Gold does much more than glitter.

The story of gold is as rich and complex as the metal itself.

Wars have been fought for it; love has been declared with it. Ancient Egyptian hieroglyphs portray gold as the brilliance of the sun; modern astronomers use mirrors coated with gold to capture images of the heavens.

By 325 BC the Greeks had mined for gold from Gibraltar to Asia Minor. In 1848 AD James Marshall found flakes of gold whilst building a sawmill near Sacramento and so triggered the gold rush in California.

Held securely in national vaults as a reserve asset, gold has an irrefutable logic; released from the tombs of pharaohs and emperors alike, gold has an undeniable magic.

Gold is the oldest precious metal known to man and for thousands of years it has been valued as a global currency, a commodity, an investment and simply an object of beauty. Gold is rare. Today there are 165,000 metric tonnes of stocks in existence above ground. If every single ounce of this gold were placed next to each other, the resulting cube of pure gold would only measure 20 metres in any direction.

The demand for this precious and finite natural commodity occurs in many geographies and sectors. Around 60% of today's gold becomes jewellery, where India and China with their expanding economic power are at the forefront of consumption. In East Asia, India and the Middle East, gold has powerful cultural meaning, accounting for approximately 70% of the world's gold jewellery in 2009.

But jewellery creates just one source of demand; investment, central bank reserves and the technology sector are all significant. Each is driven by different dynamics, adding to gold's strength and independence.

In creating supply, gold mining companies operate on every continent of the globe. This broad geographical dispersal means that issues, political or otherwise, in any single region are unlikely to impact the supply of gold. Beyond mine production, recycling accounts for around a third of all current supply. In addition, central banks can also contribute to supply should they sell part of their gold reserves. It is worth noting that after 18 years as net sellers, collectively central banks are now effectively net buyers, causing not only a significant decrease in supply but a corresponding, simultaneous increase in demand.

Numbers and facts draws together some of the more extraordinary statistics which gold has accumulated across the centuries and around the world.

Major Characteristics

• Gold (Chemical Symbol-Au) is primarily a monetary asset and partly a commodity.
• Gold is the world's oldest international currency.
• Gold is an important element of global monetary reserves.
• With regards to investment value, more than two-thirds of gold's total accumulated holdings is with central banks' reserves, private players, and held in the form of high-karat jewellery.
• Less than one-third of gold's total accumulated holdings are used as "commodity" for jewellery in the western markets and industry.

Global Scenario London is the world's biggest clearing house. Mumbai is under India's liberalised gold regime. New York is the home of gold futures trading. Zurich is a physical turntable. Istanbul, Dubai, Singapore, and Hong Kong are doorways to important consuming regions. Tokyo, where TOCOM sets the mood of Japan. Factors Influencing the Market Above ground supply of gold from central bank's sale, reclaimed scrap, and official gold loans. Hedging interest of producers/miners. World macroeconomic factors such as the US Dollar and interest rate, and economic events. Commodity-specific events such as the construction of new production facilities or processes, unexpected mine or plant closures, or industry restructuring, all affect metal prices. In India, gold demand is also determined to a large extent by its price level and volatility.

Heritage Despite its unrivalled properties, gold is an inert material. It does nothing until man discovers it, mines and refines it and bends it to his will. So the history of gold is very much the history of civilisation. Here are some points in time where that history was made. 3600 BC First smelting of gold Egyptian goldsmiths carry out the first melting or fusing of ores in order to separate the metals inside. They use blowpipes made from fire-resistant clay to heat the smelting furnace.   2600 BC Early gold jewellery Goldsmiths of ancient Mesopotamia (modern-day Iraq) craft one of the earliest pieces of gold jewellery, a burial headdress of lapis and carnelian beads with willow leaf-shaped gold pendants. Image © Trustees of The British Museum   1200-1500 BC Advances in jewellery making Artisans develop the lost-wax jewellery casting technique. The process allows for improved hardness and colour variation which in turn broadens the market for gold products.

