Berkshire Ruminations

Thursday, November 29, 2007

New CNBC show - Warren Buffett: The Billionaire Next Door Going Global

CNBC is airing a new show about Warren Buffett in which I may appear tomorrow, November 30 at 8:00pm central time. Here is a link to CNBC's listing for it.

Several weeks ago, a crew from CNBC visited our college and my class while preparing a new documentary about Warren Buffett. As you may know, the network also visited last year and featured the Buffett class as part of the original show, Warren Buffett: The Billionaire Next Door. Last year before the show aired I warned that there was no guarantee they would even use the footage of our class, and of course they actually devoted an entire five-minute segment to it. Nonetheless I will again issue the same warning. I don't really know what direction they are taking the show this year so I don't know for certain that I will appear, but it will be worth watching regardless.

***** UPDATE, 12/1/07 4:00pm *****
In case you missed it, looks like the show will re-air for the first time tomorrow, Sunday Dec. 2 at 10:00pm central. But I expect many more reruns in the near future too.

***** UPDATE, 12/4/07 6:00pm *****
Here are some more show times as listed on
Wednesday, December 12th, 8:00pm and 11:00pm central time
Sunday, December 16th, 10:00pm central

Monday, November 26, 2007

What makes Warren Buffett successful?

I was asked this question during a job interview I had some six years ago with a St. Louis-based brokerage firm. I bombed it. And it has haunted me ever since. How could I fail to articulate a coherent response to such a simple question? Well, it’s complicated, so allow me to explain.

First of all, if the success of Warren Buffett were easily understood and replicable, clearly there would be many more wildly successful investors in the world, but of course there are not. While I concede that this observation comes dangerously close to efficient market theorist’s six-sigma explanation of Mr. Buffett’s success – that with so many coin-flipping investors you are bound to have an outlier like Buffett simply by chance – I do not think it is a null hypothesis that can easily be rejected. The truth is there are very few investors even in the same ballpark as Buffett. But why? Is it just chance?

Kind of. Mr. Buffett has explained it by acknowledging that he is “wired” in such a way that makes him very adept at capital allocation. This might be a disconcerting notion to some as it implies that you either have it or you don’t.

But what is “it” anyway? To me, it is a combination of an array of characteristics, some very learnable, some less so. The learnable ones are characteristics every CFA charterholder probably has. These are things like strong analytical skills as well as simply a good knowledge of the financial markets. That is not especially hard to replicate. Moreover, with tens of thousands of CFAs in the world you would expect a few more Buffetts were this all it takes.

It is the less-learnable characteristics that set Buffett apart and this is where watching Warren Buffett the person may help the most. People who have spent time with Mr. Buffett notice two things. For starters, he reads – constantly. Sometimes he can spend his entire day reading, and it’s not just for pleasure. He reads because he is hungry for information that will make him a more successful businessman. Very few people have the drive Warren Buffett has.

Easy enough right? You are probably thinking, “Well if all I have to do to become a billionaire is read all the time then sign me up for the value investor’s book club.” Not so fast. A lot of people read a lot. The difference is Buffett’s memory. Not only does he read but he remembers everything he reads. Folks familiar with the man know how tremendous his memory is. Very few people have the memory Warren Buffett has.

The most important less-learnable characteristic Buffett possesses, though, is very uncommon. It is emotional discipline. By this I mean the ability to resist the natural human instincts of fear, greed, pride, regret and all the other irrational biases to which people are inherently inclined to succumb. I have been trying myself to master these biases for years and, let me tell you, it is tough. Even once an investor is cognizant of these biases he may find it extremely difficult to control them. I can’t let myself buy because stocks are going up (greed) or sell because they are going down (fear). I have to base my decisions entirely on an unbiased assessment of the underlying business. This is far easier said than done.

Several years ago the WSJ ran a story about entitled “Lessons From the Brain-Damaged Investor.” The article discussed studies in the field of “neuroeconomics,” a sub-field of the more general category of behavioral economics. Some of these studies suggest that brain chemistry itself can explain irrational financial decision making and that individuals with damage to the part of the brain responsible for controlling emotion actually make better financial decisions. A sample of brain damaged individuals more appropriately weighed risk and payoffs in a simple gambling game than a control group consisting of individuals with similar IQ but no brain damage.

No, I am not suggesting Warren Buffett has brain damage. Rather, I think he has an innate acuity to controlling emotions that most people do not. Perhaps some people have as much control over their emotions, but the number is probably small. Further, it is unlikely that such a person also has the intelligence, knowledge, ambition, memory and patience of Warren Buffett. Said differently, all the characteristics necessary to construct a master investor may exist independently in many different people, but the probability of them all existing in the same person is very low. Warren Buffett happens to be the only one to date.

Consider some of the other personal qualities that have contributed to Mr. Buffett’s success. He is very personable and pleasant. That certainly hasn’t encumbered his road to riches, as it took the personal relationships he had with the original investors in the Buffett Partnership for Mr. Buffett to get started. He is also very good at reading people, whatever you think “reading” them might involve. Just look at how many successful investments were in part due to his ability to assess the integrity of the business’s management.

