Warren Buffett and Active Management of Money

Hi Sam -

Perhaps the Buffet quotes are food for thought, but they are entirely unsatisfying and, more importantantly, unequivocally wrong.

"I'd be a bum on the street with a tin cup if the markets were always efficient."

Almost no one believes markets are completely efficient. Market efficiency is actually a continuum of theories, where the best evidence resides in what is described as th "semi-strong" form of the theory. Additionally, not all markets are greated equal. The large-cap market in the US (say the one defined by the SP500) is highly efficient. But, you won't find alot of people willing to make the same claim about the Indonesian stock market. Regarding how many academics think about market efficiency, perhaps a quote by Eugene Fama is appropriate -- "A problem in developing an overall perspective on long-term return studies is that they rarely test a specific alternative to market efficiency. Instead, the alternative hypothesis is vague, market inefficiency. This is unacceptable. Like all models, market efficiency is a faulty description of price information. But following the standard scientific rule, market efficiency can only be replaced by a better specific model of price formation, itself potentially rejectable by emperical tests".

"Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards."

This is a terrible analogy. The truth is more akin to a bridge game where the best players in the world are competing. In a game like this, chance plays a huge role. In the market there are literally thousands of highly skilled participants. This fact contributes greatly to market efficiency and makes mature, large-cap markets very difficult to beat on a consistent basis.

"It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn't do any good to think."

Again, this quote is a bad reflection of reality. In truth, the VAST majority of investments (both in mutual funds and private pensions) are actively managed. Perhaps the non-thinking these active managers are guilty of is that they can beat the market. The real thinking actually comes from the minority of investors who realize that passive investment is very hard to beat consistently and who realze that fundementals like asset allocation, keeping you costs low, and buying makets precisely are the key determinants of long term performance.

PK,

How then do you explain the fact that Buffett has soundly beaten the S&P 500 over two decades while investing in the same types of companies (S&P 500 companies) that the S&P 500 benchmarks?

Hi Whopper-

There are two competing explanations for Buffett's performance. First, and likely the one you subscribe to, is that he has differential skill. I do not reject this possibility. But, chance is another possible explanation. When hundreds of thousands of people are flipping coins, you expect some of them to flip alot of heads in a row. In the scientific method, chance is always the hurdle that must be beat. To date, no valuation strategy has been empirically shown to explain mature, large-cap markets better and more simply than chance. Also remember that in science, you never accept an hypothesis, you just fail to reject it. And in this type of situation you always fail to reject the simpliest possible hypothesis.

Hi PK,

Buffett has simply been flipping 'heads' for 20 years?.....Sir John Templeton and Mark Holowesko have, all told, been flipping 'heads' for 40 years?.....I doubt that very much.

It's irrelevant whether they've been flipping lucky coins or possess a super-human ability to purchase winning securities. (I believe it's probably an interplay of both variables.) What really does matter though, is we have no way of knowing who the next Templeton or Buffet is going to be. It's counter-intuitive for many people to grasp this concept, and admittedly, it took me the better part of 20 years to accept it. If I had adapted a disciplined, passive strategy when I started investing, I'd be one heck of a lot richer today.

... but not richer than you would be had you invested with Buffet or Templeton for the last 25 years...

Hi Whopper-

If you recall I did not reject the possibility that Buffett has differential skill. Additionally, in my first post I choose to quote Fama who presented a very balanced view of the market efficiency debate. I could have found hundreds of quotes that accepted the theory completely, but I did not do so. The purpose of my first post was to illustrate that Buffett's quotes, and his quotes alone, were wrong.

All of the discussions and debates surrounding market efficiency, modern portfolio theory, the skill or lack of skill of investment managers, and many other topics are intellectually stimulating and one of the reasons I come to this forum. But setting those debates aside, an investor still has to make decisions. Given the evidence, I am not comfortable making a substantive bet on the skill of any manager going forward (this is the key point that Keith raises). Instead, in markets that I believe to be highly efficient (primarily the mature, large cap markets) I prefer to match a passive index with most of my money. Might I make a bet with some of my money in markets I think are less efficient or on managers, like Buffett, who have a great HISTORICAL track record? Sure.

Just one other thing (and my apologies to Kieth) about the coin flipping analogy. It is one thing to find individuals who have a long history of success when you look backwards. It is quite another thing to predict who will succeed going forward. Also, coincidences are often not that coincidental. To illustrate, I rember reading about an individual you won a lotto 649 style lottery twice. The odds of this happening where reported as literally billions to one. But those odds are only valid if you make predictions that a given individual will win a lottery twice going forward in time. In this case, with thousands of people having already won a lottery, the chance that one of those people will win again is actually on the order of 100-1. So, just because you find a couple of people you have long track records of success, don't be so quick to reject chance, because it is often way more likely than you think.

