Sense and nonsense in modern corporate f inance


Published on

  • Be the first to comment

  • Be the first to like this

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Sense and nonsense in modern corporate f inance

  1. 1. sense andnonsensein moderncorporate finance
  2. 2. Thought # 1: A lot of what you’ve been taught is wrong
  3. 3. Example # 1:The Notion of “Risk” in Academic Corporate Finance
  4. 4. William Sharpe,Noble Laureate σ
  5. 5. High degree of variability means “high risk”
  6. 6. Low degree of variability means “low risk”
  7. 7. Inference: Treasury bonds are “risk-free” securitiesbecause they have zero variability of return.
  8. 8. “Treasurybonds arerisk free” Hmmm
  9. 9. “We define risk, using dictionary terms, as “the possibility of loss or injury.”“The real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) willover his prospective holding period, give him at least as much purchasingpower as he had to begin with, plus a modest rate of interest on that initialstake.”
  10. 10. Investing is often described as the process of laying out money now in the expectation of receiving more money in the future.At Berkshire we take a more demanding approach, defining investing as thetransfer to others of purchasing power now with the reasoned expectationof receiving more purchasing power – after taxes have been paid onnominal gains – in the future. More succinctly, investing is forgoingconsumption now in order to have the ability to consume more at a laterdate.From 2011 Letter.
  11. 11. If you forego ten hamburgers to purchase an investment;
  12. 12. receive dividends which, after tax, buy two hamburgers;and receive, upon sale ofyour holdings, after-tax proceeds that will buy eight hamburgers,
  13. 13. then you have had no real income from yourinvestment, no matter how much itappreciatedin dollars.
  14. 14. You may feelricher,
  15. 15. but you won’t eatricher.
  16. 16. “Bonds promotedas offering risk-free returns are now priced to deliver return- free risk.”From 2011 Letter commenting on the prevailing almost zerointerest rates on treasury bonds.
  17. 17. Example # 2:The Relationship between “Risk”and “Return” in Academic Corporate Finance
  18. 18. Academic Finance’s Definition of “Risk”Two components: Systematic andUnsystematic risk
  19. 19. Investors will not get paid to assume unsystematic risk because thatcomponent of total risk can be diversified away.
  20. 20. Investors will get paid only for taking systematic risk, a proxy of which is “beta” to define investment “risk” differently, averring that it isthe relative volatility of a stock or portfolio of stocks - that is, their volatilityas compared to that of a large universe of stocks.
  21. 21. High Risk High Return Low Risk Low Return Stocks with high beta are riskier than stocks with lower betas but are expected to deliver higher returns. HmmmmmStocks with high beta are riskier than stocks with lower betas but areexpected to deliver higher returns.
  22. 22. Do ?Do stocks with large betas outperform stocks with low betas?Ans: No
  23. 23. Do = ?Do stocks with identical beta produce same returns?Ans: No
  24. 24. a proxy Is ? forAns: NoVolatility is not the same as risk.
  25. 25. Beta does not capture risk
  26. 26. How does He think of Risk?“Though this risk cannot be calculated with engineering precision, it can insome cases be judged with a degree of accuracy that is useful…“The primary factors bearing upon this evaluation are:
  27. 27. A. “Thecertainty with which the long-term economiccharacteristic s of the business can be evaluated
  28. 28. B. “Thecertainty with which management can be evaluated, both as to its ability to realize thefull potentialof the business and to wisely employ its cash flows
  29. 29. C. “Thecertainty with which managementcan be countedon to channel the rewards from the business to the shareholders rather than to itself.
  30. 30. D. Thepurchase price of thebusiness
  31. 31. E. “The levelsof taxation and inflation that will beexperienced and that will determine thedegree by which an investors purchasing-power return is reduced from his gross return.”
  32. 32. The Trouble with his definition of risk? You cannot objectively measure it!Is that a problem?
  33. 33. “False precision is totally crazy... It only happens to people with high IQs.”The desire to be PRECISE makes people do some incredibly FOOLISH things.
  34. 34. “It’s better to be approximately right than to be precisely wrong” - John Maynard keynesThe desire to be PRECISE makes people do some incredibly FOOLISH things.
