In the Context of Modern
Berkshire Hathaway Phenomenon
In the Context of Modern Finance Theory
Over the 46 years ending December 2012, Warren Buffett (Berkshire Hathaway) has achieved a compound, after-tax, rate of return in excess of 20% p.a. Such consistent, long term, out performance might be viewed as incompatible with modern finance theory.
This essay discusses the Berkshire Hathaway phenomenon in the context of modern finance theory.
Part 1 Modern Portfolio Theory
Berkshire Hathaway’s investing strategies mainly differ with modern portfolio theory on two aspects. The first one is the attitude towards the undesirable thing in investment. And the second one is the perspective of diversification.
As Harry Markowitz pointed out in Portfolio Selection, one of the assumptions is (Markowitz, 1952)“the investor does (or should) consider expected return as a desirable thing and variance of return an undesirable thing”. However, in Warren Buffet’s point of view, (Roberg G, 2005) the only undesirable thing should be the possibility of harm. He emphasizes on conducting fundamental analysis to work out a company’s future profits, so as to determine the intrinsic value instead of monitoring the stock prices. This is because in the long term, the investment outcome is mainly harmed by misjudging the business value, including misjudging of inflation rate and interest rate etc. As such, risk is defined differently between Mr Buffett and Modern Portfolio Theory; one is defined by possibility of misjudging the intrinsic value of business, the other being simplified to variance of expected returns. If we consider risk as a probability statement, then maybe Mr Buffett’s definition is closer to the original meaning.
Also, the assumption of maximising one-period expected utility is not what Buffet focuses on in his investment strategies.
(Roberg G, 2005)In this case, Justin Industries, which was acquired by Berkshire Hathaway in 2000, can serve as a good example. During the five years prior to the acquisition, stock price of Justin Industries dropped by 37 percent, which should result in a huge variance of expected return. But Mr Buffett saw it as a perfect opportunity to purchase a well-managed traditional business with over 100 years of history. He offered a 23 percent premium over stock price at the time, and the stock price shot up by 22% on the day of announcement.
It is also stated by Markowitz that, (Markowitz, 1952)“a rule of behaviour which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim”. On the contrary, Mr Buffett has his famous quote, (Roberg G, 2005)“diversification serves as a protection against ignorance. If you want to make sure that nothing bad happens to you relative to the market, you should own everything. There is nothing wrong with that. It’s a perfectly sound approach for somebody who doesn’t know how to analyse business”.
One can always argue that Berkshire Hathaway does not operate in only one industry, and they tend to invest in more industries in recent years. But as the business grows in volume, it is reasonable to be involved in new industries when there are few sound investment opportunities in the industries they already operate in, let alone that the technology industry was rarely in the list of holdings of Berkshire Hathaway, not even when Apple’s stock was soaring. The reason being, (Roberg G, 2005)“investment
success is not about how much you know but how realistically you define what you don’t know”.
Chart 1 (Martin & Puthenpurackal, 2007)
Distribution of Berkshire Hathaway Investments by Industry
The chart above shows distribution of Berkshire Hathaway’s investments by industry and firm size during the time frame 1976-2006. Judging by the size and number of investments, it can be concluded that a large amount of wealth was placed in manufacturing industry during the 30 years in study, although for diversification purpose, more weight could have been placed in the industry of agriculture, forestry and fishing, construction or retail trade.
Having compared the differences, it is still worth noting that Markowitz did not rule out fundamental analysis in portfolio selection process, as is said in his foregoing paper,(Markowitz, 1952)“the process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with relevant beliefs about future performances and ends with the choice of portfolio. This paper is concerned with the second stage”.
Part 2 Efficient Market Hypothesis
The strong form of efficient market hypothesis states that all information, no matter public or private, instantaneously affects current stock price. Semi-strong form is only concerned with public information, while the weak form suggests that current stock price reflects information in the previous prices. In short, they simply imply that in the long run, no one should be able to beat the market in terms of investment return.
As is said in Fama’s paper in 1970, (Eugene F, 1970)“the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) contradictory evidence is sparse”. However, Warren Buffet has always criticised efficient market hypothesis as much as he could. The major reason is that, as a fundamental analysis advocate, (Roberg G, 2005)he thinks analysing all available information make an analyst at advantage. He once said, (Banchuenvijit, 2006)”investing in a market where people believe in efficiency is like playing bridge with someone who has been told it does not do any good to look at the cards.” Also in his speech at Columbia University in 1984, he mentioned, “ships will sail around the world but the Flat Earth Society will flourish. There will continue to be wide discrepancies between price and value in the marketplace, and those who read their Graham & Dodd will continue to prosper.”