Hi PK

Looks like I've rustled up some allies in the active-passive debate. (also looks like you're refining the argument extremely , well, efficiently..... :-) )

Hi PK -

Given my science background I cannot let the following sentence go unchallanged. Sorry about opening up another "front" on you.

You say: - "Also remember that in science, you never accept an hypothesis, you just fail to reject it"

That's not the way I see it.

Take the "Law of Conservation of Energy" - we have never ever seen one single verifiable exception to it. I would say that is pretty "accepting". There are many other similar hypothesis in science that are as close to absolute as any empirical observation can be.

Hi again PK,

I hear what you and Keith are saying. The only point I was trying to make is that it is quite possible (and, I believe, likely) that people like Buffett are evidence that markets (even the S&P 500) are not always efficient, and that if you know what you're doing, outperformance is possible.

True, most managers of large cap U.S. Equity funds do indeed fail to match the S&P 500 return. This however, does not mean that such an index is impossible to beat - it could very well be that most CFAs, etc. who manage money do not know how to appropriately value stocks.

I realize the following analogy may appear a little wierd, but I think it's appropriate. Take 'magic' for example. David Copperfield is considered to be a master of this art. His 'tricks' seem to defy logic, physics, etc., and even though audiences (and most other 'professional illusionists') cannot explain how he does it, most realize, given his ability to successfully perform such acts on a consistent basis, that his 'feats' are not based on pure chance or luck. In other words, he has certain knowledge about the art of illusion that all other magicians and 'lay people' fail to understand, yet we know there is a 'method to his madness' since he can pull off these amazing feats on a consistent basis - i.e., we don't attribute what he does to random chance, even though no one else can explain the things he does.

My guess is that Buffett shares many of these same traits. Here is a man who, like Copperfield, has clearly 'outperformed' his peers over the long term. Just because we can't explain how Buffett does it doesn't mean his success is merely an abberation. Also, just as Copperfield doesn't tell the world how his tricks are done, Buffett also does not broadcast to the world the investments his analysis determines represent good value and why (he does not disclose anything that he is not required by law to disclose, and often waits until the last possible moment to reveal his trading activity). He is also very much an independent decision-maker who pays little attention to what others think ("My idea of a group decision is to look in the mirror.").

In other words, I think that Buffett's success is more likely a result of what he knows rather than what the rest of us know.

Here is another thought.

Time! To my knowledge "time" is not treated as a serious variable in modern portfolio theory.

Perhaps the "efficiency" of the market decreases with how far into the future one tries to anticipate it. That is, it may be very efficient as far as todays or the near terms market analysis goes - but quite inefficient as far as the market goes say a year from now or five years from now.

Almost all fund managers have a near term focus, where the market is efficient, and where they therefore cannot beat the market consistently.

Individuals like Buffet seem to have a long term perspective - where the market is perehaps inefficient. Buffet seems to invest on general principles, sound management and a forever time scale.

They say that weather forcasting is correct {efficient] in the short term but fails miserably in the long term. The science of weather forcasting simply cannot assimilate all the information it needs to be efficient in the long term. Perhaps the market is similar.

Just a thought.

To George - While I often make statements that lead me on to a slippery slope, I'm on pretty solid ground re my "failing to disprove" statement. As you yourself said, the hypothesis is close to absolute. But in the EXTREMELY unlikely occurance of a better hypothesis, it would be rejected.

To thbox - I've been known to defect.

To Whopper - David Copperfield's best trick is that he married Claudia Shiffer.

But PK - more quibbles from me.

I would claim that scientific hypothesis like the "Law of Conservation of Energy" are "accepted" truths.

Otherwise I do not see any meaning or need for a word like "accepted" - because then nothing that I know about can ever be accepted. Can we really "accept" the hypothesis that you and I are having this silly quibble? [If you get what I mean.]

And established scientific Laws that do not conform with new experiments are not always rejected - sometimes they are "qualified". After Einstein's Relativity Theory, Newton's prior Laws of Motion were "qualified" to be valid at non-relativistic speeds - but Newton's Laws themselves were not rejected. We still build bridges and buildings using his hypothesis. We still accept them.

George - I think you may have it exactly backwards. I think the market is inefficient in the short term but efficient in the long term.

Buffet tends to buy well managed companies with good products in good industries with good earnings. He seems to have the knack for identifying these companies before the market as a whole has fairly valued them (in other words when they are inefficiently priced). He holds for the long term during which his good company continues to increase earnings until the market takes notice and recognizes their true value (when they become efficiently priced).

Conversly, when all the quick buck artists are bidding up "Whizbang Gizmo's R Us" to astronomical P/E values (i.e. pricing it inefficiently) or investing in junior mining companies with no earnings and nothing but wishes and prayers, Buffet avoids these stocks like the plague. In time when these companies earnings fail to live up to optomistic forcasts, the market gets around to pricing them efficiently and their prices drop considerably.

