Problem:

Pete Morgan recently completed his Master of Applied Finance degree. He has been subsequently approached by Berkshire Hathaway Incorporated to consider joining this well-known company and contribute in its plan to take a new direction in the overall management of its wide range of business activities. Pete has decided to take up the offer from Berkshire and is enthusiastic about applying his knowledge to contribute to the performance of a company that has such a strong reputation for sound investing.

Berkshire has been successfully buying, improving and managing businesses for a long time. Despite strategically divesting some of its business holdings, the company has accumulated an impressive stable of somewhat diverse businesses as well as a portfolio of holdings in key financial markets. Warren Buffett is concerned that there has developed a lack of co-ordination across the breadth of investment types. He is worried that the impact of market movements may overshadow the consistent performance his company achieves from running the individual businesses. This is of particular concern given the long period of predominantly positive earnings the company has reported and the possible negative impact that could occur if the company reported a series of losses. Warren is therefore looking to Pete to propose some long-run strategic guide-lines for managing Berkshire's overall market exposures. This project represents a totally new direction for Berkshire. It will therefore require Pete to be very clear and to the point in his presentation and explanations. It will also require recognizing any key characteristics of Berkshire and attempting to reflect the firm's style and circumstances in his recommendations.

Pete plans to produce a strategic asset allocation plan for Berkshire in a similar form to that which a fund manager would apply to a diversified fund. He commences his analysis with a review of the historical return patterns of the three major US asset classes (shares, bonds and cash) to understand what Berkshire is likely to experience as it invests in these markets. He then applies his analysis to finding a portfolio configuration that might be appropriate for Berkshire. Warren has already raised concerns on the best way to implement their business buying activities in light of an overall strategic framework. In an attempt to illustrate how decisions on individual business acquisitions might be coherently carried out within the strategy, Pete has collated historical return data for a sample of individual stocks representative of the types of businesses BH invests in. This will be useful for analyzing the risk patterns of the underlying business exposures relative to each other and the overall exposure to the US share market. However, there are a number of different approaches to constructing portfolios and Pete will need to select and recommend the most appropriate approach.

Warren intends to make full use of Pete's capabilities and has therefore asked him to also contribute to other internal projects that have strategic importance. There is a hotly contested debate raging across the financial community on the issue of how best to value BH. To reduce the confusion that this debate is causing, Warren would like Pete to provide an opinion on the best approach to valuing BH.

Required:

1) Pete starts his analysis by looking at long-run return and risk numbers for shares, bonds and cash.

Use the index data from BuffettData11.xls for the S&P Index, the Barclays Capital Aggregate Bond Index and the Money Market Benchmark Index to calculate: arithmetic average annual returns and population versions of standard deviations of returns for shares, bonds and cash, and correlations for these three asset classes (tip: read through the case study Appendix for further information on the data, spreadsheets and carrying out the calculations).

2) Pete is concerned with the data choices he has made in Question 1 and takes the opportunity to reconsider one of his major decisions. He is aware that the Dow Jones is frequently referred to as a bell weather indicator for the US equity market and wonders whether he should use that index (the data for the Dow Jones is also provided for reference in BuffettData11.xls) instead of the S&P Index data he has used. Explain which of these two share indices would be more appropriate in the context of this case study.

3) Buffet is widely accepted as an aggressive investor - eg with a risk tolerance level which is about twice that of the average market participant. Pete goes ahead and uses the results from Question 1 to construct a strategy that would suit BH. However, he decides to treat cash as a proxy for the risk free asset. Construct a strategy that would suit BH. (tip: use the share and bond indices to represent risky assets).

4) Pete uses historical risk numbers for each of the stocks listed in References Data.xls as a representative collection of equity holdings. (a) Regress the shares' excess returns on the excess returns of the S&P index and report the shares' alphas, betas and related t-statistics.

(b) Calculate the population version of the standard deviation of excess returns for each share and the S&P index.

(c) Calculate the non-systematic risk (implied from the betas and standard deviations of excess returns).

5) Construct stock portfolios using the results from the previous question. Use solver to find the optimal portfolio weights to achieve:

(a) the portfolio with the highest Sharpe ratio (using the standard deviations from part (b) of Question 4);

(b) the portfolio with the highest alpha; and

(c) the portfolio with the highest information ratio.

Assume the correlations of the stocks' excess returns are zero. Also assume the correlations of the stocks' firm specific returns are zero. State the portfolios' investment weights, alpha, beta, standard deviation of excess returns, Sharpe ratio, non-systematic risk and information ratio (tip: there will be three different portfolios).

6) Select one of the portfolios from the previous question as Pete's recommendation to best suit BH. Justify your choice.

7) What improvements could be made to the portfolio s you have recommended and the processes you employed to construct them?

8) Describe the alternative methods that could be used to value BH and explain which one would be the most appropriate.

Additional Information:

This question is basically belongs to Finance as well as it explains about case study on Warren Buffett. The case study is Why Buffett's a Bargain by Richard Teitelbaum. Questions about the case study have been answered in the solution in detail.

The case study has been enclosed along with the solution.