  35. 35. “Not everything that countscan be counted, and not everything that can be counted, counts.” - Einstein
  36. 36. Buffett on RISKExtract from 2011 Annual Report of Berkshire HathawayThe Basic Choices for Investors and the One We Strongly PreferInvesting is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defininginvesting as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used inmeasuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period.Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, anon-fluctuating asset can be laden with risk.Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.• Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments arethought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.
  37. 37. Buffett on RISKBerkshire Hathaway’s AGM for 1993: Comments on RiskShareholder: There appears to be inconsistencies between your view of risk and the conventional view.Derivatives are dangerous. And yet you feel comfortable playing derivatives through Salomon.Betting on hurricanes is dangerous. And yet you feel comfortable playing with hurricanes through insurance companies. So it appears that you have some view of risk that’s inconsistent with whatwould appear on the face of it to be conventional view of risk.Buffett: We do define risk as the possibility of harm or injury. Therefore, we think it’s inextricably would up in our time horizon for holding an asset. If you intend to buy XYZ Corporation at 11:30 thismorning and sell it out before the close today, that’s a very risky transaction in our view -because we think that 50% of the time, you’re going to suffer some harm or injury. On the other hand, given asufficiently long time horizon . . .For example, we believe that the risk of buying something like Coca Cola at the price we paid a few years ago is close to nil -given our prospective holding period. But if you asked me to assess therisk of buying Coca-Cola this morning and selling it tomorrow morning, I’d say that that’s a very risky transaction.As I pointed out in the annual report, it became very fashionable in the academic world -and it spilled over into the financial markets -to define risk in terms of volatility of which beta is a measure. Butthat is no measure of risk to us.The risk in terms of our super-cat business is not that we lose money in any given year. We know we’re going to lose money in some given day. That’s for certain. And we’re extremely likely to losemoney in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon ofinvestment, we think that it is not a risky business.And it’s a whole lot less risky than writing something that is much more predictable. It’s interesting to us that using conventional measures of risk, something whose return varies from year-to-yearbetween +20% and +80% is riskier than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how they measure risk.
  38. 38. Buffett on RISKBerkshire Hathaway’s AGM for 1993: Comments on RiskShareholder: Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results -and likewise, measures money managers’ riskiness bytheir volatility. I know you guys don’t agree with that approach. Could you give us some detail about how you measure risk?Buffett: We regard volatility as a measure of risk to by nuts. And the reason its used is because the people that are teaching want to talk about risk -and the truth is that they don’t knowhow to measure it in business. Part of our course on how to value a business would also be on how risky the business is. And we think about that in terms of every business we buy.Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that there’s just an inadequate return on the kind of capital weput in.However, it doesn’t relate to volatility at all. For example, our See’sCandy business will lose money-and it depends on when Easter falls -in two quarters each year. So it has this hugevolatility of earnings within the year. Yet it’s one of the least risky businesses I know. You can find all kinds of wonderful businesses that have great volatility in results. But that doesn’tmake them bad businesses.Similarly, you can find some terrible businesses with very low volatility. For example, take a business that did nothing. It’s results wouldn’t vary from quarter to quarter. So it just doesn’tmake any sense to equate volatility with risk.ENDNotice he talks about two types of risks: Risk of permanent loss of capital and Opportunity loss.