1223 BC Creation of Tutankhamun's funeral mask Instantly recognised the world over, the funeral mask of Tutankhamun is a triumph of gold craftsmanship from the ancient world. 950 BC Solomon builds gold temple The Queen of Sheba from Yemen presents King Solomon of Israel with 2,500 kilos of gold, bringing the contents of his treasury to 5,700 kilos. Solomon uses part of his holdings to construct his famed temple, allegedly overlaid with gold. © Nir Levy   600 BC First gold dentistry practiced The first use of gold in dentistry as the Etruscans begin securing substitute teeth with gold wire. Bio-compatibility, malleability and corrosion resistance still make gold valuable in dental applications.   564 BC First international gold currency created King Croesus develops improved gold refining techniques, permitting him to mint the world's first standardised gold currency. Their uniform gold content allows 'Croesids' to become universally recognised and traded with confidence.   300 First gold nanoparticles The Romans use gold to colour the Lycurgus Cup. Melting gold powder into glass diffuses gold nanoparticles throughout which then refract light, giving the glass a luminous red glow. Image © Trustees of The British Museum   1300 Hallmarking practice established The world's first hallmarking system, scrutinising and guaranteeing the quality of precious metal, is established at Goldsmith's Hall in London - where London's Assay Office is still located today. Image © The Assay office, Birmingham   1370 The Great Bullion Famine begins During the years 1370-1420, various major mines around Europe become completely exhausted. Mining and production of gold declines sharply throughout the region in a period known as 'The Great Bullion Famine'.   1422 Venice's record year The Venice Mint strikes a record 1.2 million gold ducats using 4.26 metric tonnes of gold from Africa and Central Asia. These small coins prove popular as they are easy to mint and carry plenty of value. Image © Classical Numismatic Group, Inc., CC-BY-SA-2.5, Wikimedia Commons   1511 Ferdinand unleashes invasion force King Ferdinand of Spain proclaims "Get gold, humanely if you can, but at all hazards, get gold!", launching unprecedented expeditions to the Americas. Within years, the Inca and Aztec civilisations would be virtually destroyed by Spanish conquerors. 1717 UK gold standard commences Britain moves onto a de facto pure gold standard, as the government links the currency to gold at a fixed rate (establishing a mint price of 77 shillings, ten and a half pennies per ounce of gold). 1803 First gold electroplating practiced The first recorded experiment in electroplating is carried out by Professor Luigi Brugnatelli at the University of Pavia. Gold electroplating ensures improved conductivity, now essential to many 21st century technologies. Image © Deep Blue, CC-BY-SA-3.0, Wikimedia Commons   1848 California Gold Rush begins John Marshall discovers gold flakes while building a sawmill near Sacramento, California. The greatest gold rush of all time follows as 40,000 diggers flock to California from around the World.   1885 South African Gold Rush begins While digging up stones to build a house, Australian miner George Harrison finds gold ore on Langlaagte farm near Johannesburg. Miners flock to the region. South Africa will go on to become the source of 40% of the world's gold. Image © Terry Davis   1885 First Faberge Easter egg crafted Carl Faberge makes his first gold Imperial Easter Egg for Tsar Alexander III. Named The Hen Egg, it was commissioned as a gift from the Tsar to his wife, the Empress Maria Fedorovna, beginning a tradition that lasts until 1917. Image © PetarM, CC-BY-SA-3.0, Wikimedia Commons,   1870-1900 Adoption of gold standard All major countries other than China switch to the gold standard, linking their currencies to gold. The practice of bimetallism is abandoned.   1925 Gold standard returns The UK returns to the gold standard at pre-war parity of $4.86=£1 with sterling convertible to gold at 77sh 10.5d per standard ounce. This follows the country's departure from the gold standard six years previously at the outbreak of World War I.   1933 Roosevelt suspends gold President Roosevelt suspends US dollar convertibility to gold (gold at US$20.67/oz). The export of all transactions in, and the holding of gold by private individuals, is forbidden. Presidential proclamation makes the dollar convertible again in January 1934 at a new price of $35 per troy ounce.   1939 World War II closes gold market The London gold market is closed on the outbreak of war, as at the beginning of World War II. The world will later return to a fixed system of exchange rates, this time with currencies fixed to the dollar and the dollar convertible into gold.   1944 Bretton Woods conference The Bretton Woods conference sets the basis of the post-war monetary system. The US dollar is set to maintain a $35=1 oz gold conversion rate. Other currencies are fixed in terms of US dollar, thus forming a Gold Exchange Standard.   