vinod1

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

I had been in 60% or more in cash since early 2012 (reminds me of stones and glass houses...), though my stock exposure is around 80-110% due to LEAPS. So I am very much on the fence. 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

Michael Pettis is the guy for you. He has been writing about this for quite a while. http://blog.mpettis.com/2013/10/hidden-debt-must-still-be-repayed/ We are also not likely to see, however, the advantages of a Lehman-style crisis, and these are a relatively quick adjustment in the process of investment misallocation. I have always said that the resolution of the Chinese banking problems is far more likely to resemble that of Japan than the US, and instead of three of four chaotic years as the system adjusts quickly, and at times violently, we are more likely to see a decade or more of a slow grinding-away of the debt excesses. The net economic cost is likely to be higher in a Japanese-style rebalancing, but American-style rebalancing is risky except in countries with very flexible institutions – financial as well as political. Another good post http://blog.mpettis.com/2014/01/will-the-reforms-speed-growth-in-china/ Low interest rates, low wages, an undervalued currency, nearly unlimited access to credit for state-owned enterprises, a relaxed attitude to environmental degradation, and other related conditions were both the source of China’s ferocious growth as well as of China’s unprecedented economic imbalances. Reversing these conditions will rebalance the economy, but will do so while lowering growth in the obverse way that these conditions had accelerated growth. Vinod

Question is what would cause ROE's to go down? There has to be massive investment by companies take advantage of high ROE, to drive down ROE to more "acceptable" levels. We do not see that. Massive investment is also precisely what GMO says is one way to keep profit margins high! Vinod

Margins are high but as pointed out by Pzena, ROE are roughly in line with average. But companies and investors care more about (correctly in my view) return on equity. The fact that a company increased its margins from 5% to 10% would not automatically invite competition and drive down margins if ROE say remain only 8%. Companies had to deploy a lot more assets to generate these margins. http://www.pzena.com/heading-our-research/investment-analysis-4q13.php What are your views on this? If God gave you a peek at interest rates over the next 20 years and they remain in the 2-3%, how would your view about equity valuations change, if any? Not trying to argue with you, just trying to understand different viewpoints on this topic. Thanks Vinod

Prem made the following comment in the annual letter. "As we did last year, we remind you that cumulative deflation in the U.S. in the 1930s and Japan in the ten years ending 2012 was approximately 14%. It is amazing to note that including 2013, Japan has suffered deflation in most of the last 19 years – beginning about five years after the Nikkei index and real estate values peaked." Japanse CPI data shows a deflation of only 1.0% over the last 10 years (2003 to 2012). Even peak to bottom from 1998 to 2013 the deflation is only about 5%. Does anyone know what inflation data Prem is using for Japan? Link to CPI data on Japan: http://www.stat.go.jp/english/data/cpi/1588.htm http://www.e-stat.go.jp/SG1/estat/CsvdlE.do?sinfid=000011288548 Thanks Vinod

Liberty - Completely agree with what you have posted in this thread. Vinod

I think we are reading too much into Klarman's cash position. I do not think his cash position has anything to do with his macro views. From my notes on Klarman but not sure if these are his exact words: People like to ask: “What do you think about the dollar or the economy?” We have those views but we refuse to bet on them. Most people don’t have any edge in macro issues. Also, it is hard to turn a macro view into a portfolio. When you go from interest rates to economy, to an industry, and to specific companies, you have to be right every step of the way and you have to be early. When you go bottom up, all you have to do is to be right about the specific one-off situation. You can be wrong about the country, wrong about the economy, wrong about the interest rates, and still make money. "Our 45% cash position is not a macro bet. It is just tough to find bargains now." (early 2006) Vinod

The way I see it there are two main risks (1) Russian government confiscating Lukoil assets (2) Russian government imposing restrictions on foreign holders of Russian businesses Given that we have an owner operator who has the benefit of learning from Yukos, I would think risk #1 might be somewhat low. However, if there are financial sanctions and asset freezes imposed by west due to Ukraine situation, #2 may be a significant risk. I do not think we can really assess these risks and we just need to manage it with position sizing. Anyway you measure it, it is trading at about 4x average earnings of the last three years. These are all in and what could be considered pretty normal level of earnings - if oil prices hold. I think the above risks are more than priced in. Vinod

Bought Lukoil. But not sure if I am investing or making a donation to Putin. Vinod

