New Research on the Miracle That is Warren Buffett: We Better Talk Low-Beta

A research paper from the quants at AQR Capital management making the rounds concludes that Warren Buffett’s investing edge comes from two quantifiable factors: a penchant for high quality firms with low betas, and the ability to harness the leverage of investing premiums from Berkshire Hathaway’s (BRK.B) insurance subsidiaries.

The low-beta angle has obvious appeal for rank-and-file investors. (Leverage? Well, that’s between you, your broker and your margin account.) And AQR’s research joins a building chorus of wonk papers that upend the conventional wisdom that says risk and reward are inextricably hitched. AQR and others sliced and diced reams of data to basically come to a simple conclusion: The least volatile stocks -- AQR uses beta, some studies focus on standard deviation -- over long stretches can provide the same or better return as the market with less volatility.

One reason for the anamoly is that most investors don’t use leverage, so to magnify the potential gains they gravitate toward the higher beta stocks, presuming they offer higher reward potential. That leaves the lower beta stocks under-loved, or in more technical terms: undervalued relative to their intrinsic worth. And that’s indeed very Buffett-ish. If you’re willing to zig a bit while everyone else is zagging, there’s a pretty good chance you can outperform on a risk-adjusted basis over the long-term.

AQR has put its theory to practice in a suite of new mutual funds. The sales literature for the AQR U.S. Defensive Equity fund sure sounds like something Buffett could warm up to:

“The Fund seeks to invest in lower beta stocks of companies with stable businesses, high profitability, low operating and financial leverage, lower earnings-per-share variability and other measures of quality.”

The five largest holdings in the new fund are Johnson & Johnson (JNJ), McDonald’s (MCD), Colgate-Palmolive (CL), Reynolds American (RAI), and Wal-Mart (WMT). Johnson & Johnson and Wal-Mart are among the largest stock holdings in Berkshire Hathaway’s investment portfolio, though recently Buffett has been trimming the Johnson & Johnson stake.

All five certainly clock in with a below-market beta.

JNJ Beta Chart

JNJ Beta data by YCharts

And they also deliver on profitability and valuation.

Here’s a look at McDonald’s using three metrics you can pull up on Ycharts to suss out quality and price.

MCD Free Cash Flow TTM Chart

MCD Free Cash Flow TTM data by YCharts

Johnson & Johnson isn’t as clear a case; but despite an embarrassing run of recalls and lawsuits the past few years, the long-term picture shows a remarkable cash-flow cow.

JNJ Free Cash Flow TTM Chart

JNJ Free Cash Flow TTM data by YCharts

Interestingly, all five stocks also show up in the 100-stock portfolio of the PowerShares S&P 500 Low Volatility ETF (SPLV), which has mushroomed to $2.5 billion in assets in its first 16 months of operation. The five largest holdings in the ETF are Southern Company (SO), Kimberly-Clark (KMB) , General Mills (GIS), Procter & Gamble (PG), and ConAgra (CAG). Though the S&P 500 Low Volatility index specifically screens on standard deviation, the reality is the S&P approach to low volatility skews toward low beta as well. (Beta measures an individual security’s volatility relative to a benchmark index; standard deviation measures the historic variability of performance for a given security. Different? You bet, but both are classic measures of risk.)

SO Beta Chart

SO Beta data by YCharts

Fishing for low-beta stocks from big profitable firms also shares plenty of overlap with another increasingly popular investment theme: dividend payers. The five largest holdings in AQR’s U.S. Defensive Equity fund pay out a lot more than the 1.75% yield on the 10-year Treasury.

JNJ Dividend Yield Chart

JNJ Dividend Yield data by YCharts

And that’s another similarity with Buffett. He loves him some dividends for Berkshire’s investment portfolio; he’s just not interested in Berkshire paying out dividends to shareholders (at least not yet.) For example, Buffett has pointed out that the amount of dividends Berkshire receives from from its Coca Cola (KO) stake will soon exceed the value of his initial investment in the stock. That’s what dividend growth does for you.

Performance wise, the AQR fund was just launched this past summer, but the slightly-longer history of the PowerShares S&P 500 Low Volatility ETF includes a few distinct up and down stretches. Here’s how it stacks up against the SPDR S&P 500 ETF (SDY):

SPLV Total Return Price Chart

SPLV Total Return Price data by YCharts

That is, of course, a ridiculously short period of time. But as the research of AQR and others shows, focusing on low volatility and low beta delivers over long market cycles. Here are the top five stocks again, looking at their five-year total returns:

JNJ Total Return Price Chart

JNJ Total Return Price data by YCharts

Just be forewarned: there’s no free lunch here. The payoff comes from losing less in bad markets and thus having less to recover on the rebound. And there’s been plenty of that happening the past five years. But in roaring bull markets the low volatility approach will lag the high-flyers. That’s why AQR slapped the term “Defensive” on its funds. Right now defensive looks great. Having the patience to stick with it when the markets are on a tear is how to make the most of the low-beta and low-volatility approaches.

Carla Fried is an editor for YCharts which includes the just released YCharts Pro Platinum for professional investors.



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