1961 First gold bonded microchips Gold bonding wire is used in microchips engineered at Bell Labs in the US. Nowadays literally billions of chips are bonded this way every year, controlling all manner of indispensible electrical devices.   1961 First gold in space The first manned space flight uses gold to protect sensitive instruments from radiation. In 1980, 41kgs of gold is included in space shuttle construction through brazing alloys, fuel cell fabrication and electrical contacts.   1967 First South African Krugerrand The Krugerrand is introduced in 1967, as a vehicle for private ownership of gold. This iconic coin is actually intended for circulation as currency.   1971 Gold window closed The Bretton Woods system of fixed exchange rates comes to an end as President Nixon "closes the gold window", suspending US dollar convertibility to gold. The world enters its present day system of floating exchange rates.   1985 First gold-based arthritis treatment Pharmaceutical giant, SmithKline & French, develops Auranofin, a gold-based drug for the treatment of rheumatoid arthritis. The drug receives regulatory approval and goes on sale for the first time.   1999 First Central Bank Gold Agreement The First Central Bank Gold Agreement (CBGA) is agreed. 15 European central banks declare that gold will remain an important element of their reserves and collectively cap gold sales at 400 tonnes per year over next five years.   2001 First gold used in heart surgery Boston Scientific markets the first gold-plated stent (Niroyal) used in heart surgery. Inserted inside large arteries and veins, such stents act like scaffolding, propping open the blood vessels to allow adequate flow. Image © Richard Lee   2003 K-gold launched in China The World Gold Council creates an entirely new market segment with the launch of K-gold, the first 18k jewellery in China. The jewellery, in predominantly white and yellow gold, takes its inspiration from Italian design.   2004 Launch of SPDR® Gold Shares The market is transformed by an innovative, secure and easy way to access the gold market. Six years later SPDR® exceeds $55bn in assets under management.   2009 Central banks return to buying In the second quarter of the year, central banks collectively become net purchasers of gold for the first time in two decades. This reflects a combination of slowing sales from European banks and growing purchases by emerging market countries. Image © National Geographic   2010 Gold price sustains record highs Fiat currencies are undermined by inflation fears and successive financial crises. The London pm fix achieves 35 separate successive highs in the year to date.   2011 Gold in catalytic converters Gold used in catalytic convertors by a leading European diesel car manufacturer. The first use of gold in automotive emissions control.   2012 Olympic Gold The custom of awarding gold, silver, and bronze in sequence for the first three places dates back to the 1904 Summer Olympics in St. Louis, Missouri in the United States. At the 2012 games, the International Olympic Committee stipulates that each gold medal must have a minimum of at least six grams of gold. The London 2012 gold medals are the biggest and heaviest summer Olympic medals ever made.   Gold's contribution Gold powers the internet. It underpins our economy. It is the bedrock of a portfolio. It is the catalyst for future revolutions in science. It expresses love in many languages. And it carries memories across generations and cultures. Gold already underpins the world's major currency systems; today the G20 nations are debating an even greater role for gold in a new world financial architecture. Learn more about the proposed role for gold in the international currency basket. Gold has provided an important store of wealth to diverse investors, from individuals to institutions, for centuries. Gold is the metal of love. It owns the moment when "I will" becomes "I do". In jewellery form, it can quicken the heart-rate and grow in significance to become the most precious possession a woman will ever own. From space exploration, to nanoparticle technology, to the bonding wire at the heart of an iPhone, gold's extraordinary physical properties make it essential to a wide range of scientific applications. From local training and employment opportunities to the creation of infrastructure, from the generation of governmental revenues to the development of whole communities, gold mining makes a tangible and transformational contribution to entire countries around the world. Gold does much more than glitter.

