vinod1
-
Posts
1,667 -
Joined
-
Last visited
-
Days Won
4
Content Type
Profiles
Forums
Events
Posts posted by vinod1
-
-
To use an example take BRK $100 strike call 2016 LEAP that is selling at about $23.6 while BRK is trading at $115.6. Since the term is roughly 2 years on the LEAP (from now until Jan 2016) I rounded it to 2.
Old way would be (23.6 + 100 - 115.6) / (100 x 2)
This gets you 4% annual costs.
The more accurate way
(115.6 - 23.6) * 1.x ^2.0 = 100
This gives you 4.25% annual interest. Not that significant since LEAP is only 2 years out and interest cost is relatively low, but as interest cost or term increases, the difference would be significant.
Vinod
-
Vinod, how do you think about the borrowing cost of these leaps?
I used to calculate it the following way:
(LEAP cost + strike price - stock price) / (strike price x term of LEAP in years)
This gets you the rough annual borrowing cost but it is not accurate as you are prepaying the interest upfront.
Eric has recently pointed this flaw and although the above calculation would still get you the cost for 1-2 year LEAPS roughly right, it would be better to calculate it the way he mentioned it.
I am copying what he wrote in another post (I do not have the thread link but I did make a copy):
You are prepaying all of this interest, long before it is due, which is effectively an interest-free loan to the very person you are borrowing it from.
Thus, you aren't really borrowing as much as you think.
Therefore, you have to figure out how much you are really borrowing first, before then calculating what interest rate you are really paying.
And that is an easy calculation.
Given:
BAC stock price $15.60
BAC "A" warrant price $6.54
Strike price $13.30
x= cost of leverage interest rate
$15.60 - $6.54 = $9.06
Now you need merely solve the following equation for 'x':
$9.06 * 1.x^5 = $13.30.
I'm using 5 years in the calculation to keep it simple, even though we're not exactly 5 years from expiry.
Viinod
-
I won't speak to the fact that I think this is an awful idea.
+1
Why lever up on something that is at 90% of IV with recourse leverage deep into a bull market? If you really that confident, why not just use LEAP? You can get 2016 BRK.B $100 strike option for $23.6. That gives you nearly 5x leverage for 2 years at an interest rate of about 4.25%.
Vinod
-
I'm not entirely sure--either there's an error in several of my examples, or the behavior is something I didn't expect. I'm looking at it more now.
Edit: Looks like it is a trade off between the value of the normal returns versus the bonus return and how often the cash is deployed. I think it makes sense, but where that point is is not intuitive.
You would get a "rebalancing bonus" when you add a non-correlating asset and you rebalance periodically. See http://www.efficientfrontier.com/ef/996/rebal.htm
I wonder if you are capturing that effect.
Vinod
-
I take back my statement about the cash % always being all or nothing. I found a situation where the ideal cash number was 35%, interestingly.
Back to the models...
How is that even possible? I had also assumed it would be all or nothing always. Are you using fixed income for cash?
Thanks
Vinod
-
1. When you assume away downside risk (very deep losses and not recovering until after several years) then I can see why cash would drag down your returns. Maybe you should try to run with Great Depression scenario like during the 1925 to 1940 period to see if cash would still outperform.
2. More than the mathematics of the returns, I hold cash more due to psychological reasons. Having some cash would allow you to continue to hold on to your stocks after a 50-60% fall in stocks. If you look in the mirror and do not see Buffett (or Eric) staring back to you, then I would think holding on to some cash would be prudent for an individual investor. If you are managing money for others, it might make sense to be fully invested if you find opportunities that meet your hurdle rate as the individual investors in your fund would have separate cash allocation.
Vinod
I just tried re-doing this where the year before the market as a whole goes down. e.g.:
Year 1: 15%
Year 2: 15%
Year 3: 15%
Year 4: -15%
Year 5: 15%
where in years 1-4 in x% cash, year 5: 100% allocated.
This makes the idea work a bit better. If you assume this occurs every 5 years, with the above returns, your extra cash only has to make 45% the fifth year to match the returns. At 6 years: 67%, at 7 years: 78%.
That starts to be similar to Pabrai's rules, assuming he can pull off those big returns on the down years.
However, note that the % cash does not matter. If the rule holds, then you should just be 100% in cash in years 1-4 and then 100% in at the high returns on year 5. Thus, I haven't seen anything where having a low percentage of cash is better than a high percentage, it either breaks the threshold or it doesn't.
During GD, the stock market went down 89% for the stock market as a whole and 86% for large cap. I am thinking if you have losses in this range just having cash should make up for all the drag. Any scenario where you have market going up long term would I think make a cash allocation a drag. What about periods when the market is volatile but maybe it just stays at that level at the end of a 10-15 year period.
Vinod
-
1. When you assume away downside risk (very deep losses and not recovering until after several years) then I can see why cash would drag down your returns. Maybe you should try to run with Great Depression scenario like during the 1925 to 1940 period to see if cash would still outperform.
2. More than the mathematics of the returns, I hold cash more due to psychological reasons. Having some cash would allow you to continue to hold on to your stocks after a 50-60% fall in stocks. If you look in the mirror and do not see Buffett (or Eric) staring back to you, then I would think holding on to some cash would be prudent for an individual investor. If you are managing money for others, it might make sense to be fully invested if you find opportunities that meet your hurdle rate as the individual investors in your fund would have separate cash allocation.
