October 26, 2011
I tried to shown in my previous article that by adopting a profit re-investment policy it was not only possible, but a simple way, to achieve an exponential Jensen ratio. The conclusion was that skill matters, and it grows with age. It's part of the very nature of an exponential time function. So the question becomes: why aren't most investors adopting such a winning strategy? Or better yet: are there ways to improve on this exponential Jensen ratio?
Just opening the door to exponential alpha may represent a major shift in modern portfolio theory. It says you are no longer bound by the efficient market frontier. That there is more out there and that simple procedures can give you access to higher returns. Not only higher returns, but returns increasing exponentially with time. This is almost heresy. Nobody has challenge the efficient market frontier for the past 60 years; no one has dared. All Modern Portfolio Theory is based on some form of the assumption of the efficient market hypothesis. And if markets are efficient, even under the weak form, then there is no long term alpha generation; and certainly no such thing as exponential alpha.
In my previous article, I tried to make the point that the exponential alpha was part of a reasonable explanation for Mr. Buffett's over-performance. If Mr. Buffett's alpha was just a number, then both performance lines (S&P and Mr. Buffett's) would not separate so fast, or maintained separate for so long. The increasing separation is the result of a measurable power function. Has anyone looked at a long term chart of KO or GE lately, two major holdings in Mr. Buffett's portfolio, which have been below their respective highs for the past decade.
The profit re-investment policy suggests that Mr. Buffett could have increased his Jensen ratio simply by re-investing more of his cash hoard in buying more companies and/or by adding more shares to his existing stock holdings. This in turn would raise another question: how high could an exponential alpha go?
From part I, a simple minor change to Mr. Buffett's pay-off matrix would be required to express his more aggressive stance:
Σ(HP(1+g+)(t-1).*ΔS+P) Mr. Buffett's pay-off matrix
where on his better stock selection process ΔS+P he would have applied a higher re-investment rate (1+g+)(t-1) using more of his generated profits to increase his holdings. And this would be sufficient to explain most of his added over-performance. Increasing his re-investment rate policy to g+ would indeed increase his overall performance.
Mr. Buffett's re-investment policy is under his control. He is the one to decide how and when to use his cash hoard. He is the one to determine at what rate it should be applied. It gives him the ability, in a way, to control where he wants to go, portfolio wise. He knows how to control, within his portfolio size constraints, at which rate he can progress in his re-investment policies. He knows when to get his “elephant gun”.
In recent years, Mr. Buffett has declared that he might not be able to sustain his high performance rate over the near future mainly due to the size of his portfolio. Increasing his re-investment rate could be the answer to compensate for the increasing portfolio size, since his increasing portfolio size will generate even more profits.
There is much to learn from Mr. Buffett's philosophy and investment procedures. If you want to improve on the bests, it becomes a good thing to know first what they do. Re-investing part of his generated profits is not all Mr. Buffett does. He has other little “tricks” to improve his overall performance.
I will try to give a different perspective and consider some of Mr. Buffett's investment procedures within the framework of my equations as if trying to explain his policies in my mathematical format, or maybe explain mine. This way, it should provide a kind of explanation to the somewhat esoteric formulas I have given. There is nothing mysterious behind my equations, they are simply expressions of various investment policies and implementation procedures.
Mr. Buffett invests for the long term. That is his primary vision. As he says, his preferred holding period is: forever. Then, he should be doomed like the rest of us to reside close but under the efficient market frontier. If you Buy & Hold, and you diversify over many companies, you are bound long term by the same constraints as everyone else. You can't change the price data and you have accepted not to change your holdings in an equation that has only two variables:
Σ(HP.*ΔSP) Σ(HD.*ΔSD) Σ(HM.*ΔSM) Profits
──────── → ──────── → ───────── = ────────
HPo*SPo HDo*SDo HMo*SMo Investment
And as was stated in part I, percentage wise, performance will tend to the average secular market trend. You can make better stock selections, but it is not enough. The No Free Lunch theory will come right back to haunt you.
I'll jump right to the point. Mr. Buffett in his arsenal of investment procedures tries to see the whole picture. He'll re-invest some of his accumulating profits, will trade, even short term if he sees an opportunity, he will write covered calls, write long term puts and will increase his bet size as his portfolio grows.
He tries to do everything at once, as long as he sees, in probability, a profitable outcome. All these investment procedures add up to provide him with a sustainable high performance level that could be considered the envy of many portfolio manager.
In my first paper in 2007 (Alpha Power), I summarized in a single formula a trading methodology (equation16) that tried to do everything at the same time. This equation evolved and was simplified at first to:
and then to the ITRADE formula. All three provide the same answer; the ITRADE formula is simply the matrix representation of the same thing.
In recent months, I've started making more parallels with Mr. Buffett's style of investing and my simplified formula. It is not that Mr. Buffett follows my equations, I don't think he is even aware of them, it is just that it does explain or provides, at least for me, a reasonable explanation for his over-achievement. And as a consequence, also serve as reasonable explanations for what the equations do. Mr. Buffett generates exponential alpha as a byproduct of his investment strategies. And as such, it is all talent, skills and know how that is at work.
The table and chart below shows my interpretation of what I think Mr. Buffett's investment policies do for him within the scope of my simplified equation. He might or might not have these investment policies in force but they do fit within my view of things; each contributing to the end results. I'll try to summarize each point as I see them:
When we look at the chart, we see that each items contributes to the bottom line. Little by little, each policy contributes to the overall performance. And I think that that is how Mr. Buffett can achieve higher levels of performance and succeed in maintaining them over the years. It is all a byproduct of his methodology, his skills at managing his huge portfolio. I must say I greatly admire the man.
Berkshire Hathaway Study: Growth Scenario
Berkshire Hathaway Study: 20 Year Chart
The presented scenario amounts to about 20.4% compounded annually.
In the first few years, it is hard to distinguish or separate the contribution of each of his investing procedures. But as time progresses, the picture becomes much clearer.
That is the question?
In this note, I've presented my equation as an explanation for Mr. Buffett's style of investing. My equation does not describe all he does but covers enough to provide a relatively close representation of his investment philosophy in action. It is not that my equations are out of this world, they are merely a representation of trading procedures and their consequences over time. And I am not making any suggestion that Mr. Buffett follows my equations either. They only serve for me as an explanation of what he might do, does or has done.
The ITRADE formula is simply a representation of trading policies in action; procedures that follow set rules of execution with a long term view of their own objectives. The formula says that by the choice of investment policies and trading procedures a portfolio manager can not only achieve positive alpha, he/she can aim for exponential alpha. And that is a major statement. You can set from day one your investment policies, what will be your trading rules and how you will monitor their progress over time. It is your knowledge of what you intend to do that will help you reach the higher levels of performance.
Based on the simplified equation, we know that a profit re-investment policy is a simple way to increase performance and already start to generate some low exponential alpha. I think it is the first requirement and probably the easiest to implement. It has the advantage of using the equity buildup which otherwise would sit idle in the portfolio.
But it is by adding a short term trading procedure that a portfolio can achieve much higher performance levels. It becomes a way of pumping cash in the account that can be used to accumulate even more shares than the re-investment policy alone.
And this can have a major impact on portfolio performance.
Created on ... October 26, 2011 © Guy R. Fleury. All rights reserved.