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sense and nonsense in modern corporate finance

Sense and nonsense in modern corporate f inance

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Page 1: Sense and nonsense in modern corporate f inance

sense and nonsense in modern corporate

finance

Page 2: Sense and nonsense in modern corporate f inance

Thought # 1: A lot of what you’ve been taught is wrong

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Example # 1:

The Notion of “Risk” in Academic Corporate

Finance

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William Sharpe, Noble Laureate

σ

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High degree of variability means “high risk”

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Low degree of variability means “low risk”

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Inference:

Treasury bonds are “risk-free” securities because they have zero variability of return.

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“Treasury bonds are risk free”

Hmmm

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“We define risk, using dictionary

terms, as “the possibility of

loss or injury.”

“The real risk that an investor must assess is whether his aggregate after-tax receipts from an investment (including those he receives on sale) will over his prospective holding period, give him at least as much purchasing power as he had to begin with, plus a modest rate of interest on that initial stake.”

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Investing is often

described as the process

of laying out money now in

the expectation of

receiving more money in

the future.

At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From 2011 Letter.

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If you forego ten hamburgers to

purchase an investment;

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receive dividends which, after tax, buy

two hamburgers;

and receive, upon sale of your holdings, after-tax proceeds that will buy

eight hamburgers,

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then you have had no real income

from your investment, no matter how much

it appreciated in dollars.

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You may feel

richer,

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but you won’t eat

richer.

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“Bonds promoted as offering risk-free returns are

now priced to deliver return-

free risk.”

From 2011 Letter commenting on the prevailing almost zero

interest rates on treasury bonds.

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Example # 2:

The Relationship between “Risk” and “Return” in

Academic Corporate

Finance

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Two components:Systematic and

Unsystematic risk

Academic Finance’s Definition of “Risk”

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Investors will not get paid to assume unsystematic risk because that component of total risk can be diversified away.

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Investors will get paid only

for taking systematic

risk, a proxy of which is

“beta”.

Academics...like to define investment “risk” differently, averring that it is the relative volatility of a stock or portfolio of stocks - that is, their volatility as compared to that of a large universe of stocks.

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Low Risk

High RiskHigh Return

Low Return

Stocks with high beta are riskier than stocks with lower betas but are expected to deliver

higher returns.

Hmmmmm

Stocks with high beta are riskier than stocks with lower betas but are expected to deliver higher returns.

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Do

?

Do stocks with large betas outperform stocks with low betas?Ans: No

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Do ?=

Do stocks with identical beta produce same returns?Ans: No

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Is a proxy for ?

Ans: No

Volatility is not the same as risk.

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Beta does not capture risk

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How does He think of Risk?

“Though this risk cannot be calculated with engineering precision, it can in some cases be judged with a degree of accuracy that is useful…

“The primary factors bearing upon this evaluation are:

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A. “The certainty with

which the long-term economic

characteristics of the

business can be evaluated

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B. “The certainty with

which management

can be evaluated,

both as to its ability to

realize the full potential of the business and to wisely

employ its cash flows

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C. “The certainty with

which management

can be counted on to channel the rewards

from the business to

the shareholders rather than

to itself.

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D. The purchase price of

the business

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E. “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.”

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The Trouble with his

definition of risk?

You cannot objectively measure it!

Is that a problem?

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“False precision is

totally crazy... It

only happens to people with high IQs.”

The desire to be PRECISE makes people do some incredibly FOOLISH things.

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“It’s better to be

approximately right than to be precisely

wrong” - John Maynard keynes

The desire to be PRECISE makes people do some incredibly FOOLISH things.

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“Not everything that counts

can be counted, and not

everything that can be

counted, counts.” - Einstein

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Buffett on RISK

Extract from 2011 Annual Report of Berkshire Hathaway

The Basic Choices for Investors and the One We Strongly Prefer

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

• Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

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Buffett on RISK

Berkshire Hathaway’s AGM for 1993: Comments on Risk

Shareholder: There appears to be inconsistencies between your view of risk and the conventional view.Derivatives are dangerous. And yet you feel comfortable playing derivatives through Salomon. Betting on hurricanes is dangerous. And yet you feel comfortable playing with hurricanes through insurance companies. So it appears that you have some view of risk that’s inconsistent with what would appear on the face of it to be conventional view of risk.

