Archive for July, 2010

Why I don’t give a WACC about Beta

July 29, 2010

One comment I always get when I worry about my financial management exams is: come on, you are an expert on this.

It seems to be a missunderstanding that since I invest and read tons about investing, I must be some kind of guru in all financial matters. Well, this is not true, I don’t get many As on finance, I don’t have a CFA and most likely would do horribly at it since I have a memory span of a fish. This, nevertheless, never stopped me from investing. From my point of view, if for investing I need to do something so complex that I don’t understand it… I don’t invest on it. I go for what I consider easy stuff, why bother if my IQ can’t hit that line? As David Allen very wisely told me: “To be rich, you don’t even need to be smart, just in case that worried you.”

So I knew what WACC was, but I’ve never had to use it. It includes Beta, and I’m mostly allergic to it. I had a conversation with one of my financial profs where I explained why I didn’t believe in Beta. He/she argueed that it was the best thing without any doubt to measure investment risk. When I asked how much he/she had made investing using this method, the reply was: “I believe the stock market is a lottery so I don’t invest.”

Good that he/she teaches it as an investment tool then.

So why I don’t believe in Beta or diversification for that matter? Because long ago I read this and I fully agree. It makes sense and it comes from a very trusted source.

The strategy we’ve adopted precludes our following standard
diversification dogma. Many pundits would therefore say the
strategy must be riskier than that employed by more conventional
investors. We disagree. We believe that a policy of portfolio
concentration may well decrease risk if it raises, as it should,
both the intensity with which an investor thinks about a business
and the comfort-level he must feel with its economic characteristics
before buying into it. In stating this opinion, we define risk,
using dictionary terms, as “the possibility of loss or injury.”

Academics, however, like to define investment “risk”
differently, averring that it is the relative volatility of a stock
or portfolio of stocks – that is, their volatility as compared to
that of a large universe of stocks. Employing data bases and
statistical skills, these academics compute with precision the
“beta” of a stock – its relative volatility in the past – and then
build arcane investment and capital-allocation theories around this
calculation. In their hunger for a single statistic to measure
risk, however, they forget a fundamental principle: It is better
to be approximately right than precisely wrong.

For owners of a business – and that’s the way we think of
shareholders – the academics’ definition of risk is far off the
mark, so much so that it produces absurdities. For example, under
beta-based theory, a stock that has dropped very sharply compared
to the market – as had Washington Post when we bought it in 1973 –
becomes “riskier” at the lower price than it was at the higher
price. Would that description have then made any sense to someone
who was offered the entire company at a vastly-reduced price?

In fact, the true investor welcomes volatility. Ben Graham
explained why in Chapter 8 of The Intelligent Investor. There he
introduced “Mr. Market,” an obliging fellow who shows up every day
to either buy from you or sell to you, whichever you wish. The
more manic-depressive this chap is, the greater the opportunities
available to the investor. That’s true because a wildly
fluctuating market means that irrationally low prices will
periodically be attached to solid businesses. It is impossible to
see how the availability of such prices can be thought of as
increasing the hazards for an investor who is totally free to
either ignore the market or exploit its folly.

In assessing risk, a beta purist will disdain examining what a
company produces, what its competitors are doing, or how much
borrowed money the business employs. He may even prefer not to
know the company’s name. What he treasures is the price history of
its stock. In contrast, we’ll happily forgo knowing the price
history and instead will seek whatever information will further our
understanding of the company’s business. After we buy a stock,
consequently, we would not be disturbed if markets closed for a
year or two. We don’t need a daily quote on our 100% position in
See’s or H. H. Brown to validate our well-being. Why, then, should
we need a quote on our 7% interest in Coke?

In our opinion, the real risk that an investor must assess is
whether his aggregate after-tax receipts from an investment
(including those he receives on sale) will, over his prospective
holding period, give him at least as much purchasing power as he
had to begin with, plus a modest rate of interest on that initial
stake. Though this risk cannot be calculated with engineering
precision, it can in some cases be judged with a degree of accuracy
that is useful. The primary factors bearing upon this evaluation

1) The certainty with which the long-term economic
characteristics of the business can be evaluated;

2) The certainty with which management can be evaluated,
both as to its ability to realize the full potential of
the business and to wisely employ its cash flows;

3) The certainty with which management can be counted on
to channel the rewards from the business to the
shareholders rather than to itself;

4) The purchase price of the business;

5) The levels of taxation and inflation that will be
experienced and that will determine the degree by which
an investor’s purchasing-power return is reduced from his
gross return.

