AbstractWarren Buffett is an American businessman who is generally thought to be the most successful investor of all time. Through the tutelage of Benjamin Graham, Buffett adopted a value-oriented style of investing that differs from modern portfolio thinking. In 1962, Buffett purchased his first shares of Berkshire Hathaway. Within a few years, Buffett would increase his share in the company’s holdings and would eventually become CEO (Buffett Secrets, n.d.). Buffett uses Berkshire Hathaway as the tool for his investments.
Berkshire Hathaway’s portfolio includes many well know companies, such as the Coca-Cola company, the Gillette Company, Moody’s Corporation and the Washington Post Company among others (CNBC, 2010). To highlight Buffett’s performance through his company, Berkshire-Hathaway has outperformed the market (Financial Times, 2010). In 2005, Mid American Energy Holdings (Buffett’s utility company) completed a takeover deal for the electricity utility PacifiCorp for a value of US$9.4 billion (Bruner, Eades, & Schill, 2010, p. 3).
On May 24, 2005, MidAmerican Energy Holdings (MEH), a subsidiary of Berkshire Hathaway, announced to acquire PacifiCorp for a value of US$9.4 billion (wanna take out the last bit as appeared in abstract already?). Before the announcement, Berkshire Hathaway’s price closed at $83,490 with a volume of 24,000.
After the announcement, its share price and volume increased to $85,500 and 102,000 respectively (Appendix D). This is triggered by significant trading activities that lead to a shift in the demand for the securities of participating firms showing that markets react positively to the news of acquisition (Morck, Shleifer and Vishny, 1988). On the following day, the trading volume decreased to 44,000 shares at a price of $85,200 and continued to fall.
Empirical studies show that announcements will lead to a sudden change in price (Shaheen, 2006). However, this change will have a very short term effect and will generally only last for a few days (Zhu and Malhorta, 2008). As PacifiCorp was never listed, the share price behaviour of PacifiCorp’s parent firm, Scottish Power should be examined instead. Before the announcement, Scottish Power closed its trading at $442 per share. On the announcement date, its share price jumped to $469.75, an increase of 6%. On May 25, 2005, the share price dropped to $467 however it remained above the $466 mark throughout the week (Appendix E). Question 1b
1) Valuation with Discount Cash Flow ModelBased on the averages given by the industry, PacifiCorp’s revenues and expenses can be calculated using the assumption that it will have rich cash flows to expand its business and repay some debt after being acquired by MEH(Appendix B). With this, the capital expenditure and interest expense growth will tend to slow. However, the U.S. energy market is forecasted to boost in the next five years (Bruner et al., 2010, p. 13). Based on these factors, the value of PacifiCorp could be estimated as $9.513 billion with discount cash flow model (Appendix A).
2) Valuation multiplesValuation multiples is a quick way to value a company by comparing similar companies (comparable company analysis). It expresses as total value of company equal to market multiple times EBITDA (Hillestad, 2007).
Figure [ 1 ]: Valuation Multiples for Comparable Regulated Energy Firms
The mean valuation multiple found in the Figure 1 for the comparable firms was 8.30 and the EBITDA of PacifiCorp ($1,093m), therefore, an implied enterprise value of PacifiCorp comes to $9.07 19 billion. Comparing with Buffett’s bid price $9.4 billion (Bruner et al., 2010, p. 3) for PacifiCorp, it can be concluded that Buffett paid a fair price for PacifiCorp. Question 2a
Semi-strong efficiency refers to the current price of an asset that incorporates all publicly available information, including historical data (Fama, 1970). One should not be able to consistently beat the market and gain abnormal returns. However, according to Martin (2008) an efficient capital market will not price all stocks correctly, but rather the prices are correct on average.
This means that skilled investors (like Buffett) would be able to identify the mispriced stocks and make profits from them (Grossman and Stiglitz, 1980). In fact, the market relies on this process to provide the information needed to ensure it is efficient.
Another point is that Buffett’s investment philosophy is substantially different to that of most others, and indeed differs from modern portfolio theory. Rather than simply buying shares, Buffett seeks to buy a large enough portion of the company so that he is able to gain a position on the company’s board (Bloomberg, 2010).
Essentially, this means that Buffett is buying the business rather than the shares (Businessweek, 1999). Failing that, Buffett has also been known to invest in companies where he knows and respects the management (Guru Focus, 2009). This shows that Buffett has used information that is not publicly available in order to gain profits, which does not reject the notion of semi-strong efficient markets.