  39. 39. Buffett on RISKBerkshire Hathaway’s AGM for 1994: Comments on RiskBuffett: We do define risk as the possibility of harm or injury. Therefore, we think it’s inextricably wound up in your time horizon for holding an asset. If you intend to buy XYZ Corporation at 11.30 this morning and sell it out before the close today, thatis a very risky transaction in our view – because we think that 50% of the time, you’re going to suffer some harm or injury. On the other hand, given a sufficiently long time horizon…For example, we believe that the risk of buying something like Coca-Cola at the price we paid a few years ago is close to nil – given our prospective holding period. But if you asked me to assess the risk of buying Coca-Cola this morning and sellingit tomorrow morning, I’d say that that’s a very risky transaction.Buffett: As I pointed out in the annual report, it became very fashionable in the academic world – and it spilled over into the financial markets – to define risk in terms of volatility of which beta became a measure. But that is no measure of risk to us.The risk in terms of our super-cat business is not that we lose money in any given year. We know we’re going to lose money in some given day. That’s for certain. And we’re extremely likely to lose money in some years. But our time horizon inwriting that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of investment, we think that that is not a risky business.And it’s a whole lot less risky than writing something that is much more predictable. It’s interesting to us that using conventional measures of risk, something whose return varies from year-to-year between +20% and +80% is riskier as it’s definedthan something that returns 5% a year every year. We think the financial world has gone haywire in terms of how it measures risk.Buffett: We’re perfectly willing to lose money on a given transaction – arbitrage being one example and any given insurance policy being another. But we’re not willing to enter into any transactions in which we think the probability of a number ofmutually independent events of a similar type has an expectancy of loss.And we hope that we’re entering into transactions where our calculations of those probabilities have validity. To do so, we try to narrow it down. There are a whole bunch of things that we just don’t do because we don’t think we can write theequation on them.Basically, Charlie and I are pretty risk-averse by nature. But if we knew it was an honest coin and someone wanted to give us 7-to-5 (odds) or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip? It wouldsound like a big number to you. It wouldn’t be a huge percentage of (Berkshire’s) net worth, but it would be a significant number. We’ll do things where the probabilities favor us.
  40. 40. Munger & Buffett on RISKMunger: This great emphasis on volatility in corporate finance we regard as nonsense…. Let me put it this way. As long as the odds are in our favor andwe’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are the favorableodds. We figure the volatility over time will take care of itself at Berkshire.Buffett: If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll makemore money in a business where we know what the end game will be if it bounces around a lot.For example, See’s may lose money in eight months in a typical year. However, it makes a fortune in November and December. If it were an independent,publicly-traded company and people reacted to that and therefore made its stock very volatile, that would be terrific for us. We could buy it in July and sellit in January – because we’d know it was nonsense.Well, obviously, things don’t behave quite that way. But when we bought The Washington Post, it had gone down 50% in a few months. Well, that was thebest thing that could have happened. It doesn’t get any better than that. Its businesses were fundamentally very non-volatile – a strong, dominantnewspaper and TV stations – but it was a volatile stock. That’s a great combination in our view.When we see a business about which we’re very certain whose fortunes the world thinks are going up and down – and so its stock behaves with greatvolatility – we love it. That’s way better than having a lower beta. We actually prefer what other people call “risk.”
  42. 42. “If someone were to sayto me, “I have here a six- shooter and I have slipped one cartridge into it“Why don’t you just spin it and pull it once? If you survive, Iwill give you $1 million.
  43. 43. I woulddecline - perhaps stating that $1million is notenough.”
  44. 44. “Then he might offer me $5million to pull the trigger twice...“Now that would be a positivecorrelation between risk and reward!”
  45. 45. “The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.”This is one of those ideas that grab you immediately, or you struggle with itall your life.For me it grabbed me immediately when I encountered it in Buffett’s essay,“The Superinvestors of Graham-and-Doddsville” while studying in London.
  46. 46. “The greater the Return potential for reward in thevalue portfolio, Risk the less risk there is.”
  48. 48. Tweedy Browne
  49. 49. “One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the margin of safety and the greater potential return when the stock price moves back to intrinsic value... “Contrary to the view of modern portfolio theorists that increased returns can only be achieved by taking greater levels of risk, value investing is predicated on the notion that increased returns are associated with a greater margin of safety, i.e. lower risk.”All true value investors believe the inverse relationship between risk and return where risk isdefined the way Buffett defines it.
  50. 50. “I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.”“The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold theassets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post,Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person whowould have paid $400 million would not have been crazy. Now, if the stock had declined even further to a price that made thevaluation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, thecheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’sriskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group ofsuch securities and you know anything at all about business valuation, there is essentially no risk in buying ten $40 million pilesfor $8 million each.”“In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how muchborrowed money the business employs. He may even prefer not to know the companys name. What he treasures is the pricehistory of its stock. In contrast, well happily forgo knowing the price history and instead will seek whatever information willfurther our understanding of the companys business. After we buy a stock, consequently, we would not be disturbed if marketsclosed for a year or two.”
