By David Foulke
Warren Buffett doesn’t like it when people use volatility to measure risk. He succinctly describes his criticism:
We bought The Washington Post Company at a valuation of $80 million back in 1974. If you’d asked any one of 100 analysts how much the company was worth when we were buying it, no one would have argued about the fact that it was worth $400 million. Now, under the whole theory of beta and modern portfolio theory, we would have been doing something riskier buying stock for $40 million than we were buying it for $80 million, even though it’s worth $400 million — because it would have had more volatility. With that, they’ve lost me.
(Click to enlarge) Buffett with Washington Post CEO, Katherine Graham, in 1973 when he started buying
Leave it to Buffett to deliver a folksy, one-off comment that calls into question the entire edifice of established portfolio theory. Buffett seems to indicate that since the Washington Post is intrinsically worth $400mm, an investment of $40mm has a lower chance of losing money permanently than one of $80mm, since the margin of safety has increased. If you view risk as “the chance of a permanent loss of capital,” then in his framework, he is right. The stock is less risky.
Enter Cliff Asness, the King of the Quants.
(Click to enlarge)
“Wall Street is Just a Casino” – Cliff Asness
In an upcoming FAJ article, Mr. Asness has some observations that can be applied to Buffett’s view.
Even the simplest quant framework allows for not just volatility, but also expected return. And volatility isn’t how much the security is likely to move; it’s how much it’s likely to move versus the forecast of expected return. In other words, after making the forecast, it’s a reflection of the amount you can be wrong on the upside or downside around that forecast.
Applying Asness’s framework to the Washington Post situation: at a $40mm valuation, the investment’s expected return has increased, there is a larger expected move versus the $400mm intrinsic value, and the range of potential outcomes around the projection has widened. This is quant “volatility,” but it is not necessarily risk.
What happens if Buffett buys and it gets cheaper?
Think about a super-cheap security, with a low risk of permanent loss of capital to a long-term holder, that gets a lot cheaper after being purchased…If the fundamentals have not changed and you believe risk is just the chance of a permanent loss of capital, all that happened was your super-cheap security got super-duper cheap, and if you just hold it long enough, you will be fine. Perhaps this is true. However, I do not think you are allowed to report “unchanged” to your clients…In a very real sense, you lost money; you just expect to make it back …
In other words, if Buffett buys at $80mm and it trades to $40mm, he can’t say, “I have not lost any money.” That would be inaccurate. Asness thinks it is more intellectually honest to describe it this way: “Here are the losses and here’s why it’s an even better bet going forward.”
But is it riskier?
Asness argues that his nuanced view of volatility is a better description of risk than is the potential for permanent losses. In this view, the Washington Post at $40mm is not necessarily “riskier,” as the quant may conclude that at $40mm, the investment is now more limited in terms of how bad things could be if Buffett is wrong about the $400mm intrinsic value, even though a quant’s “volatility” may have increased. Further, a quant may not rely solely on symmetric volatility measures when managing risk, and applying risk controls (e.g., downside deviation versus standard deviation).
Asness also adds:
…risk is the chance that you are wrong. Saying that your risk control is to buy cheap stocks and hold them…is another way of saying that your risk control is not being wrong. That’s nice work if you can get it.
Take that, Warren
So who is right? Is Buffett’s clear logic more appealing, with Asness playing semantic games, or is Buffett oversimplifying, with Asness providing a deeper view of reality?