Buffett’s investment philosophy was the Buy and Hold (B&H) approach. A B&H strategy is characterised by an initial mix of securities that are bought and then held (Perold and Sharpe, 1988). This requires an investor to decide assets of interest up front and use a portion of the accessible funds to acquire some risky assets.
A shortcoming is that the risk of the portfolio increases over time (Leggio and Lien, 2001). Another disadvantage of the B&H strategy is that it does not factor in environmental effects and the interactions among different factors other than the outputs (Patel and Marwala, 2006).
Buffett mentioned not to use leverage in investments but, some firms choose to be highly leveraged due to tax advantages (Opler and Titman, 1994). In cases of mergers, an increase in financial leverage benefits shareholders through tax deductibility of interest payments on corporate debt. It might also enhance shareholders wealth through an expropriation of wealth from bondholders (Ghosh and Jain, 2000). Merging firms increase their financial leverage around mergers can signal better acquisitions, which increases the market value (Maloney, McCormick & Mitchell, 1993).
Figure [ 2 ]: Corporate Social Responsibility
Bufett’s personality suggests that he is an ethical person, by his willingness to donate a large share of his wealth to charity (Bill & Melinda Gates Foundation, 2010). This attitude conforms to the Utilitarianism’s belief in acting for the greater good of society (Beauchamp, Bowie & Arnold, 2009, p. 18), while his self control shown by not over indulging is representative of Virtue Ethics (Fisher & Lovell, 2006, p. 103).
This is also shown by Buffett prioritising the performance of the firm over his own capital gains, which according to Mallen (n.d.), the company answers to CSR issues from having a positive impact on the global economy and development.
An example supporting Buffett’s ethical belief is that during Goldman’s incident, Buffett said, “Lose money for the firm and I will be understanding. Lose a shred of reputation for the firm and I will be ruthless” (Money News, 2010). To be able to voice publically such strong enforcement upon staying with his values in ethics, this requires a strong conviction and a willingness to take action.
Buffett acknowledges that there is a difference in what is legal and what is ethical and he endeavours to pass on this attribute to his employees. Buffett stated, “Let’s start with what is legal, but always go on to what we would feel comfortable about being printed on the front page of our local paper” (Sox First, 2006).
As seen above, Buffett’s leadership in Berkshire Hathaway has been ethically and socially managed, which is what a highly ethical investor would look for.
ReferencesADVFN Australia. (2010). Scottish Power Share Price SPW. Retrieved August 26, 2010, from http://au.advfn.com/quote_Scottish-Power-_LSE_SPW.html Alliant Inc. (2005). Alliant Annual Report 2005. Retrieved August 21, 2010, from
http://library.corporate-ir.net/library/71/714/71431/items/316968/2005AR.pdf Beauchamp, T., Bowie, N. & Arnold, D. (2009). Ethical theory and business practice. Upper Saddle River: Pearson/Prentice Hall. Berkshire Hathaway Inc. (2005). Berkshire Hathaway Annual Report 2005. Retrieved August 21, 2010, from http://www.berkshirehathaway.com/letters/2005ltr.pdf
Bill and Melinda Gates foundation. (2010). Implementing Warren Buffett’s Gift. Retrieved August 27, 2010, from http://www.gatesfoundation.org/about/Pages/implementing-warren-buffetts-gift.aspx Bloomberg Businessweek. (2010). Warren Buffett: Executive profile & biography. Retrieved August 24, 2010, from http://investing.businessweek.com/businessweek/research/stocks/people/person.asp?personId=255253&ticker=BRKA:GR
Bruner, R. F., Eades. K. M. & Schill. M. J. (2010) Case Studies in Finance: Managing for Corporate Value Creation. New York: McGraw-Hill/Irwin.
Buffett Secrets. (n.d.). Warren Buffett: A Short Biography. Retrieved September 1, 2010, from http://www.buffettsecrets.com/warren-buffett-biography.htm Businessweek. (1999). The Warren Buffett you didn’t know. Retrieved August 27, 2010, from http://www.businessweek.com/1999/99_27/b3636001.htm CNBC. (2010). Berkshire Hathaway Holdings. Retrieved September 1, 2010, from http://www.cnbc.com/id/22130601/ Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work.
The Journal of Finance 25(2), 383-417. Retrieved August 24, 2010, from JSTOR database. Financial Times. (2010). Interactive Charting: Bershire Hathaway. Retrieved September 1, 2010, from http://markets.ft.com/tearsheets/performance.asp?s=us:BRK.A Fisher, C. & Lovell, A. (2006). Business ethics and values. Harlow: Pearson/Prentice Hall. Ghosh, A., & Jain, P. C. (2000). Financial leverage changes associated with corporate mergers. Journal of Corporate Finance, 6(4), 377-402. Retrieved August 22, 2010, from ScienceDirect database.