Buffett: We do define risk as the possibility of harm or injury. Therefore, we think it’s inextricably would up in our time horizon for holding an asset. If you intend to buy XYZ Corporation at 11:30 this morning and sell it out before the close today, that’s a very risky transaction in our view -because we think that 50% of the time, you’re going to suffer some harm or injury. On the other hand, given a sufficiently long time horizon . . .

For example, we believe that the risk of buying something like Coca Cola at the price we paid a few years ago is close to nil -given our prospective holding period. But if you asked me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning, I’d say that that’s a very risky transaction.

As I pointed out in the annual report, it became very fashionable in the academic world -and it spilled over into the financial markets -to define risk in terms of volatility of which beta is a measure. But that is no measure of risk to us.

The risk in terms of our super-cat business is not that we lose money in any given year. We know we’re going to lose money in some given day. That’s for certain. And we’re extremely likely to lose money in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of investment, we think that it is not a risky business.

And it’s a whole lot less risky than writing something that is much more predictable. It’s interesting to us that using conventional measures of risk, something whose return varies from year-to-year between +20% and +80% is riskier than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how they measure risk.

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Buffett on RISK

Berkshire Hathaway’s AGM for 1993: Comments on Risk

Shareholder: Wall Street often evaluates the riskiness of a particular security by the volatility of its quarterly or annual results -and likewise, measures money managers’ riskiness by their volatility. I know you guys don’t agree with that approach. Could you give us some detail about how you measure risk?

Buffett: We regard volatility as a measure of risk to by nuts. And the reason its used is because the people that are teaching want to talk about risk -and the truth is that they don’t know how to measure it in business. Part of our course on how to value a business would also be on how risky the business is. And we think about that in terms of every business we buy.

Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that there’s just an inadequate return on the kind of capital we put in.

However, it doesn’t relate to volatility at all. For example, our See’sCandy business will lose money-and it depends on when Easter falls -in two quarters each year. So it has this huge volatility of earnings within the year. Yet it’s one of the least risky businesses I know. You can find all kinds of wonderful businesses that have great volatility in results. But that doesn’t make them bad businesses.

Similarly, you can find some terrible businesses with very low volatility. For example, take a business that did nothing. It’s results wouldn’t vary from quarter to quarter. So it just doesn’t make any sense to equate volatility with risk.

END

Notice he talks about two types of risks: Risk of permanent loss of capital and Opportunity loss.

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Buffett on RISK

Berkshire Hathaway’s AGM for 1994: Comments on Risk

Buffett: We do define risk as the possibility of harm or injury. Therefore, we think it’s inextricably wound up in your time horizon for holding an asset. If you intend to buy XYZ Corporation at 11.30 this morning and sell it out before the close today, that is a very risky transaction in our view – because we think that 50% of the time, you’re going to suffer some harm or injury. On the other hand, given a sufficiently long time horizon…

For example, we believe that the risk of buying something like Coca-Cola at the price we paid a few years ago is close to nil – given our prospective holding period. But if you asked me to assess the risk of buying Coca-Cola this morning and selling it tomorrow morning, I’d say that that’s a very risky transaction.

Buffett: As I pointed out in the annual report, it became very fashionable in the academic world – and it spilled over into the financial markets – to define risk in terms of volatility of which beta became a measure. But that is no measure of risk to us.

The risk in terms of our super-cat business is not that we lose money in any given year. We know we’re going to lose money in some given day. That’s for certain. And we’re extremely likely to lose money in some years. But our time horizon in writing that business would be at least a decade. And we think that our probability of losing money over a decade is low. So in terms of our horizon of investment, we think that that is not a risky business.