On Dalio's Wisdom and the "China Study"!

Hi!,

 

Ray Dalio, who runs Bridgewater Associates (the world's largest -$130 billion -and one of the most successful hedge funds with a 37 year track-record), recently gave a fascinating and broad ranging talk  (link below) on the  current global financial and economic landscape, the deleveraging  process and its implications and what is the key risk factor for the global economy going forward. Dalio provides a unique and insightful perspective on the workings of the financial and economic system which clarifies some of the prevalent misconceptions on important topics such as austerity, fiscal and monetary policies and debt deleveraging. To summarise the key points:

 

-Financial crises repeat  themselves regularly, in a familiar pattern, over history and are a surprise to most people as they view them from a frame of reference which only extends only to their life-time experience rather than a serious study of history.

 

-The economic  machine, at its essence, comprises of transactions involving the purchase of goods, services and financial assets with money or credit. Demand should be measured in terms of money or credit used rather than good and services as economic theory suggests.

 

-Credit is created out of thin air, and credit cycles are key in understanding booms and busts and they tend to repeat themselves every 10 years or so.

 

-Borrowing is key to growth as goods purchased with credit creates income and leads to a positive cycle of increasing debt and economic activity.

 

-Lowering interest rates has a positive impact on the economy as it lowers the cost of servicing the debt, makes it less costly to purchase goods and services and boosts asset prices due to a positive present value impact. The increase in asset prices leads to increased wealth and therefore more borrowing and increased economic activity.

 

-However, eventually (and inevitably) debt begins to grow faster than income (i.e. increasing debt/income ratios) , making it difficult to service the debt with income which then forces debt growth to slow down leading to decreased economic activity and a negative cycle. This is a period of debt deleveraging.

 

-This can result in a depression which involves a combination of austerity, debt restructuring (i.e. debt write-down) and eventually the printing of money to  counter the negative wealth impact of the former activities. 

 

-The printing of money is key to dealing with a depression type scenario as it makes up for the shortfall in money created by the negative wealth impact of austerity and debt restructuring.

 

-During a period of deleveraging, balance between austerity, debt restructuring (which are both deflationary) and money printing (which is inflationary) is critical to avoid a depression.

 

-Debt to income ratios will gradually decline as long as nominal GDP is growing faster than the interest cost of servicing the debt. This has been borne out repeatedly over history – for example, UK after World War 11.

 

-The mistake of government policy is to target growth and inflation only – it should also target debt/income  growth as bubbles are more pernicious than inflation and much harder to correct – i.e. US in 1929, Japan in 1989.

 

-The 2008 financial crisis arose because investors and banks played the carry game (invest in high-yield assets and borrow at low interest cost)  with a backdrop of low volatility in markets. With mark-to-market accounting it was easy to see the impact of leverage in the financial markets, but regulators lacked awareness as their frame of reference was  only recent financial history.

 

-Europe has a Euro 2 trillion "hole" in terms of the amount of debt which needs to be written down (with bank assets of Euro 31 trillion and sovereign debt of Euro 3.5 trillion).  

 

-This can only be resolved by massive fiscal transfer from the north to the south  which is unlikely, leaving the alternative of austerity and debt restructuring leading to a depression and a "lost decade" with alternating bull and bear markets.

 

-The printing of money is the only way to make this process less painful – for example, the breaking of the dollar link to gold (i.e. printing of money) in March 1933 marked the bottom of the Great Depression in the US.

 

-With the ECB being subject  to a voting system, the southern countries effectively  influence  the decision on printing money – which they have recently exercised.

 

-The US and Japan  cannot support the amount of total debt in the system – but since they have the ability to print money they can keep interest rates very low and therefore keep the system going for a long time.

 

-The  debt issue will need to dealt with  when the buyers of government debt in the two countries choose to invest in inflation assets. This is unlikely to happen for  a while (about 5 years) as we are in a global deflationary environment with the US, Europe and Japan  deleveraging and China dealing with the aftermath of its real estate bubble.

