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Combining Factor and Value Investing Mirroring Warren Buffett; a Five-Factor Model, Applied to the FTSE 100

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Combining Factor and Value Investing Mirroring Warren Buffett; a Five-Factor Model, Applied to the FTSE 100 Combining factor and value investing Mirroring Warren Buffett; a five-factor model, applied to the FTSE 100 Abstract Using a previous study, this paper aims to apply a model that mirrors the performance of investor Warren Buffett to the FTSE100. An outperformance of the FTSE100 is expected. The model is applied and one of the factors, describing the quality of an investment, is not significant. By going long the predicted 30 best performers and shorting the predicted 30 worst performing stocks, an outperformance of the FTSE 100 with 25.87% is measured. Bachelor Thesis Economics and Business Specialization Finance and Organization July 1st, 2014, Amsterdam Name: Bob Verhagen, 6058310 Thesis Supervisor: V. Malinova 1 1. Introduction When people, companies, pension funds, governments and many other entities have an excess amount of cash there are, abstractly spoken, two ways to invest the money. Either, an investor assumes a market's return and invests in an index (tracker), or an investor selects a specific investment (fund) and assumes the return of that specific investment (fund). Usually, a selection is based on the higher expectations of the risk-adjusted returns of a (basket of) security('s). Investors, when selecting which securities to invest in, dedicate time and money to research individual securities (financial) background. One of these investors, Warren Buffett, has an interesting track record of above average risk-adjusted return profiles for the past 30 years. From several of his statements in annual reports and at press releases, his appetite for qualitative companies for a good price has become known. Mirroring his stock picking ability, though, has proved nearly impossible. To mirror his performance, Frazzini, Kabiller and Pedersen (2013) launched a factor model which should copy Buffett's way of picking securities; high quality, low risk and high risk- adjusted return securities. They manage to mirror his risk-return profile, but express they can only do it with the benefits of hindsight; insight in Buffett's theories and principles. Investors, always looking for above average returns, can be expected to want to know if Frazzini, Kabiller and Pedersen (2013) have opened up Warren Buffett's returns to the public. Frazzini, Kabiller and Pedersen (2013) use a dataset with securities from the United States. This paper will research if investing securities by using the model from Frazzini, Kabiller and Pedersen (2013) in the FTSE 100, during the time period from 01-01-2002 to 31-13-2008 yields an above market return. In the literature review I will first explain the doctrine of efficient capital markets and the impossibility to beat the market. Investors can choose a risk-return profile along the capital market line, supported by the capital asset pricing model and with the existence of a riskless asset, which can also be shorted. Questioning the capital asset pricing model and its assumptions, I introduce abnormalities in the pricing of securities, which open up opportunities for investors to outperform the risk-adjusted market return and earn above average returns. This is followed by the rejection of the efficient capital market hypothesis and the joint hypothesis problem. With the support of several studies, the Frazzini, Kabiller and Pedersen (2013) model is constructed to mirror the performance of Warren Buffett. 2 This model is applied to the FTSE 100 market index, to investigate outperformance within the London Stock Exchange. The investments are mirrored from 01-01-2002 until 31- 12-2008, to mirror the holding period of a value investor. 2. Literature review efficient capital markets and outperformance Investors are always looking to outperform the market. Whether or not this is possible, has been up for debate by supporters and opponents of the theory on efficient capital markets. For opponents, Warren Buffett's performance is part of the ‘proof’ of imperfect efficient capital markets. As the founder and manager of Berkshire Hathaway, an investment fund, he has been able to outperform the market over a long period of time (Lowenstein, 2008). This section reviews the existing literature. First we move from the random walk of the capital markets to the efficient capital markets theory. In the efficient capital markets theory, investors can only choose a risk-return profile along the capital market line. Second, we look at flaws in the efficient market theory and potential ways to outperform the market. Third, we look at how these flaws are used to construct a factor model. 