  51. 51. Example # 3: The CapitalAsset PricingModel (CAPM)
  52. 52. “Employing databases and statistical skills, these academics compute withprecision the "beta" of a stock - itsrelative volatility in the past - and then build arcane investment andcapital-allocation theories around this calculation.”
  53. 53. “In their hunger for a single statistic to measure risk,however, they forget a fundamentalprinciple: It is better to beapproximately right than precisely wrong.”
  54. 54. His first critique of CAPM is that it uses beta, which is a flawed measure of risk. But there is a second, terribly important critique of CAPM.To understand that, we need to jump over a jurisdictional boundary of corporate finance into the realm of psychology.
  55. 55. Jumping over jurisdictional boundaries: An introduction tomultidisciplinary thinking.
  56. 56. envyEnvy is the only one of the seven deadly sins which gives us nothing. There is NO upside in envy.Rejecting opportunities that would make you rich because others have better ones is envy.You will never find the mention of envy in any corporate finance textbook. Does that mean you should ignoreits influence on human decisions simply because the idea belong to another discipline?
  57. 57. “How crazy it would be to be made miserable by the fact that someone else is doing better because someone else is always going to be doing better at any human activity you can name.” - Charlie Munger“What the hell do I care if somebody else makes money faster. There’s always going to besomebody who is making money faster, running the mile faster or what have you. Once youget something that works fine in your life, the idea of caring terribly that somebody else ismaking money faster strikes me as insane.”“If you’ve got a way of investing your money that is overwhelmingly likely to keep youcomfortably rich and someone else finds something that would make him richer faster, thatis not a big tragedy.”
  58. 58. Reject projects where Don’t be IRR<WACC enviousLet’s digress a bit here because I want to talk to you a bit more aboutmultidisciplinary thinking. We will return to discussion of envy in corporatefinance in a while.Here is a story in corporate finance illustrating one of the best decisionsmade by Warren Buffett in his career.
  59. 59. Physics envyLet’s return to the subject of envy
  60. 60. “B schools aspire to the same standards of academic excellence that hard disciplines embrace—an approach sometimes waggishly referred to as “physics envy.””- Warren BennisVirtually none of today’s top-ranked business schools would hire, let alone promote, a tenure-track professor whose primary qualification ismanaging an assembly plant, no matter how distinguished his or her performance. Nor would they hire professors who write articles only forpractitioner reviews, like this one. Instead, the best B schools aspire to the same standards of academic excellence that hard disciplinesembrace—an approach sometimes waggishly referred to as “physics envy.”Business school professors using the scientific approach often begin with data that they use to test a hypothesis by applying such tools asregression analysis. Instead of entering the world of business, professors set up simulations (hypothetical portfolios of R&D projects, forinstance) to see how people might behave in what amounts to a laboratory experiment. In some instances those methods are useful,necessary, and enlightening. But because they are at arm’s length from actual practice, they often fail to reflect the way business works inreal life.When applied to business—essentially a human activity in which judgments are made with messy, incomplete, and incoherent data—statistical and methodological wizardry can blind rather than illuminate.
  61. 61. “In physics it takes three laws to explain 99% of the data; in finance it takes more than 99 laws to explain about 3%.”- Andrew LoWatch this video: Warning: Physics Envy May be Hazardous to Your Wealth
  62. 62. “Imagine how much harderphysics would be if electrons had feelings!” – Richard Feynman
  63. 63. Why are economists trained so formally? It makes sense to axiomatize a discipline when the axioms are true (or almost so) and have strongpredictive power. That’s the case for euclidean geometry, for example, as well as Maxwell’s electromagnetic theory, where many valid, useful,and accurate predictions follow from applying the laws of deduction to a few initial assumptions.But economists seem to have embraced formality and physics envy without the corresponding benefits of accuracy or predictability. In physics,Maxwell’s theory and quantum mechanics allow you to predict the way an electron spins about its own axis inside a hydrogen atom to anaccuracy of twelve decimal places. Something that accurate isn’t just a model—it’s a law. In economics, by contrast, there are no laws at all,only models, and you’re immensely lucky if you can predict up from down...Clearly, then, when someone shows you an economic or financial model that involves mathematics, you should understand that, despite theconfident appearance of the equations, what lies beneath is a substrate of great simplification and—sometimes— great and wonderfulimagination. That’s not a bad thing—financial markets are all about imagination. But you should never forget that even the best financialmodel can never be truly valid because, unlike the physical world, the mental world of securities and economics is much less amenable to thepower of mathematics.