 

-Money printing  almost always works – the two major surprises of his career were 1) the breaking of the dollar link with gold in August 1971  which lead to a 4% overnight jump in the stock market and an ensuing bull market, 2) the Latam debt crisis with overexposed US banks, culminating in the Mexican default in 1982, which lead to the printing of money and the bottom for the stock market (Dow at 777).

 

-Money printing does not necessarily give rise to inflation as the investors selling their treasury bonds to the Fed go out and buy other similar assets (i.e. agency bonds and high grade credit)  - it is  inflationary only when they buy goods and services. This is in contrast to fiscal policy where the government actually buys goods and services.

 

-The US has so far been able to achieve the right balance between austerity, debt restructuring and monetary and fiscal policy (a "beautiful deleveraging")  - but with growth likely to persist at 1.5-2% for a while it is vulnerable to hitting an "air-pocket" as the room for expansive fiscal and monetary policies is more limited making the balancing act difficult.

 

-China is likely to experience more normal business cycles as they deal with lower domestic demand, slowdown in exports and inefficient use of capital – however, downturns are likely to be temporary as they have the ability to act decisively on the fiscal and monetary front and are a surplus nation.

 

-Emerging markets should outperform developed economies as they are largely surplus producing economies and therefore are net creditors.

 

-There are four basic economic environments which govern the prices of all assets – lower inflation than expected (good for bonds) , higher inflation than expected (bad for bonds) , lower growth  than expected (bad for stocks) and higher growth than expected (good for stocks).

 

--Individual investors should  construct a well diversified asset portfolio  assuming they do not know what scenario is unlikely to unfold-i.e. include four pieces  which  perform well under all the above scenarios  - i.e. cash, stocks, long duration bonds and gold. The weighting of portfolio should be based on the risk of the assets rather than a simple dollar weighting.

 

-Stocks are likely to outperform bonds going forward, but the  age of high returns is over as the declining interest rate cycle (which led to higher stock and bond prices) has run its course with short-term rates at zero.

http://www.economist.com/blogs/freeexchange/2012/09/learn-macroeconomics-hour?fsrc=gn_ep

http://www.foreignaffairs.com/discussions/audio-video/foreign-affairs-focus-the-global-economy-with-ray-dalio#

 

Fascinating stuff – providing a simple yet powerful framework to analyse the critical issues the global economy and financial markets face today – deleveraging, austerity, money printing and fiscal policy. As I have noted before, there tends to be a lot of views being expressed in the media on these topics, based on ideological and personal preferences rather than an in-depth analysis of the issues involved. So the key variables to observe going forward is the ability of governments across the globe to maintain a judicious  mix of austerity, debt restructuring, money printing and fiscal expansion.  Countries which are unable to maintain this   balance are likely to underperform, while countries which are able to act decisively on this front are likely to outperform. Europe has crossed the inflection point with the ECB being able to print money  - while they still face "a lost decade" going forward, the tail risk event has been decisively taken out.  The US faces its biggest challenge in terms of the fiscal cliff and its political impasse vis-a-vis the  austerity versus spending debate.  

 

The China stock market offers a buying opportunity of the decade, being the worst performing major stock market this year  (-9%, Spain was at -8.7%!), historically low valuations (p/e dipping well below the previous historical  low of 15, government yields equalling stock dividend yields), extreme investor pessimism (new brokerage accounts falling below 100,000), global media bearishness ( books and articles titled "The End of the Chinese Dream" , "The Falling  Star"), and  perhaps most importantly –  decisive action on the fiscal policy front after the regime handover in October.

 

The key here is to construct a well diversified "all weather" portfolio which has something for the four scenarios described above – as noted previously on numerous occasions – EM equities, high quality multinationals, natural resource stocks, EM credit and high quality government bonds, US  high yield credit and private mortgages, cash and gold.

Foreign Direct Investment (FDI)

Foreign Direct Investment, or FDI, is a type of investment that involves the injection of foreign funds into an enterprise that operates in a different country of origin from the investor.

Investors are granted management and voting rights if the level of ownership is greater than or equal to 10% of ordinary shares. Shares ownership amounting to less that the stated amount is termed portfolio investment and is not categorized as FDI.

