Friday, 16 April 2010

Buffett (1993): His views on real risk and how 'beta" fails to spot competitive strengths inherent in certain companies

Concentration over excessive diversification and the futility of using a stock's beta were the two key concepts that were discussed in Warren Buffett's 1993 letters to shareholders. However, the master does not stop here and, in the follow up paragraphs, puts forth his views on what is the real risk that an investor should evaluate and how the 'beta' as defined by the academicians fails to spot competitive strengths inherent in certain companies.

First up, the master explains what is the real risk that an investor should assess and goes on to suggest that the first thing that needs to be looked at is whether the aggregate after tax returns from an investment over the holding period keeps the purchasing power of the investor intact and gives him a modest rate of interest on that initial stake. He is of the opinion that though this risk cannot be measured with engineering precision, in a few cases it can be judged with a degree of accuracy. The master then lists out a few primary factors for evaluation. These would be:

  • The certainty with which the long-term economic characteristics of the business can be evaluated;

  • The certainty with which management can be evaluated, both as to its ability to realise the full potential of the business and to wisely employ its cash flows;

  • The certainty with which management can be counted on to channel the rewards from the business to the shareholders rather than to itself;

  • The purchase price of the business; and

  • The levels of taxation and inflation that will be experienced and that will determine the degree by which an investor's purchasing-power return is reduced from his gross return.
Indeed, the above qualitative parameters are not likely to go down well with analysts who are married to their spreadsheets and sophisticated models. But this in no way reduces their importance. These parameters, the master says, may go a long way in helping an investor see the risks inherent in certain investments without reference to complex equations or price histories.

Buffett further goes on to add that for a person who is brought up on the concept of beta will have difficulties in separating companies with strong competitive advantages from the ones with mundane businesses and this he believes is one of the most ridiculous things to do in stock investing. This is what he has to say in his own inimitable style.

"The competitive strengths of a Coke or Gillette are obvious to even the casual observer of business. Yet the beta of their stocks is similar to that of a great many run-of-the-mill companies who possess little or no competitive advantage. 
  • Should we conclude from this similarity that the competitive strength of Coke and Gillette gains them nothing when business risk is being measured? 
  • Or should we conclude that the risk in owning a piece of a company - its stock - is somehow divorced from the long-term risk inherent in its business operations? 
We believe neither conclusion makes sense and that equating beta with investment risk also makes no sense."

He further states, "The theoretician bred on beta has no mechanism for differentiating the risk inherent in, say, a single-product toy company-selling pet rocks or hula hoops from that of another toy company whose sole product is Monopoly or Barbie. But it is quite possible for ordinary investors to make such distinctions if they have a reasonable understanding of consumer behavior and the factors that create long-term competitive strength or weakness. Obviously, every investor will make mistakes. But by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy."

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