And it’s a whole lot less risky than writing something that is much more predictable. It’s interesting to us that using conventional measures of risk, something whose return varies from year-to-year between +20% and +80% is riskier as it’s defined than something that returns 5% a year every year. We think the financial world has gone haywire in terms of how it measures risk.

Buffett: We’re perfectly willing to lose money on a given transaction – arbitrage being one example and any given insurance policy being another. But we’re not willing to enter into any transactions in which we think the probability of a number of mutually independent events of a similar type has an expectancy of loss.

And we hope that we’re entering into transactions where our calculations of those probabilities have validity. To do so, we try to narrow it down. There are a whole bunch of things that we just don’t do because we don’t think we can write the equation on them.

Basically, Charlie and I are pretty risk-averse by nature. But if we knew it was an honest coin and someone wanted to give us 7-to-5 (odds) or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip? It would sound like a big number to you. It wouldn’t be a huge percentage of (Berkshire’s) net worth, but it would be a significant number. We’ll do things where the probabilities favor us.

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Munger & Buffett on RISK

Munger: This great emphasis on volatility in corporate finance we regard as nonsense…. Let me put it this way. As long as the odds are in our favor and we’re not risking the whole company on one throw of the dice or anything close to it, we don’t mind volatility in results. What we want are the favorable odds. We figure the volatility over time will take care of itself at Berkshire.

Buffett: If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.

For example, See’s may lose money in eight months in a typical year. However, it makes a fortune in November and December. If it were an independent, publicly-traded company and people reacted to that and therefore made its stock very volatile, that would be terrific for us. We could buy it in July and sell it in January – because we’d know it was nonsense.

Well, obviously, things don’t behave quite that way. But when we bought The Washington Post, it had gone down 50% in a few months. Well, that was the best thing that could have happened. It doesn’t get any better than that. Its businesses were fundamentally very non-volatile – a strong, dominant newspaper and TV stations – but it was a volatile stock. That’s a great combination in our view.

When we see a business about which we’re very certain whose fortunes the world thinks are going up and down – and so its stock behaves with great volatility – we love it. That’s way better than having a lower beta. We actually prefer what other people call “risk.”

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HOW DOES HE THINK ABOUT

THE RELATIONSHIP

BETWEEN RISK AND RETURN

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“If someone were to say to me, “I have here a six-

shooter and I have slipped one cartridge into it“Why don’t you just spin it and pull it once? If you survive, I

will give you $1 million.

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I would decline - perhaps stating that $1

million is not

enough.”

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“Then he might offer me $5 million to pull the trigger

twice...

“Now that would be a positive correlation between risk and

reward!”

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“The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s

riskier than if you buy a dollar bill for 40 cents, but the

expectation of reward is greater in the latter case.”

This is one of those ideas that grab you immediately, or you struggle with it all your life.

For me it grabbed me immediately when I encountered it in Buffett’s essay, “The Superinvestors of Graham-and-Doddsville” while studying in London.

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“The greater the potential for reward in the

value portfolio, the less risk

there is.”

Risk

Return

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TO MAKE MONEY

TAKE RISK

TO MAKE MONEY

SHUN RISK

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Tweedy Browne

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“One of the many unique and advantageous aspects of value investing is that the larger the discount from intrinsic value, the greater the

margin of safety and the greater potential return when the stock price moves back to intrinsic value... “Contrary to the view of modern portfolio theorists that increased

returns can only be achieved by taking greater levels of risk, value investing is predicated on

the notion that increased returns are associated with a greater margin of safety, i.e. lower risk.”

All true value investors believe the inverse relationship between risk and return where risk is defined the way Buffett defines it.

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“I have never been able to figure out

why it’s riskier to buy $400 million

worth of properties

for $40 million than $80 million.”

“The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy. Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater. And to people who think beta measures risk, the cheaper price would have made it look riskier. This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million. And, as a matter of fact, if you buy a group of such securities and you know anything at all about business valuation, there is essentially no risk in buying ten $40 million piles for $8 million each.”