Rhetorical question? Bonds had a $900 million loss and equities underperformed the hedges by $500 million. These pretty much accounted for the underperformance. Vinod

I did not quite understand why you would not believe the accident year CR. Could you please explain? Thanks Vinod They sandbag the accident year reserve. If they think they are going to have losses of $100 on a policy they put $115 into the reserve. They say they are being conservative (which they very well may be, who knows what will happen between a reserve being established and claim identification/settlement. Courts could become more hostile to insurers, inflation could go up, an unforseen risk might not have been excluded from a policy). However, at a certain point you've reserved for the unknowns that I've bracketed and you are effectively setting up redundant reserves that you will bleed through calendar year combined ratios in future years. That is what FFH is doing...it's also what BRK.b and WRB are notorious for. Thanks! FFH in the past had to keep adding to the reserves, so I would be glad to see this change going forward. Vinod

I did not quite understand why you would not believe the accident year CR. Could you please explain? Thanks Vinod

+1 It is good to see underwriting going in the right direction, but it is aided by $440 million reserve release. Accident year CR is at 100%. Vinod

I hope someone asks a question on the CPI derivatives. Despite all the hoopla about deflation in Japan, the CPI index there peak to bottom went down by less than 5%. Fairfax seems to be preparing really for a repeat of Great Depression. Otherwise CPI derivatives do not provide much bang for the amounts being invested. Vinod

Fairfax could have done either of the following: 1. Buy puts. That would have been true insurance. 2. Had brought some protection in case stocks shoot up. Four years ago it seemed likely that markets would go down again. Fairfax was positioned as if this is nearly certain. Fairfax bought the hedges as a protection against 1 in 100 year event. Has it been Fairfax's assessment that the market had much less than 1 in 100 chance of shooting upwards? What kind of insurance is it that if it does not work out produces as much losses as it is supposed to protect? Vinod

In hindsight, but Fairfax lost $4 billion cumulatively pre-tax over the last 4 years on equity hedges and CPI derivatives. All this to protect $4 billion in equity investments at cost. Vinod

Gio, Makes sense. Thanks for pointing out that the hedges were on Russell 2000. Let us hope the markets cooperate in providing an opportunity. Vinod

Gio, For me, for FFH to be "right" on the hedges, S&P 500 would have to fall significantly below (say 20% or more) the level at which they hedged (~1060). This would imply S&P 500 to go down to about the 800 level. What is your criteria for FFH to be right on the hedges? I say this not to disrespect Watsa in any way. They got 3 big macro calls right (Japan 1989, Tech bubble in 2000 and 2008 crisis). Even if they got this wrong, that would make 3 macro calls right out of 4. That is a pretty good ratio on such complex macro events. Vinod

Ross, Thanks for setting this up and sharing with all of us. A great idea and I really like your approach to weighting the portfolio as well. Did you consider equal weighting for say the top 10 stocks with no cash allocation. I would think this might more clearly reflect the board's ability to pick stock vs S&P 500. This could be a separate portfolio. The current method combines a bit of board ability to market time (due to cash) and also introduces some noise around the stock weights. Vinod

Fantastic post oddballstocks. I only wish you have written this a few years back. I had come to pretty much similar conclusion but not before wasting some effort. Thanks Vinod

Not quite. Growth is funded by investment and that is invariably done by issuing more stock. So while earnings would grow in line with GDP and stock market would grow in line with earnings, that does not translate into a corresponding per share growth in earnings which is what really matters to the investor. Vinod

Could it be hindsight bias? There are risks every year, but in some years it is more pronounced than others. 2005, 2006, 2007 happened to be such years but it only materialized in 2007. If things have played out only slightly differently (Govt stepping in for Lehman and possibly some arm twisting to get AIG CDS counter parties to back off, etc) we might have had an economic impact similar to 2000 tech bubble burst. In hindsight it is easy to think that the financial crisis of 2008-2009 has a clear cut sign from the housing bubble. I do not think that is really the case. Personally I was worried about housing bubble and high stock market values due to high profit margins which I thought were a near certanity to mean revert. I was very defensive but it worked out for all the wrong reasons. I had no clue about all the leverage and the risks that turned up are not remotely close to what I was worried about - except for the housing bubble. The lesson I took from it is that when valuations are rich, bad things happen in ways we cannot anticipate and it is better to ensure that we live to fight another day i.e. no deep losses of 50% magnitude. Vinod