This does not include foreign investments in stock markets. Instead, FDI refers more specifically to the investment of foreign assets into domestic goods and services. FDIs are generally favored over equity investments which tend to flow out of an economy at the first sign of trouble which leaves countries more susceptible to shocks in their money markets. 

Classifications of Foreign Direct Investment

Inward FDI and Outward FDI, depending on the direction of flow of money.

Inward FDI occurs when foreign capital is invested in local resources. The factors propelling the growth of inward FDI include tax breaks, low interest rates and grants. Outward FDI, also referred to as "direct investment abroad", is backed by the government against all associated risk.

Determinants of Foreign Direct Investment

One of the most important determinants of foreign direct investment is the size as well as the growth prospects of the economy of the country where the foreign direct investment is being made. It is normally assumed that if the country has a big market, it can grow quickly from an economic point of view and it is concluded that the investors would be able to make the most of their investments in that country.

In case of foreign direct investments that are based on export, the dimensions of the host country are important as there are opportunities for bigger economies of scale, as well as spill-over effects.
The population of a country plays an important role in attracting foreign direct investors to a country. In such cases the investors are lured by the prospects of a huge customer base. Now if the country has a high per capita income or if the citizens have reasonably good spending capabilities then it would offer the foreign direct investors with the scope of excellent performances. 

The status of the human resources in a country is also instrumental in attracting direct investment from overseas. 

There are certain countries like China that have taken an active interest in increasing the quality of their workers. They have made it compulsory for every Chinese citizen to receive at least nine years of education. This has helped in enhancing the standards of the laborers in China.

If a particular country has plenty of natural resources it always finds investors willing to put their money in them. A good example would be Saudi Arabia and other oil rich countries that have had overseas companies investing in them in order to tap the unlimited oil resources at their disposal.

Inexpensive labor force is also an important determinant of attracting foreign direct investment. The BPO revolution, as well as the boom of the Information Technology companies in countries like India has been a proof of the fact that inexpensive labor force has played an important part in attracting overseas direct investment.

Infrastructural factors like the status of telecommunications and railways play an important part in having the foreign direct investors come into a particular country.

It has been observed that if the infrastructural facilities are properly in place in a country then that country receives a substantial amount of foreign direct investment. If a country has extended its arms to overseas investors and is also able to get access to the international markets then it stands a better chance of getting higher amounts of foreign direct investment.

It has been observed in the recent years that a couple of countries have altered their stance vis-a-vis overseas investment. They have reset their economic policies in order to suit the interests of the overseas investors. These companies have increased the transparency of the legal frameworks in place. This has been done so that the overseas companies can understand the implications of their investment in a particular country and take the appropriate decisions.

Chasing Warren Buffett’s Alpha

November 1976 to the end of 2011, Warren Buffett delivered an average annual return of 19% in excess of the Treasury bill rate, as measured by shares of his publicly traded conglomerate, Berkshire Hathaway (BRK.A, BRK.B), versus a 6.1% average excess return for the stock market. In addition, Berkshire's Sharpe ratio — a measure of return per unit of risk — is higher than all U.S. stocks that have been traded for more than 30 years from 1926 to 2011, as well as all U.S. mutual funds in existence for more than three decades.

So how does he do it?

If a newly published paper is any guide, the answer is pretty straightforward. According to "Buffett's Alpha," authored by AQR Capital Management's Andrea Frazzini, David Kabiller, CFA, and Lasse Pedersen, who also teaches finance at the NYU Stern School of Business, Buffett buys low-risk, cheap, and high-quality stocks; he employs modest leverage to magnify returns; and he sticks to his investment discipline even during rough periods in the markets that would force investors with less conviction or capital "into a fire sale or a career shift," as the authors put it.

Previous researchers analyzing Buffett's returns using conventional size, value, and momentum factors haven't been able to adequately explain his outperformance, the authors say, leaving admirers to conclude that Buffett's magic is pure alpha. So they extend the analysis by testing Buffett's impressive returns — as measured by Berkshire's stock — against two factors that better reflect his folksy investing wisdom: One called "Betting Against Beta," which represents safe, low-beta stocks, and another called "Quality Minus Junk," which represents the stocks of high-quality companies that are profitable, growing, and paying dividends.

