vinod1

Can you elaborate on why you think it "unfairly penalizes Fairfax"? You don't feel 15-20 years is multiple cycles? If they had not hedged and had done great for the past 5 years, I don't think people would say that right now is not representative, just like they weren't saying that after the CDS win, and just like nobody is saying that now is not a good time to evaluate the performance of BRK and MKL, whether we're at a top or not. Another question we could ask is how fast book value would have to grow over the next few years to bring up the average BV growth when you include the past 15 years. They say they're aiming for 15%, and I know they say results will be lumpy, but you'd need many years of 30% growth to compensate for those who bought 15 years ago.. By cycle I mean a complete bear and a complete bull market. So you can measure it from top of a bull market to the top of the next bull market or from bottom of one bear market to the bottom of another bear market. Due to the way people approach investments, some are more likely to outperform during the bear phase (most value investors including Prem), while some are more likely to do better over the bull phase (Bill Miller for example). So if you measure it only over 1.5 or 2.5 cycle, etc. you are not likely to capture their true performance. It is like taking a measure of who is ahead at the 40 meter, 60 meter and 80 meter line for a 100 M sprint. Possibly interesting but not likely to reflect true skill. So if you measure the performance at the top a bull market, value investors like Prem would not look good. If you measure them at the bottom of a bear market they would look much better than warranted. The only way to normalize this is to look at the complete cycle. Just remembered that Buffett has mentioned this in the AR: Charlie Munger, Berkshire’s vice chairman and my partner, and I believe both Berkshire’s book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%. Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again. Vinod

This is one point I disagree with in the article. We should always evaluate performance over a complete cycle, preferably over multiple cycles. We are arguably closer to top of bull market. So the performance even very long term ending at this point would unfairly penalize Fairfax. Vinod

Agreed. I bought them this morning. Vinod

Al, Which strike JPM LEAPS have you bought? Thanks Vinod

He is saying don't buy a full position to start since you will almost certainly have an opportunity to buy more if (when) the price falls. So scale into a full position. Likewise, on the way out start selling as something reaches fair value or close to it and leave some room (if warranted) for some additional upside and sell on a scale on the way out. Thanks Kraven.

Does any know what he means by "Buy on a scale and sell on a scale up"? I am assuming it means buy incrementally as price goes down and sell incrementally as price goes up. Thanks Vinod

I think TBV is a bit misleading in Citigroup's case as nearly 30% of TBV is made up of DTA's. The DTA's would be utilized over the next 10-20 years in Citigroup's case, since profits are generated in different jurisdictions compared to where DTA's are located. So if you take PV of these DTA's they should be 30 cents to the dollar. If you make this adjustment, it is trading at about TBV. Not saying Citigroup is not attractive, just that TBV would give you a misleading picture. Better I think to look at cash earnings. Vinod

My understanding is that banking is an exception. That is why you do not see Berkshire having any banking sub but having lots of insurance subs. AIG is another example, lots of insurance subs which are regulated individually but parent falls under Fed as they own a smallish bank. Vinod

Thank you! That provides a lot of additional color on the hedges. Very helpful. I am not entirely convinced of the rationale 1. I do not see a big issue with stocks being counted only as 50% for statutory reasons. It is not even close to being a binding constraint on Fairfax w.r.t. how much business they can underwrite. Per the AR. "On average we are writing at about 0.8 times net premiums written to surplus. In the hard markets of 2002 – 2005 we wrote, on average, at 1.5 times." So they can easily write twice as much if not more given their current levels. If stocks constitute 70% of statutory surplus, and it weighs only 35% they still would had a statutory level of about 65% of their current level. Down but not so much that it effects their business. Second, Fairfax really is making most of the money on investments rather than on underwriting. So why constrain yourself on your strength (investments) to make way for possible making a bit more money on the part which is not really your strength (underwriting)? 2. "It's a timing issue, they expect the market to fall before these investments are realized." Put simply it seems to be market timing. Vinod

