Berkshire Hathaway Phenomenon In the Context of Modern Finance Theory Essay

Berkshire HathawayPhenomenonIn the Context of red-brickFinance possibilitySepttember2013Berkshire Hathaway PhenomenonIn the Context of neo Finance TheoryIntroductionOver the 46 years ending December 2012, warren tabulatort (Berkshire Hathaway) has achieved a compound, after-tax, rate of snuff it in excess of 20% p.a. Such consistent, long term, come in mathematical operation might be gazeed as incompatible with modern finance possible action.This look for discusses the Berkshire Hathaway phenomenon in the context of modern finance theory. neighborhood 1 Modern Portfolio TheoryBerkshire Hathaways investing strategies mainly differ with modern portfolio theory on two aspects. The first maven is the attitude towards the undesirable subject in coronation. And the minute one(a) is the perspective of variegation.As Harry Markowitz pointed come out in Portfolio Selection, one of the assumptions is (Markowitz, 1952)the investor does (or should) enumerate expected return as a desirable thing and partition of return an undesirable thing. However, in Warren Buffets point of get word, (Roberg G, 2005) the only if undesirable thing should be the misfortune of harm. He emphasizes on conducting fundamental abstract to change state out a companys future profits, so as to determine the intrinsic value instead of monitoring the argument bells. This is because in the long term, the investment outcome is mainly harmed by misjudging the business value, including misjudging of puffiness rate andinterest rate etc. As such, risk is delineate 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, hence maybe Mr Buffetts definition is closer to the original meaning.Also, the assumption of maximise one-period expected utility is not what Buffet focuses on in his investme nt strategies.(Roberg G, 2005)In this case, Justin Industries, which was acquired by Berkshire Hathaway in 2000, bum serve as a upright example. During the five years prior to the acquisition, stock cost of Justin Industries dropped by 37 percent, which should result in a huge variance of expected return. provided 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 demeanour which does not imply the captainity of diversification must be spurned 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 over against ignorance. If you fatality to make sure that nothing bad happens to you relative to the mart, you should own eve rything. there is nothing wrong with that. Its a perfectly sound cash advance for somebody who doesnt cope how to analyse business.One throw out always argue that Berkshire Hathaway does not operate in only one pains, and they tend to invest in more industries in recent years. unless as the business grows in volume, it is reasonable to be involved in new industries when there be few sound investment opportunities in the industries they already operate in, let alone that the technology industry was seldom in the list of holdings of Berkshire Hathaway, not even when Apples stock was soaring. The reason being, (Roberg G, 2005)investmentsuccess is not active how much you know but how realistically you define what you dont know. map 1 (Martin & Pu whereforepurackal, 2007)Distribution of Berkshire Hathaway investitures by IndustryThe chart above shows dissemination of Berkshire Hathaways investments by industry and firm size during the time contour 1976-2006. Judging by the siz e and number of investments, it evoke be conclude that a large amount of wealth was placed in manu itemuring industry during the 30 years in study, although for diversification purpose, more weight could be possessed of been placed in the industry of agriculture, forestry and fishing, construction or retail trade.Having compared the differences, it is be quiet worth noting that Markowitz did not rule out fundamental psychoanalysis in portfolio alternative process, as is said in his foregoing paper,(Markowitz, 1952)the process of selecting a portfolio may be divided into two items. The first stage starts with expression and experience and ends with beliefs about the future per pretendances of available securities. The second stage starts with germane(predicate) beliefs about future performances and ends with the choice of portfolio. This paper is refer with the second stage.Part 2 cost-efficient food market HypothesisThe strong form of effective market hypothesis states t hat all information, no matter familiar 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 sample 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 majorreason 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 conceive 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 go forth swing around the world but the Flat Earth Society bequeath flourish. There provide 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 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 padded during GFC, so the possibility of competitive bids was low according to Tony Russo, a confederate at Gardner Russo & Gardner, which holds Berkshire shares. If efficient market hypothesis does stand, the market would rebound rapidly when GFC took place, and such opportunity of relatively low-priced acquisition would not exist. thus far if it exists, other investor should anticipate quick upward adjustment of price and inser t in bidding when they find out about this opportunity.However, this does not adjudicate that fundamental analysis is superior, because intrinsic value is not yet the whole way defined, and how does Mr Buffet calculate the intrinsic value is still a mystery.Part 3 Capital summation 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 earlier, Mr Buffett does not delicacy variance of expected return as an absolute drawback, so the second rule that Markowitz Efficiency must follow does not stand.Secondly, the model is approve by the assumption that investors havehomogeneous expectations and equal access to opportunities, which suggests that everyone is conjectural 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 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 easy as Mr Buffett, when the reality is the opposite. So Mr Buffett would not agree with this assumption either.The terce 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 work within one period time horizon, is apparently against Mr Buffetts semipermanent 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 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 analysing businesses he is familiar with, because the market portfolio we use cannot truly represent the stainless market.Part 4 Multi-factor Pricing ModelsUnlike Capital Asset Pricing Model, which has only one factor, in Multi-factor Pricing Models, such as merchandise 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 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 thorny 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 apply 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 agree 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 com mon 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 of import during the recent decade.Part 5 Black-Scholes Option Pricing Modelharmonize to Berkshire Hathaways letter to shareholders in 2008,(Buffett, 2008)their specify contracts reported a mark-to-market going away of $5.1 billion, and this led to Mr Buffetts criticism towards the Black-Scholes expression as is claimed by the media.However, the bolshy 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 mum 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 call up 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 chief operating officer of any large financial organization must be the party boss 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 take care of the option is ve ry 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 consecrated writ in finance, and we use it when valuing our equity put options for financial statements purposes. observe inputs to the calculation include a contracts maturityand engage price, as well as the analysts expectations for volatility, interest grade and dividends and that even so, we will continue to useBlack-Scholes when we are estimating our financial-statement liability for long 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 made(Cornell, 2009)He first ruled out unhazardous rat e, 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 take note to the horizon over which it is measured, was discussed at length with controversial evidence. As such, its defame 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 reservation 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 stra tegies and Modern Finance Theories. Now we summarize the main points as follows viridity 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 delimitate as Volatility2. Short Investment Horizon3. DiversificationEfficient Market HypothesisCapital Asset Pricing Model dependableness of Fundamental summary1. Markowitz Efficient Investors2. Homogeneous Expectation andEqual opening to Opportunities3. Markets in Equilibrium4. Short Investment Horizon5. Predicting Function Leads to meditation6. Impractical Market Portfolio7. DiversificationMulti-factor Models1. Macro Factors2. DiversificationChart 4Detailed Divergences between Modern Finance Theory and Mr Buffetts StrategiesBibliographyBanchuenvijit, W., 2006. Investment Phi losophy of Warren E. Buffet, Bankok The University of Thai Chamber ofCommerce.Black, F. & Scholes, M., 1973. The Pricing of Options and Corporate Liabilities. The daybook of Political Economy, 81(3), pp. 637-654.Bowen, R. M. & Rajgopal, S., 2009. Do Powerful Investors Influence Accounting, Governance and Investing Decisions?, capital letter 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. 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