Warren Buffett and Efficient Market Theory

I like Warren Buffett--or at least his public persona and mythology--for a lot of reasons.  He makes a lot of money without much use for computers or technology, he claims to invest only in what he understands (e.g., insurance, candy, etc.), he treats people with respect (including his shareholders), and he says that his taxes are too low.  Buffett also agreed to give away 85% of this wealth to the Bill & Melinda Gates Foundation upon his death.  He could have built a monument to himself, but instead he concluded that his money would go further by giving it to Gates. 

But my favor reason might be in the below abstract from a top-ranked paper on SSRN: that  Warren Buffett et al.'s 31 year track record is not consistent with Efficient Market Theory.    See Gerald S. Martin (American/Texas A&M) & John Puthenpurackal (UNLV), Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway:

We analyze Berkshire Hathaway's equity portfolio over the 1976 to 2006 period and explore potential explanations for its superior performance. Contrary to popular belief, we find Berkshire Hathaway invests primarily in large-cap growth rather than "value" stocks. Over the period the portfolio beat the benchmarks in 27 out of 31 years, on average exceeding the S&P 500 Index by 11.14%, the value-weighted index of all stocks by 10.92%, and a Fama and French characteristic-based portfolio by 8.56% per year. Although beating the market in all but four years can statistically happen due to chance, incorporating the magnitude by which the portfolio beats the market makes a luck explanation extremely unlikely even after taking into account ex-post selection bias. We find that Berkshire Hathaway's portfolio is concentrated in relatively few stocks with the top five holdings averaging 73% of the portfolio value. While increased volatility is normally associated with higher concentration we show the volatility of the portfolio is driven by large positive returns and not downside risk. The market appears to under-react to the news of a Berkshire Hathaway stock investment since a hypothetical portfolio that mimics the investments at the beginning of the following month after they are publicly disclosed also earns significantly positive abnormal returns of 10.75% over the S&P 500 Index. Our evidence suggests the Berkshire Hathaway triumvirates of Warren Buffett, Charles Munger, and Lou Simpson possess investment skill unlikely to be explained by Efficient Market Theory.

So here is my question:  If you know how to make money like Buffett et al., what would you do:  apply the strategy in the market and make supra normal returns, or publish it all in a finance journal to settle an academic debate (and ruining the strategy prospectively)?

Comments

[John]

Could it be that you're comparing his returns to the wrong baseline? Despite his disdain for the private equity world, Buffett for many years has been a private equity investor rather than a portfolio manager. He buys entire companies rather than small (<5%) passive stakes, he buys in negotiated transactions rather than in the open market, and he uses a lot of leverage (in the form of the float on his reinsurance business). Based on these characteristics, he looks more like KKR and Carlyle than Fidelity and Vanguard. How do his returns compare to KKR and Carlyle?

[Bill Henderson]

Lefty, Righty, Centrist, and Publish? all raise interesting points.

Let me restate my point (with the benefit of these comments). Publish? is right: Buffet publishes his philosophy in his annual shareholder letters (see http://www.berkshirehathaway.com/letters/letters.html)

But Buffett is not attempting to engage financial theorists; he is not trying to be part of any academic debate.

I also agree that Buffett is not the first datapoint that contradicts EMT. The weak form of the efficient capital market hypothesis posits that "chartist" cannot beat the market over the long-run. But I am quite certain that some hedge funds do have mathematical algorithms that produce supra normal returns.

For example, I remember waiting in the lobby of one of the world's most successful hedge funds for my friend who worked there; it was literally impossible to get past the (amazing plush) lobby; I had never witnessed such a high level of security. The place was protecting proprietary trading strategies that were based on historical data. The performance of Yale and Harvard's endowments over the last decade or so also represents problems for Efficient Market Theory. (I would be interesting in learning of other examples; I am sure they exist.)

Regarding centrist's point, sure, you can publish later. But often the financial success speaks for itself. At some point, insisting the financial markets are efficient becomes just an "academic" theory. In this game, getting published in a peer-reviewed journal is what constitutes success. Why bother?

Between Righty and Lefty, I think Righty has the best of the argument. Efficient Market Theory can be propped up by narrowing the scope of its application; that is certainly fair and appropriate.

But I think it is time to come up with a new and more ambitious theory that better fits all available data points, including Warren Buffett, the Harvard & Yale money managers, and successful hedge funds. I think that the theory might be pretty banal: there is a market for the best money managers who produce supra normal returns, and they either work for themselves or go to the highest bidder.

[Publish?]

Buffett does publish his methods. Just read the annual shareholder letters. Additionally, read Security Analysis (only editions prior to the fifth), the Intelligent Investor, and the works of Fisher. He is extremely open on how he invests. He even discusses his losses. This being the case, I do not believe there is a strategy perspective to lose as you claim.

His method is not exciting by common standards and takes a great amount of discipline. You should also remember that Buffett was not the first to disprove the efficient market hypothesis.

[Centrist]

In response to Mr. Henderson's question, I'd like merely to note that the two options (making money & revealing your secret to doing so) are not mutually exclusive: you could make your money first.

[Righty]

Your assertion rests upon the existence of a distinction between (a) being a ``darn good booky'' and (b) being a darn good investor in a company that is a ``darn good booky.'' Your purported distinction is illusory. First, one can be a bookmaker in securities. Second, and conversely, bookmakers face the opportunity cost of investing in good companies. Buffett knows (close to) the best allocation for his money, and he allocates it accordingly--be it in securities or, as his recent actions in the insurance market for municipal bonds suggests, other bets.

[Lefty]

i think Warren Buffett is a brilliant oddsmaker. The vast majority of the appreciation of BKHY is attributable to holding bets (owning insurance companies) not making bets in the stock market. It is ridiculous to compare his track record with a benchmark or other investors. The only conclusion that can be reached is that he is a darn good booky!