Given Warren Buffett's standing as one of America's most prominent dealmakers, it's not uncommon for some investors to think they can load up on shares of Berkshire Hathaway to fortify their portfolios.

The problem, though, is that placing such oversized bets on a single stock — even if it's the company which Buffett built — can inject a lot more risk into an otherwise globally diversified portfolio. This begs a rather fundamental question: Has Berkshire Hathaway sufficiently rewarded investors over time for accepting a higher level of risk?

Any in-depth analysis of Buffett's performance needs to consider his ability to produce 'alpha.' This is a word used in finance to express how much excess return a manager makes relative to a comparative benchmark.

Of course, Buffett isn't a mutual fund manager. Instead, he sits in the position of overseeing a business conglomerate that also happens to own equity positions in several blue-chip companies. Since Berkshire Hathaway is not a mutual fund, its share price reflects the market's estimate of the value added by Buffett's Rolodex, his capital allocation abilities and his company's acquisition prowess. This means any degree to which Buffett can add value in the future is already incorporated into today's price of Berkshire Hathaway.

As a result, IFA's wealth advisors like to warn investors that most of this Buffett-led company's oversized alpha happened long ago. Along these lines, we've compiled alpha data for Berkshire Hathaway and the Russell 1000 Value Index from 1981 through 2023, the largest data set available to us for calculating such a statistical analysis. 

Figure 1 below is a chart showing Buffett's ability to produce alpha for investors in Berkshire Hathaway over the initial 20-plus years (1981-2002) studied. The t-stat of the stock's alpha during this period was 3.13. That's notable since any such t-stat greater than 2.00 provides us with 97.5% confidence this period of outperformance exhibited some degree of skill, not just pure luck. (At the bottom of this report, we show what goes into calculating the t-stat.) 

Figure 1

By contrast, consider the next 20-plus years (2003-2023). As depicted below in Figure 2, Buffett's alpha produced a t-stat of 0.60. Not only does that reveal a big drop from his earlier days heading Berkshire Hathaway, but it also raises a major red flag.

If this period is used as an indicator of Berkshire Hathaway's performance going forward, it'd take an inconceivable number of years for an investor to gain enough statistical confidence that generating positive alpha was attributable to skill, not luck. 

Figure 2

In Figure 3, notice how such a significant later period of lagging performance is obfuscated by Buffett's earlier days running the company. Viewing this entire 43-year period indicates that almost his entire alpha occurred in the initial 22 years. 

Figure 3

It's also worth pointing out that we're not alone in coming to such a conclusion. Indeed, many other researchers have found much the same when analyzing Warren Buffett's performance record over time.

One of the most frequently cited and comprehensive research works we've found on the issue — "Buffett's Alpha" by Frazzini, Kabiller and Pedersen — attributed Berkshire's returns to the use of leverage as well as an investment focus on cheap stocks of companies with higher earnings quality.¹

In fact, a primary source of Berkshire's ability to raise capital has been the "float" coming from its insurance operations, according to the study. This refers to the difference between premiums collected and claims paid. Combined with Berkshire's ability to issue AAA-rated debt, these researchers found that Buffett has used such flexibility to operate the company with a low cost of capital.

Investors shouldn't be surprised by such findings. Leading market research continues to find that generating alpha on a consistent and longer-term basis is an unsustainable investment strategy. Even in those cases where it has been identified, tactical alpha opportunities have proved to be fleeting, at best.

In one of his notable letters to investors published by Berkshire Hathaway, Buffett himself observed:

At IFA, our investment strategy echoes Buffett's repeated endorsements of index funds as the best way for most investors to accomplish their investment goals over time. 

Below is a calculator to determine the t-stat. Don't trust an alpha or average return without one.

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^Footnotes:

1) "Buffett's Alpha," by Andrea Frazzini, David Kabiller and Lasse Pedersen, Jan. 10, 2019 (latest revision).  

2.) Berkshire Hathaway, Warren's Letter, Feb. 22, 2020. 

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