  64. 64. “in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions”- Ben Graham“There is a special paradox in the relationship between mathematics and investmentattitudes on common stocks, which is this: Mathematics is ordinarily considered asproducing precise and dependable results; but in the stock market the more elaborateand abstruse the mathematics the more uncertain and speculative are the conclusionswe draw therefrom. In 44 years of Wall Street experience and study I have never seendependable calculations made about common-stock values, or related investmentpolicies, that went beyond simple arithmetic or the most elementary algebra. Whenevercalculus is brought in, or higher algebra, you could take it as a warning signal that theoperator was trying to substitute theory for experience, and usually also to give tospeculation the deceptive guise of investment.”- Ben Graham
  65. 65. “Economics should emulate physics’ basic ethos, but its search for precision in physics-like formulas is almost always wrong.”
  66. 66. Buffett on CAPMBerkshire Hathaway’s AGM for 1998Shareholder: Do you differentiate between types of businesses in your discounted cash flow analysis given that you use the same discount rate across companies? For example, when you valueCoke and GEICO, how do you account for the difference in the riskiness of their respective cash flows?Buffett: We don’t worry about risk in the traditional way – for example, in the way you’re taught at Wharton. It’s a good question, believe me. If we could see the future of every businessperfectly, it wouldn’t make any difference to us whether the money came from running street cars or selling software because all of the cash that came out – which is all we’re measuring –between now and Judgement Day would spend the same to us.Therefore, the industry that earned it means nothing to us except to the extent that it may tell you something about the ability to develop the cash. But it doesn’t tell you anything about thequality of the cash. Once it becomes distributable, all cash is the same.Buffett: When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in thefuture, that doesn’t mean it’s risky for everyone. It means we don’t know – that it’s risky for us. It may not be risky for someone else who understands the business.However, in that case, we just give up. We don’t try to predict those things. We don’t say, “Well, we don’t know what’s going to happen.” Therefore, we’ll discount some cash flows that we don’teven know at 9% instead of 7%. That is not our way to approach it.Once it passes a threshold test of being something about which we feel quite certain we tend to apply the same discount factor to everything. And we try to only buy businesses about whichwe’re quite certain.Buffett: As for the capital asset pricing model type reasoning with its different rates of risk adjusted returns and the like, we tend to think of it – well, we don’t tend to think of it. We consider, itnonsense.
  67. 67. Learn to focus on avoidance of foolish behaviorLet’s return to the examples of how you’ve been mis-taught (in my view).
  68. 68. Example # 4:Markets are“Efficient”
  69. 69. From William Sharpe’s book, “Investments”“If investors did get an extra return (a risk premium) for bearing unsystematic risk... “ would turnout that diversified portfolios made up of stocks with large amounts of unsystematic risk would givelarger returns than equally risky portfolios of stocks with less unsystematic risk... “Investors wouldsnap up the chance to have these higher returns, bidding up the prices of stocks with largeunsystematic risks and selling stocks with equivalent betas but lower unsystematic risk... “Thisprocess would continue until the prospective returns of stocks with the same betas were equalizedand no risk premium could be obtained for bearing unsystematic risk.. “Any other result would beinconsistent with the existence of an efficient market.”In other words, assume a theory [EMT] is true, then make another theory [CAPM] based on that. Thensay, hey, if something happens that disproves CAPM, that must mean EMT is not true, but because weKNOW it’s true, then CAPM must also be true!
  70. 70. There are no undervalued or overvalued securities and that market prices are always correct. Price= ValueEMT: Stock prices reflect everything about a company’s prospects and the state of theeconomy.
  71. 71. Implication: Investors who seem to beat the market year after year are just lucky
  72. 72. No pointdoing any type of analysisPrice already reflects all possible analysis
  73. 73. Supporting Argument:Prices change quickly in response to new information. But do price change correctly?
  74. 74. or Do markets tend to overreact? Do they Under-reactYes. This has been empirically tested several times.“Stock market is a semi-psychotic creature given to extremes of elation anddespair.”
