As always, I am playing with fire when I critique Warren Buffett, but he does indulge in hyperbole (I hope that is all it is..) when he strays from his preferred habitat. In fact, my previous post on him evoked some strong responses. In the last Berkshire Hathaway report, he is quoted as saying “Both Charlie and I believe that Black-Scholes produces wildly inappropriate values when applied to long-dated options… Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination. For that matter, so does the academic’s inclination to dwell on the valuation of options. You can be highly successful as an investor without having the slightest ability to value an option”.
Let's take apart this statement:
a. "Both Charlie and I": I presume that Charlie here stands for Charlie Munger, the other fount of wisdom from Omaha. I guess this is supposed to add to the intimidation factor. If Charlie Munger agrees with Warren Buffett, what right-minded person would disagree, right? Charlie Munger has a way with words (I especially love this quote: "If the only tool you have is a hammer, everything starts to look like a nail.") But so do Yogi Berra and Lady Gaga, and I am not listening to investment advice from either one..
b. "Black-Scholes produces wildly inappropriate values when appled to long-dated options": So, the Black-Scholes that Mr. Buffett must be referencing must be the original Black-Scholes, with no dividend or dilution adjustments to value European options? And what exactly are these long dated options that are being valued? Warrants or management options? Since US companies are light users of the former, I would assume that it is the latter, which are not traded. If they are not traded, two questions:
i. How would Mr. Buffett know that they are wildly inappropriate? Because the values he got from these options were higher than Mr. Buffett's gut said that they should be worth? Perhaps, he should take a look at LEAPs (long term call and put options) traded on US stocks on the exchanges. As the value guru, he may think that all of these options are being over valued. If so, I would welcome his intervention in these markets.
ii. What exactly did Mr. Buffett do with the Black-Scholes model? The Black-Scholes model is only as good as its inputs. With long term options, the variance that should be used in the model is a long term variance (which may be well below the current level) and if the options are management options, you should be correcting for dilution and illiquidity. Since FASB has required companies to value management options and expense them for the last three years, this is a well researched area of finance. With the adjustments, the Black Scholes delivers reasonable values for options.
Here is the bottom line. The Black Scholes under values deep out of the money options (because of its assumption that prices move continuously) and over values options that are illiquid. To compensate, we can either modify the Black Scholes or use a binomial option pricing model, both of which deliver much better estimates of option value than any individual's gut...
c. "Academic’s inclination to dwell on the valuation of options": I love this one! Where does Warren Buffett's academic live? Is he a Phd student that Buffett and Munger trapped in the 1970s and put in a hut in Omaha, poring over old Journals of Finance (preferably from the 1960s)? That may explain Buffett's fixation with the CAPM and the Black Scholes. There are some academics and many practitioners who dwell on the valuation of options, but there is a reason for that. It is their job is to assess the value of listed options, warrants or convertibles, and if that is their job, they have to just dwell on the valuation of options. I am an academic (in Buffett's sense of the word) but option valuation is an after thought to me, not a central part of either corporate finance and valuation..
d. "Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination: I would be interested in what constitutes "current" practice to Mr. Munger and Mr. Buffett. Furthermore, what are these nasty academics doing? Are they telling their students to value options using the Black-Scholes model, to buy under valued options and sell over valued options?
e. "You can be highly successful as an investor without having the slightest ability to value an option": Here is the only statement that I completely agree with. Absolutely, but only if you stay away from option laden investments (which includes companies like Cisco which have a significant management option overhang, oil companies with undeveloped reserves like Petrobras, pharmaceutical companies with potential blockbuster drugs making their way through the pipeline).
I am sorry if you find me to be disrespectful for not treating Warren Buffett as a minor deity, whose every word is gospel. It is clear that all of the praise that he receives from his followers has gone to his head. He sound absurd when he talks about derivatives and seems to think that he is a macro forecaster (which actually cuts against everything he stood for two decades ago). I will pay him the ultimate compliment (or insult) by taking every macro suggestion that he makes and doing the opposite.
Let's take apart this statement:
a. "Both Charlie and I": I presume that Charlie here stands for Charlie Munger, the other fount of wisdom from Omaha. I guess this is supposed to add to the intimidation factor. If Charlie Munger agrees with Warren Buffett, what right-minded person would disagree, right? Charlie Munger has a way with words (I especially love this quote: "If the only tool you have is a hammer, everything starts to look like a nail.") But so do Yogi Berra and Lady Gaga, and I am not listening to investment advice from either one..
b. "Black-Scholes produces wildly inappropriate values when appled to long-dated options": So, the Black-Scholes that Mr. Buffett must be referencing must be the original Black-Scholes, with no dividend or dilution adjustments to value European options? And what exactly are these long dated options that are being valued? Warrants or management options? Since US companies are light users of the former, I would assume that it is the latter, which are not traded. If they are not traded, two questions:
i. How would Mr. Buffett know that they are wildly inappropriate? Because the values he got from these options were higher than Mr. Buffett's gut said that they should be worth? Perhaps, he should take a look at LEAPs (long term call and put options) traded on US stocks on the exchanges. As the value guru, he may think that all of these options are being over valued. If so, I would welcome his intervention in these markets.
ii. What exactly did Mr. Buffett do with the Black-Scholes model? The Black-Scholes model is only as good as its inputs. With long term options, the variance that should be used in the model is a long term variance (which may be well below the current level) and if the options are management options, you should be correcting for dilution and illiquidity. Since FASB has required companies to value management options and expense them for the last three years, this is a well researched area of finance. With the adjustments, the Black Scholes delivers reasonable values for options.
Here is the bottom line. The Black Scholes under values deep out of the money options (because of its assumption that prices move continuously) and over values options that are illiquid. To compensate, we can either modify the Black Scholes or use a binomial option pricing model, both of which deliver much better estimates of option value than any individual's gut...
c. "Academic’s inclination to dwell on the valuation of options": I love this one! Where does Warren Buffett's academic live? Is he a Phd student that Buffett and Munger trapped in the 1970s and put in a hut in Omaha, poring over old Journals of Finance (preferably from the 1960s)? That may explain Buffett's fixation with the CAPM and the Black Scholes. There are some academics and many practitioners who dwell on the valuation of options, but there is a reason for that. It is their job is to assess the value of listed options, warrants or convertibles, and if that is their job, they have to just dwell on the valuation of options. I am an academic (in Buffett's sense of the word) but option valuation is an after thought to me, not a central part of either corporate finance and valuation..
d. "Academics’ current practice of teaching Black-Scholes as revealed truth needs re-examination: I would be interested in what constitutes "current" practice to Mr. Munger and Mr. Buffett. Furthermore, what are these nasty academics doing? Are they telling their students to value options using the Black-Scholes model, to buy under valued options and sell over valued options?
e. "You can be highly successful as an investor without having the slightest ability to value an option": Here is the only statement that I completely agree with. Absolutely, but only if you stay away from option laden investments (which includes companies like Cisco which have a significant management option overhang, oil companies with undeveloped reserves like Petrobras, pharmaceutical companies with potential blockbuster drugs making their way through the pipeline).
I am sorry if you find me to be disrespectful for not treating Warren Buffett as a minor deity, whose every word is gospel. It is clear that all of the praise that he receives from his followers has gone to his head. He sound absurd when he talks about derivatives and seems to think that he is a macro forecaster (which actually cuts against everything he stood for two decades ago). I will pay him the ultimate compliment (or insult) by taking every macro suggestion that he makes and doing the opposite.
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