Berkshire Hathaway Phenomenon In the Context of Modern Finance Theory Essay Example for Free

Berkshire Hathaway Phenomenon In the context of use of Modern pay guess EssayBerkshire HathawayPhenomenonIn the Context of Modern pay TheorySepttember2013Berkshire Hathaway PhenomenonIn the Context of Modern Finance TheoryIntroductionOver 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, break performance might be viewed as incompatible with neo finance theory.This essay discusses the Berkshire Hathaway phenomenon in the context of in advance(p) finance theory.Part 1 Modern Portfolio TheoryBerkshire Hathaways 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 Buffets 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 companys future profits, so as to determine the congenital survey instead of monitoring the channel equipment casualtys. This is because in the long term, the investment expiry is mainly harmed by misjudging the business value, including misjudging of inflation rate and use up rate etc. As much(pre nominal phrase), risk is defined differently between Mr Buffett and Modern Portfolio Theory one is defined by possibility of misjudging theintrinsic value of business, the other being simplified to variance of expected returns. If we consider risk as a probability statement, then maybe Mr Buffetts definition is closer to the original meaning.Also, the assumption of maximising one- level expected utility is non what Buff et 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 tralatitious 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 non imply the high quality of diversification must be rejected both(prenominal) 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 grocery, you should own everything. There is nothing wrong with that. Its a perfectly enunciate approach for somebody who doesnt experience how to analyse business.One can always argue that Berkshire Hathaway does not operate in only one industry, and they feed 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 thither be 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 Apples stock was soaring. The reason being, (Roberg G, 2005)investmentsuccess is not about how much you know but how realistically you define what you dont know.Chart 1 (Martin Puthenpurackal, 2007)Distribution of Berkshire Hathaway Investments by IndustryThe chart above shows distribution of Berkshire Hathaways investments by industry and firm size during the time haul up 1976-2006. Judging by the s ize 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 natural selection process, as is said in his foregoing cover,(Markowitz, 1952)the process of selecting a portfolio may be divided up 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 foodstuff meditationThe dependable form of efficient market hypothesis states that all information, no matt er 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 Famas 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(ip)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 step at the cards. Also in his s peech at Columbia University in 1984, he mentioned, ships will sail around the world but the Flat body politic Society will flourish. There will lead 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 hold Berkshire Hathaways 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 aristocratic 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 control when they find out abo ut 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 enceinte asset set ModelWhen 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 primitively, Mr Buffett does not treat variance of expected return as an imperative drawback, so the second rule that Markowitz Efficiency must follow does not stand.Secondly, the model is backed by the assumption that investors havehomogeneous expectations and equal admission 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 Buffetts return is largely due to his selection of stocks. If everyone has the s ame 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 Buffetts view point.The final one, which is that Capital Asset Pricing Model only works within one period time horizon, is apparently against Mr Buffetts long-term holding strategy.Apart from model assumptions, one of the strongest contradictions between Mr Buffetts 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 Buffetts way of only analysi ng businesses he is familiar with, because the market portfolio we use cannot truly represent the entire market.Part 4 Multi-factor Pricing ModelsUnlike 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 Buffets strategies and Multi-factor PricingModels.Moreover, differences also lie in the fact that multi-factor models ordinarily 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 general 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 PortfoliosIn 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 Buffetts fundamental analysis. In addition, the factors of firm size and momentum are not likely to be considered by Mr Buffett. Also, both Berkshires and mimicking portfolios 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 ModelAccording to Berkshire Hathaways letter to shareholders in 2008,(Buffett, 2008)their beat contracts reported a mark-to-market loss of $5.1 billion, and this led to Mr Buffetts criticism towards the Black-Scholes formula as is claimed by the media.However, the loss was in fact caused by comprehension 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 lengthened time periods, it can produce absurd results. In fa irness, 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 Buffetts 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 wherefore 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 woof is very far in the future, then the price of the bond that pays the exercise price on the maturit y 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 contracts maturityand strike price, as well as the analysts expectations for volatility, interest rates and dividends and that even so, we will continue to useBlack-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 Buffetts confession, a scholar studied the letter and reached a different conclusion why the loss was do(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 h e 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 practical solution is making the left-hand tail truncated to reduce the value of long-dated put options.SummaryThroughout this essay, we have discussed the common views and divergences between Mr Buffetts investment strategies and Modern Finance Theories. Now we summarize the main points as followsCommon viewsDivergencesBlack-Scholes Option Pricing ModelModern Portfolio TheoryEfficient Market HypothesisCapital Asset Pricing ModelMulti-factor ModelsChart 3Common Views and Divergences between Modern Finance Theory andMr Buffetts StrategiesModern Finance TheoriesModern Portfolio TheoryDivergences with Warren Buffet1. Risk Defined as Volatility2. in short Investment Horizon3. DiversificationEfficient Market HypothesisCapital Asset Pricing ModelReliability of Fundamental Analysis1. Markowitz Efficient Investors2. Homogeneous Expectation andEqual Access to Opportunities3. Markets in Equilibrium4. Short Investment Horizon5. Predicting Function Leads toSpeculation6. Impractical Market Portfolio7. DiversificationMulti-factor Models1. Macro Factors2. DiversificationChart 4Detailed Divergences between Modern Finance Theory and Mr Buffetts StrategiesBibliographyBanchuenvijit, W., 2006. Investment Philosophy of Warren E. Buffet, Bankok The University of Thai Chamber ofCommerce.Black, F. Scholes, M., 1973. The Pricing of O ptions and Corporate Liabilities. The Journal of Political Economy, 81(3), pp. 637-654.Bowen, R. M. Rajgopal, S., 2009. Do Powerful Investors Influence Accounting, face 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 Methodsand 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 Fl attery 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.