Dont they need to short the bond market also to hedge this risk? Vinod

Thanks for the meeting notes. Common share holder equity is about $7 billion and Stock/Preferred stock investments are about $5 billion. So I cannot see how even a 50% loss on equity/preferred stock would wipe out Fairfax. It does not make sense to consider a loss of 25% on the entire investment portfolio consisting of stocks, bonds, cash. The hedges only protect the equity portion. Vinod

+1

Good article in WSJ Vinod High-Frequency Hyperbole Beware of critics who are 'talking their book' about trading that lowers costs. By Clifford S. Asness And Michael Mendelson A few nights ago, CBS's "60 Minutes" provided a forum for author Michael Lewis to announce that Wall Street is "rigged" and for the sponsors of a new trading venue called IEX to promise to unrig it. The focus of the TV segment was high-frequency trading, or HFT, an innovation now over 20 years old. The stock market isn't rigged and IEX hasn't yet generated a lot of interest. In our profession, what we saw on "60 Minutes" is called "talking your book"—in Mr. Lewis's case, literally. The onslaught against high-frequency trading seems to have started about five years ago when a blogger made a wildly exaggerated claim about one firm's HFT profits. Nowadays after any notable market event, and again last Sunday for no reason other than a book launch, the world gets bombarded with arcane details and hyperbolic assertions about HFT strategies. If you find the discussion overwhelming, we have some good news: The debate can be understood without knowing how equity orders are routed, matched or canceled. Few professionals completely understand the details of market microstructure. Rather, when someone has a strong opinion about the subject, it's likely to be what they want you to believe, not what they know. Our firm, AQR Capital Management, is an institutional investor, primarily managing long-term investment strategies. We do not engage in high-frequency trading strategies. Here is where our interest lies: What is good for us is lower trading costs because it translates into better investment performance and happier clients, which makes our business slightly more valuable. How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve. But we devote a lot of effort to understanding our trading costs, and our opinion, derived through quantitative and qualitative analysis, is that on the whole high-frequency traders have lowered costs. ... How HFT has changed the allocation of the pie between various market professionals is hard to say. But there has been one unambiguous winner, the retail investors who trade for themselves. Their small orders are a perfect match for today's narrow bid-offer spread, small average-trade-size market. For the first time in history, Main Street might have it rigged against Wall Street. Mr. Asness is managing and founding principal of AQR Capital Management, where Mr. Mendelson is a principal and portfolio manager. Aaron Brown, chief risk officer at the firm, also contributed to this op-ed.

Got it. If we have low interest rates far out into the future, required return for stocks should be far less than 10%. If 3% bond yields are going to here to stay, a premium of say 4% over bonds I think should be adequate. So that puts required stock market returns at 7%. That should support higher PE multiple. Say the S&P 500's normalized profit margin is 7% versus the 9% projected (which is only 30% higher than the 7%). "normal" eps would be $77. With low rates forever, say it's worth 18X, or $1,386. Assuming rates get to somewhat normal levels and the PE is 16X, fair value is 1,232. The possibilities are endless. And why after years of remaining above fair value should the market stop at fair value? Don't assets usually overshoot? What if we get a sustained bout of above-average inflation and the market races down to 10 or 12 times earnings and stays at that valuation for a decade? Who knows. Do not disagree at all. It is a struggle we have to live with. I would understand if you do not want to answer, but how is your stock/cash allocation? I am nominally long 75% stocks via LEAPS and some stocks but also have around 70% in cash. Vinod

The 20% number is just my guess. I really dont know. I am not sure what index you are talking about, the russell 2500 index? Also, I can see how you can relate BV multiple to ROE but not to PE. If I use S&P 500 index, sales per share are about $1100. Using preliminary 2013, Q4 data, reported earnings for 2013 are about $100 per share. Even if you believe these are not sustainable, companies are in fact generating these earnings. Put a 15 multiple then fair value is about 1500 or about 20% overvaluation from its current levels. The index trades at 19 times. Expensive, sure. But do not see 40% or 50% losses. This again assumes that interest rates are going to normal levels pretty soon. If interest rates remain low for a very long time, then I can see why a higher multiple would be justified. We have to assume that most investors would stupidly earn 1-2% (after-tax) on bonds while equity investors would get to enjoy 9-10% returns in stocks. GMO also makes the same point about interest rates and valuation levels. Given the uncertanity around rates, do we really have strong enough evidence that markets are vastly overvalued as in 70-80%? Vinod