(Roberg G, 2005)To illustrate, we can take Berkshire Hathaway’s acquisition of Burlington Northern Santa Fe Corp. in 2009 for example. At the time, shares of Burlington Northern had dropped 13 percent in 12 months. Also, the market was soft during GFC, so the possibility of competitive bids was low according to Tony Russo, a partner at Gardner Russo & Gardner, which holds Berkshire shares. If efficient market hypothesis does stand, the market would rebound quickly when GFC took place, and such opportunity of relatively low-priced acquisition would not exist. Even if it exists, other investor should anticipate quick upward adjustment of price and participate in bidding when they find out about this opportunity.
However, this does not prove that fundamental analysis is superior, because intrinsic value is not yet clear defined, and how does Mr Buffet calculate the intrinsic value is still a mystery.
Part 3 Capital Asset Pricing Model
When examining assumptions of Capital Asset Pricing Model, it is obvious that Mr Buffett is at odds with almost every one of them.
Firstly, the model assumes that all investors are Markowitz efficient, but as mentioned earlier, Mr Buffett does not treat variance of expected return as an absolute drawback, so the second rule that Markowitz Efficiency must follow does not stand.
Secondly, the model is backed by the assumption that investors have homogeneous expectations and equal access to opportunities, which suggests that everyone is supposed to have the same view of future profit stream. However, as a recent paper pointed out, (Frazzini, et al., 2013)Mr Buffett’s return is largely due to his selection of stocks. If everyone has the same view with Mr Buffett and the same access to the investment opportunities, then if not everyone, a large number of people should be as rich as Mr Buffett, when the reality is the opposite. So Mr Buffett would not agree with this assumption either.
The third assumption is that capital markets are in equilibrium, which is practically what only efficient markets can achieve, which, as discussed above, is not in line with Mr Buffett’s view point.
The final one, which is that Capital Asset Pricing Model only works within one period time horizon, is apparently against Mr Buffett’s long-term holding strategy.
Apart from model assumptions, one of the strongest contradictions between Mr Buffett’s view point and Capital Asset Pricing Model is that the model is for short-term predicting
purpose, which would clearly be categorised into (Roberg G, 2005)“speculation” instead of “investment” by Mr Buffett. In addition, “market portfolio” is not of practical use, compared with Mr Buffett’s way of only analysing businesses he is familiar with, because the market portfolio we use cannot truly represent the entire market.
Part 4 Multi-factor Pricing Models
Unlike Capital Asset Pricing Model, which has only one factor, in Multi-factor Pricing Models, such as Arbitrage Pricing Theory and Fama-French three-factor model, the rate of return is linked to several factors.
As diversification is still suggested by the model, the same divergence on diversification exists with Mr Buffet’s strategies and Multi-factor Pricing
Moreover, differences also lie in the fact that multi-factor models usually take in some macroeconomic factors, which investors should not consider according to Mr Buffett, (Roberg G, 2005)the rationale being that if a single stock price cannot be predicted, the overall economic condition would be more difficult to predict.
Despite the differences, some micro factors included in the multi-factor model, such as P/E ratio and book-to-market ratio, can also be used to conduct fundamental analysis to determine the intrinsic value and possibility of growth of a business. As such, the ideas of which factors to take into account can coincide within the two different approaches.
Chart 2(Martin & Puthenpurackal, 2007)
Factor Regressions of Berkshire Hathaway and Mimicking Portfolios
In a paper by Gerald S. Martin and John Puthenpurackal, they conduct a regression analysis using Fama-French three-factor and Carhart four-factor models on monthly returns of Berkshire Hathaway and mimicking portfolios. (Martin & Puthenpurackal, 2007)The adjusted excess returns turn out to be significant with p-values < 0.024; the excess market return and high-minus-low book-to-market factors are again significant with p-values < 0.01. However, small-minus-big and prior 2-12 month return momentum factors are not significantly explanatory factors.
As such, preliminary conclusion can be reached that book-to-value highminus-low can be a common factor in both multi-factor models and Mr Buffett’s fundamental analysis. In addition, the factors of firm size and momentum are not likely to be considered by Mr Buffett. Also, both Berkshire’s and mimicking portfolio’s returns outperform the multi-factor models in study. (Bowen & Rajgopal, 2009)But as is pointed out in another thesis, the superior performance is attributed to the earlier years and they observe no significant alpha during the recent decade.
