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Lessons from Warren Buffett - XII

Sep 13, 2007

In our previous article on Warren Buffet's letter to shareholders, we discussed the master's 1987 letter and got to know his preference for businesses that are simple and easy to understand. In the same letter, Buffett also explained the concept of 'Mr Market' in a rather detailed way. Let us now see what the master has to offer in his 1988 letter to shareholders.

The year 1988 turned out to be quite an eventful one for Berkshire Hathaway, the master's investment vehicle. While the year saw the listing of the company on the New York Stock Exchange, it also turned out to be the year when Warren Buffett made what can be termed as one of its best investments ever. Yes, we are talking about the company Coca Cola. The letter too was not short on investment wisdom either. Although he did discuss previously touched upon topics like accounting and management quality, these are not what we will focus on. Instead, let us see what the master has to say on some novel concepts like arbitrage and his take on the efficient market theory.

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For those of you who would have thought that Warren Buffett is all about value investing and extremely lengthy time horizons, the mention of the word 'arbitrage' must have come as a pleasant surprise or may be, even as a shock. However, the master did engage in 'arbitrage' but in very small quantities and this is what he has to say on it.

"In past reports we have told you that our insurance subsidiaries sometimes engage in arbitrage as an alternative to holding short-term cash equivalents. We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments."

First of all, let us see how does he define arbitrage.
"Since World War I the definition of arbitrage - or "risk arbitrage," as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event won't happen."

Just as in his long-term investments, in arbitrage too, the master brings his legendary risk aversion technique to the fore and puts forth his criteria for evaluating arbitrage situations.

"To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"

And how exactly does he differ from other arbitrageurs? Let us hear the answer in his own words.

"Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation. So far, Berkshire has not had a really bad experience. But we will - and when it happens we'll report the gory details to you."

"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumors or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities."

Another important topic that the master touched upon in his 1988 letter was that of the Efficient Market Theory (EMT). This theory had become something like a cult in the financial academic circles in the 1970s and to put it simply, stated that stock analysis is an exercise in futility since the prices reflected virtually all the public information and hence, it was impossible to beat the market on a regular basis. However, this is what the master had to say on the investment professionals and academics who followed the theory to the 'Tee'.

"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 order to justify his stance, the master states that if beating markets would have been impossible, then he and his mentor, Benjamin Graham, would not have notched up returns in the region of 20% year after year for an incredibly long stretch of 63 years, when the market returns during the same period were just under 10% including dividends. Hence, despite evidences to the contrary, EMT continued to remain popular and forced the master to make the following comment.

"Over the 63 years, the general market delivered just under a 10% annual return, including dividends. That means US$ 1,000 would have grown to US$ 405,000 if all income had been reinvested. A 20% rate of return, however, would have produced US$ 97 m. 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."

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