Grossman, S. & J. Stiglitz. (1980). On the impossibility of informationally efficient markets. American Economic Review 70(3), 393-408. Retrieved August 24, 2010, from JSTOR database.
Guru Focus. (2009). Geico: The security Buffett liked best. Retrieved August, 27, 2010, from http://www.gurufocus.com/news.php?id=61740 Hillestad. O.C. (2007). An analysis of financial ratios for the Oslo Stock Exchange. Norges Bank. Economic Bulletin. 78(3), 115-131. Retrieved August 21, 2010, from ProQuest database.
Leggio, K. B., & Lien, D. (2001). Does loss aversion explain dollar-cost averaging?. Financial Services Review, 10(1), 117-127. Retrieved August 22, 2010, from ScienceDirect database. Maloney, M. T., McCormick, R. E., & Mitchell, M. L. (1993). Managerial Decision Making and Capital Structure. Journal of Business, 66(2), 189-217. Retrieved August 22, 2010, from Business Source Elite database.
Martin, G. S., & Puthenpurackal, J. (2008) Imitation is the Sincerest Form of Flattery: Warren Buffett and Berkshire Hathaway. Retrieved August 24, 2010, from http://ssrn.com/abstract=806246 Mallen Baker. (n.d.). Definitions of Corporate social responsibility. Retrieved September 7, 2010, from http://www.mallenbaker.net/csr/definition.php Morck, R., Shleifer, A. & Vishny, R. W. (1988). Characteristics of Targets of Hostile and Friendly Takeovers.
In A. J. Auerbach (Eds.), Corporate Takeovers: Causes and Consequences. (pp. 101-136). Chicago: University of Chicago Press. NSTAR Inc. (2005). NSTAR Annual Report 2005. Retrieved August 21, 2010, from http://media.corporate-ir.net/media_files/irol/92/92689/reports/nst_2005ar.pdf
Opler, T. C., & Titman, S. (1994). Financial Distress and Corporate Performance. The Journal of Finance, 49(3), 1015-1040. Retrieved August 22, 2010, from JSTOR database.
PacifiCorp Inc. (2005). PacifiCorp Annual Report 2005. Retrieved August 21, 2010, from http://www.getfilings.com/o0000075594-05-000015.html
Patel, P. B., & Marwala, T. (2006). Forecasting closing price indices using neural networks. Systems, Man, and Cybernetics, 3, 2351-2356. Retrieved August 22, 2010, from IEEE Xplore Online database.
Perold, A. F., & Sharpe, W. F. (1988). Dynamic Strategies for Asset Allocation. Financial Analysts Journal, 44(1), 16-27. Retrieved August 22, 2010, from ProQuest database.
PEW CENTRE. (2005). Getting Ahead of the Curve: Corporate Strategies That Address Climate Change. Retrieved August 21, 2010, from http://www.pewclimate.org/docUploads/Cinergy%20case%20study.pdf SCANA Inc. (2006). SCANA Annual Report 2006. Retrieved August 21, 2010, from http://www.scana.com/NR/rdonlyres/E0217065-A1C9-4052-A1DD-3C1727F5372E/0/2006ProxyStatement.pdf Shaheen, I. (2006). Stock Market Reaction to Acquisition Announcements using an Event Study Approach. Retrieved August 24, 2010, from DSpace database (Identifier:
http://dspace.nitle.org/bitstream/handle/10090/4167/Shaheen.pdf?sequence=1) Sox First. (2006). Ethics from the top: Warren Buffett’s ethics lesson. Retrieved August 28, 2010, from http://www.soxfirst.com/50226711/ethics_from_the_top_warren_buffetts_ethics_lesson.php This is money. (2010).
Buffett tells AGM: Economy is improving. Retrieved September 7, 2010, from http://www.thisismoney.co.uk/investing/article.html?in_article_id=503803&in_page_id=166 Wisconsin Inc. (2005). Wisconsin Summary Annual Report 2005. Retrieved August 21, 2010, from http://ccbn.mobular.net/ccbn/7/1270/1357/
Yahoo Finance. (2010). Berkshire Hathaway Inc. (BRK-A). Retrieved August 26, 2010, from http://finance.yahoo.com/q?s=brk-A Zhu, P. & Malhotra, S. (2008). Announcement Effect and Price Pressure: An Empirical Study of Cross-Border Acquisitions by Indian Firms. International Research Journal of Finance and Economics. (13), 24-41. Retrieved August 25, 2010, from Euro Journals database.