“In assessing risk, a beta purist will disdain examining what a company produces, what its competitors are doing, or how much borrowed money the business employs. He may even prefer not to know the company's name. What he treasures is the price history of its stock. In contrast, we'll happily forgo knowing the price history and instead will seek whatever information will further our understanding of the company's business. After we buy a stock, consequently, we would not be disturbed if markets closed for a year or two.”

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Example # 3:The Capital

Asset Pricing Model (CAPM)

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“Employing databases and

statistical skills, these academics

compute with precision the "beta"

of a stock - its relative volatility

in the past - and then build arcane

investment and capital-allocation theories around

this calculation.”

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“In their hunger for a

single statistic to

measure risk, however, they

forget a fundamental

principle: It is better to be

approximately right than precisely wrong.”

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His first critique of CAPM is that it

uses beta, which is a flawed measure of

risk.

But there is a second, terribly

important critique of CAPM.

To understand that, we need to jump over a jurisdictional boundary of corporate finance into the realm of psychology.

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Jumping over jurisdictional boundaries:

An introduction to multidisciplinary thinking.

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envy

Envy is the only one of the seven deadly sins which gives us nothing. There is NO upside in envy.

Rejecting opportunities that would make you rich because others have better ones is envy.

You will never find the mention of envy in any corporate finance textbook. Does that mean you should ignore its influence on human decisions simply because the idea belong to another discipline?

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“How crazy it would be to be made miserable by the fact that someone

else is doing better because someone else is always going to be doing better at any human activity you can name.” - Charlie Munger

“What the hell do I care if somebody else makes money faster. There’s always going to be somebody who is making money faster, running the mile faster or what have you. Once you get something that works fine in your life, the idea of caring terribly that somebody else is making money faster strikes me as insane.”

“If you’ve got a way of investing your money that is overwhelmingly likely to keep you comfortably rich and someone else finds something that would make him richer faster, that is not a big tragedy.”

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Reject projects where

IRR<WACC

Don’t be envious

Let’s digress a bit here because I want to talk to you a bit more about multidisciplinary thinking. We will return to discussion of envy in corporate finance in a while.

Here is a story in corporate finance illustrating one of the best decisions made by Warren Buffett in his career.

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Physics envy

Let’s return to the subject of envy

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“B schools aspire to the same standards of academic excellence that hard disciplines

embrace—an approach sometimes waggishly referred to as “physics envy.””- Warren Bennis

Virtually none of today’s top-ranked business schools would hire, let alone promote, a tenure-track professor whose primary qualification is managing an assembly plant, no matter how distinguished his or her performance. Nor would they hire professors who write articles only for practitioner reviews, like this one. Instead, the best B schools aspire to the same standards of academic excellence that hard disciplines embrace—an approach sometimes waggishly referred to as “physics envy.”

Business school professors using the scientific approach often begin with data that they use to test a hypothesis by applying such tools as regression analysis. Instead of entering the world of business, professors set up simulations (hypothetical portfolios of R&D projects, for instance) to see how people might behave in what amounts to a laboratory experiment. In some instances those methods are useful, necessary, and enlightening. But because they are at arm’s length from actual practice, they often fail to reflect the way business works in real life.

When applied to business—essentially a human activity in which judgments are made with messy, incomplete, and incoherent data— statistical and methodological wizardry can blind rather than illuminate.

http://en.wikipedia.org/wiki/Warren_Bennis

http://www.rasalevickaite.lt/kmtm/skaitinys.pdf

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“In physics it takes three laws to explain

99% of the data; in finance it takes more

than 99 laws to explain about 3%.”-

Andrew Lo

Watch this video: Warning: Physics Envy May be Hazardous to Your Wealth

http://mitworld.mit.edu/video/794/

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“Imagine how much harder

physics would be if

electrons had

feelings!”– Richard Feynman

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Why are economists trained so formally? It makes sense to axiomatize a discipline when the axioms are true (or almost so) and have strong predictive power. That’s the case for euclidean geometry, for example, as well as Maxwell’s electromagnetic theory, where many valid, useful, and accurate predictions follow from applying the laws of deduction to a few initial assumptions.