Personally, I feel the market is 100% efficient but the way it is efficient is not well understood. Someone just needs to come up with a perfect mathematical model to measure human psychology as it pertains to stock market investing. Combined with traditional fundamental analysis of business factors, the result would probably predit market movement perfectly. Too bad I can't even imagine this being possible. There's never a Harry Seldon (from Asimov's Foundation series) around when you need one.

PK - I think the joke is: David Copperfield's best trick is that he made Claudia Schiffer's taste disappear.

Hi George-

Re your quibbles, I draw your attention to the third paragraph from the following link:

We can debate adnauseum but what separates Warren Buffet from his less successful counterparts is that he is a non-linear thinker.

One More Thing George -

I thought you might interested in the following links. Link 1 is the homepage of a site called Investor Home that has lots of interesting stuff. Link 2, is a subset of Investor Home called Anomalies which discusses the efficient market debate. Link 3 is a 1997 article by Eugene Fama called "Market Efficiency, Long-Term Returns and Behavioral Finance". Note that for Fama's article you need to have Adobe Accrobat installed.

I know that Bylo and Gummy gave you lots to read re MPT on another thread, but I thought you might be interested.

PK,

I have Adobe Acrobat installed on my computer, yet I'm not sure how to view web sites with it - would you please tell me how this is done? Thanks in advance.

Thomas

PK, I have read and re-read the statement from Fama that you quoted: "A problem in developing an overall perspective on long-term return studies is that they rarely test a specific alternative to market efficiency. Instead, the alternative hypothesis is vague, market inefficiency. This is unacceptable. Like all models, market efficiency is a faulty description of price information. But following the standard scientific rule, market efficiency can only be replaced by a better specific model of price formation, itself potentially rejectable by emperical tests".

For the life of me, I can make no sense of it. This looks to me like the most blatant case of scientific gobeldegook that I have seen in a long time. It says nothing when you actually read it.

Perhaps I'm wrong, and you can explain it to me in regular person terminology.

To Thomas - If you have accrobat installed, documents that use it will load automatically -- you shouldn't have to do anything.

To AKO - Basically the statement says that a better model for market pricing does not exist. Alternatives to the efficiency theory are usually not specifically stated, so they cannot be tested. If you cannot test a theory, it does not deserve to replace an existing one. Any competing theory has to be broad enough to explain as much about market pricing as does EMT, but they do not. If a competing theory was developed that could do this, Fama would be prepared to reject EMT. This is how the scientific method works.

BTW, since I read this kind of academic stuff all the time, I'm more use to the jargon -- so I can understand and empathize with your "gobeldegook" statement. Frankly, there are times that I get to the bottom of a page and I don't have a clue what I've read.

i believe that markets are mostly efficient. I mean they have to be somewhat efficient, or else no one would ever know what a company's market value should be. Even Mr. Buffett needs to depend on the markets being somewhat efficient or his stocks would never increase in value, because no one would ever realize the true value of those companies. He needs the market to become efficient and realize the true market value of the stock that he purchased at a discounted price.

Let me add though, that I think that sometimes we get so caught up in the numbers and statistics and ratios that we forget what the market really is. All the market is, is some people needing money, and other people supplying that money to those who need.

In the simplest case we have a young couple who need money to buy a farm, and another older couple lending that money to the young couple for a set price. The deal is then closed on a hand-shake, and the money is transfered.

In real life, there are millions of borrowers, and millions of lenders. Millions of companies needing cash to opperate or expand, and millions of people or companies that lend or purchase part of that company to help it opperate or expand. But basically it all boils down to people, and more people.

I don't know any two people that are exactly the same, or think the same. Therefore, because there is a human factor, (and it's sometimes a forgotten factor) in the markets, the market can never be 100% efficient, (even in the long term it won't be 100%). That fact allows for room to move on both sides of index. There will allways be some individuals that can consistantly outperform the index, like Buffet, and Templeton. There will also be some who never seem to even match the index forget trying to beat it, (like Alex Christ).

Darn - hit the Return by accident above.

To PK:

Thank you for the links. I've printed out Famas paper - it looks like a long slog. And perhaps written more for other "experts in academia" than for me.

My impression is that the academic world is staying away from explaining the Buffett-anomalie [or Lynch etc] issue in relation to the efficient market theory. Is this true? If so, why I wonder. Have you seen any papers on it?

My wife and I are getting ready to go away for most of the summer - without acces to the web, so I shall have to wait until the late summer to get re-involved here.

To Chuck M

Maybe I have confused myself a bit but what you say about Buffett I agree with I would interpret to mean that his investment philosophy exploits todays inefficiency in regards to the long term market. I think we both agree on this. [That is the long term market is "inefficient" today but as time passes and when what was the future now becomes the present - the market is efficient.]

