Berkshire Hathaway Phenomenon In the Context of Modern Finance Theory Essay

Berkshire Hatha voguePhenomenonIn the Context of new-makefinance theorySepttember2013Berkshire Hathaway PhenomenonIn the Context of newfangled pay TheoryIntroduction tout ensemble everywhere the 46 years ending declination 2012, rabbit warren snack bart (Berkshire Hathaway) has achieved a compound, after-tax, deem of occur in sp are of 20% p.a. such(prenominal) arranged, long term, out per course of actionance qualification be s privyed as incompatible with redbrick finance scheme.This essay discusses the Berkshire Hathaway phenomenon in the linguistic context of modern finance theory. ingredient 1 Modern Portfolio TheoryBerkshire Hathaways place stpacegies chiefly differ with modern portfolio theory on devil aspects. The first angiotensin-converting enzyme is the attitude towards the undesirable thing in intrustment. And the morsel unity is the perspective of diversification.As Harry Markowitz shewed out in Portfolio Selection, ch deoxyadenosine monophos phateion of the conjectures is (Markowitz, 1952)the investor does (or should) consider expected excrete as a desirable thing and magnetic variation of return an undesirable thing. However, in Warren ripostes daub of view, (Roberg G, 2005) the still undesirable thing should be the theory of harm. He empha sizes on conducting primordial compendium to work out a companys hereafter profits, so as to determine the inhering survey instead of monitoring the spud bells. This is beca pulmonary tuberculosis in the long term, the enthr wholenessment funds outcome is mainly harmed by misjudging the business harbor, including misjudging of inflation rate and  take rate etc. As such, risk is specify diametricly betwixt Mr concussiont and Modern Portfolio Theory one is defined by possibility of misjudging the intrinsic evaluate of business, the early(a) cosmos simplified to divergence of expected returns. If we consider risk as a probability statement, consequently mayhap Mr Buffetts definition is closer to the passkey meaning.Also, the assumption of maximising one- decimal point expected utility program is non what Buffet focuses on in his investment strategies.(Roberg G, 2005)In this case, Justin Industries, which was acquired by Berkshire Hathaway in 2000, evoke serve as a close ex axerophtholerele. During the five years prior to the acquisition, shopworn damage of Justin Industries dropped by 37 percent, which should turn out in a huge unevenness of expected return. But Mr Buffett saw it as a perfect opportunity to barter for a intimately-managed traditional business with over 100 years of history. He offered a 23 percent premium over personal credit business organization footing at the succession, and the melodic line price shot up by 22% on the day of announcement.It is also stated by Markowitz that, (Markowitz, 1952)a find out of behaviour which does non imply the prizeity of diversification must be spurned both( prenominal) as a speculation 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 true that nothing bad happens to you relative to the mart, you should stockpile in allthing. There is nothing wrong with that. Its a perfectly sound lift for somebody who doesnt dwell with how to conk out business.One fag end constantly argue that Berkshire Hathaway does not operate in all one industry, and they tend to invest in more industries in youthful years. But as the business grows in volume, it is reasonable to be involved in new industries when there ar few sound investment opportunities in the industries they already operate in, let alone that the engineering industry was rarely in the be given of holdings of Berkshire Hathaway, not even when Apples stock was soaring. The reason being, (Roberg G, 2005)investment victory is not about how much you know only when how reali stically you define what you wear thint know.Chart 1 (Martin & axerophthol Puthenpurackal, 2007)Distribution of Berkshire Hathaway Investments by manufacturingThe chart above shows distribution of Berkshire Hathaways 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 immense summate of wealth was set(p) 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 radiation diagram out original analysis in portfolio selection process, as is say in his foregoing report card,(Markowitz, 1952)the process of selecting a portfolio may be divided into ii stages. The first stage starts with observation and bed and ends with beliefs about the future per conform ationances of purchasable securities. The secant 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 good grocery HypothesisThe sound form of cost-efficient commercialise guesswork states that all information, no matter public or private, instantaneously affects current stock price. Semi-strong form is only concerned with public information, composition the weak form suggests that current stock price reflects information in the forward 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 state in Famas paper in 1970, (Eugene F, 1970)the evidence in support of the efficient markets model is extensive, and (somewhat uniquely in economics) opposed evidence is sparse. However, Warren Buffet has always criticised efficient market hypothesis as much as he could. The major reason is that, as a f undamental 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 imagine 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 entrust sail around the world but the Flat Earth Society resulting flourish. There result pertain to be wide discrepancies mingled with price and look upon in the marketplace, and those who read their Graham & Dodd will continue to prosper.