Research Note: The Superior Economics of Fractional Ownership Through Stock Markets
An Analysis Based on Warren Buffett's 1978 Shareholder Letter
Executive Summary
A significant valuation disconnect exists between public stock markets and private negotiated transactions, creating opportunities for investors to acquire fractional ownership in exceptional businesses at prices substantially below what mediocre companies command in corporate deals. This research note examines why this arbitrage opportunity persists and how investors can exploit it for superior long-term returns.
The Valuation Disconnect
The stock market's auction pricing mechanism frequently values outstanding businesses at substantial discounts to their intrinsic worth, while the negotiated acquisition market simultaneously prices mediocre companies at significant premiums to book value. This paradox stems from different buyer motivations: stock market participants often focus on short-term price movements and market sentiment, leading to periodic pessimism that depresses valuations regardless of business quality. Corporate acquirers, conversely, pay premiums for control, synergies, and empire-building, often justifying prices well above 100 cents on the dollar for average businesses. The institutional imperative to "do deals" and deploy capital drives investment bankers and corporate development teams to complete transactions even at inflated prices. This structural difference creates a persistent arbitrage opportunity where patient investors can acquire fractional interests in superior businesses through the stock market at prices that would be impossible in negotiated transactions.
Evidence from Berkshire's Portfolio
Berkshire's experience from 1975-1978 dramatically illustrates this value gap, with their insurance equity portfolio growing from $39.3 million to $129.1 million in cost while reaching $216.5 million in market value, generating $112 million in gains during a period when the Dow Jones declined from 852 to 805. Their crown jewel example was SAFECO Corporation, which Buffett identified as "probably the best run large property and casualty insurance company in the United States" with superb underwriting, conservative reserving, and sensible investment policies. Despite SAFECO's clear superiority to Berkshire's own insurance operations and to any insurance company available for acquisition, Berkshire could purchase shares at substantially below book value through the stock market. The $6.1 million in look-through earnings attributable to Berkshire's SAFECO stake represented real economic value, even though only the dividends (18% of earnings) appeared in reported results. This same pattern repeated across their portfolio: Washington Post ($43.4 million market value), GEICO ($47.4 million), and Interpublic ($19 million) all represented fractional ownership in exceptional businesses acquired at bargain prices impossible to achieve in negotiated deals.
The Control Premium Fallacy
The traditional corporate preference for control acquisitions often destroys rather than creates value, as buyers pay excessive premiums for the ability to direct operations that may already be optimally managed. Buffett's insight that "if one controlled a company run as well as SAFECO, the proper policy also would be to sit back and let management do its job" exposes the fallacy of paying extra for control over excellent businesses. The record shows that SAFECO's existing management produced better results than Berkshire could have achieved directly, making the lack of control irrelevant or even beneficial by preventing harmful interference. Furthermore, the costs of full acquisition extend beyond the premium paid: integration expenses, management distraction, cultural disruption, and the impossibility of starting new operations at less than 100 cents on the dollar all reduce returns. The stock market's fractional ownership approach eliminates these frictions while providing liquidity, diversification options, and the ability to gradually build positions during periods of pessimism.
Market Psychology and Timing Advantages
The persistence of this valuation gap reflects predictable patterns in institutional investor behavior, as evidenced by pension fund managers investing a record 122% of net funds in equities at full prices in 1971, then only 21% at the 1974 bottom, and a new record low of 9% in 1978. This procyclical behavior by supposedly sophisticated investors creates recurring opportunities for contrarian buyers to acquire exceptional businesses during periods of widespread pessimism. Berkshire's preference for markets that "revalue slowly or not at all" demonstrates another advantage of fractional ownership: the ability to accumulate larger positions over time at attractive prices. Unlike corporate acquisitions that require immediate full payment at negotiated premiums, stock market investors can methodically build stakes during extended periods of market neglect. The concentration of holdings in a small number of exceptional businesses (eight positions representing 74% of Berkshire's $220.9 million equity portfolio) shows how this patient accumulation strategy can create a portfolio of trophy assets that would be impossible to assemble through corporate acquisitions.
Key Metrics from Berkshire's Implementation
Portfolio Performance: $112 million gains (1975-1978) while Dow declined 5%
Valuation Arbitrage: SAFECO purchased below book value vs. corporate deals at "far more than 100 cents on the dollar"
Portfolio Growth: From $39.3 million to $216.5 million market value in three years
Concentration: Top 8 positions = $163.9 million of $220.9 million total (74%)
Look-through Earnings: $6.1 million from SAFECO alone (vs. only $1.1 million in dividends received)
Bottom Line
Investors seeking superior long-term returns should prioritize fractional ownership of exceptional businesses through stock markets over corporate acquisitions or private equity investments, particularly institutional investors with patient capital (endowments, family offices, sovereign wealth funds) who can weather short-term volatility to capture long-term value discrepancies. Value-oriented fund managers with concentrated portfolio mandates and 3-5 year performance horizons should systematically exploit this arbitrage by acquiring stakes in demonstrably superior businesses during periods of market pessimism when institutional selling creates bargain prices. Individual investors with business analysis skills and emotional discipline represent ideal practitioners of this strategy, as they lack the institutional pressures that drive poor timing decisions and can hold positions indefinitely without career risk. Corporate executives contemplating acquisitions should instead consider redirecting capital to purchasing shares of superior competitors at discounts to book value, acknowledging that excellent management creates more value when left undisturbed than any control premium could justify. The only investors who should avoid this approach are those requiring immediate control for specific strategic reasons (vertical integration, patent access, distribution channels) or those with time horizons under two years who cannot wait for market revaluation of their holdings.