Last year legendary investor Warren Buffett, with help from a law professor, Lawrence Cunningham, brought out a third edition of The Essays of Warren Buffett (Carolina Academic Press).
The third edition of a book would not usually be a matter worth comment here. But it gives me an excuse to discuss a well-known quip of Buffett’s, one that is included in that book and that have bugged me since the days of the collapse of Enron. Further, co-author Cunningham himself highlighted the quip in question in a brief essay for the Columbia Law School’s blog, summarizing his view of Buffett’s message.
Cunningham quotes Buffett saying that CAPM and its notion of beta are worth little. After all, he says, “a stock that has dropped very sharply compared to the market … becomes ‘riskier’ at the lower price than it was at the higher price.” Value investors, like Benjamin Graham, know better. It may well be a bargain at the lower price, while it was an unreasonable risk while it was still at the higher price.
Is there really paradox here? Let us now let ourselves be lulled by Buffett’s avuncular charm into seeing paradox where there is none. Let’s analyze this in pieces.
First, most of those who try to state modern portfolio theory carefully – whether they’re arguing pro or con or neither – make a point of distinguishing between volatility and risk. The theory treats vol as a useful proxy for risk, but hardly as the same thing. In a foundational essay in 1952, Harry Markowitz wrote, “Usually if the term ‘yield’ were replaced by ‘expected yield’ or ‘expected return’ and ‘risk’ by ‘variance of return,’ little change in apparent meaning would result.” Cautious words like “usually” and “apparent” surely indicate that he was suggesting something less than a simple synonymous relationship between risk and variance/volatility.
But let’s ignore that for now. Even if we simply equate these terms, what does Buffett’s hypothetical establish?
I submit that this depends entirely on why the hypothetical stock’s price dropped very suddenly relative to the market: dropped so suddenly as to have an impact on the historical vol for that stock. I submit further that there are three distinct possibilities. The stock’s price may have experienced its sharp drop for (1) no real reason, (2) for a reason that is transparent to most market participants – as when a takeover deal has fallen through, or (3) for a reason that is opaque to many market participants.
If the emphasis is on (1), then Buffett is making a Talebian “fooled by randomness” point. That is a possible construction, but far from an obvious one, and it isn’t very Graham-like of him, so I’ll move on.
Perhaps the emphasis is on (2). Consider a situation in which Smallish Firm’s stock experienced a run-up in its price after rumors, eventually confirmed, that Bigger Firm was interested in buying SF with a hefty premium to market. One would expect the market price to rise to close that premium, producing something close to Mr. Market’s best estimate of the coming offer. Then (on our hypothesis) Bigger Firm backs away, deciding that the expected operational synergies aren’t there after all. In this case, the backing-away will unsurprisingly cause a sharp drop and an increase in the historic volatility (continuing a process no doubt begun by the rumor-sparked run up of preceding weeks.) But of course, everybody important has been reading the Wall Street Journal and everybody knows why the price of SF stock collapsed.
If this is the sort of price fall Buffett had in mind, I have to rate his point “valid, but not all that interesting.” Since by hypothesis everybody knows what happened, the new increased vol figure won’t enter as a separate factor in a potential investor’s calculations in any case. The “straw man” here is a very mechanical follower of a very simplified view of MPT – hardly a worthy opponent for someone of Buffett’s stature.
In the Wake of Due Diligence
But let’s move on to (3). Suppose the real reason BF backed away from the deal with SF was that when they got into their due diligence in a serious way, when they looked at the books, they encountered reasons to worry: they came to suspect that many of SF’s assets were overvalued on those books, and its liabilities understated. I have in mind here a situation in which the withdrawal of BF’s offer is not itself the only new information reflected in the price drop: this drop reflects the leakage into the broader market of BF’s unhappy discoveries in SF’s books.
In this case, I submit, MPT looks pretty good. It may alert us to the fact that, even though we don’t know the reason for the drop (or the drop seems larger than justified by the reason we do know about), there is a reason, and that the lower-priced stock of SF is not a “buying opportunity” but a trap.
Consider late November 2001. A walking-dead stock known as Enron, or NYSE: ENE, receives a boost from news that Dynegy has appeared as a white knight. This doesn’t last long: Dynegy looked at the books and said “goodbye” by November 28th. This brought more than just a reversal of the preceding bounce – it was a big push toward $0.
By that time, if it took volatility figures to persuade you that buying ENE was not a great plan: well, you would have been historically dense. Still, if this news caused an increase in the vol figure and that caused some mechanistic follower of CAPM to back out of such a purchase: it did that individual a good deed just ahead of the December 2d bankruptcy filing.