They say that one reason that high-priced meteorologists running their weather predicting models on the world's largest super-computers cannot predict the future weather more than about 7 days in advance, - is because small things - like a butterfly fapping its wings in the Amazon could be the perturbation that determines the future weather in Toronto. So they say. It seems to that Buffet avoids this long term issue by staying with old-fashioned common sense basics and so steering the odds in his favour.

George,

If you are the cottage for the summer, ensure that you stock up on lots Double Cheeseburgers, Gillette "bug spray" and Coke coolers. These type of conspicuous consumer perishables are representative of Buffett's active investment portfolio acumen. I certainly admire the profitability of his security selections. But I have utter disdain for the vacuous moral acumen in his personal life.

To the question at hand and to paraphrase the "grove of Academe" [and PK perhaps if I be allowed some scientific effrontery] - Buffett's apparent success is primarily attributable to some teleologically mutual exclusivity inexplicably randomized by anomalous market occurrences that are incapable of independent verification.

Tough slugging indeed!

IMO, statistical anomaly is the simple answer to the question. And incidentally, anomaly is the genesis of the marketers' dream. Without it (real[?] or perceived), there would be no consumer need for actively managed investment portfolios.

Have a great summer with the missus and looking forward to posting with you again.

I submit that many of you miss the elegance of Buffett's investing.

He is successful because he concentrates on where the easy money lies within the stock market, and because he gains enough acumen about the underlying businesses to make sensible, rational decisions about the prospective fundamentals of those business - 10 years out.

As to Michaels statement that ...

Buffett's apparent success is primarily attributable to some teleologically mutual exclusivity inexplicably randomized by anomalous market occurrences that are incapable of independent verification.

I'd tend to disagree with that statement just on general principle. (that is of course, if I had any idea what he's trying to say - jargon - ya gotta love it!!)

AKO & PK Re: Fama

I do not agree with Fama's statement that I would say as 'the best "worst" theory will survive until another stinky one comes along that is marginally better.'

The efficient market theory, as I understand it, basically says that stocks ARE correctly priced at any given time, based upon all facts then known.

First of all, this is completely nonsensical in the most basic way: it assumes that human beings are entirely 'Spock-like' and that they are never governed by their emotions, when it comes to making decisions about stocks. So long as emotion remains in investing, markets will never be 'efficient' in the way suggested.

Secondly, the whole idea presupposes somehow that each market participant involves with any one stock has the whole panapoly of information about that company available. What nonsense.

And if the foundation is that all the knowledge available, divided unequally between the market participants make them 'efficient', well what can I say to such a nonsensical argument?

It's like the old saw about three blind men, each at differetn parts of the elephant, being asked to describe it. All come up with something different, but none really describe the elephant.

And finally, I would ask HOW? can a market actually be efficient at pricing, when so few market participants are actually using the most stable and durable valuation methodology? The p/e ratio nonsense continues practically unabated to this day, added to by other 'simple' valuation tools like the 'PEG' ratio and so on.

HOw can a market be efficient at pricing when most participants are using a poor valuation model to estimate the value of these companies?

Simply doesn't make sense to me, but then I've got a rather simple mind.

This - and more - coming to a bookstore near you, in the near future.

Cheers!

Jay: Do you really believe that Buffet can continue to outperform the market now that his (possibly superior) stock valuation methods are common knowledge and widely practiced by a huge following? I'd place my money on the market beating Buffet over the next 20 years any day. The statistical probability remains somewhere in the range of 4 to 1 that I would win this bet (even though he won the last round, figuratively speaking).

Keith, a couple of points:

1. His 'methods' may be practiced (I wouldn't suggest 'widely' however), but one main point is that the valuations typically performed are of inferior methodology (i.e. p/e ratio's etc). I don't agree that the valuation methodology he proposes, Discounted Cash Flow, is widely practiced.

Therefore, in this regard, I think that he still has a huge edge over most investors.

2. As to the market beating Berkshire over the next 20 years, I think that Buffett will probably continue to outperform the market (after adding back in paid income taxes). However, I agree that this will become harder and harder over time, simply due to the size of Berkshire. Meaningful outperformance becomes harder and harder as size increases, a fact Buffett has practically harped on for the last 15 years.

As you point out, you have the 'odds' in your favor - I only have the best stockpicker of the 20th century, practising a relatively simple and 'tried and true' method.

While the 'bet' may not be settled, it certainly makes for interesting conversation in the interim, yes?

Cheers! :-)

(PS All this and more, coming to a bookstore near you, in the near future!)

Jay Walker:

The name of this impending opus would be....?

:-)

Ah, txbox, it is not an 'OPUS', rather something condensed and readable for the average person, and secondly, the title has not been settled yet ...

Cheers!

:-)