But economists seem to have embraced formality and physics envy without the corresponding benefits of accuracy or predictability. In physics, Maxwell’s theory and quantum mechanics allow you to predict the way an electron spins about its own axis inside a hydrogen atom to an accuracy of twelve decimal places. Something that accurate isn’t just a model—it’s a law. In economics, by contrast, there are no laws at all, only models, and you’re immensely lucky if you can predict up from down...

Clearly, then, when someone shows you an economic or financial model that involves mathematics, you should understand that, despite the confident appearance of the equations, what lies beneath is a substrate of great simplification and—sometimes— great and wonderful imagination. That’s not a bad thing—financial markets are all about imagination. But you should never forget that even the best financial model can never be truly valid because, unlike the physical world, the mental world of securities and economics is much less amenable to the power of mathematics.

http://www.ederman.com/new/docs/beware.hbr.pdf

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“in the stock market the

more elaborate and abstruse the mathematics

the more uncertain and

speculative are the

conclusions”- Ben Graham

“There is a special paradox in the relationship between mathematics and investment attitudes on common stocks, which is this: Mathematics is ordinarily considered as producing precise and dependable results; but in the stock market the more elaborate and abstruse the mathematics the more uncertain and speculative are the conclusions we draw therefrom. In 44 years of Wall Street experience and study I have never seen dependable calculations made about common-stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment.”- Ben Graham

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“Economics should emulate physics’ basic ethos, but its search for

precision in physics-like formulas is almost always wrong.”

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Buffett on CAPM

Berkshire Hathaway’s AGM for 1998Shareholder: Do you differentiate between types of businesses in your discounted cash flow analysis given that you use the same discount rate across companies? For example, when you value Coke and GEICO, how do you account for the difference in the riskiness of their respective cash flows?

Buffett: We don’t worry about risk in the traditional way – for example, in the way you’re taught at Wharton. It’s a good question, believe me. If we could see the future of every business perfectly, it wouldn’t make any difference to us whether the money came from running street cars or selling software because all of the cash that came out – which is all we’re measuring – between now and Judgement Day would spend the same to us.Therefore, the industry that earned it means nothing to us except to the extent that it may tell you something about the ability to develop the cash. But it doesn’t tell you anything about the quality of the cash. Once it becomes distributable, all cash is the same.

Buffett: When we look at the future of businesses we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know – that it’s risky for us. It may not be risky for someone else who understands the business.

However, in that case, we just give up. We don’t try to predict those things. We don’t say, “Well, we don’t know what’s going to happen.” Therefore, we’ll discount some cash flows that we don’t even know at 9% instead of 7%. That is not our way to approach it.

Once it passes a threshold test of being something about which we feel quite certain we tend to apply the same discount factor to everything. And we try to only buy businesses about which we’re quite certain.

Buffett: As for the capital asset pricing model type reasoning with its different rates of risk adjusted returns and the like, we tend to think of it – well, we don’t tend to think of it. We consider, it nonsense.

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Learn to focus on avoidance of foolish

behavior

Let’s return to the examples of how you’ve been mis-taught (in my view).

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Example # 4:

Markets are “Efficient”

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From William Sharpe’s book, “Investments”

“If investors did get an extra return (a risk premium) for bearing unsystematic risk... “...it would turn out that diversified portfolios made up of stocks with large amounts of unsystematic risk would give larger returns than equally risky portfolios of stocks with less unsystematic risk... “Investors would snap up the chance to have these higher returns, bidding up the prices of stocks with large unsystematic risks and selling stocks with equivalent betas but lower unsystematic risk... “This process would continue until the prospective returns of stocks with the same betas were equalized and no risk premium could be obtained for bearing unsystematic risk.. “Any other result would be inconsistent with the existence of an efficient market.”

In other words, assume a theory [EMT] is true, then make another theory [CAPM] based on that. Then say, hey, if something happens that disproves CAPM, that must mean EMT is not true, but because we KNOW it’s true, then CAPM must also be true!

