In a series of previous articles on Seth Klarman’s book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” I showed how his statement that indexing assures mediocre returns was very clearly incorrect. I demonstrated as well that many of his additional contentions about indexing and market efficiency were also false. Today I’ll conclude by examining some of Klarman’s other claims.
When discussing the efficient market hypothesis, Klarman asserts: “Yes, the market does tend to incorporate new information into prices, yet the market is far from efficient. There is simply no question that investors applying disciplined analysis can identify inefficiently priced securities and achieve superior returns.” He added: “The pricing of large-capitalization stocks tends to be more efficient than that of small-capitalization stocks … and other less-popular investment fare.”
Klarman then concludes: “The elegance of the efficient market theory is at odds with the reality of how financial markets work.”
This idea about mispricings in less efficient markets is one of the more popular and most repeated myths in investing. There simply isn’t evidence to support this claim. No matter how many times it’s repeated, it is just not true. If it were, then how did both DFA’s Emerging Markets Small Cap Fund (DEMSX) and its International Small Cap Value Fund (DISVX) achieve Morningstar’s first-percentile ranking for the 15-year period ended Sept. 18?
The DFA International Small Company Fund (DFISX) had a 20th percentile ranking, meaning it outperformed 80 percent of surviving funds. The firm’s U.S. Small Cap Fund (DFSTX) and its U.S. Micro Cap Fund (DFSCX) also outperformed a large majority of their actively managed counterparts, with percentile rankings of 38 and 37, respectively, and that’s without accounting for survivorship bias in the data (about 7 percent of all funds disappear every year).
The Superinvestors Of Graham-and-Doddsville
Like many before him, Klarman cites a group of investors who delivered market-beating returns (they all came from the same “ZIP code,” which Warren Buffett famously referred to as Graham-and-Doddsville). These investors all hailed from the same place, which for Klarman serves as proof that their outperformance could not have been a coincidence, or random outcome. This is his evidence that markets are inefficient.
Klarman stated: “There is no doubt that the group of superstar investors that Buffett identified in the talk he gave in 1984 in honor of the 50th anniversary of the publication of Benjamin Graham and David Dodd’s book, “Security Analysis,” had outperformed the market.”
I would add that there is also no doubt that, at the time (and keep this in mind), their outperformance should have been considered true alpha—meaning that it wasn’t just outperformance, but outperformance on a risk-adjusted basis.
In his book, Klarman wrote: “Buffett’s argument has never, to my knowledge, been addressed by the efficient-market theorists; they evidently prefer to continue to prove in theory what is refuted in reality.” If Klarman had read the literature, he would know that this statement is false.
As discussed in my own book, “The Incredible Shrinking Alpha,” which was co-authored with Andrew Berkin, by studying the historical data, including the performance of the great investors, academic researchers have, in fact, been able to identify systematic factors that explain the outperformance of these superstar investors quite well.
Evidence Of Factors
And as we further describe, by identifying these systematic factors, academics have converted what once was alpha into beta (or loading on a factor). For example, in 1981, Sanjoy Basu in “The Relationship Between Earnings’ Yield, Market Value and Return for NYSE Common Stocks” found that the positive relationship between the earnings yield (E/P) and average return is left unexplained by the market beta.
In 1985, Barr Rosenberg, Kenneth Reid and Ronald Lanstein found a positive relationship between average stock returns and book-to-market (B/M) ratio in their paper, “Persuasive Evidence of Market Inefficiency.” These two studies provided evidence that, in addition to a beta and a size premium, there also was a value premium. And since 1926, the annual value premium has been about 5 percent.
Finding the value premium went a long way, though not all the way, to explaining the superior performance of those superstar investors from Graham-and-Doddsville. Now that evidence is 30 years old.
A more recent contribution to our understanding of the sources of returns to diversified portfolios—and one that helps further explain the results of the Graham-and-Doddsville investors—comes from Robert Novy-Marx. His June 2012 paper, “The Other Side of Value: The Gross Profitability Premium,” provided investors with new insights into the cross section of stock returns. Novy-Marx found that profitable firms generate significantly higher returns than unprofitable ones, despite having significantly higher valuation ratios.
Controlling for profitability, defined as revenue minus cost of goods sold divided by assets, increases the performance of value strategies, particularly if value is defined by book-to-market. The stocks of the most-profitable firms earn average returns that are 3.7 percent per year higher than the stocks of the least-profitable firms. This concept has also been extended to a quality factor, which captures a broader set of quality characteristics (discussed below). And once again, what was once alpha became beta (or loading on systematic factor).