For nearly 10 years the market went nowhere with two significant drawdowns. The CAPE contracted from 20 to 10. Ugh. Now I think the biggest lesson to be learned from all of this - which Grantham touches on in his Barron's interview - is that you need a recession to bring all of this stuff back to the mean. So yes the market can stay overvalued for a long time. Though it doesn't mean cyclical factors such as sentiment, technicals etc.... can't get out of whack and produce something like 2011, the 1987 crash, EM crisis in 1997/8. Yes, but that has nothing to do with profit margins! Market went down during the first 10 years because of unexpected inflation due to oil shock. So if you had a bearish outlook based on profit margins, you would have been right for the wrong reasons. If all we need is a recession to bring down profit margins, we had a pretty big recession during 2008-2009. If profit margin bears had been correct, the margins would have remained depressed after the recession has ended. But they went back right up. Cyclical factors like recessions would bring down profit margins temporarily, but we are talking more about long term margins. I had been very bearish primarily due to very high profit margins and that is the principal reason I was down only 1.5% in 2008. I had invested most of my available cash during the crisis. I felt vindicated that I had been right all along. Then as recovery took hold and in 2011, much to my horror profit margins recovered all the way. Primarily due to availability of very cheap banking stocks I had been able to maintain about a 100% stock exposure. See, I got bailed out of my stupidity twice entirely due to luck - first time banking crisis knocked down the market, second time making bank stocks ridiculously cheap. I am worried market might not be so kind to bail me out a third time if I make another pig headed move based on worry about profit margins. Vinod

What happened the last time profit margins fell from 12% to 6%? From philosophical economics blog: From January 1967 forward, the 20 year nominal total return (in contrast to the 10 year) was more than 10% per year–despite the domestic NIPA profit margin contracting from roughly 12% to roughly 6%. Vinod

If one is worried about high profit margins and mean reversion, why would they not invest in say the banks which have historically low profit margins over the last few years? Mean reversion is the last thing they would need to worry about in that case. GMO, Hussman and few others who are making these arguments on profit margins being high compared to history, specifically avoided this segment! Vinod