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There are no undervalued

or overvalued securities and

that market prices are

always correct.

Price= Value

EMT: Stock prices reflect everything about a company’s prospects and the state of the economy.

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Implication: Investors who seem to beat the market year after year are just lucky

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No point doing any type

of analysisPrice already reflects all

possible analysis

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Supporting Argument:

Prices change quickly in

response to new

information. But do price

change correctly?

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or Do markets tend to overreact? Do they Under-react

Yes. This has been empirically tested several times.“Stock market is a semi-psychotic creature given to extremes of elation and despair.”

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Supporting Argument:

Most investors can’t beat the market

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But how could

most investors do better than the

market when they are the market?

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If superior performance was

caused due to luck, would not

that performance revert to the mean

over time?

EMT proponents insist that it’s not worth looking at the track record of Buffett, Munger, Walter Schloss, Tweedy Browne, and other super-investors

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The proposition that the market is rational some of

the time is different from the

proposition that the market is

always rational.

The proposition that the market is rational some of the time is different from the proposition that the market is always rational.

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Even a broken clock

tells the correct

time twice a day

Negative Empericism. We don’t have to prove that markets are efficientWe can prove that if they were efficient then some things should not happen. For example the following should not exist:1.Cash Bargains2.Debt-Capacity bargains3.Over and under reactions4.Closed-end fund puzzle

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Buffett on EMT

Extract from 1988 Annual Report of Berkshire Hathaway

This doctrine became highly fashionable - indeed, almost holy scripture in academic circles during the 1970s. Essentially, it said that analyzing stocks was useless because all public information about them was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient. The difference between these propositions is night and day.

In my opinion, the continuous 63-year arbitrage experience of Graham-Newman Corp. Buffett Partnership, and Berkshire illustrates just how foolish EMT is. (There’s plenty of other evidence, also.) While at Graham-Newman, I made a study of its earnings from arbitrage during the entire 1926-1956 lifespan of the company. Unleveraged returns averaged 20% per year. Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%. (Of course, I operated in an environment far more favorable than Ben’s; he had 1929-1932 to contend with.)

All of the conditions are present that are required for a fair test of portfolio performance: (1) the three organizations traded hundreds of different securities while building this 63- year record; (2) the results are not skewed by a few fortunate experiences; (3) we did not have to dig for obscure facts or develop keen insights about products or managements - we simply acted on highly-publicized events; and (4) our arbitrage positions were a clearly identified universe - they have not been selected by hindsight.

Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means $1,000 would have grown to $405,000 if all income had been reinvested. A 20% rate of return, however, would have produced $97 million. That strikes us as a statistically-significant differential that might, conceivably, arouse one’s curiosity.

Yet proponents of the theory have never seemed interested in discordant evidence of this type. True, they don’t talk quite as much about their theory today as they used to. But no one, to my knowledge, has ever said he was wrong, no matter how many thousands of students he has sent forth misinstructed. EMT, moreover, continues to be an integral part of the investment curriculum at major business schools. Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians.

Naturally the disservice done students and gullible investment professionals who have swallowed EMT has been an extraordinary service to us and other followers of Graham. In any sort of a contest - financial, mental, or physical - it’s an enormous advantage to have opponents who have been taught that it’s useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT.

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Buffett on EMT

Berkshire Hathaway’s AGM for 1998

Buffett: The hard-form efficient market theory has been quite helpful to us…. If you had a merchant shipping business and all of your competitors believed the world was flat, you’d have a huge edge – because they wouldn’t take on cargo going to places where they think they’d fall off the earth. So we should be encouraging the teaching of hard-form efficient market theories at universities.

It amazes me, I think it was Keynes who said, “Most economists are most economical about ideas – they make the ones they learned in graduate school last a lifetime.”

