Case Studies in Finance: Managing for Corporate Value Creation 7th Edition solution manual

Benefits of portfolio diversification: Although Buffett disavows portfolio diversification, the breadth of Berkshire Hathaway’s holdings probably approaches efficient diversification. Case Exhibit 2 gives a breakdown of Berkshire’s diverse business segments (also described in the case); case Exhibit 3 gives a listing of Berkshire’s 10 major investees. From the list, students could be asked whether the portfolio looks diversified—this should stimulate a discussion of what diversification means to them and what it might mean in finance theory.
The case does not provide the data with which to complete an analysis based on market values and asset allocations, but by just looking, one might identify possible industry concentrations in Berkshire’s holdings. Those concentrations do not seem to account for the bulk of Berkshire’s market value. The firm’s portfolio consists of an assortment of odd manufacturing and service businesses suggested in the case, plus some major equity holdings (case Exhibit 3) that are not easily classified in the concentration groups. The mass of research on portfolio diversification suggests that it does not require very many different equities to achieve the risk-reduction benefits of diversification. Despite his public disagreement with the concept of diversification, Buffett seems to practice it.
Capital-market efficiency: Buffett’s emphasis on the value of information asymmetries seems to confirm some appreciation for efficiency in security prices. From his public statements as reported in the case, Buffett’s disagreement with efficiency focuses on two aspects:
The concept of passive portfolio management (i.e., indexing)
The implication that quoted prices equal intrinsic values
The theory of efficiency does not absolutely preclude benefits of active management or the possibility that prices may not equal intrinsic values. But it does suggest that without an information advantage or some unusual skill, it would be very difficult to earn supernormal returns consistently over time. It is in this context that Warren Buffett appears to be a major anomaly. The supernormal returns of Berkshire Hathaway suggest that it is possible to beat the market by a wide margin. Still, Buffett’s investment style is consistent with efficiency in some important ways:
Discipline and rationality: If one is trying to beat the market, it makes no sense to invest in shares that are fairly priced. Buffett’s quotations in the case and his acquisition philosophy in case Exhibit 8 suggest that he is looking for the market’s pricing anomalies. Looking for the anomalies (the rationality part) and waiting to find them (the discipline part) are not inconsistent with a market that generally prices securities efficiently. Indeed, one could argue that the activities of investors such as Buffett help to create the efficiency that he denies.
Information: By virtue of Berkshire’s large stockholdings in selected firms, Buffett holds directorships and enjoys an informational advantage unavailable to outside investors. Information advantages are valuable in a world of only semi-strong efficient markets.
 
 
Conclusion
 
The final issue raised by the case has to do with the sustainability of Buffett’s record. A bid for PacifiCorp of $9.4 billion does not seem unreasonable relative to current comparable valuations. For the PacifiCorp acquisition to be a success in the sense of matching historical returns at Berkshire, Buffett’s expectations for PacifiCorp must be radically different from current, implied, and expected values for peer firms. With an investment of this size, a mistake will have lasting adverse consequences for Berkshire and Buffett. Even if Buffett’s bet on PacifiCorp in May 2005 is correct, the need to deploy larger amounts of money will invite mistakes—as Buffet said, “A fat wallet is the enemy of superior investment results.” With more than $40 billion in cash and cash equivalents, Buffett would have been mindful of this admonition.
 
As described here, the case gives the novice a broad introduction to the valuation of, and investment in, equities. The elements of this introduction include the following:
 
ex post analysis of investment returns (Berkshire, MidAmerican, and the Big Four) and comparison of those returns with a benchmark, such as the S&P 500 Index or the Ibbotson total return figures
peer multiples valuation analysis of PacifiCorp
discussion of the meaning of share-price movements following the announcement of the PacifiCorp acquisition
review of the major tenets of finance in the context of Buffett’s investment philosophy
 

Exhibit TN1
WARREN E. BUFFETT, 2005
Bibliography for Warren E. Buffett
 
 
Buffett, Mary, and David Clark. The New Buffettology: The Proven Techniques for Investing Successfully in Changing Markets That Have Made Warren Buffett the World’s Most Famous Investor. (New York: Simon & Schuster), 2002.