Crunching the Numbers

At Berkshire Hathaway's annual meeting last Saturday, Buffett and Charlie Munger commented on what the WSJ called "their complete disdain for modern portfolio theory and the use of higher-order mathematics in finance."  

I agree.  Over the years, I've seen analysts produce incredibly complex models used to make valuation judgements on stocks.  What's not said is that the models frequently are based on some core assumptions which may or may not prove to be true.  For example, until 2008 most assessments about mortgage insurance stocks offered a range of outcomes based on various levels of "HPA" (housing price appreciation).  They typically showed how revenue and earnings projections varied depending on whether housing prices rose by 2%, or 4%, or 6 or 8% per year.  A few wacky analysts even "stress-tested" their models with the assumption that home prices didn't appreciate at all!  We all know how that turned out.

Some other quotes from the meeting:

Mr. Buffett said he was once asked by a student at the University of Chicago, a hub of modern portfolio theory,  "What are we learning that's most wrong?"  To which Charlie Munger quipped, "How do you handle that in one session?"

Mr. Buffett on complex calculations used to value purchases:  "If you need to use a computer or a calculator to make the calculation, you shouldn't buy it."

Mr. Munger on the same theme:  "Some of the worst business decisions I've ever seen are those with future projections and discounts back.  It seems like the higher mathematics with more false precision should help you but it doesn't.  They teach that in business schools because, well, they've got to do something."

Here's a link to the WSJ article.

I'm not anti-intellectual, or even anti-business school.  But new investment theories come and go.  Core principals like quality businesses, talented management, and solid balance sheets stand the test of time.