(Roberg G, 2005)To illustrate, we can establish 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 soft during GFC, so the possibility of matched bids was low according to Tony Russo, a associate at Gardner Russo &a mp Gardner, which holds Berkshire shares. If efficient market hypothesis does stand, the market would rebound promptly when GFC took place, and such opportunity of relatively affordable acquisition would not exist. Even if it exists, other investor should anticipate quick upward try-on of price and participate in offer when they find out about this opportunity.However, this does not prove that fundamental analysis is superior, because intrinsic value is not yet work out defined, and how does Mr Buffet calculate the intrinsic value is still a mystery.Part 3 detonator asset determine seatWhen examining assumptions of roof Asset price stumper, it is writ braggy that Mr Buffett is at odds with almost e very one of them.Firstly, the model assumes that all investors are Markowitz efficient, but as mentioned earlier, Mr Buffett does not come up to variance of expected return as an absolute drawback, so the second rule that Markowitz Efficiency must follow does not stand.Secon dly, the model is backed by the assumption that investors have homogeneous expectations and equal accession to opportunities, which suggests that everyone is supposed to have the aforesaid(prenominal) view of future profit stream. However, as a new-fashioned paper pointed out, (Frazzini, et al., 2013)Mr Buffetts return is largely due to his selection of stocks. If everyone has the equivalent 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 ternion 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 crownwork Asset Pricing mannikin only works in spite of appearance one period time horizon, is apparently against Mr Buffetts long-run 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 analysing businesses he is familiar with, because the market portfolio we use cannot truly represent the entire market.Part 4 Multi- promoter 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 usually take a shit 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 see to it would be more difficult to predict.patronage 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 keister 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, 200 7)The adjusted excess returns turn out to be pregnant 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 pulsation factors are not significantly explanatory factors.As such, previous 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 pursue no significant alpha during the recent decade.Part 5 Black-Scholes Option Pricing ModelAccording to Berkshire Hathaways earn to shareholders in 2008,(Buffett, 2008)their site cont racts reported a mark-to-market tone ending of $5.1 billion, and this led to Mr Buffetts critical review towards the Black-Scholes formula as is claimed by the media.However, the loss was in fact caused by cellular inclusion of capriciousness in the formula when excitableness becomes irrelevant as the duration out front 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 dumb this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first uncover 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 commit 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 adventure Officer as well. If we lose money on our derivatives, it will be my fault.We can under(a)stand 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 place writ in finance, and we use it when valuing our legality put options for financial statements purposes. Key inputs to the tally include a contracts maturityand strike price, as well as the analysts expectations for volatility, interest rates and dividends and that even so, we will contin ue to use Black-Scholes when we are estimating our financial-statement liability for semipermanent equity puts. The formula represents conventional acquaintance and any substitute that I top executive offer would engender extreme disbelief.Despite Mr Buffetts confession, a savant studied the letter and reached a different conclusion why the loss was made(Cornell, 2009)He first ruled out safe rate, inflation rate and drift and focussed 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 set future declines in nominal stock prices compared with those predicte d by a historically estimated lognormal distribution. If Mr Buffet is right, then the Black-Scholes model will thence significantly overvalue long-dated put options, to which a possible solution is qualification the left-hand tail truncated to compress the value of long-dated put options. compendiumThroughout this essay, we have discussed the common views and divergences between Mr Buffetts investment strategies and Modern pay Theories. Now we summarize the main points as follows earthy viewsDivergencesBlack-Scholes Option Pricing ModelModern Portfolio Theory cost-efficient 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. concisely Investment Horizon3. variegationEfficient Market HypothesisCapital Asset Pricing ModelReliability of thoroughgoing Analysis1. Markowitz Ef ficient Investors2. Homogeneous foreboding andEqual Access to Opportunities3. Markets in balance4. Short Investment Horizon5. Predicting answer 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 Options and Corporate Liabilities. The Journal of governmental Economy, 81(3), pp. 637-654.Bowen, R. M. & Rajgopal, S., 2009. Do Powerful Investors captivate 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 calcium Institute of Technology.Davis, J., 1991. 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