I have been worrying about profit margins since about 2000 so I understand where you are coming from. Reading Hussman every Sunday night for nearly 600 weeks and following GMO and Shiller very closely would ensure that. 1. P/S ratio is screwed up due to inconsistent way in how sales are accounted for. Take GM for instance, they have equity partnerships in China, their sales do not show up in the denominator. Profits however show up on their income statement and this effects the earnings that are being reported and thus the price being paid for GM. The author shows that this effect is quite big over the last several years. P/S may in fact be high but the point is that it is nowhere near as high as implied by your chart due to this inconsistent data. 2. The same argument above also applies to profit margins. In addition, we also need to look at ROE. Just because profit margins are high does not mean they would mean revert. Say a company used to generate 10% ROE in the past with 6% margins, if the same company needs 10% margins to generate the same 10% ROE, then there would be no need to mean revert. There is evidence that this in fact had a major effect. Pzena had data around this in one of his recent letters. To take a more extreme example if your profit margins are higher than the past but your ROE is say below 5%, would other companies be rushing in to get the 5% ROE due to high profit margins? Vinod Regarding point #1: The author goes into excruciatingly painful detail to simply conclude that DOMESTIC CORPORATE BUSINESS NET PROFIT MARGINS are 49% above the 1947-2013 average and 55% above the 1947-2002 average. Please see attached. So honestly I have next to no idea what his overall point is, outside of debunking a chart that is simply one of many (even if it is wrong) pointing to the same thing.....profit margins are elevated well above historic norms. I'd love to see data supporting the "JV income is so massive it is distorting NPMs across the board" argument. Most of Coke's revenue flows through its sales line versus a JV calculation. Yes GM happens to have a large JV line - but what about Parker Hannifan, Cummins, Pepsi, Mondelez etc... etc....? That's hardly a factor, and I think it comes through in the author's chart I've attached. Regarding point #2: It's a great point if in fact average ROEs are at or below historic norms due to lower leverage and lower asset turnover. I would posit that given the exceedingly high leverage across sectors (govt, house, corp) and the low level of investment since the GFC, that leverage ratios and asset turns are higher than historic averages. Combined with above average profit margins, I imagine a broad look at ROEs would show well above-average levels. Point #1 Please see attached. The first chart shows EBIT vs GDP over the last 66 years. You would see that EBIT margin is about 12% higher than the median for the last 66 years. The main point is that margins are not as higher as it is made out to be by the bears. He is not saying margins are not high. Just that they are not as high as Hussman makes it out to be i.e. something like 60% or 70% higher than average. There are lots of reasons for why margins are high today. If you account for all these factors (JV income, lower taxes, lower interest expenses), margins are probably only 20% or so higher. This suggests caution not panic and abandonment of stocks which is which is what is implied by bears who suggest margins are 70% higher than historical average. Margins might go down to historical averages but even if it happens, it would be a multi-decade long process. Point #2 From the limited data that I have seen current ROE (properly adjusted as there are changes by S&P from what I heard during the late 1980s) is only modestly higher than in the past. Take a look at the bottom chart in the attached. It has historical ROE for developed countries together. A very kind gentleman on Fool provided some data for US when I asked this question (http://boards.fool.com/ot-long-term-averages-31148472.aspx?sort=whole#31151116). ROE for US is about 15% higher currently than the average of the past 3 decades. It does not include Financials & Utilities, so it is likely ROE is not even that high right now compared to historical averages. Vinod Charts.pdf

You are not going to get Buffett style corporate governance in Russia or in any of the emerging markets. It is going to be a continuum but at 4-5 times PE, even if you assume 30% of earnings are going to be stolen or misdirected into unprofitable ventures you have a decent margin of safety. Vinod

This is pretty much the norm in every emerging market country. Petrobras in Brazil, ONGC & SBI in India to name just a few for example. Article is BS. Vinod

There are a couple of more reasons for higher net profit margins 1. Tax rates companies are paying is much lower compared to past. 2. Interest expenses companies are paying is also much lower compared to past. So some of it would revert when rates go higher but rates have to go up first. Vinod

I have been worrying about profit margins since about 2000 so I understand where you are coming from. Reading Hussman every Sunday night for nearly 600 weeks and following GMO and Shiller very closely would ensure that. 1. P/S ratio is screwed up due to inconsistent way in how sales are accounted for. Take GM for instance, they have equity partnerships in China, their sales do not show up in the denominator. Profits however show up on their income statement and this effects the earnings that are being reported and thus the price being paid for GM. The author shows that this effect is quite big over the last several years. P/S may in fact be high but the point is that it is nowhere near as high as implied by your chart due to this inconsistent data. 2. The same argument above also applies to profit margins. In addition, we also need to look at ROE. Just because profit margins are high does not mean they would mean revert. Say a company used to generate 10% ROE in the past with 6% margins, if the same company needs 10% margins to generate the same 10% ROE, then there would be no need to mean revert. There is evidence that this in fact had a major effect. Pzena had data around this in one of his recent letters. To take a more extreme example if your profit margins are higher than the past but your ROE is say below 5%, would other companies be rushing in to get the 5% ROE due to high profit margins? Vinod

This sounds like pretty much full equity exposure (or 80-110%) with 40% OTM put protection or protective puts strategy... Not sure this means you are on the fence here... Cash is not really cash in regular speak when you have a portfolio of cash and derivatives (I assume you meant LEAP calls here). It more resembles synthetic equity position, but with 40% OTM put protection. Equity exposure I think is in the 70% range now as I moved out a little from the LEAP calls to direct stock but cash is still pretty high. Vinod

