Letters

How to beat the market! Readers respond to Andrew Leonard's "Warren Buffett's Revenge."


Salon Staff
January 31, 2003 1:30AM (UTC)

[Read the story.]

From here in Maine, Buffett looks like just another greedy cat. Buy Dexter shoe, one of the last operating shoe plants in the U.S.? Sure! Promise to run it the way the original family owners did? Absolutely! Break every promise, dismantle the company piece by piece and ship production overseas, destroying town after town? Mais Oui! There's nothing left but big empty buildings and destroyed lives.

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He's no hero. He's just a different kind of jerk. And not too different at that.

-- Rob Oakley

I'm afraid you have misunderstood what is meant by the efficient market hypothesis (EMH). The EMH makes a claim about what investors do with information that is available. It says information spreads very quickly once it is public and is reflected in the price of stocks before you have a chance to act on it. Clearly a few people will make money on the information. But for individual investors, with the trading costs and delays of information we face, the market is very close to efficient.

Volatile stock gyrations like Enron are largely the result of new information coming to the market quickly as lies are discovered and the house of cards falls. The efforts by market reformers are designed to reveal information quickly and regularly, so that lies cannot be maintained. But the lies were not public information precisely so the market could not act on them. That is why Ken Lay and other insiders made so much money. They were playing with loaded dice.

No market is perfectly efficient, as most economists will agree. However, the U.S. stock markets are some of the most efficient in the history of man. This efficiency has come through regulations like the Clinton era regulation FD -- full disclosure -- which says that corporate announcements must be made broadly to news services rather than to a few select analysts whose firms can then profit. It is one of the things that drives the powerhouse of the American economy. I believe that market regulation is key to making the markets fair. This includes punishing white-collar crime vigorously and fully funding the SEC. But efficiency and fairness are two different things. It is important that Salon readers know that difference.

-- Edward Fine

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I enjoyed your article on Warren Buffet. As you note, a lot of the press has described his success as a stock picker, rather than as an investor in companies, which is incorrect.

I think that Buffett is a decent person, with many admirable traits. But you don't succeed in business by simply being a nice guy. Lowenstein has an instructive description of Buffett's takeover of Berkshire-Hathaway, which used to be a textile company. He came in and fired the existing management and put in his own CEO. Warren Buffett views companies from the point of view of cash flow (cash above expenses), which is one reason that historically he has loved insurance companies. As long as the company meets his cash flow objectives, he's fine. But if it does not, he will force changes, which in the case of Berkshire-Hathaway meant firing all the employees over time (Berkshire-Hathaway is just a shell now).

I'm sure that Buffett would point out that no company that is run without a close eye on cash flow can survive and prosper for long. Berkshire-Hathaway was doomed and Buffett used it as a cash cow. He may have slowed the arrival of its eventual fate. There is nothing he could have done to alter it. So while Buffett's business model may be necessary, it is also rather cold-blooded. It is interesting to contrast this with his general public image.

On efficient market theory: I spent two years working for a hedge fund. At least in the short term, it is possible to prove mathematically that the market does not act like a random walk. So the "random walk down Wall Street" is not entirely true. People can and do make money off of market inefficiencies. In fact, if people did not believe that such inefficiencies existed, they would not trade. It is, however, a strange business. The more people take advantage of small inefficiencies, the more efficient and random the market becomes. Markets are living and dynamically changing environments, so what works today may not work as well or at all six months from now. As you note, the market would not be efficient if lots of value investors did not closely follow stock prices. Since lots of value investor "eyes" exist, people like you and I are best advised to invest in a diversified portfolio of index funds. For a reasonable book on this see "The Four Pillars of Investing: Lessons for Building a Winning Portfolio" by William J. Bernstein. One thing I find ironic is that if we all followed the advice of Bernstein, there would be no value investors and the market would become chaotic and investing in index funds would not work.

