Experienced readers of Warren Buffett’s letters to the shareholders of Berkshire Hathaway Inc. have gained an enormously valuable informal education. The central theme uniting Buffett’s lucid essays is that the principles of fundamental business analysis, first formulated by his teachers at Columbia Business School, Ben Graham and David Dodd, should guide investment practice.
This stance conflicts with the dominant view of contemporary teachers of finance, which stresses modern finance theory’s efficient market hypothesis to challenge whether such fundamental analysis can be practiced successfully. Debate over this question nevertheless continues, in academia and on Wall Street, raising issues of great important to corporate law and securities regulation as well. This post, adapted from my book, The Essays of Warren Buffett: Lessons for Corporate America, which grew out of a law school conference, will highlight some of Buffett’s perspectives on this question.
Modern finance theory, now nearly 50 years old, was among the most revolutionary investing ideas of our time. This is an elaborate set of ideas that boil down to onesimple and misleading practical implication: it is a waste of time to study individual investment opportunities in public securities. According to this view, you will do betterby randomly selecting a group of stocks for a portfolio by throwing darts at the stock tables than by thinking about whether individual investment opportunities make sense.
One of modern finance theory’s main tenets is modern portfolio theory. It says that you can eliminate the peculiar risk of any security by holding a diversified portfolio—that is, it formalizes the folk slogan “don’t put all your eggs in one basket.” The risk that is left over is the only risk for which investors will be compensated, the story goes.
This leftover risk can be measured by a simple mathematical term—called beta—that shows how volatile the security is compared to the market. Beta measures thisvolatility risk well for securities that trade on efficient markets, where information about publicly traded securities is swiftly and accurately incorporated into prices. In the modern finance story, efficient markets rule.
Reverence for these ideas was not limited to ivory tower academics, in colleges, universities, business schools, and law schools, but became standard dogma throughout financial America in the past thirty-five years, from Wall Street to Main Street. Many professionals still believe that stock market prices always accurately reflectfundamental values, that the only risk that matters is the volatility of prices, and that the best way to manage that risk is to invest in a diversified group of stocks.
Being part of a distinguished line of investors stretching back to Graham and Dodd which debunks standard dogma by logic and experience, Buffett thinks most marketsare not purely efficient and that equating volatility with risk is a gross distortion. Accordingly, Buffett worried that a whole generation of MBAs and JDs, under the influence of modern finance theory, was at risk of learning the wrong lessons and missing the important ones.
A particularly costly lesson of modern finance theory came from the proliferation of portfolio insurance—a computerized technique for readjusting a portfolio in decliningmarkets. The promiscuous use of portfolio insurance helped precipitate the stock market crash of October 1987, as well as the market break of October 1989. It neverthelesshad a silver lining: it shattered the modern finance story being told in business and law schools and faithfully being followed by many on Wall Street.
Ensuing market volatility could not be explained by modern finance theory, nor could mountainous other phenomena relating to the behavior of small capitalizationstocks, high dividend-yield stocks, and stocks with low price-earnings ratios. Periodic market bubbles undercut the model as well, whether the technology and Internet stock bubble that blew up in the late 1990s and early 2000s of the bubble in the financial sector a decade later. Growing numbers of skeptics emerged to say that beta does not really measure the investment risk that matters, and that capital markets are really not efficient enough to make beta meaningful anyway.
In stirring up the discussion, people started noticing Buffett’s record of successful investing and calling for a return to the Graham-Dodd approach to investing andbusiness. After all, for more than forty years Buffett has generated average annual returns of 20% or better, which double the market average. For more than twenty years before that, Ben Graham’s Graham-Newman Corp. had done the same thing.
As Buffett emphasizes, the stunning performances at Graham-Newman and at Berkshire deserve respect: the sample sizes were significant; they were conducted overan extensive time period, and were not skewed by a few fortunate experiences; no data-mining was involved; and the performances were longitudinal, not selected byhindsight.
Threatened by Buffett’s performance, stubborn devotees of modern finance theory resorted to strange explanations for his success. Maybe he is just lucky—the monkey who typed out Hamlet— or maybe he has inside access to information that other investors do not. In dismissing Buffett, modern finance enthusiasts still insist thatan investor’s best strategy is to diversify based on betas or dart throwing, and constantly reconfigure one’s portfolio of investments.
Buffett responds with a quip and some advice: the quip is that devotees of his investment philosophy should probably endow chaired professorships at colleges anduniversities to ensure the perpetual teaching of efficient market dogma; the advice is to ignore modern finance theory and other quasi-sophisticated views of the market andstick to investment knitting. That can best be done for many people through long-term investment in an index fund. Or it can be done by conducting hard-headed analyses of businesses within an investor’s competence to evaluate. In that kind of thinking, the risk that matters is not beta or volatility, but the possibility of loss or injury from an investment.
Assessing that kind of investment risk requires thinking about a company’s management, products, competitors, and debt levels. The inquiry is whether after-taxreturns on an investment are at least equal to the purchasing power of the initial investment plus a fair rate of return. The primary relevant factors are the long-term economic characteristics of a business, the quality and integrity of its management, and future levels of taxation and inflation. Maybe these factors are vague, particularlycompared with the seductive precision of beta, but the point is that judgments about such matters cannot be avoided, except to an investor’s disadvantage.
Buffett points out the absurdity of beta by observing that “a stock that has dropped very sharply compared to the market . . . becomes ‘riskier’ at the lower price than it was at the higher price”—that is how beta measures risk. Equally unhelpful, beta cannot distinguish the risk inherent in “a single-product toy company selling pet rocks or hula hoops from another toy company whose sole product is Monopoly or Barbie.” But ordinary investors can make those distinctions by thinking about consumer behavior and the way consumer products companies compete, and can also figure out when a huge stock-price drop signals a buying opportunity.
Contrary to modern finance theory, Buffett’s investment knitting does not prescribe diversification. It may even call for concentration, if not of one’s portfolio, then atleast of its owner’s mind. As to concentration of the portfolio, Buffett reminds us that Keynes, who was not only a brilliant economist but also an astute investor, believed that an investor should put fairly large sums into two or three businesses he knows something about and whose management is trustworthy. On that view, risk rises when investments and investment thinking are spread too thin. A strategy of financial and mental concentration may reduce risk by raising both the intensity of an investor’s thinking about a business and the comfort level he must have with its fundamental characteristics before buying it.
The fashion of beta, according to Buffett, suffers from inattention to “a fundamental principle: It is better to be approximately right than precisely wrong.” Long-terminvestment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success.
Such “flitting from flower to flower” imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor “is like calling someone who repeatedly engages in one-night stands a romantic.” Investment knitting turns modern finance theory’s folk wisdom on its head: instead of “don’t put all your eggs in one basket,” we get Mark Twain’s advice from Pudd’nhead Wilson: “Put all your eggs inone basket—and watch that basket.”