The Greatest Money Maker: A critical exploration of his investment philosophy

“You look at Berkshire and you think of things like the furniture company or Dairy Queen, but when you look at where the massive profits and the cash generation is coming from, it’s really from the insurance business, it’s really from derivatives, it’s really from the investments that he is making on Wall Street […] there is a divide between what you see on one side, which looks very simple, and what’s actually happening behind the curtain” (Sorkin, 2009, 00:52:20).

Since its founding in 1955, there have been enough books, newspaper articles or blogs written about Berkshire Hathaway and its founder Warren Buffett, to keep a person busy for the rest of his life reading. Therefore, it seems unnecessary to summarize Buffett’s way of becoming the most popular investor of all time. Rather, I want to directly start analysing excerpts of what the 2009 published documentary titled “The World’s Greatest Money Maker: Evan Davis meets Warren Buffett” identified as Berkshire Hathaway’s investment principles and discuss them by taking into consideration academic research.

1. "Invest, don't speculate"

In the investment manager’s opinion, a clear distinction between speculating and investing in financial markets can be drawn. While the former describes simplified the act of “betting” on prices going up or down, the latter expresses the way of looking at the underlying asset itself and its future return. However, research suggests that there is a difference between the commonly shared definition of investing and speculating but it is a blurred line as speculation is neither defined in terms of time frame, risk level and expected return, nor in terms economic utility (Arthur, Williams & Delfabbro, 2016). Furthermore, it would be simply false to think of fundamentally analysed investments as purely rational decision with determined outcomes and even Benjamin Graham, Buffett’s mentor and source of wisdom, wrote: “some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." (Graham, 2009, Chapter 1).

2. "You don't have to diversify"

Figure 1. Berkshire Hathaway's public holdings. Reprinted from
Yahoo Finance, https://finance.yahoo.com/

I want to remind again that this list of investment principles was created by the producers of the BBC documentary and the reason this fact is worth being highlighted again is simple: It is truly questionable if Warren Buffett would ever make this statement as it is scientifically proven that diversification has major advantages concerning the elimination of unsystematic risk (Markowitz, 1952; Statman, 1987). Moreover, the latest data of Berkshire’s current portfolio allocation shows that the holding invested in 20 publicly listed companies in addition to their private investments, clearly taking advantage of diversification effects (Yahoo Finance). There is a reason behind the saying that “Diversification is the only free lunch” and it is important to remind oneself that even the possibly greatest of all investors does not do everything different than the regular shareholder.

3. "Don't get into debt"

When it comes to the question of optimal capital structure, there is still disagreement among academics. Classical theories like  Modigliani & Miller (1958) state the irrelevance of capital structure concerning the cost of capital while more recent approaches like Kraus & Litzenberger (1973) manage taking into consideration observable market imperfections like taxes and behavioural aspects in form of asymmetric information to create a model that states an optimal debt to equity level for every individual company. Although the latter approach has drawbacks like, for example, the quantification of debt disadvantages through financial distress and therefore the actual determination of an optimal debt to equity level, it is still the more realistic and applicable approach. Hence, it seems quite ignorant to make such a bold statement like “Don’t get into debt” in the factual presence of tax advantages of debt. For the benefit of the shareholders, there is happening something different behind the curtains of Berkshire Hathaway: Recent research on Buffett's investment strategy revealed average leverage of 1.7 to 1, significantly increasing Berkshire’s investment return (Frazzini, Kabiller, & Pedersen, 2018). In conclusion, the documentary’s findings and the actual reality fall significantly apart again.

After only having criticised the documentary in this blog, I want to highlight that Warren Buffett is in my opinion unquestionably the greatest investment mogul on this planet and his portfolio performance and constant success over decades speak for itself. Therefore, it remains a mystery for me how he can provide investment principles like the “Don’t diversify” one, that surely worked for himself in the past but that are highly dangerous for regular investors who are no financial geniuses. If I am being honest, I have not read any books written by Buffett himself, hence, it is possible that the BBC production team came up with the presented principles on their own. In any case, it is this ubiquitous discrepancy between Buffett’s success and the way he presents himself, what he does and how he does it, that my opening quote and the whole documentary highlight so well: There is happening more behind Berkshire Hathaway’s curtains than outsiders believe and maybe they even have a reason to make people believe it is that easy. The truth is: It is not. 

Bibliography

Arthur, J. N., Williams, R. J., & Delfabbro, P. H. (2016). The conceptual and empirical relationship between gambling, investing, and speculation. Journal of behavioral addictions, 5(4), 580-591.

Frazzini, A., Kabiller, D., & Pedersen, L. H. (2018). Buffett's alpha. Financial Analysts Journal, 74(4), 35-55.

Graham, B. (2009). The Intelligent Investor, Rev. Ed. London: HarperCollins.

Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial leverage. The Journal of Finance, 28(4), 911-922.

Markowitz, H. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.

Miller, C., Crossley-Holland, D. (Producers), & Sorkin, A. R. (Journalist). (2009). The World’s Greatest Money Maker: Evan Davis meets Warren Buffett [Motion Picture]. Retrieved from https://learningonscreen.ac.uk/ 

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 261-297.

Statman, M. (1987). How Many Stocks Make a Diversified Portfolio? The Journal of Financial and Quantitative Analysis, 22(3), 353-363.