We’ll now turn specifically to looking at Warren Buffett’s alpha.
Explaining Buffett’s Alpha
As we explain in “The Incredible Shrinking Alpha,” the “conventional wisdom” has always been that Warren Buffett’s success can be explained by his stock-picking skills and his discipline (meaning his ability to keep his head while others are losing theirs).
However, a 2013 study authored by Andrea Frazzini, David Kabiller and Lasse Pedersen, titled “Buffett’s Alpha,” provides us some interesting and unconventional answers.
The authors found that, in addition to benefiting from the use of cheap leverage provided by Berkshire Hathaway’s insurance operations, Warren Buffett bought stocks that are safe, cheap, high-quality and large. The most interesting finding in the study was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys.
High-quality companies have the following traits: low earnings volatility, high margins, high asset turnover (indicating efficiency), low financial leverage, low operating leverage (indicating a strong balance sheet and low macroeconomic risk) and low specific stock risk (volatility unexplained by macroeconomic activity). Companies with these characteristics historically have provided higher returns, especially in down markets.
In other words, it is Buffett’s strategy (or exposure to factors) that explains his success, not his individual stock-picking skills. Frazzini and Pedersen, authors of the 2014 study “Betting Against Beta,” found that once all factors—market beta, size, value, momentum, betting against beta, quality and leverage—are accounted for, a large part of Buffett’s performance is explained, and his alpha is statistically insignificant.
Martijn Cremers and Ankur Pareek—authors of the September 2014 paper, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently”—reached the same conclusion as Frazzini and Pedersen.
They write: “Our results thus indicate that Warren Buffett’s skill seems generally shared by mutual fund managers in the top Active Share and Fund Duration [turnover] quintiles: the clear majority of their outperformance seems due to their picking safe (low beta), value (high book-to-market) and quality (profitable, growing, less uncertainty, higher payout) stocks and holding on to those over relatively long periods.” In other words, there wasn’t evidence of statistically significant alphas once exposure to systematic factors was taken into account.
Still A Superstar
It is important to understand that these findings don’t detract in any way from Warren Buffett’s performance (or that of the other superstar investors from Graham-and-Doddsville). After all, it took decades for modern financial theory to catch up with him (or them) and discover his (or their) “secret sauce.”
And being the first, or among the first, to discover a strategy that beats the market is what will buy you that yacht. Copying the strategy after it is already well-known, and after all the low-hanging fruit has already been picked, will not.
That said, these findings provide insight into why Warren Buffet and his “neighbors” in Graham-and-Doddsville were so successful. His genius appears to be in recognizing long ago that these factors work. He applied leverage without ever resorting to a fire sale and stuck to his principles. Buffett himself stated in Berkshire Hathaway’s 1994 annual report: “Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
For investors, it’s important to understand that once the systematic factors have been discovered, and low-cost, passively managed investment vehicles are introduced, providing access to them for all investors, alpha gets converted to beta. Investors no longer have to pay the high costs of active management to access these factors.
And you can invest using the same philosophies and strategies of those superstar investors. Today the funds my firm uses to help construct client portfolios (in the interest of full disclosure, those include AQR, DFA and Bridgeway) incorporate exposure to these factors into their fund strategies.
Top Fund Performance
Since Klarman mentioned the superstar investors, I thought it worth reviewing the records of the two funds that Buffett mentioned in that 1984 speech, which are still live and have public records. They are the Sequoia Fund and Tweedy Browne Value.
Because both SEQUX and TWEBX are global funds that invest in large value stocks, we can look at the performance of these funds and compare their returns to those of the DFA U.S. Large Cap Value Fund (DFLVX) and the DFA International Value Fund (DFIVX).
For the 15-year period ending Sept. 21, 2015, SEQUX returned 9.94 percent, TWEBX returned 4.94 percent, DFLVX returned 8.02 percent and DFIVX returned 5.95 percent.
Clearly, no matter what combination of domestic and international stocks we choose, SEQUX outperformed the DFA funds and TWEBX didn’t. One winner, SEQUX, and one loser, TWEBX, certainly isn’t any evidence of market inefficiency.
The bottom line is that the evidence we have reviewed doesn’t support Klarman’s claims that the market is inefficient. It also provides clear support that he was incorrect in his assertion that academics haven’t addressed the issues raised by Buffett in his 1984 speech.
This commentary originally appeared October 2 on ETF.com
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