Friday, December 23, 2011

Beta, Risk, and the Inconvenient Real World Special Case

Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns... - Investopedia

From The Superinvestors of Graham-and-Doddsville:

"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 that 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." - Warren Buffett

For some additional thoughts on beta and risk from well known value investors check out this Gurufocus article. In addition to the above quote from Buffett, it includes quotes from Charlie Munger and Seth Klarman among others.

Jeremy Grantham added this about these flawed models* in the context of 'quality' stocks in his 1Q 2010 letter:

"Warren Buffett doesn't really talk much about the fact that he is playing in a superior universe. Why should he? It's like having the Triple A bond outperforming the B+ bond in the long term by 1% a year when, in a reasonable world, it 'should' yield, say, 1% less. And how nicely this messes up the Fama and French argument on risk and return."

Later in the letter he added...

"Since the market is efficient, to Fama and French quality must be a risk factor! So, by protecting you in the 1929 Crash and in 2008, and by having a low beta for that matter, Quality as represented by Coca-Cola and Johnson & Johnson must be a hidden risk factor. Oh, I know: 'The real world is merely an inconvenient special case!'"

Since that was written by Grantham the higher quality stocks have become more expensive. Yet, the essential insight remains true: quality stocks over the long haul tend to produce greater returns at less risk despite what fans of Fama and French might otherwise predict (especially when bought cheap, of course).**

Some otherwise smart people seem to get annoyed when a simple good idea works better than a complicated bad one.

In this Barron's interview from a while back, Marty Whitman added what he thinks about modern portfolio theory when asked about it:

" far as value investing, control investing, distress investing and credit analysis is concerned, that stuff is absolute garbage."

Hard to disagree.

Never underestimate how long it takes for flawed yet influential ideas to fade away.


Related posts:
-Black-Scholes and the Flat Earth Society
-Buffett: Indebted to Academics
-Grantham on "The Greatest-Ever Failure of Economic Theory"
-Friends & Romans
-Superinvestors: Galileo vs The Flat Earth
-Max Planck: Resistance of the Human Mind

* To me, much of modern finance theory is not just flawed in some harmless way. It's difficult to quantify the damage done, but it is not difficult to argue that their influence has been less than a wonderful thing.
** It's worth noting that their three factor model attempts to bring size and value into the equation. Others might find this of some use or interest. I do not.
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