The point you mentioned above, is really the key difference between bulls and bears at this time. Almost all who are bearish at this time, Klarman, Rodriguez, Watsa, Hussman, Grant, Grantham, etc bring some version of morality/justice into their equation. For all of them it boils down to justice not being done, for the sinners (who participated in the bubble) got bailed out, the profilgate debtors who got their burden reduced by low interest rates, the prudent savers who are getting punished, the unemployed who did not benefit from fed policies while the rich investors who have stock holdings have gained massively. It does not seem fair. Watsa codes it as "7 lean years and 7 fat years", others are more direct but morality is a common ground for all these investors. Hussman in particular seems to have expected some version of great depression to play out and was caught by surprise when the historical script did not play out. I did incline towards moralists for a long time, but I am coming to the conclusion that while Market serves lots of purposes, enforcing morality is not one of them. It is interesting that the most hyper rational investor of all, Buffett, does not ever mention any of these. Vinod Vinod, Among the list of bears you forgot to mention Mr. Soros… If we are talking about market timing, Mr. Soros’ point of view is not one you want to dismiss…!! Besides, even Mr. Buffett has allocated 76% of BRK’s assets in ways that are much insulated from what the stock market will do in the future… I think I have shown this in the LRE thread. Like they say: pay attention to what they are doing, not to what they are saying! ;) Morality/justice have nothing to do with this. Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried. Imo there is nothing wrong about getting worried. It all depends on how you decide to act on your worries: Mr. Buffett, for instance, decides to concentrate on building earning power for BRK, instead of investing in the stock market; Mr. Klarman decides to give back capital to his investors; Mr. Watsa decides to hedge 100% FFH’s exposure to the stock market… Given the results of the last three years, I might agree with you Mr. Buffett and Mr. Klarman chose the wisest courses of action. ;) Gio Gio, 1. I do understand that it not simply morality/justice with the bears. But having this paradigm in the back of the head seems to be corrupting the mind to see the market impartially. Many of the those I mentioned are great investors and they are likely to do very well despite this. Klarman with 50% cash is nearly certain to beat mere mortals like me even in bull markets and even if I am 100% invested. I am not so sure it is strictly about price vs. value, Hussman would have been invested heavily in stocks during the crisis and Watsa would not have started worrying about the market when S&P was in the 1000 range (I understand he is short Russell 2000). Morality influences the way we perceive value via (a) profit margins and (b) interest rates. Profit margins are mean reverting but they is no divine rule that says profits should always revert to 6% margins (let us call the 6% profit margins the Hussman constant). The mean for profit margins could be higher or lower than the Hussman constant in future and revert around that higher or lower level. Munger I think admitted to as much. Some perceive higher profit margins as immoral as they take away income from people and transfer them to corporations. I do not think anyone can come to a strong conclusion on profit margins at this time. There are so many countervailing forces that given all the uncertanity, one is inclined to believe what they want to believe. If you think profit margins would go back to 6% levels that we are vastly overvalued and at pretty dangerous market levels. Same goes to interest rates. Why should rates be higher? Why cant they remain low for a long time as they have been in the past? If rates stay low for say the next 10-20 years 10-year treasury is below 3% then stocks are a decent alternative. If one is not agnostic about this, and see this in moral terms and think interest rates should be higher, that influences what you think about the stock market as well. Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried. Do you really think Watsa was worried that people are doing dumb things in 2011? People are being as conservative as can be. I cannot think of a time when consumers and businesses were behaving as prudently as after the financial crisis. 2. I too was worried about the market since 2011, but due to a lucky coincidence banking stocks got super cheap at that time and I was able to move into a barbell type portfolio with LEAPS/heavy cash and around 100% long portfolio exposure. If these are not available at that time, I shudder to think what I would have done. I was wrong but got lucky. 3. I do not follow Soros but maybe I should. Vinod