So there you have it. Warren Buffett’s success is indeed the result of luck. But it is not the coin-flipping kind of luck that academics would like to believe. Rather, he is simply lucky to be endowed with all the requisite qualities that make for investment success. This begs the question, then, is it worthwhile to study what has made Mr. Buffett successful? Can we even hope to acquire the skills driving his success? Without hesitation, I would answer in the affirmative. Even if we cannot hope to ever be as wealthy or respected, any effort to be will make us both better investors and better businesspeople. Warren Buffett is the pinnacle of investing perfection. While we may never get to his level ourselves, we can still benefit from trying.

Sunday, November 25, 2007

BCS Title, here we come.

Yeah, I realize this is a financial blog, but this is just too exciting for me to neglect to mention. The Missouri Tigers beat the #2 Kansas Jayhawks last night and for the first time since 1960 are the #1 football team in the nation. Words cannot express how huge this is. Nobody saw it coming.

Now, I have been a Tiger fan all my life, but like many others had avowed that Mizzou would forever put up a second-rate D1 football team. The border war last night changes everything. We are now on the main stage with the likes of LSU, Ohio State and USC. A win over Oklahoma next week puts Mizzou in the national championship. Could somebody please pinch me?

And rumor has it that the Heisman-contender that conducted last night's orchestra, Mr. Chase Daniel, is a finance major. Maybe he will take my course next semester...

This is huge for the sports fan in me, but I think its also good for the university in general. A big time football program gives the school a national presence and makes it easier to recruit quality faculty. In my field, we sometimes categorize finance programs based on the university's athletic conference affiliation - it gives the program an identity even if the relation between quality football teams and quality finance faculty is, well, dubious at best. At least this is the way it seems to me in my short career as an academic thus far.

Anyway, I am just so frickin proud to be living in this town of Columbia and attending the University of Missouri - I just had to say something. Sorry bout that. I'll get back to ruminating about Berkshire Hathway soon.

Monday, November 05, 2007

Borrow now, while you're still young.

Sometimes the cleverest ideas are the ones that initially seem the most preposterous. Such was the case with a paper I recently heard presented by Yale Law Professor Ian Ayers, coauthored with Yale Business School professor Barry Nalebuff.

These authors contend that the typical young person should invest 200% of his net worth in stocks. That is, buy everything on 50% margin. This is because far too little is invested in stocks by individuals when those individuals are young, resulting in very poor diversification across time. What? You’ve never heard of inter-temporal diversification? Well the intuition behind it is obvious once you mull over it for a while. For me it was one of those “yeah-I-never-thought-about-like-that” moments. We all accept that exposure to only certain asset classes is risky, but what about the differential exposure to stocks that I have in 2007 (when I am young and less wealthy) and 2040 (when I am older and, of course, wealthier)?

Ever heard of the traditional wisdom by which you subtract your age from 110 and then invest that percentage of your wealth in stocks? Well as Warren Buffett might say, traditional wisdom is often long on tradition and short on wisdom. In this case, there is no theory behind the advice at all. It is just made up. Sure, it’s convenient for the investment adviser who needs to create the impression he is following some sort of strategy, and is a great marketing tool for the life cycle mutual funds that actually practice the principle. But why should we believe this is correct?

Ayers and Nalebuff argue that this rule is too conservative and actually provide theoretical support for their notion through a simulation of the strategy. Investors should leverage up significantly in their early years and then reduce their leverage over time. This gives them equivalent exposure to the stock market when they are young and when they are old and this diversification reduces the overall risk to their savings.

If you are like me, you can understand the intuition but nonetheless have some gut-level objection to the idea. The authors are prepared for this and address the issue directly.

There is definitely an aversion to borrowing to invest in our culture. Individuals have no problem borrowing to purchase a home, car or education. But borrowing to invest is taboo. Is this justified? Most folks will point to the ’29 market crash, when margin calls perpetuated an unstoppable slide. While this point is valid, the type of margin borrowing that occurred at that time was done for the purposes of speculating in the short-term. What these authors are suggesting is far different, with a time horizon for the borrowed funds several decades in length.

Margin calls are usually thought of as portfolio-destroying, but in this simulation the authors show that margin calls actually have no meaningful effect, since they assume that performance of the market after a margin call is as likely to be positive as it is negative. So sometimes a margin call will result in forgone profits, sometimes forgone losses.

And what about those high margin interest rates? Well in real terms they are still considerably lower than even conservative estimates of the equity premium, so the young investor still stands to benefit. But in fact margin rates should be much lower anyway. A loan secured by highly liquid assets with positive expected returns over which the custodian has power to liquidate at a moments notice is far from risky to the lender. Nonetheless margin rates are often double that of mortgage rates or student loan rates. That they persist at levels so high may, in fact, be further evidence of the cultural objection to margin investing. The perceived risk is far higher than the actual risk.

I hope I have accurately portrayed these scholars’ proposal. It is fascinating to me, both because I am a victim of the natural margin-aversion that many others are, but also because it suggests that aggressive investing, when done responsibly, can reduce risk.

Whether or not new ideas such as this prove to be wise, I think it’s always good practice to question the traditional wisdom. For instance, Warren Buffett’s assessment of diversification, and how lower diversification can actually reduce risk by increasing the deliberation made over any single investment, has always seemed a counterintuitive proposition. But there is certainly truth to it. Likewise, the idea of borrowing when young is counterintuitive and there may indeed be truth to it as well.