By James Mackintosh 

The story of Kraft Heinz Co.'s takeover bid for Anglo-Dutch consumer-goods giant Unilever is short, having lasted from Friday only to Sunday. But behind it lies a tale of market anomalies that have lasted decades, helped make Warren Buffett's fortune and may -- perhaps -- have ended in a mini-bubble last year.

Mr. Buffett is renowned as a savvy "value" investor. But much of the billions made by the Sage of Omaha at Berkshire Hathaway was earned by exploiting two market mistakes: the tendency for quality companies and low-risk stocks to outperform.

There are many ways of measuring the anomalies, and Kraft Heinz and Unilever fit all of them. They are high-quality companies with predictable earnings and strong cash flow, whose shares have lower-than-average volatility and move less closely in line with the market than the norm -- in the jargon, they have lower beta. Kraft is piled high with debt, and Unilever is not, but investors bought into both of their stories last year.

The big question is why such stocks outperform, and so whether they will continue to do so.

The explanation for last year's performance is pretty clear. Rock-bottom bond yields pushed many investors to buy stocks paying steady dividends instead, and there is a big overlap between measures of low volatility, high quality and a secure dividend.

The result was a stunning performance from those exploiting the anomalies, followed by a snap-back when the fervor for dividends subsided. MSCI's minimum-volatility index did fabulously well until July, then turned around. The pattern for low-beta stocks was similar, while quality stocks had a hard time keeping up with the rebound in highly indebted oil-related stocks.

Ryan Taliaferro, who runs managed-volatility portfolios at Acadian Asset Management in Boston, says the market was distorted by exchange-traded funds that try to exploit these anomalies. At one point he calculated that the stocks in the minimum-volatility index were significantly more expensive than similar stocks not in the index. "That felt kind of bubbly," he says.

Last year's boom-bust pattern is unlikely to be repeated, but there are two competing explanations for the longer-run performance record of safe stocks.

The first is about human behavior. Investors like to get rich quick, like to gamble and have too much faith in their own analysis, so stocks that look like lottery tickets are particularly appealing. High-volatility and more market-sensitive (in the jargon, high-beta) stocks should be overpriced as a result, and so deliver lower returns in the future. So long as get-rich-quick investors remain ignorant of the mistake they are making, the anomaly will continue for everyone else.

The alternative theory is about leverage. Leverage can be added to the safest stocks to bring them up to the same level of risk as the wider market and deliver higher absolute returns. Mr. Buffett found a smart way to gear up using an insurer, but many investors prefer to avoid leverage because of drawbacks such as margin calls. Others are prevented from borrowing by investment mandates. Those who can't use leverage chase higher returns by buying inherently riskier stocks instead -- the same ones that appeal to the get-rich-quick investors. Again, the anomaly remains.

There is something in both explanations, according to a new paper by Cliff Asness, Andrea Frazzini and Lasse Pedersen of fund manager AQR and Niels Gormsen of Copenhagen Business School. Investors don't like or can't get loans, and prefer "lottery-ticket" stocks.

This is where we come back to Mr. Buffett and Kraft. Kraft is the embodiment of a strategy to exploit both anomalies: It is a high-quality underlying business but no longer especially low volatility because it has been loaded up with debt. Unilever doesn't have the debt, so it is still a quality, low-volatility stock.

Mr. Buffett's extraordinary investment record rests on the same principles, according to an earlier AQR analysis by Mr. Frazzini and colleagues. They found that Mr. Buffett's preferences for safe and high-quality stocks "almost completely explain the performance of Buffett's public portfolio," once leverage was accounted for.

Kraft has walked away from Unilever, but investors should be keeping an eye on the sheer amount of money now dedicated to these anomalies. The more cash chasing them, the less powerful the anomalies will be.

"It's something to worry about," says Prof. Pedersen. "I think as awareness of these effects increases that could certainly diminish the returns."

It's hard to track the amount of money investors have dedicated to exploiting the anomalies, and impossible to establish how much leverage is used. But valuation offers one proxy, because safer stocks and higher-quality stocks ought to be worth more than risky ones or lower-quality ones.

As investors have tried to exploit the anomaly, valuations have indeed risen. MSCI's USA Minimum-Volatility Index has a higher price-to-book and higher forward price-to-earnings ratio than the wider market. California-based Research Affiliates calculates that at the end of last year the valuation premium for a low-volatility portfolio above the wider market was about as big as it has ever been. The valuation premium for quality stocks depends on how quality is measured, but on RA's own metric it is above the historic average.

Kraft's bid suggests Mr. Buffett and his private-equity partners 3G Capital think there is more to go before the anomalies are played out. For many investors, Mr. Buffett's view is enough.

Write to James Mackintosh at James.Mackintosh@wsj.com

 

(END) Dow Jones Newswires

February 20, 2017 15:59 ET (20:59 GMT)

Copyright (c) 2017 Dow Jones & Company, Inc.
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