What happens is that you spend years getting your Ph.D. in finance. And (in the process), you learn theories with a lot of mathematics that the average layman can’t do. So you become sort of a high priest. And you wind up with an enormous amount of yourself in terms of your ego – and even professional security – invested in those ideas. Therefore, it gets very hard to back off after a given point. And I think that to some extent that’s contaminated the teaching of investing in the universities.

Buffett: I’ve always found the word ‘anomaly’ interesting because Columbus was an anomaly. AI suppose – at least for awhile. What it means is something the academicians can’t explain. And rather than reexamine their theories, they simply discard any evidence of that sort as anomalous.

On the other hand, Charlie and I believe that when you find information that contradicts your existing beliefs, you’ve got a special obligation to look at I – and quickly Charlie says that one of the things Darwin did whenever he found anything that contradicted any of his cherished beliefs was that he would write it down immediately – because he knew that the human mind was so conditioned to reject contradictory evidence that unless he put it down in black and white very quickly, his mind would push it out of existence….

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Buffett on EMT

Extract from 2006 Annual Report of Berkshire Hathaway

Walter did not go to business school, or for that matter, college. His office contained one file cabinet in 1956; the number mushroomed to four by 2002. Walter worked without a secretary, clerk or bookkeeper, his only associate being his son, Edwin, a graduate of the North Carolina School of the Arts. Walter and Edwin never came within a mile of inside information. Indeed, they used “outside” information only sparingly, generally selecting securities by certain simple statistical methods Walter learned while working for Ben Graham. When Walter and Edwin were asked in 1989 by Outstanding Investors Digest, “How would you summarize your approach?” Edwin replied, “We try to buy stocks cheap.” So much for Modern Portfolio Theory, technical analysis, macroeconomic thoughts and complex algorithms.

Following a strategy that involved no real risk – defined as permanent loss of capital – Walter produced results over his 47 partnership years that dramatically surpassed those of the S&P 500. It’s particularly noteworthy that he built this record by investing in about 1,000 securities, mostly of a lackluster type. A few big winners did not account for his success. It’s safe to say that had millions of investment managers made trades by a) drawing stock names from a hat; b) purchasing these stocks in comparable amounts when Walter made a purchase; and then c) selling when Walter sold his pick, the luckiest of them would not have come close to equaling his record. There is simply no possibility that what Walter achieved over 47 years was due to chance.

I first publicly discussed Walter’s remarkable record in 1984. At that time “efficient market theory” (EMT) was the centerpiece of investment instruction at most major business schools. This theory, as then most commonly taught, held that the price of any stock at any moment is not demonstrably mispriced, which means that no investor can be expected to over-perform the stock market averages using only publicly-available information (though some will do so by luck). When I talked about Walter 23 years ago, his record forcefully contradicted this dogma.

And what did members of the academic community do when they were exposed to this new and important evidence? Unfortunately, they reacted in all-too-human fashion: Rather than opening their minds, they closed their eyes. To my knowledge no business school teaching EMT made any attempt to study Walter’s performance and what it meant for the school’s cherished theory.

Instead, the faculties of the schools went merrily on their way presenting EMT as having the certainty of scripture. Typically, a finance instructor who had the nerve to question EMT had about as much chance of major promotion as Galileo had of being named Pope.

Tens of thousands of students were therefore sent out into life believing that on every day the price of every stock was “right” (or, more accurately, not demonstrably wrong) and that attempts to evaluate businesses – that is, stocks – were useless. Walter meanwhile went on over-performing, his job made easier by the misguided instructions that had been given to those young minds. After all, if you are in the shipping business, it’s helpful to have all of your potential competitors be taught that the earth is flat.

Maybe it was a good thing for his investors that Walter didn’t go to college.

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Insanity out of EMT:

Since price = value there

are no wealth effects in IPOs

and stock buybacks

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Example # 5:

The Human Rationality

Assumption in Economics

Almost all of traditional economics is based on the notion of the rational man assumption.

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Choose between:

85% chance of winning $100 (the gamble)

or

sure gain of $85 (the sure thing)

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Choose between:

85% chance of losing $100 (the gamble)

or

sure loss of $85 (the sure thing)

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I am 90% sure that empty 747’s weight is between ____ and ____ tons.