These factors will probably strike many analysts as unbearably
fuzzy, since they cannot be extracted from a data base of any kind.
But the difficulty of precisely quantifying these matters does not
negate their importance nor is it insuperable. Just as Justice
Stewart found it impossible to formulate a test for obscenity but
nevertheless asserted, “I know it when I see it,” so also can
investors – in an inexact but useful way – “see” the risks inherent
in certain investments without reference to complex equations or
price histories.

Is it really so difficult to conclude that Coca-Cola and
Gillette possess far less business risk over the long term than,
say, any computer company or retailer? Worldwide, Coke sells about
44% of all soft drinks, and Gillette has more than a 60% share (in
value) of the blade market. Leaving aside chewing gum, in which
Wrigley is dominant, I know of no other significant businesses in
which the leading company has long enjoyed such global power.

Moreover, both Coke and Gillette have actually increased their
worldwide shares of market in recent years. The might of their
brand names, the attributes of their products, and the strength of
their distribution systems give them an enormous competitive
advantage, setting up a protective moat around their economic
castles. The average company, in contrast, does battle daily
without any such means of protection. As Peter Lynch says, stocks
of companies selling commodity-like products should come with a
warning label: “Competition may prove hazardous to human wealth.”

The competitive strengths of a Coke or Gillette are obvious to
even the casual observer of business. Yet the beta of their stocks
is similar to that of a great many run-of-the-mill companies who
possess little or no competitive advantage. Should we conclude
from this similarity that the competitive strength of Coke and
Gillette gains them nothing when business risk is being measured?
Or should we conclude that the risk in owning a piece of a company
– its stock – is somehow divorced from the long-term risk inherent
in its business operations? We believe neither conclusion makes
sense and that equating beta with investment risk also makes no

The theoretician bred on beta has no mechanism for
differentiating the risk inherent in, say, a single-product toy
company selling pet rocks or hula hoops from that of another toy
company whose sole product is Monopoly or Barbie. But it’s quite
possible for ordinary investors to make such distinctions if they
have a reasonable understanding of consumer behavior and the
factors that create long-term competitive strength or weakness.
Obviously, every investor will make mistakes. But by confining
himself to a relatively few, easy-to-understand cases, a reasonably
intelligent, informed and diligent person can judge investment
risks with a useful degree of accuracy.

In many industries, of course, Charlie and I can’t determine
whether we are dealing with a “pet rock” or a “Barbie.” We
couldn’t solve this problem, moreover, even if we were to spend
years intensely studying those industries. Sometimes our own
intellectual shortcomings would stand in the way of understanding,
and in other cases the nature of the industry would be the
roadblock. For example, a business that must deal with fast-moving
technology is not going to lend itself to reliable evaluations of
its long-term economics. Did we foresee thirty years ago what
would transpire in the television-manufacturing or computer
industries? Of course not. (Nor did most of the investors and
corporate managers who enthusiastically entered those industries.)
Why, then, should Charlie and I now think we can predict the
future of other rapidly-evolving businesses? We’ll stick instead
with the easy cases. Why search for a needle buried in a haystack
when one is sitting in plain sight?

Of course, some investment strategies – for instance, our
efforts in arbitrage over the years – require wide diversification.
If significant risk exists in a single transaction, overall risk
should be reduced by making that purchase one of many mutually-
independent commitments. Thus, you may consciously purchase a
risky investment – one that indeed has a significant possibility of
causing loss or injury – if you believe that your gain, weighted
for probabilities, considerably exceeds your loss, comparably
weighted, and if you can commit to a number of similar, but
unrelated opportunities. Most venture capitalists employ this
strategy. Should you choose to pursue this course, you should
adopt the outlook of the casino that owns a roulette wheel, which
will want to see lots of action because it is favored by
probabilities, but will refuse to accept a single, huge bet.

Another situation requiring wide diversification occurs when
an investor who does not understand the economics of specific
businesses nevertheless believes it in his interest to be a long-
term owner of American industry. That investor should both own a
large number of equities and space out his purchases. By
periodically investing in an index fund, for example, the know-
nothing investor can actually out-perform most investment
professionals. Paradoxically, when “dumb” money acknowledges its
limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able
to understand business economics and to find five to ten sensibly-
priced companies that possess important long-term competitive
advantages, conventional diversification makes no sense for you.
It is apt simply to hurt your results and increase your risk. I
cannot understand why an investor of that sort elects to put money
into a business that is his 20th favorite rather than simply adding
that money to his top choices – the businesses he understands best
and that present the least risk, along with the greatest profit
potential. In the words of the prophet Mae West: “Too much of a
good thing can be wonderful.”

From Warren Buffett in 1992 annual report. Full text in: