petec

Great post TCC and this bit in particular. I do think people forget Fairfax isn't an asset manager, they're an insurance company, and protecting downside is paramount for them. They got the timing wrong, absolutely. But they locked in their BV, and that's what they were trying to do. Fine by me. Also, ref your point about frequent big market falls: it's not just about how likely they are, but how catastrophic they will be. Fairfax identified (correctly in my view) that if the market did collapse, with the world at this level of leverage, things could get very serious. And, being a levered business with regulators and customers who care about whether they can pay, they decided to make sure they were bulletproof. The cost of this was that they would give up some upside. I love that they run their *insurance* company this way. I also think it is fascinating that people (not necessarily rb!) are declaring victory for monetarist intervention when we are only halfway through. If gdp accelerates to grow faster than loans; and if that state of affairs can survive rising interest rates (which incidentally will cause asset markets to fall, throwing the wealth effect into reverse) - then I will declare victory for monetarism. As it stands what I see is a world which, under enormous stimulus, is growing loans much faster than GDP, which stubbornly will not accelerate. We simply do not yet know whether this easy money experiment has worked and if it does not, we will spend our time debating whether Fairfax were just lucky or were, in fact, well within their circle of competence.

I'm the other way on. The deflation bet is a cheap bit of insurance against an unlikely event that has disastrous consequences. The equity hedge was an expensive bet against an unlikely event (markets were still cheap in 2010) that would have had disastrous consequences (for a levered insureco). That said, I'm not in the camp that criticises them for the equity hedges. Whether or not a nuclear winter is coming, they always had an offsetting long position so what they did was lock in alpha at a time when they were uncertain about the markets. They were wrong. But they run a highly levered company in a market where regulators and clients scrutinise capital levels carefully, and in which equity investing is not the prime value creator. They wanted to minimise their risk and they did. I don't fault them for that.

Count me as a deep sceptic. Jim Grant's book comparing the 1921 depression (government did not intervene, slump corrected itself in 18 months) to the 1929 depression (government intervened heavily, counter to popular wisdom, and it lasted a decade) is interesting. What developed through the late 1920s and out of the GD was the idea that every mild setback should be met with ever easier money. That has encouraged the accumulation of records amounts of debt. Some say that does not matter. Some say it does. My point is, we do not yet know whether what we learned from the 1930s was how to avoid a crisis, or simply how to create a different kind of crisis. I'm going to wait another 50 odd years before declaring victory for modern economics ;)

I've struggled with what kind of multiple to apply in the past, but this thought always crossed my mind. It doesn't make sense for me to discount their future earnings streams by some massive percentage unless if I think they'll be equity-hedged with bonds yields at 2% into perpetuity. I have no idea where bonds yields go, but I bet they're higher in 10 years. Also, Fairfax has a history of hedging and then removing the hedges so we cant expect them to hedge into perpetuity. So today they're worth x, but tomorrow they take equity hedges off and they're worth 1.3x because of the increase in earnings power? It'd be hard for me to get behind such a drastic change in valuation for something that is so easily changed and that they have a history of changing. I think it might be better to change your position sizing instead of multiple you buy at. Maybe instead of a 10% position if they were fully unhedged, you do a 3-5% position so the opportunity cost doesn't kill if you they're wrong. If they remove the hedges, or appear to be right, you can rebuild your stake. It seems like this would be an easier way of controlling for the uncertainty than trying to come up with a different multiple of book for every change in interest rates, deflation hedges, and %-equity hedged status. In theory I completely agree. My tweak would be that with these multiples and corporate margins, I actually don't see a lot of opportunity cost in a hedged portfolio. As a result I have a far higher allocation to FFH than I did in 2010, for example. What did excite me was the stock falling with the market recently.

Absolutely right and I wonder where it ends. *Overall* US debt:gdp is up significantly, although the rate is lower and the tenor longer because it is government not personal debt, but it ultimately still has to be serviced by the people. Two possibilities: 1. The people delever to the point where they can spend again and gdp grows and suddenly government debt:gdp doesn't look so bad (this happened after WW2); or 2. The people don't take up the demand slack, the government has to keep spending, the gdp doesn't grow very fast, and the debt:gdp rises inexorably. For the US I am squarely in camp 1, but I think Japan went to camp 2 and it's not impossible.

The referencing can go both ways: CPI is dramatically understating real inflation at the moment (partly because real rents are outstripping the imputed owner's rent nonsense) and I wonder if FFH have built this into their thesis. Understating CPI is part of the reason the Fed can get away with being so easy with money. I agree that the government is what's stopping deflation. For me the risks are: 1. What happens if they run out of tools? They've failed to get the fractional reserve banking system to create money, so they've had to do it themselves. The channels for that are: buy assets and stick them on the central bank balance sheet, putting cash into the hands of the seller; fund government spending with newly printed money; or throw the stuff out of helicopters. All three of these almost certainly have political limits. What happens if those limits are reached? 2. To keep inflating you need to keep adding debt. (Borrowing creates money; paying debt back destroys it. When there is more money, money is worth less; and when there is less, it is worth more.) But eventually people want to stop borrowing because their balance sheet looks too uncomfortable. So what happens when, on aggregate, the world reaches that point? Emerging markets went on a borrowing spree which stopped the world deflating from 2009-2014. Who is going to take up the baton and drive debt ever higher? Because if there isn't anyone, deflation is a serious possibility. I don't predict or expect deflation. But it's quite possible and I like having the insurance! That said, I am for the first time considering some sort of gold exposure to hedge the other way.

I should have been clearer - I give them credit for the unrealised gains that they report in their annuals. It's clouded now by the fact that they have sold some of these investments but 'my' BV is still a little above quarterly reported BV. I also tent to take the view that one should value it *without* taking a macro view. I know that's going to be very unpopular but the fact is that a) their equity hedges still allow them to profit from outperformance, b) the deflation hedges are a very valuable option currently on the books for virtually nothing, and c) they could re-orient their portfolio very quickly if needed. I'd pay >1x bv for a) good underwriting, b) good investing over my multi-decade intended holding period, and c) sleep-safe-at-night option value which is almost unique. But that's just me.

Amazing how quiet this section of the board goes when stocks are going up ;) Meanwhile FFH slips lower, much to my delight. I have it at about 1.1x book value now (not marked to market) and I have a question: does anyone think FFH should trade at or below 1x book value and if so why (e.g. maybe it should trade at 1x tangible book, etc.)? My view is that is should trade at 1x book value as a base: they have built a great franchise and their investment returns are superb over time. I'm happy to pay for the goodwill (largely capitalised on the acquisition of companies they knew well) and more. But I am genuinely interested to hear from people who don't think 1x book value is a good proxy floor for intrinsic value. Pete

WeiChiLoh I think you are thinking about it right and I would focus hard on how known the expenses are. If they are locked in then your reduced cash balance can be counted upon, but if they are liable to change (and the change can't be passed through to the customer somehow) then those changes will have a big impact on the value of the company.

Bizarre indeed. Just noticed Brent crude down 8%. :o

FFH. I liked it before and now it's getting more valuable every day and the price is falling. Heaven ;) I'm about 30% cash and 22% FFH (my biggest position by far). As for this all being reactionary BS...let's hope so. But with valuations high, monetary policy tapped out, huge global imbalances unwinding, and commodities/currencies collapsing along with global trade, maybe not. Commodity savings don't lead to 1-1 additional spending elsewhere because some of the saving is, well, saved. Which is deflationary, and that's dangerous in an epically indebted world. So while I'm in awe of those with the balls to invest in levered cyclicals after what might only be the beginnings of a downturn (economic, not market), I am not one of them!

Do we have any info on the size of current individual shorts as opposed to the Russell hedges? I assume they have not been heavily short individual commodity names or we would have seen the results already.

I agree. I think relatively few people understand (or maybe it is just that I have only recently started to understand!) how credit bubbles inflate and deflate. How during the leverage phase consumers and governments lever up to consume, creating demand so that producers lever up to build factories and produce more; but when consumers stop levering up more, the demand evaporates leaving lots of empty capacity. Prices fall as inputs (commodities) collapse and as producers compete for the demand that remains. It's fine if all the money saved on commodities gets spent on more things, but price elasticity doesn't work that way. I don't buy twice as many clothes because cotton got cheaper. I might go out for dinner more, but I'll also pay down some debt. Delevering takes everything down with it. There is a distinct possibility that the global economy is at that stage, and a distinct possibility that monetary policy isn't enough to offset it. And Fairfax can buy protection against this turn of events for virtually nothing. That's not a lottery ticket. And I don't know of any other equities that would benefit, so I don't think it gets too much attention! There's also scope for a vicious carry trade unwind: as the dollar rises, borrowing cheap dollars to fund investments (in anything) gets less attractive. Unwinding the trade pushes the dollar up further so it's circular. Look at currency and commodity volatility in the last year: something is happening. I read today that: -45% of world GDP is in commodity exporting countries. -World exports have recently started shrinking; this usually only happens in recessions. - $10tn of annual revenues have been lost throughout the commodity value chain. Yes, some of that becomes demand elsewhere. Some doesn't, it gets saved or just vanishes as debts go bad. That's deflationary. - EDIT: despite incredible monetary stimulation (ZIRP everywhere significant, QE in Europe and Japan, 48 Central Bank easings ytd) nominal global gdp is growing at rates normally only seen in the depths of recessions. That thought startled me. It's quite possible we muddle through. It's more than usually likely that we don't. These swaps offer protection against that. I bought more FFH today.

Agreed. Thanks for taking the time though - has helped me clarify my thoughts a lot.

Completely different discussion but isn't it one or the other? I mean, you can liquidate it *or* you can have the earnings stream. I agree - unless you take the Buffett view that the business exists in perpetuity, in which case I can see why he argues that float is an interest-free permanent loan, worth its face value. If you place a big weight on the possibility that Berkshire might see such big underwriting losses that its ability to earn what it currently earns on float is permanently impaired then the Buffett method is wrong. Anyway... ;)

I think this is also a perfectly fair way of looking at it to be honest (i.e. lumping the two earnings streams together and viewing it as one spread. I'd personally argue that this is an example of the market being bad at *very* long run valuations. Buffett's two-column approach rests entirely on his argument that Berkshire's insurance businesses will exist virtually forever. If you are prepared to assume that then I think his method is right for the reasons I have given, but the market just doesn't do that. With Berkshire, I probably sit somewhere between the two approaches. EDIT: putting it another way, if you assume the spread between underwriting profit/loss and investment returns is fixed over time, and that the operation has the inflation linked/in perpetuity characteristics I describe above, then I think it is worth a high multiple of total earnings if you assume that no underwriting loss will permanently impair the business, which I think is fair here.

Put it this way. Say you have $100 in the bank. You promise to raise the principal in line with inflation, and you pay me the interest. In return, I perform a service for you, and you also pay me slightly more than my average costs to perform that service. We agree to have this relationship in perpetuity, so long as I provide a good service. I would value that as: 1. equity multiple on the profits from performing the service, because I take risks. 2. a very high multiple on the interest payments, which are almost risk free to me. Why might I not apply the going discount rate for risk-free, inflation-linked investments to #2? a. because I can't go out and spend the principal - which is not a major issue because I don't need to, but one day I might. b. because there is a slight risk that I fail to provide a good service and you end the agreement - but I back myself that this will not happen. But you can offset that a bit with: c. the fact this is about the only investment I can think that is inflation linked and gives optionality to rising rates but doesn't risk a rising discount rate. That's extraordinary. The current rate on a 10y US government inflation-protected bond is 0.6%, implying a multiple of 167! Knock a bit off for risks a and b and let's call it 100. Now, I'm not actually arguing that 100x is the right multiple. My point is simply that a well-above-equity multiple is justified for this particular stream of earnings. How high is up to you and is entirely up to how you want to weight risks a, b, and c. EDIT: the more I think about it, the inflation-hedged nature of the float and the perpetual nature of it are very important and justify a high multiple. Both are predicated on the following: d. insurance will always be needed (not something you can say for many businesses) e. insurance premiums will move with inflation over time (in fact I'd argue they'll grow with nominal gdp which is even better) f. Berkshire will maintain its share of the insurance market (which is also probably fair given the fortress nature of its balance sheet and its reputation). If you're not happy with these assumptions you should opt for a low multiple.

No I'm not. I bear equity risk on the equity portion of Berkshire and cash risk on the cash portion. The cash portion can't impair my equity, so that's fair. That's not entirely stupid when a) there is zero risk (on the cash holdings), b) inflation is at 0.2%, and c) most other investments are priced to give a similarly poor risk-adjusted return. Why not? Someone pays me money to lend me money (underwriting profit) and I get to keep the interest when I invest at zero risk...in perpetuity. Sounds like a good business to me. Would it be worth more if I could invest all the float in equities? Not necessarily: I'd get higher returns, but I'd take a massive levered risk with my own equity. That's because you're putting an equity multiple on earnings from cash. I'm not sure that's the right thing to do. When I value Microsoft, for example, I put an equity multiple on the earnings from the business and then add the net cash. It's obviously different because they own the cash (Berkshire doesn't); but I don't value it by putting an equity multiple on the interest. Bottom line here is that I agree that the float should not be valued at 100% of face value because I can't go and spend it as I could if it were my cash; but I do think that a very low risk stream of earnings should get a higher multiple than a high risk one, and I regard the interest on Berkshire's permanent float invested at zero risk as being a low risk stream of earnings. Plus, there's optionality on rising rates (there's also a risk that inflation erodes the value of the cash, which we haven't considered, although presuming inflation gets reflected in rising premiums it ought to raise the nominal value of the float, so we ought to be inflation-hedged). BTW I wasn't assuming underwriting profits would happen year in, year out. What I'm assuming is that an operation as disciplined as Berkshire's will earn and underwriting profit on average over time and I'm happy to put a multiple on that.

I do get what you're saying and you don't suck at explaining it - but I only half agree. My thoughts: 1. The *cash* belongs to the policy holder but the *cash flows* from investing the cash belong to Berkshire. Since the float is likely to be permanent, and since the value of something is the sum of discounted cash flows, we can say we have an asset (the future cash flows) that is worth what the cash is worth. It's a bit like owning shares of Coke that you will never be allowed to sell: I'd value that at market on my personal balance sheet (although I wouldn't argue with someone who applied a discount on the basis that they could not sell the shares in an emergency). The problem that cash today doesn't earn anything (this is what I meant by bonds being overvalued - I should have included cash in that comment). That means our asset (as opposed to the cash owned by the policy holder) is worth nothing unless rates rise...and we could spend days arguing about how to value that option! 2. Then you get the underwriting profits. Here I do disagree. I would actually give this a decent multiple, because the long term record is outstanding. I don't depress the multiple for volatility. I'd make an estimate of say 10y average annual underwriting profits after subtracting CAT losses and give that a market multiple, because I think that earnings stream is at least as sustainable as the average company and should grow with nominal GDP. Useful discussion - I hadn't thought (1) through until I read your post.

http://brooklyninvestor.blogspot.com/2013/03/value-of-investments-per-share.html http://brooklyninvestor.blogspot.com/2011/12/so-what-is-berkshire-hathaway-really.html If I have understood you right, what you are saying is 1) you would place a low P/E on underwriting profits and 2) bonds are overvalued. Is that the gist of it?

Just noticed Japanese PPI went -ve in about April, most recent reading -3%.

I think it's more complex than this, at least in the long term. I certainly look at debt vs. assets as well. So, for example, if my house value fell below my mortgage I'd be worried, regardless of whether I had cash left after the monthly service payment. That's where I find rising rates worrying. If I put down 20% on a house and max out on an interest-only mortgage for the rest, then a doubling of rates would reduce what I can afford to pay for the house by 40%. The impact is smaller for an amortising mortgage but it's still significant. Since house prices are set by what current buyers can afford to pay, they are influenced by current interest rates. So as rates rise, the debt:equity ratio can change for homeowners regardless of whether their debt is fixed or floating, and I think that impacts on the willingness to spend vs. pay down debt. (The same argument could be made for holders of stocks, bonds, etc.) Now, I don't know the US housing market enough to know whether this is a risk - you could argue that the above maths only applies if everyone is stretching to buy their houses. Maybe most people are currently putting 40% down, or maybe they are not maxing out on their mortgage. If so, then they have scope to pay more for homes despite rising rates. But that is *not* the case where I live and it's not the case in several parts of the world. And if asset prices start to fall, or even look uncertain, as rates start to rise, then I think we go into a very uncertain world. So, while I fully agree with Ericopoly about the importance of debt service ratios when thinking about medium term consumer spending, I do think absolute debt levels play a part in economic decision-making over the longer term and I think they are a big determinant of the level of risk in the system. We call debt leverage for a reason: it magnifies the impact of changes. I think that's the danger of the world we live in. House price falls wouldn't impact confidence much if the other side of the balance sheet wasn't extended, but it is. EDIT: I realise Ericopoly's comment was specific to US consumers and again I'm not really disputing that. This is more about my model for thinking where the whole world economy is at the moment, and I want protection against a deflationary episode because of the way the world looks not because of the way the US looks.

Randomly listening to this and it is very relevant from 30 minutes in: https://www.youtube.com/watch?v=HZB5IWFK3XA (Russell Napier)

Actually, let's just go with a Munger quote: "This has basically never happened before in my whole life. I can't remember 1½ percent rates. It certainly surprised all the economists. It surprised the people who created the life insurance industry in Japan, who basically all went broke because they guaranteed to pay a 3% interest rate. I think everybody’s been surprised by it, including all the people who are in the economics profession who kind of pretend they knew it all along. But I think practically everybody was flabbergasted. I was flabbergasted when they went low; when they went negative in Europe – I’m really flabbergasted. How many in this room would have predicted negative interest rates in Europe? Raise your hands. [No hands go up]. That’s exactly the way I feel. How can I be an expert in something I never even thought about that seems so unlikely. It’s new territory…. I think something so strange and so important is likely to have consequences. I think it’s highly likely that the people who confidently think they know the consequences – none of whom predicted this – now they know what’s going to happen next? Again, the witch doctors. You ask me what’s going to happen? Hell, I don’t know what’s going to happen. I regard it all as very weird. If interest rates go to zero and all the governments in the world print money like crazy and prices go down – of course I’m confused. Anybody who is intelligent who is not confused doesn’t understand the situation very well. If you find it puzzling, your brain is working correctly."

You'll notice that the numbers I reported were only for every 6 months. There were definitely period of time where it traded at 20x, or lower, in this period that aren't captured by the individual points. The low point in Nov of 2008 was right around 15x trailing 12 month earnings. I was merely illustrating the range of multiples that it traded in and not trying to capture the absolute highs and lows of the range. Two, it's not cherry picking an example. It's pretty much exactly what I did. I purchased a massive position in January of 2009 @ $308. I would have bought more, but I was buying BofA between $2.50 and $4.00 at the same time. I purchased more through 2010 and considered adding in 2011 but already had a very large position relative to my portfolio. From that point, I simply waited. The stock price was basically range-bound for 2010 through 2013 until it exploded at the end of the year. I started trimming at $900 (around 26x earnings at the time) and had sold the last of the shares when it hit $1200 (around 30x earnings at the time). Then I watched the shares do absolutely nothing from 2013 until the last 3 weeks. Not cherry picking. My experience. Maybe it was just luck - maybe Goog will never trade at a 20x multiple again. I will simply say if that is the case, than it's highly likely the returns you'd get elsewhere are more attractive than what you'll likely get out of Google. Google is only worth owning if you can get it at a signficantly lower multiple. People who did this significantly outperformed the buy/hold mantra over the same period of time (not that buying and holding didn't provide satisfactory results) Great discussion guys. But with respect to TCC, you *are* cherry picking an example because you're cherry picking one that worked. I don't think anyone here would dispute that prices fluctuate around IV and that buying below IV and selling above generates probably the best compound return. The problem comes in: 1) Calculating IV. I can think of plenty of examples where I've tried and failed to do what you did, because I got the IV wrong. Things can just change fast. 2) Getting a return (or having the discipline to not need one) when you're not invested in the stock you're trading in and out of. I am *not* arguing that one should hold at any price - I definitely aim to sell when things are glaringly overvalued. But I'd never have had the confidence that 30x was glaringly overvalued for Google because of what revenue accelerations with extraordinarily high incremental earnings can do to profits. So I think that, most of the time, your experience is tough to repeat (for me at least).