2.1 Efficient capital market theory As one of the first to provide a solid view on competition and efficiency in (financial) markets, Samuelson (1965) and Mandelbrot (1966) find that past performance cannot be extrapolated to the price of a security in the future. This is supported by Samuelson's (1965) s random walk model (equation (1)). (1) Xt = µ + Xt-1 + εt Where - Χ is the price of a stock a time t, - μ depicts de arbitrary drift parameter, - ε depicts random disturbance In the random walk model, the unspecific pattern of availability of newly available information is assumed. Therefore, the price of a security shows a random walking pattern, as it reacts on new publicly available information, which cannot be predicted, is available to all and is free to find out to investors. Fama (1970) reviews the efficient capital market theory and, in particular, its three forms: weak, semi-strong and strong. In weak form efficient capital markets, prices reflect 3 historical capital market prices. All the historical financial information from a security is available to all investors. Based on the weak-form efficient capital market theory, it is impossible to beat the market by predicting the future price of stock, based on all stock price information. In the semi strong form of the efficient capital markets theory, prices adjust efficiently to new information which is publicly made available. As soon as new information, relevant to the company, is out in the open, this is reflected in the stock price. In the strong form of the efficient capital market theory all information, both publicly and privately available, is reflected in the price of a security. For the three forms, Fama (1970) shows extensive, yet contradictory, evidence for weak and semi-strong efficient capital markets. To research investor’s ability to beat the efficient capital markets, academics encounter the problem of joint hypotheses. In a test of the efficient capital market theory, investors are simultaneously testing the efficiency of the market and the asset pricing model, driven by the risk preference of the investor (Sewell, 2011). The right performance of a security is found in an efficient capital market, where the security is rightly priced. If the security is an outperformer and the efficiency of capital markets is assumed, there are two potential cases: (1) Capital markets are efficient, but the pricing model is wrong. This causes the wrong price for a security to be expected (2) The capital pricing model is correct, but the capital markets are inefficient. This causes outperformance to be linked to the inefficiency of capital markets. The problem with these two hypotheses is that to price a security in an efficient market, these two hypotheses would have to hold simultaneously. If outperformance is found, this cannot be linked to either inefficient capital markets or an incorrect pricing model. Therefore, we cannot reject the efficient capital market theory. The strong-form of efficient capital markets contradicts with Buffett’s ability to outperform the capital markets and find a significant alpha (α), a measure for outperforming the market, for the long period of time that Warren Buffett has been investing (Lowenstein (2008) and Frazzini, Kabiller and Pedersen (2013)). An investor, unable to use the inefficient capital markets to outperform under the strong-form of the efficient capital market theory, can only assume the level of risk that he is willing to take to match with the corresponding level of return. This is shown by the capital market line (Markowitz, 1959). Markowitz's (1959) risk return profile corresponds with the uselessness of investing either time or money in stockpicking; an investor researching a stock has no extra return over 4 his chosen risk profile. Tobin (1958) shows that, as a result of the capital market line, an investor only needs to decide on the optimal risky asset portfolio and on the division of his investments between the risky asset portfolio as produced by the capital market line and the riskless asset. Sharp (1964) depicts this as picking the optimal point on the investment opportunity curve, optimizing risk-adjusted return to maximize an investors wealth. Lintner (1965) continues Sharp (1964) under the assumptions that all investors follow the mean- variance portfolio and agree on the true joint distribution, comprised of the value weighted market portfolio. In Lintner's (1965) system, only bearing the risk of the market is rewarded, as risks of individual securities are diversified and the market risk remains. This is reflected in the Sharp ratio, a measure for the risk-adjusted return of a security. Black, Jensen and Scholes (1972) develop the Capital Asset Pricing Model (CAPM, described in equation (2) (2) E (R) = R(f) + βi * (E(Rm) – R(f)) Where: - E (R) is the expected return of a security, - Rf is the riskfree rate, - βi is the beta of security I, the amount of risk, relative to the market risk, - E(Rm) is the market return which states that securities have different riskprofiles relative to the marketrisk. Investors choose a certain risk level, relative to the market risk and receive a corresponding return, relative to the market return. If an investor buys a security with a higher risk, relative to the market risk, he can expect a higher return, relative to the market return.
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