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There are (at least) four sad truths in investing:

1. You are rewarded for risk.

2. Not all risk is rewarded equally (just because you took a risk does not mean that you get rewarded).

3. You are rewarded for having an "edge," which may consist of factors like effort, technological advantage (good computer models), talent, intelligence or access to cheap money (investment banks have a cheaper cost of funds than you or I do).

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4. Making money in investing is not easy (you need an "edge").

Modern portfolio theory attempts to minimize risk and to make sure that you are rewarded for the risk you take. But it does not eliminate it. Buffett's cash flow comes with risk too. Berkshire-Hathaway has lost some serious money on their reinsurance business, although I think that GEICO remains strong.

Modern portfolio theory is based on the idea that returns (profit and loss) are distributed in a Gaussian (bell) curve. This allows a whole set of mathematics to be applied. In the last 20 years huge databases of financial data have become available and computer power has become widespread. This has allowed mathematical methods to be applied that were not used in the original work that suggested that markets had an underlying Gaussian structure. It is becoming more widely accepted that returns are not distributed in a Gaussian curve, which means that bubbles and crashes happen much more than the mathematics predicts. So even standard portfolio theory will not save you from significant loss. It is up to the user to recognize when the mathematics does not apply (personally, I have my money in money market funds in these days of Bush II and war without end). Which brings me to the final point: Investment is not easy. It takes a reasonable amount of intelligence, work and talent, which is one reason that most people don't do well at it. Sadly, I'm still a salaried employee, so it's pretty clear that I don't have any special "edge" either.

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-- Ian L. Kaplan

As I am not an economist, nor have I read the technical literature, I do not profess to understand the academic version of the efficient market hypothesis any better than you. However, my view of the efficient market hypothesis both validates Buffett's investing style, captures the gestalt of your EMH and accounts for all market conditions including the speculative ones we've encountered recently.

My theory uses the same premise as the intuitive one the academics focus on: Given the unlimited attention, resources, observers and actors in today's financial market prices will quickly converge on a "true value" in that a company's share price will reflect every piece of publicly revealed information. On this then, we agree. However, I differ from classic economics in defining the true value of a share as the expected value of the sum of all future dividends (earnings) discounted to present value. As used by classical economists this definition implies a sort of mechanical/pre-destined universe of economics; if analysts can study, understand and predict the impact of every trend in consumer desires, marketing, input prices, labor prices, political considerations, on a business then the analyst/market can accurately define all future revenue streams, costs and thus profits. This view suggests that effective valuation simply requires a more comprehensive understanding of the financial universe in order to converge on an accurate concept of future earnings.

This definition is incomplete in its analysis of the information that analysts do not know. Expected goes beyond a mere mathematical equation, it goes beyond the best information available, it goes beyond cold considerations of probabilities of events.

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What (most) classical economists miss in their analysis is the role of psychology (i.e., the human) and, more important, group psychology in the valuation of shares. In this sense, a better definition for true value of a share is: What do you feel others expect all future dividends discounted to present value to be worth. This definition then is closer to that of speculation. In that sense the market is efficient in instantaneously valuing the true value that all financial actors believe a company to have. And this value can diverge dramatically from actual earnings for many reasons, such as manipulation of earnings, a belief that an industry will be more important in the future than the present, a belief that technology can cure all problems, overestimating or underestimating the impact of trends and public reactions.

Please note that this is not a simple matter of mistaken analysis. We saw this during the last bubble. We saw valuations for firms that implied markets, shares of markets, consumer purchasing power, or industry growth that by simple mathematics was impossible. Thus, we can say that the efficient market valued shares based not on a rational but misguided estimate of the future earnings of Amazon, but rather based on what people believed others would be willing to pay for shares in Amazon in the future. In this way, we can then see how valuations can become divorced from a "rational" economic consideration of earnings.

This analysis then reinforces what you are saying about Warren Buffet. In this environment an investor who looks for real future earnings rather than expected valuations of future earnings should never rely on share prices to reflect the best public knowledge and analysis of what those earnings should be.

-- Jonathan Hyde

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Salon Staff

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