The secrets of Buffett’s success: Beating the market with beta
The S&P 500 has had the second greatest return among assets over the last 80 years only behind small stocks. The S&P 500 is made up of 500 large cap stocks, which make up roughly 80% of the equity market capitalization. S&P 500 has been a bench mark that investors tend to use to track their own performance in the market.
One of the factors that investors look at when picking stocks to invest in is beta. The beta helps determine how volatile the stock is to the market. For example if a company has a beta greater than one it is more volatile, resulting in greater risk and possible greater return. Consequently, a company with a low beta is less volatile making it a safer, more conservative investment.
Investors can measure their expected rate of return using the Capital Asset Pricing Model (CAPM). CAPM uses beta, risk free rate and market rate to determine the expected return on the stock; the higher the beta, the higher the market-related risk and the higher the expected return. This helps investors to determine if they believe that the investment is work the risk.
Mutual funds and pension funds, chasing (higher risk) higher returns tend to invest highly in high beta stocks, Because they are prohibited from borrowing money, leverage as a way of obtaining higher returns is not open to them; hence they rely disproportionately on high beta stocks to allow them to increase the value of their portfolio.
Large players such as mutual funds and pension funds avoiding low beta stocks and concentrating on high beta stocks thus leads to an undervaluation of low beta stock and an overvaluation of high beta stocks.
Buffet was able to use the undervaluation of low beta stocks to his advantage in making a success of Berkshire Hathaway. He used the strategy of investing in high-quality companies when they were having a down turn. He believed it was best to invest in a great company at a fair price rather than a fair company at a great price. That is why some of his big investments include Coca-Cola and General Electric. He acquired these investments when they were both experiencing a temporary down turn and presumably at a time when they were experiencing low return volatility and exhibited low betas. As the article says, “He has also steered largely clear of more volatile sectors(.)”
Buffet was able to use a low beta strategy to his advantage by using the capital available to him from the insurance division of Berkshire Hathaway. He accomplished this essentially by borrowing cash from the insurance division and investing it in low beta companies. The use of its insurance diversion allowed Berkshire Hathaway to borrow money at a rate of 2.2%, which has been 3 percentage points less than the yield on government bonds over the same period. This strategy helped Buffet and Berkshire Hathaway have the great returns they have had over the last few decades.
- Why has no one else been able to imitate Buffett’s success?
- From a personal investing stand point, is it better to invest in high beta or low beta stocks? Why?
- Explain how Warren Buffett used a form of arbitrage to make his profits? How is this technique similar to arbitrage and how does it differ from pure arbitrage