The results? "Controlling for these factors," the authors write, "drives the alpha of Berkshire's public stock portfolio down to a statistically insignificant annualized 0.1%, meaning that these factors almost completely explain the performance of Buffett's public portfolio." The factors also explain "a large part" of Berkshire's overall stock return, the authors add, as well as Berkshire's private portfolio, insofar as their alphas also become statistically insignificant.

As one commentator put it, "It's some evidence that Buffett is doing what he says he's doing." But the takeaway is more nuanced. Buffett is in fact best known as a value investor par excellence, yet the authors' findings suggest that his focus on safe, quality stocks "may in fact be at least as important" as his value bent in accounting for his consistent outperformance.

One of the most interesting aspects of the paper is its analysis of Buffett's use of leverage. The authors deconstruct Berkshire's balance sheet and find that on average the conglomerate is levered 1.6 to 1, which they describe as "non-trivial" and say at least partly explains why the volatility of its stock is high relative to the market — 24.9% versus 15.8% — despite investing in many relatively stable businesses. Still, they note that leverage alone does not account for Buffett's stellar returns: Applying the same 1.6-to-1 leverage to the market yields an average excess return that is still nine percentage points below Buffett's over the time span studied by the authors.

Of course, cheap financing doesn't hurt. The authors note that Buffett benefited from Berkshire's AAA rating from 1989 to 2009 and that he reaps the benefit of its cheap insurance float, which checks in at an estimated average annual cost of 2.2% — more than 3 percentage points below the average Treasury bill rate. The authors find that 36% of Berkshire's liabilities, on average, consist of insurance float.

The paper also tackles a provocative question: Can Warren Buffett be reverse engineered? The authors take a stab at it by constructing a hypothetical "Buffett-style strategy" that is similarly leveraged and tracks Buffett's market exposure and stock-selection themes — and find that it "performs comparably" to the real Berkshire Hathaway. (In fact, it outperforms, but the authors caution that the simulated strategy does not account for transaction and other costs, and also benefits from hindsight. The main takeaway, they assert, is the high covariation between the actual and simulated Buffett strategies.)

So why don't investors just mirror Buffett's trades? Blame hubris: As detailed in a separate academic paper published a few years ago, between 1980 and 2006 an investor could have achieved investment results similar to Buffett's simply by following his trades as disclosed in public filings — yet the market seemed to under react to such disclosures. The authors of the paper surmise that analysts and fund managers overestimate their own stock-picking skill or the "precision of their independent private information" and underweight the value of public disclosures, even Buffett's.

There is at least one more very practical reason why investing like Buffett is harder than it may seem: Thanks to current U.S. Securities & Exchange Commission disclosure rules, he doesn't always have to tell us what he owns.

Source: http://blogs.cfainstitute.org/

CAPM

The Capital Asset Pricing Model (CAPM) was introduced by Jack Treynor (1961,1962), William Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics. The model is based on the portfolio theory developed by Harry Markowitz. The model emphasises the risk factor in portfolio theory is a combination of two risk, systematic risk and unsystematic risk. The model suggest that a security's return is directly related to its systematic risk, which cannot be neutralised through diversification. The combination of both types of risk is called as total risk. The total variance of return is equal to market related variance of plus company's specific variance. CAPM explains the behaviour of security prices and provides a mechanism whereby investors could assess the impact of a proposed security in such a way that the risk premium or excess returns are proportional to systematic risk, which is indicated by the beta coefficient. The model is used for analysing the risk-return implications of holding securities. 
CAPM refers to the manner in which securities are valued in line with their anticipated risks and returns. A risk-averse investor prefers to invest in risk-free securities. For a small investor having few securities in his portfolio, the risk is greater. To reduce the unsystematic risk, he must build up well-diversified securities in his portfolio. 

