Berkshire Hathaway Phenomenon In the Context of Modern Finance Theory Septtember 2013Berkshire Hathaway Phenomenon In the Context of Modern Finance Theory Introduction 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 attitudeBerkshire Hathaway Phenomenon In the Context of Modern Finance Theory 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 predictingpurpose 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 Models. 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 maturityand 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.Summary 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: Common views Divergences Black-Scholes Option Pricing Model Modern Portfolio Theory Efficient Market Hypothesis Capital Asset Pricing Model Multi-factor Models Chart 3 Common Views and Divergences between Modern Finance Theory and Mr Buffett?s StrategiesModern Finance Theories Modern Portfolio Theory Divergences with Warren Buffet 1. Risk Defined as Volatility 2. Short Investment Horizon 3. Diversification 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 Speculation 6. Impractical Market Portfolio? 7. Diversification Multi-factor Models 1. Macro Factors 2. Diversification Chart 4 Detailed Divergences between Modern Finance Theory and Mr Buffett?s StrategiesBibliography 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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