  75. 75. SupportingArgument: Most investors can’t beatthe market
  76. 76. But how couldmost investors do better than the market when they are the market?
  77. 77. If superior performance was caused due to luck, would not that performance revert to the mean over time?EMT proponents insist that it’s not worth looking at the track record ofBuffett, Munger, Walter Schloss, Tweedy Browne, and other super-investors
  78. 78. The proposition that the market is rational some of the time is different from the proposition that the market is always rational.The proposition that the market is rational some of the time is differentfrom the proposition that the market is always rational.
  79. 79. Even a broken clock tells the correct time twice a dayNegative Empericism. We don’t have to prove that markets are efficientWe can prove that if they were efficient then some things should nothappen. For example the following should not exist:1.Cash Bargains2.Debt-Capacity bargains3.Over and under reactions4.Closed-end fund puzzle
  80. 80. Buffett on EMTExtract from 1988 Annual Report of Berkshire HathawayThis doctrine became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words,the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working securityanalyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient.The difference between these propositions is night and day.In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings fromarbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, Ihave done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929-1932 to contend with.)All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we didnot have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. Thatstrikes us as a statistically-significant differential that might, conceivably, arouse one’s curiosity.Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousandsof students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it’s an enormous advantage tohave opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.
  81. 81. Buffett on EMTBerkshire Hathaway’s AGM for 1998Buffett: The hard-form efficient market theory has been quite helpful to us…. If you had a merchant shipping business and all of your competitors believed the worldwas flat, you’d have a huge edge – because they wouldn’t take on cargo going to places where they think they’d fall off the earth. So we should be encouraging theteaching of hard-form efficient market theories at universities.It amazes me, I think it was Keynes who said, “Most economists are most economical about ideas – they make the ones they learned in graduate school last a lifetime.”What happens is that you spend years getting your Ph.D. in finance. And (in the process), you learn theories with a lot of mathematics that the average layman can’tdo. So you become sort of a high priest. And you wind up with an enormous amount of yourself in terms of your ego – and even professional security – invested inthose ideas. Therefore, it gets very hard to back off after a given point. And I think that to some extent that’s contaminated the teaching of investing in the universities.Buffett: I’ve always found the word ‘anomaly’ interesting because Columbus was an anomaly. AI suppose – at least for awhile. What it means is something theacademicians can’t explain. And rather than reexamine their theories, they simply discard any evidence of that sort as anomalous.On the other hand, Charlie and I believe that when you find information that contradicts your existing beliefs, you’ve got a special obligation to look at I – and quicklyCharlie says that one of the things Darwin did whenever he found anything that contradicted any of his cherished beliefs was that he would write it down immediately –because he knew that the human mind was so conditioned to reject contradictory evidence that unless he put it down in black and white very quickly, his mind wouldpush it out of existence….
  82. 82. Buffett on EMTExtract from 2006 Annual Report of Berkshire HathawayWalter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the NorthCarolina School of the Arts. Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. WhenWalter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made apurchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.I first publicly discussed Walter’s remarkable record in 1984. At that time “efficient market theory” (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at anymoment is not demonstrably mispriced, which means that no investor can be expected to over-perform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefullycontradicted this dogma.And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business schoolteaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory.Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile wenton over-performing, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.Maybe it was a good thing for his investors that Walter didn’t go to college.
  83. 83. Insanity out of EMT: Since price = value there are no wealtheffects in IPOs and stock buybacks
  84. 84. Example # 5: The Human Rationality Assumption in EconomicsAlmost all of traditional economics is based on the notion of the rationalman assumption.
  85. 85. Choose between:85% chance of winning $100 (the gamble) or sure gain of $85 (the sure thing)
  86. 86. Choose between:85% chance of losing $100 (the gamble) or sure loss of $85 (the sure thing)
  87. 87. I am 90% sure that empty 747’s weight is between ____ and ____ tons.Ans: 177 tons
  88. 88. I am 90% sure that the moon’s diameter is between ____ and ____ kilometers.Ans: 3,476 kms
  89. 89. Converting Confidence Level into a money bet
  90. 90. Rs 1,000 saved on a Rs 10 lac car is worth MORE than the Rs 1,000 savedon a Rs 10,000 lamp. Really it is!After all the Rs 1,000 saving when compared to Rs 10 lacs looks SO MUCHSMALLER than the Rs 1,000 saving on a Rs 10,000 lamp.