Assumptions of CAPM
1. All assets in the world are traded.
2. All assets are infinitely divisible. 
3. There are only two periods of time in our world.
4. Security distributions are normal, or at least well described by two parameters. 
5. Preferences are well described by simple utility functions.
6. Everyone agrees on the inputs to the Mean-STD picture. 
7. All investors in the world collectively hold all assets. 
8. For every borrower, there is a lender. 
9. There is riskless security in the world.
10. All investors borrow and lend at the riskless rate. 

CAPM Graph, formula and calculations:-

Example:- Suppose an investment is twice as risky as investing in the stock market. The beta is 2, in this example. Suppose the stock market has yielded 11% return in the last fifty years, so the market rate of return is 11%. Suppose the Treasury note which matures in 10 years currently yields 6%, so the risk-free rate of return is 6%. 

Using CAPM, the discount rate r is calculated as follows:

r = 6% + 2 (11% - 6%) = 6% + 10% = 16%

So, 16% should be used as r in the NPV (net present value) calculations. 

Security market line

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML.

The relationship between β and required return is plotted on the securities market line (SML), which shows expected return as a function of β. The intercept is the nominal risk-free rate available for the market, while the slope is the market premium, E(Rm)− Rf. The securities market line can be regarded as representing a single-factor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's expected return versus risk is plotted above the SML, it is undervalued since the investor can expect a greater return for the inherent risk. And a security plotted below the SML is overvalued since the investor would be accepting less return for the amount of risk assumed.

Difference Between CML and SML

CML stands for Capital Market Line, and SML stands for Security Market Line.

The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time.
One of the differences between CML and SML, is how the risk factors are measured. While standard deviation is the measure of risk for CML, Beta coefficient determines the risk factors of the SML.
The CML measures the risk through standard deviation, or through a total risk factor. On the other hand, the SML measures the risk through beta, which helps to find the security’s risk contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios.

While calculating the returns, the expected return of the portfolio for CML is shown along the Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis. The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta of security is shown along the X-axis for SML.

Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected returns of individual assets. The CML determines the risk or return for efficient portfolios, and the SML demonstrates the risk or return for individual stocks.

Well, the Capital Market Line is considered to be superior when measuring the risk factors.

Summary:

1. The CML is a line that is used to show the rates of return, which depends on risk-free rates of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic Line, is a graphical representation of the market’s risk and return at a given time.

2. While standard deviation is the measure of risk in CML, Beta coefficient determines the risk factors of the SML.

3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line graphs define both efficient and non-efficient portfolios.

4. The Capital Market Line is considered to be superior when measuring the risk factors.

5. Where the market portfolio and risk free assets are determined by the CML, all security factors are determined by the SML.

Empirical tests show market anomalies like the size and value effect that cannot be explained by the CAPM and is explained by Fama–French three-factor model

In asset pricing and portfolio management the Fama-French three factor model is a model designed by Eugene Fama and Kenneth French to describe stock returns. Fama and French were professors at the University of Chicago Booth School of Business.

The traditional asset pricing model, known formally as the Capital Asset Pricing Model, CAPM, uses only one variable, beta, to describe the returns of a portfolio or stock with the returns of the market as a whole. In contrast, the Fama–French model uses three variables. Fama and French started with the observation that two classes of stocks have tended to do better than the market as a whole: (i) small caps and (ii) stocks with a high book-to-market ratio (BtM, customarily called value stocks, contrasted with growth stocks). They then added two factors to CAPM to reflect a portfolio's exposure to these two classes:

Here r is the portfolio's expected rate of return,  is the risk-free return rate, and  is the return of the whole stock market. The "three factor"  is analogous to the classical  but not equal to it, since there are now two additional factors to do some of the work.  stands for "small (market capitalization) minus big" and  for "high (book-to-market ratio) minus low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks. These factors are calculated with combinations of portfolios composed by ranked stocks (BtM ranking, Cap ranking) and available historical market data. 

Moreover, once SMB and HML are defined, the corresponding coefficients  and  are determined by linear regressions and can take negative values as well as positive values. The Fama-French three factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM. The signs of the coefficients suggested that small cap and value portfolios have higher expected returns—and arguably higher expected risk—than those of large cap and growth portfolios.