Part 5 Black-Scholes Option Pricing Model
According to Berkshire Hathaway’s letter to shareholders in 2008,(Buffett, 2008)their put contracts reported a mark-to-market loss of $5.1 billion, and this led to Mr Buffett’s “criticism” towards the Black-Scholes formula as is claimed by the media.
However, the loss was in fact caused by inclusion of volatility in the formula when volatility becomes irrelevant as the duration before maturity lengthens. As Mr Buffett said in the letter,(Buffett, 2008)if the formula is applied to extended time periods, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula. As such, Mr Buffett’s comment on Black-Scholes formula is more of self-criticism than the other way around.
This is reflected in his earlier comment on performance in the letter,(Buffett, 2008)”I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.”
We can understand why Mr Buffett gave this “fair” comment about the formulae when referring to the Black-Scholes paper,(Black & Scholes, 1973)”if the expiration date of the option is very far in the future, then the price of the bond that pays the exercise price on the maturity date will be very low, and the value of the option will be approximately equal to the price of the stock. “
Mr Buffett also commented that (Buffett, 2008)”The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statements purposes. Key inputs to the calculation include a contract’s maturity
and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends” and that “even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme scepticism”.
Despite Mr Buffett’s confession, a scholar studied the letter and reached a different conclusion why the loss was made:(Cornell, 2009)He first ruled out risk-free rate, inflation rate and drift and focused on volatility, which is consistent with where Mr Buffett thought he made a mistake. The lognormal diffusion assumption, which implies that volatility increases linearly with respect to the horizon over which it is measured, was discussed at length with controversial evidence. As such, its misuse is not a strong explanation regarding the absurd results.
He then found out in the letter that Mr Buffett believed that inflationary policies of governments and central banks will limit future declines in nominal stock prices compared with those predicted by a historically estimated lognormal distribution. If Mr Buffet is right, then the Black-Scholes model will indeed significantly overvalue long-dated put options, to which a possible solution is making the left-hand tail truncated to reduce the value of long-dated put options.
Throughout this essay, we have discussed the common views and divergences between Mr Buffett’s investment strategies and Modern Finance Theories. Now we summarize the main points as follows:
Black-Scholes Option Pricing Model
Modern Portfolio Theory
Efficient Market Hypothesis
Capital Asset Pricing Model
Common Views and Divergences between Modern Finance Theory and
Mr Buffett’s Strategies
Modern Finance Theories
Modern Portfolio Theory
Divergences with Warren Buffet
1. Risk Defined as Volatility
2. Short Investment Horizon
Efficient Market Hypothesis
Capital Asset Pricing Model
Reliability of Fundamental Analysis
1. Markowitz Efficient Investors
2. Homogeneous Expectation and
Equal Access to Opportunities
3. Markets in Equilibrium
4. Short Investment Horizon
5. Predicting Function Leads to
6. Impractical “Market Portfolio”
1. Macro Factors
Detailed Divergences between Modern Finance Theory and Mr Buffett’s Strategies
Banchuenvijit, W., 2006. Investment Philosophy of Warren E. Buffet, Bankok: The University of Thai Chamber ofCommerce.
Black, F. & Scholes, M., 1973. The Pricing of Options and Corporate Liabilities. The Journal of Political Economy, 81(3), pp. 637-654.
Bowen, R. M. & Rajgopal, S., 2009. Do Powerful Investors Influence Accounting, Governance and Investing Decisions?, Washington D.C.: University of Washington.
Buffett, W. E., 2008. Letter to Shareholders, Omaha: Berkshire Hathaway, Inc..
Cornell, B., 2009. Warren Buffet, Black-Scholes and the Valuation of Long-dated Options, Pasadena: California Institute of Technology.
Davis, J., 1991. Lessons from Omaha: an Analysis of the Investment Methods
and Business Philosophy of Warren Buffett, Cambridge: Cambridge University.
Eugene F, F., 1970. Efficient Capital Markets: A Review of THeory and Empirical Work. The Journal of Finance, 25(2), pp. 383-417.
Eugene F, F. & Kenneth R, F., 1992. The Cross-Section of Expected Stock Return. The Journal of Finance, XLVII(2).
Markowitz, H., 1952. Portfolio Selection. The Journal of Finance, VII(1), pp. 77-91.
Martin, G. S. & Puthenpurackal, J., 2007. Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway, Reno: University of Nevada.
Roberg G, H., 2005. The Warren Buffet Way. 2 ed. Hoboken: John Wiley& Sons, Inc..
William F, S., 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, 19(3), pp. 425-442.
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