  91. 91. Example # 6:The Bell Curve Assumption
  92. 92. In a world described by the bell curve, most values are clustered around the middle. The average value isalso the most common value. Outliers contribute very little statistically. If 100 random people gather in aroom and the worlds tallest man walks in, the average height doesnt change much.But if Bill Gates walks in, the average net worth rises dramatically.
  93. 93. Winner Takes AllHeight follows the bell curve in its distribution. Wealth does not. It follows a L-shaped distribution called“power law where most values are below average and a few far above. In the realm of the power law, rareand extreme events dominate the action.If you observe low-probability-high-impact events, then the bell curve is the wrong distribution tocapture that.In a power law world, outliers matter a lot. In a bell curve world, they don’t matter.
  94. 94. Nassim TalebThere’s a place he calls Mediocristan (Bell Curve). This was where early humans lived. Mostevents happened within a narrow range of probabilities – within the bell-curve distributionstill taught to statistics students. But we don’t live there any more. We live in Extremistan(power law), where black swans proliferate, winners tend to take all and the rest get nothing.
  95. 95. there’s Bill Gates, Steve Jobs and a lot of software writers living in a garage.
  96. 96. there’s Domingo and a thousand opera singers working in Starbucks.
  97. 97. there’s JK Rowling, and a million starving fiction writers
  98. 98. Winner Takes All
  99. 99. 7 SD is once every 3 billion years!Models based on the bell curve distribution, massively underestimate theboth the probability as well as the impact of of outlier events.
  100. 100. Would you like to jump out of this plane with this parachute which opens 99% of the time? Modern Risk Management Practices Advocate that you should jumpModern risk management practices (e.g. VAR) assume that we live in aworld best described by a bell curve where outliers are extremely rare, andthat resulted in management practices that were far more risky than waspreviously imagined
  101. 101. “What you really want a course on investing is how to value a business. That’s what the game is about...“And if you look at what’s being taught, I think you see very little of how tovalue a business.
  102. 102. σ σ β σ β Ɣ Ɣ α β α Ɣ σ Ɣ β α αAnd the rest of it is playing around with numbers or Greek symbols of something ofthat sort... But that doesn’t do you any good. In the end, what you have to decide iswhether you’re going to value a business at $400 million, $600 million or $800 million- and then compare that with the price. That’s what investing is. And I don’t know anyother kind of investing to do. And that just isn’t taught. And the reason why it isn’ttaught is because there aren’t teachers around who know how to teach it... They don’tknow themselves. And since they don’t, they teach that nobody knows anything - whichis the efficient market theory. . .
  103. 103. Some of the worst business decisions I’ve seen came with detailed analysis.The higher math was false precision. They do that in business schools,because they’ve got to do something. - 2009 AGM
  104. 104. Buffett on Academic FinanceExtract from 1996 Annual Report of Berkshire HathawayTo invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. Youmay, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose financecurriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How toValue a Business, and How to Think About Market Prices.
  105. 105. Buffett on Academic FinanceExtract from 2008 Annual Report of Berkshire HathawayInvestors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta,gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behindthe symbols. Our advice: Beware of geeks bearing formulas.
  106. 106. Thought # 1: A lot of what you’ve been taught is wrong
  107. 107. Example # 1:The Notion of “Risk” in Academic Corporate Finance
  108. 108. Example # 2:The Relationship between “Risk”and “Return” in Academic Corporate Finance
  109. 109. Example # 3: The CapitalAsset PricingModel (CAPM)
  110. 110. Example # 4:Markets are“Efficient”
  111. 111. Example # 5: The Human RationalityAssumption in Economics
  112. 112. Example # 6:The Bell Curve Assumption
  113. 113. Thought # 2: While people areirrational in very predictable ways, you can work towards becoming rational That’s what you’ll learn in Behavioral finance module
  114. 114. Thought # 3: You can make money off people who are irrationalThat’s what you’ll learn in Business Valuation module
  115. 115. Thank You