional returns for Berkshire Hathaway investors: an annualized 19 points above the Treasury bill rate between November 1976 and the end of 2011.

Mr. Buffett's use of “non-trivial” amounts of leverage — an average of 1.6-to-1, according to AQR's analysis — has been one pillar of the strategy he employs to achieve superior returns at higher risk, the paper argues.

With leverage a dirty word for many pension executives struggling with crisis-level funding gaps, the fact that Mr. Buffett is “a very big user of leverage” should serve as a reminder that the returns he enjoys aren't possible “without taking a lot of risk,” Mr. Kabiller said.

One period exemplifying that willingness to take — and bear — risk was mid-1998 to Feb. 29, 2000, the final stage of the Internet bubble, when Berkshire's stock price dropped 44% even as the broad Russell 3000 index was climbing 26%, according to AQR.

Mr. Kabiller said Mr. Buffett's skill in structuring Berkshire Hathaway as an investment vehicle may be almost as important as his skill in making specific investments. In particular, the company's insurance affiliates accrue premium payments years before the policies pay out, strengthening Mr. Buffett's ability to maintain leverage in environments where less deep-pocketed investors would have to resort to fire sales, he noted.

According to the paper, Mr. Buffett's “low-cost insurance and reinsurance businesses have given him a significant advantage in terms of unique access to cheap, term leverage.”

The float from that insurance business has provided, on average, 36% of the funding Berkshire Hathaway uses to lever up its portfolio, at a cost AQR estimates at more than three percentage points below the average T-bill rate.

Mr. Kabiller said another major finding of AQR's paper pertains to the type of company in which Mr. Buffett invests.

For the 35 years of data studied, controlling for standard equity market factors such as company size, momentum and value did little or nothing to explain Mr. Buffett's success. However, controlling for low-beta stocks and high-quality stocks (defined as companies that are profitable, growing and paying out dividends) — when applied to systematic portfolios AQR designed to simulate Mr. Buffett's investment style — did manage to account for the bulk of his outperformance, according to the paper.

In the interview, Mr. Kabiller said the low-beta arguments share the intellectual foundations that have led a growing number of money managers to launch low-volatility or managed-volatility strategies in recent years: that a portfolio of stocks with bottom-quartile beta can match or exceed the returns of the broader market with only a fraction of the volatility.

An October 2011 paper by Messrs. Frazzini and Pedersen said AQR's “betting-against-beta” version of that factor — which involves going long and leveraging low-beta assets while shorting high-beta assets — can produce “significant risk-adjusted returns.”

AQR's paper on Mr. Buffett's investment approach concludes that Mr. Buffett “has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance.”

The three authors say their analysis is helping guide AQR in developing strategies that can give investors access to the types of market exposures Mr. Buffett has exploited so successfully.

In the joint interview, Mr. Pedersen said while AQR has been trading for years on the specific themes touched on in their latest paper, the company next month will use partners' capital to launch a strategy to combine the factors — betting against beta, quality, value and leverage — in an optimal way.

AQR will look to source leverage in a cost-efficient manner by tapping prime brokers and using derivatives. With AQR looking to sell short high-beta stocks, the strategy will have a beta of roughly 0.5%.

AQR has forwarded a copy of their paper to Mr. Buffett.

Mr. Buffett didn't respond to calls seeking comment on the analysis.

Robert Hagstrom, an industry veteran and author of “The Warren Buffett Way,” said while he hasn't had a chance to vet AQR's math, the paper's broad conclusions — that Mr. Buffett favors investing in high-quality companies with resilient businesses when their stocks are trading at attractive prices, and that Berkshire Hathaway's insurance float leaves him better positioned to buy at moments when others are inclined to panic — are sound.

AQR's argument that Mr. Buffett takes on considerable risk, meanwhile, isn't incorrect if the context is modern portfolio theory's definition of risk as a function of volatility, noted Mr. Hagstrom. However, Mr. Buffett would likely opt for his own context and argue that buying high-quality, safe stocks at low prices effectively reduces his risk rather than increases it, he added.