Ans: 177 tons

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I am 90% sure that the moon’s diameter is between ____ and ____ kilometers.

Ans: 3,476 kms

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Converting Confidence Level into a money bet

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Rs 1,000 saved on a Rs 10 lac car is worth MORE than the Rs 1,000 saved on a Rs 10,000 lamp. Really it is!After all the Rs 1,000 saving when compared to Rs 10 lacs looks SO MUCH SMALLER than the Rs 1,000 saving on a Rs 10,000 lamp.

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Example # 6:

The Bell Curve Assumption

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In a world described by the bell curve, most values are clustered around the middle. The average value is also the most common value. Outliers contribute very little statistically. If 100 random people gather in a room and the world's tallest man walks in, the average height doesn't change much.

But if Bill Gates walks in, the average net worth rises dramatically.

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Winner Takes All

Height follows the bell curve in its distribution. Wealth does not. It follows a L-shaped distribution called “power law where most values are below average and a few far above. In the realm of the power law, rare and extreme events dominate the action.

If you observe low-probability-high-impact events, then the bell curve is the wrong distribution to capture that.

In a power law world, outliers matter a lot. In a bell curve world, they don’t matter.

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Nassim Taleb

There’s a place he calls Mediocristan (Bell Curve). This was where early humans lived. Most events happened within a narrow range of probabilities – within the bell-curve distribution still taught to statistics students. But we don’t live there any more. We live in Extremistan (power law), where black swans proliferate, winners tend to take all and the rest get nothing.

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there’s Bill Gates, Steve Jobs and a lot of software writers living in a garage.

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there’s Domingo and a thousand opera singers working in Starbucks.

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there’s JK Rowling, and a million starving fiction writers

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Winner Takes All

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7 SD is once every 3 billion years!

Models based on the bell curve distribution, massively underestimate the both the probability as well as the impact of of outlier events.

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Would you like to jump out of this plane with this parachute which opens 99% of

the time?

Modern Risk Management Practices Advocate that you should jump

Modern risk management practices (e.g. VAR) assume that we live in a world best described by a bell curve where outliers are extremely rare, and that resulted in management practices that were far more risky than was previously imagined

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“What you really want a

course on investing is

how to value a business. That’s what the game

is about...

“And if you look at what’s being taught, I think you see very little of how to value a business.

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α

βƔ

σ α

β

Ɣ

σ

α

β

Ɣσ

α

β Ɣσ

And the rest of it is playing around with numbers or Greek symbols of something of that sort... But that doesn’t do you any good. In the end, what you have to decide is whether you’re going to value a business at $400 million, $600 million or $800 million - and then compare that with the price. That’s what investing is. And I don’t know any other kind of investing to do. And that just isn’t taught. And the reason why it isn’t taught is because there aren’t teachers around who know how to teach it... They don’t know themselves. And since they don’t, they teach that nobody knows anything - which is the efficient market theory. . .

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Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something. - 2009 AGM

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Buffett on

Academic Finance

Extract from 1996 Annual Report of Berkshire Hathaway

To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these. That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects. In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.

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Buffett on

Academic Finance

Extract from 2008 Annual Report of Berkshire Hathaway

Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.

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Thought # 1: A lot of what you’ve been taught is wrong

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Example # 1:

The Notion of “Risk” in Academic Corporate

Finance

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Example # 2:

The Relationship between “Risk” and “Return” in

Academic Corporate

Finance

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Example # 3:The Capital

Asset Pricing Model (CAPM)

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Example # 4:

Markets are “Efficient”

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Example # 5:

The Human Rationality

Assumption in Economics

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Example # 6:

The Bell Curve Assumption

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Thought # 2: While people are irrational in very predictable ways,

you can work towards becoming rational

That’s what you’ll learn in Behavioral finance module

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Thought # 3: You can make money off people who are irrational

That’s what you’ll learn in Business Valuation module

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Thank You