Monday, March 2, 2009

Buffett: Man or Myth

Warren Buffett is now more myth than man. The investors who claim to follow Buffetology, read the Berkshire Hathaway annual report and actually make the trip to Omaha (the value investing Woodstock) numbers in the tens of thousands, if not millions. I think that we do a disservice to Buffett, when we put him on a pedestal and treat every word he says as gospel. At the risk of sounding like a curmudgeon, here is my take on Mr. Buffett.

Let's start with the obvious. Warren Buffett has been an incredibly successful investor and his string of successess cannot be explained by luck. He has been able to make money with diverse investment strategies, but with a core philosophy that has remained unchanged over the last four decades. That core philosophy: you buy a business, not a stock. Hence, his competitive advantage has been assessing the value of an underlying business, especially in chaotic times, and buying stock in that business, when the price is down.

Buffett has never been an activist investor, i.e., he has seldom taken positions in poorly managed companies and tried to change the management. In fact, one of his criteria for investing in a company is that he admires the management. He has also never been comfortable straying from his niche, which is mature businesses: I cannot think of a single, big investment that he has made in a technology or young company.

I like to read Buffett's comments on the markets. Unlike many market strategists at investment banks, who cloak their recommendations in buzz words and hedge them until they are meaningless, Buffett is to the point and says what he means. His emphasis on corporate governance puts most institutional investors to shame.

My only real issue with Buffett is that he sometimes lets his "Aw, shucks! I am just a regular investor" persona cover up two things that he does that contribute to his success. One is his careful focus on cash flows; he might not use the terminology of valuation but Buffett has been using free cash flows to measure investments for as long as he has been investing. The second is that he is now an insider in many of the companies that he invests in; he has an advantage over you or I, when taking the same investments.

One final point about Buffett. The mythology is that Buffett does not adjust for risk, when he invests. I have even heard people say that he settles for the riskfree rate. Right? Buffett may not use betas or risk-adjusted discount rates but he certainly factors risk into the analysis by making conservative estimates of the cash flows. In effect, he reduces the expected cash flows of riskier businesses, i.e., uses certainty equivalents.

Be like Buffett, if that is what you want to do. But don't view this as a license to ignore risk and to just buy companies with good management (no matter what the price). You are almost certainly not going to make money that way.


  1. I do follow a bit of buffetology and infact what makes me believe in this intrinsic value thing is that there is an investor out there who is the biggest of them all and has been using basic intrisic valuation all through even though he doesnt like using betas, gammas etc. I think it would make perfect sense not to use those if you are already reducing your risky cash flows like you mentioned...

    However he too does make mistakes like a few mistakes he owned up this year with buying ConocoPhillips shares when oil and gas prices were near their peak and buying two irish banks which he had to writedown 90%.

    This brings me to two points (1) it is actually useless valuing commodities (no one can predict the values of these)(2) is there a safe way of valuing a bank ...even dividend method seems to be falling apart as dividends are all over the place.

    It would be great to have a comment from you on this.

  2. I believe how many people USED to value banks was based on book value. The problem with this using this methodology now is who the hell knows what the actual book values for a lot of these banks actually are.

    I'd be curious to hear your thoughts on mark to market. It seems to me getting rid of it could alleviate some of the problems by sweeping write-offs underneath the rug. However, I think it is not a REAL solution to the problem. If anything it would just cause a bigger blowup down the road.

  3. I think Buffets methodology works (we have fact - 20.3% compounded aannual gain 1965-2008).
    But on the other hand I totaly agree with you Prof. that if you just invest in companies with good management at no maater whart price its a suicide.
    Also I think when Buffet decided investing in non-US companies it was mistake.

    Prof. I also have question to you about Gold. There are projections that in 2009 demand for gold from ETF will rise from 307 tonnes in 2008 to 1355 tonnes.
    Don't you thinkk it cann be a new "gold" bubble?

  4. Hi Mr.Damodaran, I'm Sing from Malaysia. May I know what's your take on 'technical analysis'? is it just myth? or merely a pyschological trend?

  5. I must confess that I find gold to be a scary investment, simply because there are so many true believers (who will buy gold no matter what). I think the argument for gold being a good investment is much stronger if you also believe that all this money being poured into stimulus packages around the world will translate into higher inflation.

  6. Prof. Totaly agree with you.
    Don't you think that at the first stage there will be deflation in developed countries and inflation in developuing countries. And the second step of crisis will be hyper inflation in the world?

  7. Yes professor i agree with u..Good companies wih good managements must be bought at the right prices. Having said that, buffetology also subscribes to the same view whereby the sage of omaha says one needs to buy companies whose market prices are much lower than their intrinsic values. Margin of safety is the sole principle on which any investment decision should be based upon.

  8. Mr Damodaran!

    Are you trying to say that, Buffetology is all about sticking to fundamentals and having an information advantage?
    While the former can be done by anyone, everyone cannot have an information advantage. In this context whats your take on market efficeiency ?

  9. I disagree with your criticism’s of Buffett in this article in which you state that, "Bufffett’s “Aw, shucks! I am just a regular investor” persona cover up: (1) his use of free cash flows; and (2) he is an insider in many of the companies that he invests in and has an advantage over you and I when taking the same investments. Also, hte inference that Buffett implies that he does not adjust for risk."
    My response is:
    (1) I have never seen Buffett indicate “Aw, shucks! I am just a regular investor”; quite the contrary, Buffett always appears to me to be playing the role of teacher, trying to teach other the basic concepts of investing which many, including yourself, don’t appear to embrace;
    (2) Buffett does not cover up that he uses free cash flows; in fact, he repeatedly emphasizes careful analysis of free cash flows and their primary importance when making investment decisions;
    (3) Buffett’s record excluding any additional investments he made after being an insider in a company is still outstanding - in fact, I am not aware that it is any different when including the investments that you object to;
    (4) Buffett repeatedly emphasizes the foremost importance of analyzing risk when making investment decisions and discusses extensively how to analyze and reduce risk. Buffett doesn’t accept or employ the framework or approach that utilizes adjusting for risk technique (risk is not variance – you can have wide variances and very little risk). Risk is not something that is adjusted for, it is part of the basic analysis.
    Finally, I have not heard anyone talk more about the importance of price and not overpaying than Warren Buffett, so I don’t agree with the implications of your statement about be Buffett if you like but don’t view this as a license to ignore risk and to just buy companies with good management (no matter what the price). This certainly would be completely against all of Warren Buffett’s advice, not consistent with it, as you seem to imply.
    Regarding gold, I think it is better to view gold as an inflation hedge, rather than as an investment.

  10. You mentioned that "Buffett may not use betas or risk-adjusted discount rates but he certainly factors risk into the analysis by making conservative estimates of the cash flows". Also in some of the books, it is mentioned that Buffett expects a 15% minimum in stocks and hence uses it as a discount factor. Please can you elaborate on the limitations of taking a constant discount factor and not the risk adjusted discount rate.

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