Saturday, March 7, 2009

Even Buffett Isn't Perfect: Chapter 1

The chapter starts with two seemingly contradictory quotes from Buffett. In one he asserts that his company does not follow standard diversification dogma, and in the other he suggests that 99 percent of investors should diversify extensively.

The chapter goes on to discuss that these statements are not in fact contradictory. Diversification is used to reduce risk for investors who have neither the time nor the inclination to study the companies they are buying. In Buffett's case, he knows his companies (and their industries) well. As such, he reduces his risk in this regard, and therefore does not require as much diversification.

The chapter continues by discussing some of the finance theory regarding diversification, defining and explaining terms such as variance, correlation and standard deviation. It then discusses why Warren Buffett is not a big fan of this theory: it is impossible to know the above parameters with certainty. For example, you might think airlines and oil prices have a certain negative correlation, but in a market panic you can basically throw that correlation out the window.

The chapter also discusses Berkshire's apparent move to diversify over the years. However, the conclusion of the author appears to be that as Berkshire has increased in size, it has had no choice but to do so. It is very difficult to find amazing deals in the tens of billion dollar ranges since the population size of this group is so low. Nevertheless, the majority of Berkshire's investments are concentrated in only a few companies, meaning Buffett is not as diversified as finance theory would suggest.


RobertCGray said...

Hello Barel - there are many things to honor about Warren Buffett's prowess. However, I'd like to add another issue for examination. When you read his shareholder letters it is impressive how he gets returns from the divisions/businesses and when they are not cash generating, he provides a story of why that is. He is, however, entirely out-integrity with his shareholders/owners - providing not a single cent of dividend/yield return. While I've not read his rationale, I'd expect him to have concocted a story about how BH knows best and the profits are better invested by BH on behalf of hte shareholders. He would NEVER accept that on the inside of the organization. So the thinking is corrupt and has no integrity. I invite you, since you seem to have some interest, to add this to the examination of Buffett and bring more to light.

Saj Karsan said...

Hi Robert,

I believe your line of thinking is correct regarding why Buffett has not paid a dividend. He has said many times that where he adds value is when it comes to capital allocation. The managers of the business are great (or should be) at managing the operations of the business, but not necessarily at allocating capital, which is where he comes in. So in his mind, that is where he is providing the value to Berkshire's shareholders.

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