Inside today’s Daily Journal…

Editor’s Note: Today’s Journal is the fifth from Porter Stansberry about the decline of Berkshire Hathaway. On Friday we will publish our new Better Than Berkshire Index for all paid-up subscribers to Porter Stansberry’s Complete Investor. This is a portfolio of common stocks we created last year specifically to outperform Berkshire Hathaway. Over the past year its “delta” (the percentage difference between our Better Than Buffett Index and Berkshire Hathaway) was 15%.

To get access to the new Better Than Berkshire Index – as well as the list of 40 or so recommended stocks, the editorial Roundtable, and so much more that we provide in Complete Investor, click here.

Warren Buffett’s public reputation rests on a simple claim: he is the greatest stock picker in history. But like most of what the public believes about Buffett and Berkshire, that is not true. There is nothing special about Buffett’s stock picking.

But that doesn’t mean that Buffett wasn’t a great investor. He was! Buffett was, by far, the greatest investor in history, by a huge margin.

Over 486 months between October 1976 and March 2017 – 41 years of continuous operating data – Berkshire Hathaway’s Class A stock earned an average excess return of 18.6% per year above U.S.Treasury bills. Annualized volatility was 23.5%. Sharpe ratio: 0.79.

(The Sharpe ratio is the standard academic measure of risk-adjusted performance. It asks a simple question: how many units of return did you earn per unit of risk you took? A Sharpe of 0.5 is ordinary for the broad U.S. stock market. A Sharpe of 1.0 is excellent – world class for any investor. Berkshire’s Sharpe ratio of 0.79 is roughly 1.6x the broad U.S. stock market’s Sharpe ratio of 0.49 over the same period. Against the S&P 500 specifically, Berkshire’s information ratio – the excess return beyond the index, adjusted for the volatility of that excess – was 0.64.)

Among all large-cap U.S. stocks and mutual funds with 30-plus-year continuous track records, those are unmatched numbers.

One dollar invested in Berkshire on October 31, 1976, was worth more than $3,685 by March 31, 2017. A dollar invested in the S&P 500 with dividends reinvested over the same period was worth approximately $76. Buffett beat a passive index by a multiple of 48.

But he didn’t do it with stock picking.

Three researchers at AQR Capital Management – Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen – dissected Berkshire’s 50 years of investments through 2013. They expanded and republished their findings in 2018 in the Financial Analysts Journal, which is the most highly respected industry publication. Their work won the Graham and Dodd Award for the best published paper of the year. The paper is called, simply, Buffett’s Alpha.

(Alpha, for those of you not up to speed on all of the latest financial jargon, is a measure of investment performance that is not correlated to the overall increase of the market itself. It is, therefore, the measure that great investors judge themselves by.)

They found, after accounting for cheap leverage and exposure to a handful of publicly documented factor premiums, Buffett’s investment skill – the portion of his returns that cannot be explained by any mechanical strategy – is 0.3% per year.

That number is statistically indistinguishable from zero. In other words, the alpha that Berkshire enjoyed for 50 years (as it compounded capital at 24% a year!) wasn’t due to Buffett’s stock picking.

So how did he do it? He did it by gaining access to a huge amount of investment capital that he did not own, for free. Buffett’s track record was built on leverage. That’s a dirty word for most investors, but it was how Buffett gained access to this leverage that is the real miracle at Berkshire Hathaway.

The AQR researchers had access to something most Buffett commentators do not: 40 years of Berkshire’s audited financial statements, the full quarterly history of the public 13F stock portfolio, and the entire academic factor-return library that has been built out since Eugene Fama and Kenneth French published their three-factor model in 1992.

The researchers asked a specific question: