Wednesday, December 21, 2005

Quiz on "The Letters of Warren E. Buffett" - Preliminary Round

As part of their course, my students at MDI were recently asked to participate in a quiz titled "The Letters of Warren E. Buffett."

The quiz was administered in two rounds. The class, consisting of 84 students, was asked to read all the letters written by Mr. Buffett to the shareholders of Berkshire Hathaway Inc.

The preliminary round was a written quiz consisting of forty questions, to be answered by each student individually.

The final round was an oral quiz consisting of thirty six questions. Six teams of four students each qualified to participate in the final round.

Ankur Jain, my colleague and ex-student, and who is also a quiz enthusiast, spent several days in the preparation of the question bank for both rounds. He also did an excellent job of administering the quiz - written as well as oral.

Ankur and I were also helped by Saroni Ray, our colleague. My thanks to both Ankur and Saroni!

I am posting the questions that were asked in the preliminary round. I will post the questions asked in the final round in a later post.

Management Development Institute

Post-Graduate Programme in Management (2004-2006)
Behavioural Finance & Business Valuation (BFBV)

20 December 2005
Quiz on The Letters of Warren E. Buffett

  1. This quiz contains three sections and a total of forty questions.
  2. Read the instructions carefully, given at the beginning of every section.
  3. Total time allowed: 60 minutes.
  4. The acronyms, “BRK” & “WEB” stand for Berkshire Hathaway and Warren E. Buffett respectively.

Your Name: __________________________________________

Your Roll No: __________________________________________

(Questions 1-10)

• Each statement in this section is either true or false.
• No reasoning is required.
• Each answer carries two marks.
• Negative marking for every wrong answer is (-1) mark.

1. The long term economic goal of BRK is to maximize the average annual rate of gain in the reported earnings on a per share basis. True/False

2. Both Mr. Graham and WEB insist on investing in companies run by exceptionally talented managers. True/False

3. In WEB’s view, because stock options are hard to value and they are not dollars out of a company’s coffers, their costs should be ignored in calculation of a company’s earnings. True/False

4. WEB believes that taxes unnecessarily reduce returns for investors and therefore he likes companies which have low tax/profit ratios. True/False

5. Stock splits create enormous value for the shareholders. True/False

6. According to WEB, businesses should borrow money only when they need it for immediate deployment in a business opportunity which promises a rate of return which is significantly higher than the promised rate of interest on the funds borrowed. True/False

7. WEB believes that treasury bonds should be treated as risk free securities. True/False

8. WEB advocates usage of stock options because they align the interests of the managers with those of the company’s stockholders. True/False

9. WEB pays special attention to political and economic forecasts made by the experts in these fields before deciding upon an investment. True/False

10. WEB favors highly liquid markets because high-volume, active trading produces low bid-offer spreads which makes the markets more efficient. True/False

(Questions 11-30)

• Each of the following questions is a multiple choice one having one correct answer. Tick the correct one.
• Each answer carries two marks.
• Negative marking for every wrong answer is (-0.50) mark.

11. According to WEB, the appropriate measure of managerial economic performance is:

  • A high operating profit margin.
  • A high return on capital.
  • A low debt/equity ratio.
  • A high level of growth in EPS.

12. The term “look-through earnings” refers to:

  • BRK’s operating earnings plus dividends received by BRK from its investee companies.
  • Earnings from the lingerie business of BRK.
  • Earnings computed by looking through vast amount of financial and other data relating to the business and its managers.
  • BRK’s operating earnings plus BRK’s share of retained operating earnings in its investee companies less taxes that would have been payable had these investee earnings been paid out to BRK.

13. BRK’s long term economic goal is to:

  • Maximize the market cap of the company over the very long term.
  • Maximize economic earnings on a per-share basis.
  • Maximize dominance of markets in which it operates.
  • Maximize the average annual rate of gain in intrinsic business value on a per-share

14. When WEB wrote, “If corporate pregnancy is going to be the consequence of corporate mating, the time to face that fact is before the moment of ecstasy,” he was referring to:

  • The need to be aware of the possibility/need of a spin off of a business division after acquiring a company.
  • The need to factor in expansion of equity capital in mergers before the merger takes place.
  • The need to not count one’s chickens before they hatch i.e. to wait for post-merger integration to take place before deciding as to whether or not it was successful.

15. When WEB wrote, “If you've a harem of forty women, you’ll never get to know any of them very well,” he was referring to:

  • The need to control one’s sexual urges.
  • The need to maintain good memory especially when in the company of women.
  • The need to burn the midnight oil in order to understand all the businesses in one’s portfolio.
  • The need to diversify very little.

16. A jump in reported earnings from $10 million to $30 million is good news when:

  • The capital employed in the business increased by a lot more than the increase in reported earnings.
  • The number of shares outstanding has increased significantly.
  • The growth in reported earnings is due to exceptional reasons not likely to be repeated.
  • The company used untapped pricing power to achieve a permanent jump in earnings i.e. it increased prices of its products which have inelastic demand curves.

17. According to WEB, a business with historic and prospective high returns on capital, and having capital expenditure potential should:

  • Distribute large part of its earnings as dividends.
  • Retain much or all of its earnings for reinvestment in the business.
  • Use its stock currency to acquire other businesses.
  • Use its earnings to build a treasury.

18. When WEB wrote “If you want to shoot rare, fast moving elephants, you should always carry a loaded gun,” he was referring to:

  • The need to by fully prepared when going to Kenya for a jungle safari.
  • The need to be fully prepared for unexpected events while underwriting risks in the insurance business.
  • The need to have ample cash available for deployment in attractive investment opportunities as and when they arise.
  • The need to have ample unutilized debt capacity to take advantage of opportunities in leveraged buyouts.

19. When WEB asked, “Why should the time taken by a planet to circle the sun synchronize precisely with the time taken for business actions to pay off?” he was referring to:

  • The futility of focusing on one years’ financial data while evaluating a business.
  • The futility of focusing on the annual budgets made by managers of many businesses.
  • The occurrence of leaps years making it difficult for managers of certain businesses to plan ahead.

20. The term “float” refers to:

  • Insurance premiums received by BRK from insuring floating, seaworthy ships.
  • Interest paid by BRK on floating rate bonds issued by it as part of its opportunistic financing operations done in anticipation of a drop in interest rates over the next few years.
  • Money held by BRK in its insurance operations but not owned by it because premiums are prepaid and there is a lag between receipt of premiums and payment of claims, if any.

21. While making investments in marketable securities, WEB believes in very little diversification. However, BRK is one of the largest diversified conglomerates in the world. How would you resolve this paradox?

  • The rules for diversification in marketable securities are different than the rules for diversification into operating businesses.
  • Insurance company rules require that BRK to own substantial liquid investments in large-cap stocks.
  • There is no paradox here- WEB promises not to diversify by buying operating businesses at prices that are higher than values BRK’s shareholders can obtain through direct purchases in the stock market.

22. Buffett talks of “Rip Van Winkle” in the context of which one of the following:

  • The fact that the top few holdings of BRK hardly change.
  • The fact that the management hardly changes in any BRK companies.
  • The nick name given to Charlie Munger by WEB.
  • The nick name given to WEB by Charlie Munger.

23. BRK once borrowed funds at 10% p.a. and parked it in short-term debt securities earnings 6.25%. WEB justified it on the which of the following grounds:

  • He did not justify it. He admitted it was a foolish mistake.
  • That you should take advantage of tax arbitrage opportunities e.g. when interest on the debt is tax deductible but dividends received from the investments in debt mutual funds are tax free.
  • That you should borrow money when it is cheap and available and deploy it only when there are lucrative investment opportunities available and since these two events do not always go together, it makes sense to borrow long-term funds and wait for the right opportunity to come by.

24. When WEB wrote that “It has been far safer to steal large sums with a pen than small sums with a gun”, he was:

  • Comparing the success rate of bank robbers with those of bank check forgers.
  • Lamenting about accounting fraudsters getting away with their crimes.
  • Advocating gun control to curb violent crime in the United States.

25. In 1996, BRK split its stock into two classes – class A and class B. The primary motive behind this transaction was:

  • To increase the liquidity of BRK’s stock so that the stock sells at a higher price.
  • To defeat the plans of some opportunistic people who wanted to profit from BRK’s high stock price by creating and selling mini BRKs.
  • To make the stock more affordable to the small investors because class B is 1/30th of class A.
  • To comply with new NYSE listing regulations.

26. WEB believes that an intelligent investor in shares will do better in the secondary market than he will do in buying new issues (IPO’s). This is because:

  • Long-term returns on IPOs tend to be much less than those earned by broad market indexes.
  • There are so few IPOs in a year but there are thousands of companies to choose from in the secondary market.
  • Investment bankers allocate shares in hot IPOs to favored clients and it’s unlikely that a typical investor will get sufficient number of shares in such IPOs.
  • The price-setting mechanism of the secondary market is conducive to the occasional emergence of bargains while this is very unlikely in the IPO market.

27. The exceptional profitability of Nebraska Furniture Mart and Geico is attributable to:

  • Low margins with high turnover
  • High margins with low turnover
  • Frequent stock buybacks which reduced capital employed
  • Extremely conservative accounting

28. The exceptional profitability of See’s Candy is primarily attributable to:

  • Pricing power arising out of brand loyalty
  • Low-cost operations in an extremely competitive market
  • Frequent stock buybacks which reduced capital employed
  • Extremely conservative accounting

29. Property-casualty insurance business has two income streams.

  • Underwriting profits and unpaid claims.
  • Underwriting profits and float income.
  • Float income and unpaid claims.
  • Premiums and capital gains on investments.

30. In WEB’s framework of risk analysis, there are five primary factors to consider. Four of these are: (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 levels of taxation and inflation that will be experienced by the investors over his/her prospective holding period. The fifth one is:

  • The purchase price of the business.
  • The expected annual future returns from the stockmarket over the next several years.
  • The extent to which the operations of the business are financed with debt as opposed to equity.
  • The return on invested capital earned by the business - both historic as well as prospective.

(Questions 31-40)

• This section contains direct questions. Write your answer in just a few words.
• Each answer carries four marks.
• There is no negative marking.

31. Fill in the blank: “In a business selling a commodity-type product, it’s impossible to be a lot smarter than your __________________.”

32. If your stock is deeply undervalued, then the most intelligent allocation of capital decision is likely to be _______________.

33. According to WEB, producers of relatively undifferentiated goods in capital intensive businesses will earn inadequate returns except when _______________________.

34. According to WEB, BRK will issue shares only if its shareholders receive _________________________.

35. According to WEB, while estimating the fair swap ratio in a merger transaction between two companies, its silly for the would-be purchaser to focus on current earnings of the target company when the prospective acquiree has

  • different prospects,
  • a different mix of operating and non-operating assets, or
  • ______________________.

36. WEB likes to think of businesses on a continuum on which at one extreme are bullet proof franchises. At the other extreme are _________________.

37. Two conditions, when they exist together, contribute towards WEB’s favoring a zero-dividend policy. One is the presence of large returns on capital employed. The other is ____________________________.

38. WEB talks a lot about the advantages of scale in many of the businesses in which it has an interest. But there is one exception i.e. there is one business in BRK’s portfolio where going for a large scale i.e. a dominant market share is not a good idea. The managers of this business are perfectly willing to accept reduced volume by refusing to lower prices in response to competition, and let its competitors take away business. WEB is referring to the _______________________ business of BRK.

39. WEB advises investors to seek answers to four questions while evaluating risk arbitrage opportunities. These are:

  1. How likely is it that the promised event will indeed occur?
  2. How long will your money be tied up?
  3. What chance is there that something still better will transpire- a competing takeover bid, for example? and
  4. The fourth one is _______________

40. WEB once used a famous Aesop’s fable to describe the process of DCF valuation. The fable is “_________________________________________.”


Saturday, December 03, 2005

To Burn a Bridge? Or to Cross it Only When You Come to it? Lessons from Black-Scholes Options Pricing Model

When the Spanish explorer Cortez landed at Veracruz, the first thing he did was burn his ships. Then he told his men: “You can either fight, or you can die.” Burning his ships removed a third alternative: giving up and returning to Spain. [from Creative Whack Pack Card # 55]

In 1334, Hochosterwitz Castle was besieged by the Duchess of Tyrol. As time wore on, the defenders became desperate: their last food was an ox. The Duchess’ situation was also severe: her troops had become unruly, and she had urgent matters elsewhere. Then, the castle’s commander had an idea that must have seem utter folly to his men. He had the last ox slaughtered and thrown over the wall in front of the enemy. The Duchess interpreted this scornful message to mean that the defenders had so much food that they could waste it. At this, the discouraged Duchess quit her siege. [Creative Whack Pack Card # 59]

Two truck drivers driving their trucks at breakneck speed towards each other on a narrow road. One of them has to go off the road to avoid a collusion. Then, one of the drivers yanks out the steering wheel of his truck and throws it out of the window leaving the other truck's driver with no choice but to go off the road to avoid getting both of them killed.

These examples show how the “burning your bridges” strategy involving deliberate elimination of one’s options is sensible under certain circumstances. In war, for example, when you need to invoke the powerful psychological influence of extreme commitment [Read chapter on Commitment and Consistency in Cialdini’s Influence] by your troops to achieve a desirable goal which appears, to most people, impossible, this strategy clearly makes sense. Great Generals like George Patton knew this. So do great business leaders.

Why does the burning your bridges strategy work?

When a man burns his bridges, there is no more turning back for him and that realization changes his attitude towards the only two choices now available to him– one which will lead to sure failure and disgrace, and another one which requires him to achieve something, which, at present, appears impossible to accomplish, but if accomplished, will lead to success and glory. The act of destroying some of his options drives the man to accomplish the impossible.

So, the burn-your-bridges tool is a good tool. Like any tool, however, its prone to be over-used by men who are afflicted by what Mr. Charlie Munger calls the man-with-the-hammer syndrome: “To a man with a hammer, everything looks like a nail”.

How does one avoid falling victim to the man-with-the-hammer syndrome in this case? Well, one way would be to invert the problem and ask the following question:

Are there situations where the burn-your-bridges tool will not work, but it’s opposite i.e. keeping-your-options-open tool, will? And once you think about the problem in this manner, the answer is obviously a “yes”.

To see how, let's go inside the guts of Black-Scholes Option Pricing Model.

Options - puts as well as calls - have value for all sorts of reasons. The elegant Black-Scholes Option Pricing Model, shows, that there are six factors that determine the value of options : (1) the stock price; (2) the exercise price; (3) risk-free rate of interest; (4) dividends; (5) time to maturity of the option; and (5) volatility.

For the purpose of this essay, two of these are important- time to maturity and volatility.

Time to Maturity: A key reason why options - calls as well as puts - have value is that there is time before which the option holder has to decide whether to exercise it or not. Options with longer lives are more valuable than options with shorter lives, other things remaining the same. This is true for both calls as well as puts.

Volatility: Another reason is volatility. An option on a volatile stock is more valuable than an identical option on a less volatile stock. This is true for call, as well as, put options.

What works in finance also works in much of life.

In rapidly changing situations (think high volatility), buying time before making a decision (think increasing time to maturity) will improve the quality of the decision, other things remaining unchanged. Dynamic situations have a high likelihood of the emergence of new, material, information. That is, stuff happens.

Therefore, sometimes it makes sense to keep your options open, to buy time, to delay decisions and wait for new information, before making decisions. In other words, you should cross a bridge only when you come to it.

Robert Rubin called this “preserving optionality”.

Mr. Rubin, who is currently chairman of Citigroup, developed his philosophy of preserving optionality while doing risk arbitrage at Goldman Sachs. In risk arbitrage, one bets money on the happening or non-happening of a corporate event such a merger. By definition, such events are dynamic i.e. they display a large degree of volatility because the chances of new developments (e.g. the emergence of a competing bid, regulatory or financial glitches etc.) is significant. While practicing risk arbitrage, Mr. Rubin learnt that preserving optionality is very often a good idea. He successfully applied the same idea in his hugely successful career as the US Treasury Secretary under President Clinton. Clearly multi-disciplinary thinking helped him a lot.

One can learn much about Mr. Rubin’s thoughts on preserving optionality and his philosophy of decision making from his excellent book, “In an Uncertain World”.

In July 1998, the New York Times Magazine published an article on Mr. Rubin. Jacob Weisberg, who wrote the article, had talked to Lawrence Summers about Mr. Rubin. An excerpt:

Rubin is someone who loves to examine and reexamine his options -- a tendency the academically minded Summers refers to as “his preference for optionality.”

One thing Summers says he has learned from Rubin is the value of not always choosing among the available options. “Rubin ends half the meetings with - 'So we don't have to make a decision on this today, do we?' Summers says. New information will evolve.”

“What so many people have a tendency to do is to lock into a scenario,” Summers says. “What Rubin will say, at times to the frustration of others, is that some questions don't have answers - which is to say that just because a problem is terrible, we don't have to act. It may not be the right time.”

In November 2003, Carol Loomis wrote a wonderful article on Mr. Rubin for a Fortune magazine cover story. An excerpt:

Part of Rubin's approach to decisions at the Treasury was to put them off as long as possible. Some people might call that procrastination; Rubin called it getting that one last fact or well-judged opinion, from whoever at the table might offer it, that might make a decision the right one. Geithner says the young members of the Treasury staff would on occasion rush into Rubin's office, imploring him for a decision about something consequential. Rubin's first question would often be, “How much time do we have before we have to decide?” Summers tabs this Rubin's habit of “preserving his optionality.”

Another person who agrees with Mr. Rubin is Steven Sample, the author of the excellent book, “The Contrarian's Guide to Leadership”. In this book, which was once recommended by Mr. Munger, Sample states one of his contrarian rules of leadership:

“Never make a decision today that can be reasonably put off till tomorrow.”

Mr. Sample gives the example of Harry Truman that reminds me of Mr. Rubin.

“Whenever a staff member would come to him with a problem or opportunity requiring a presidential decision, the first thing Truman would ask was, “How much time do I have?" Was it essential that he make the decision in thirty seconds, in an hour, in a day, sometime next week, in a month, within a year.”

Of course, Benjamin Graham, the father of value investing also knew about the idea of preserving optionality. In his book, Security Analysis, Mr. Graham discussed the wisdom of the principle:

“Never convert a convertible”.

Suppose that a bond issued by a sound company, having a face value of $100 is convertible into 2 shares of the company at a fixed price of $50 per share. The option to convert is available to the bondholder for the next 3 years, and the stock price of the underlying company is $60 per share.

Such a bond should sell for $100 plus some premium reflecting the value of the option to convert. The option to convert itself is worth $20 plus some additional value due to the long period of 3 years till conversion.

Suppose this bond is selling in the market for $150. Should the bondholder convert?

Mr. Graham suggested that he should not convert. Why so? Because by converting his bond which can be sold in the market for $150, the bond holder will get two shares having an aggregate market value of $120, a loss of $30.

So, the bond holder should not convert because doing so will result in the loss of the time value embedded in the option to convert. If the bondholder is bullish on the company, he should continue holding the convertible and if he is bearish on the company he should sell the convertible, but he must not convert it because doing so will destroy the time value of the option.

Conclusion: So, after much deliberation over the creative whack pack, the option pricing model, the wisdom of Robert Rubin, Steven Sample, Benjamin Graham, and others, what's my conclusion?

My conclusion is that sometimes it makes sense to burn a bridge after crosssing it, so that there is no turning back, and at other times it makes sense to cross a bridge only when you come to it.

The trick, of course, is to know, when to do what.

If I look back at my own life and identify key decisions I took that explain my current situation, I find that most of those decisions required burning bridges. On the other hand, in my day-to-day affairs including investment-related affairs, I find that preserving optionality has helped me in making better decisions.