How Warren Buffet creates alpha?

The mystery over how Buffet creates alpha when most fund managers fail is an amazing one. It is the stupendous success of Buffet  which keeps active fund management going and stands against passive fund management/indexing etc.

Here is a paper which tries to figure where the gains come from? The authors shows that it is a simple strategy. First the fund has higher leverage which comes from stable sources (insurance premiums etc..). Then Buffet invests the leveraged proceeds into good quality stocks. The leverage magnifies the returns which generates higher alpha:

We estimate that  Berkshire’s average leverage is about 1.6-to-1 and that it relies on unusually low-cost and  stable sources of financing. Berkshire’s returns can thus largely be explained by the use  of leverage combined with a focus on cheap, safe, quality stocks. We find that  Berkshire’s portfolio of publicly-traded stocks outperform private companies, suggesting  that Buffett’s returns are more due to stock selection than to a direct effect on management.

Is it that simple? Conclusion nicely says it as Lessons from an Alpha Male…


One Response to “How Warren Buffet creates alpha?”

  1. Tirath Muchhala Says:

    The trouble with certain economists is that they try to simplify answers way too much. If one were to go through certain of Berkshire’s companies (good reads would be the ones by Roger Lowenstein and the Warren Buffett CEO, in addition to his letters) one would see that a lot of Berkshire’s success was through capital allocation decisions pertaining to cash generated by businesses. Look up See’s Candies or Nebraska Furniture Mart for example – small businesses which didn’t require significant ploughback of capital; this money usually found its way into other acquisitions. Hence, a comparison between the privately held companies and the publicly listed companies’ holdings are not apples to apples. More like apples to pizzas 🙂

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