Vinod
-
I did not read the whole thread, but I had a similar situation at the end of last year. I had a few HP 2013 calls that were being quoted around 2c, I put a limit order for 1c and then tried a market order but it did not execute. Since the amount I invested is very small I did not give it much thought.
I wrote a post on this and there was a suggestion that I could get a friend to put in a bid, but others have commented that it might be matched up to someone else's ask.
Vinod
-
I can't say I've seen anything but inflation in the US in my day-to-day life, but apparently the CPI is falling . . . is it possible that Fairfax was making a bet on the specific components of the CPI rather than a depression? Or that they are just right and I am thick in the head? Either way, I hope those derivatives work out for them (but I don't hope for a deflationary recession):
http://www.businessinsider.com/historical-cpi-in-one-chart-2013-11
I think Fairfax was expecting the 2nd dip like US had in 1932 and a very deep recession. Otherwise, they would not have hedged at S&P 500 value of 1062. Buffett came out with "Buy America" article when S&P 500 was at 900 a couple of years earlier. It could not have been due to valuation. GMO and even Hussman consider fair value to be about 1000 - 1100. Hedging would not have been for a mere 10-20% drop in value, they must have been expecting something like 30-40% from the hedge level of 1062 or S&P 500 to fall to something like 640 to 740. That is an economy in deep trouble and very deflationary.
Vinod
-
In Hussman's defense, it takes real guts to lay out his rationale every week for why the fund is positioned that way it is. I do not think anyone would do such a thing if they do not have real conviction.
The problem I see is that he thinks the way markets behaved the past 100 years are pretty much how markets behave in the next 100 years. Thus you see not a hint of probabilistic thinking, for example, by even entertaining the thought that profit margins might be higher in the future than in the past or that they could be higher for a longer period of time then they have in the past, etc. He seems pretty convinced they would revert in short order.
Vinod
-
All I really need answered is if Grantham and Hussman are right so often, where are their returns? Not market beating like Buffett, Marks and Tepper. They are playing a fools game in which no one has the right answer because the economy is not machine and is run by people who are not always rationale. I have been tempted to invest based upon some of Gratham's ideas then I look at his returns and caution comes to mind. What am I missing?
Packer
As far as Grantham is concerned, you need to understand where he is coming from. His firm invests money for institutions and his objective is to earn a couple of percent over the respective asset class returns. He is spectacularly successful in that regard if you measure it over the full market cycle. If you look at his record of asset class predictions over the next 7 or 10 years period around the time of the internet bubble, he nailed it something like 10 out of 10 in rank order of performance.
He started one of the very first index fund, so he is not really into security selection. In addition, the firm now manages something like $100 billion.
Vinod
-
I think his point was that the talk of bubbles now is premature based upon valuation.
Packer
I thought Shiller's is making the same exact point. No bubble but on expensive side.
Vinod
-
I wonder why he disclosed the position at $3.7 billion instead of keeping it a secret. Given all the talk about size, and since he doesn't believe in making small investments, why not build it up secretly to $10-20 billion?
I guess that is pretty much close to the position size he wanted. He also said he wanted to invest about $10 billion in IBM and I think he disclosed the position once he got close to that limit.
Vinod
-
To me it looks like the deal is really all about getting full 100 cents on the dollar for the preferreds for Fairholme. If this deal passes they would have made 5x on the preferreds. Even if it means locking that capital for 5 years, it represents a pretty good return.
Vinod
-
Fairholme funds has case study on Fannie and Freddie. They have quite a few litigation documents also here. Apologies if this has already been referenced.
http://fairholmefunds.com/case-studies
Vinod
-
No, Vinod! Not 20 years, only 16 years, and they are like this:
Year 1, 2, 3: 0% CAGR
Year 4, 5, 6: 35% CAGR
Year 7, 8, 9, 10, 11, 12, 13: 0% CAGR
Year 14, 15, 16: 35% CAGR
This would increase BVPS 6 folds in 16 years, which is more or less an average 12% CAGR.
I think I have linked the excel files in a previous post of this thread.
If you find some errors in them, I wouldn’t be surprised… and please let me know! :)
Gio
Gio,
Got it. Your model is probably a lot closer to how FFH generates value. It makes sense.
It all goes back to time frames. You are looking at really long term (16 years out), while I am focused on the next few years. Especially since, near zero growth in book value is is baked into the cake for the next few years and the lumpy growth that is expected several years out is less certain.
Vinod
-
Have you taken a look at “My 7 lean years model for FFH”? It very simply considers a CAGR in BVPS of 12% (less than 15%!!) for the next 16 years. Then it applies a 9% discount rate, to arrive at FFH’s Present Value of Equity. And you get a present value of 1.54 x BVPS. This assumes that beginning in year 17 FFH completely ceases to create value… which, I hope you might agree with me, is quite conservative… Therefore, I think FFH’s Present Value of Equity, as computed by “My 7 lean years model for FFH”, significantly underestimates FFH’s fair value…
giofranchi
Giofranchi,
If I understand your model correctly, it takes a look at 20 years, it assumes no growth for 4 years, then a 16 year growth of 12%, assumes it would be at book at the end of 20 years and discounts it back at 9%.
If I do this I get an IV of a BV multiple of 1.1. I compounded at 12% for 16 years and then discounted by 9% for full 20 years. I think you might have discounted only for 16 years. Maybe I did not understand you model correctly.
Vinod
-
I also want to make clear, that I am 100% comfortable with Watsa. He has always made macro bets, just that in the previous cases they have come off relatively quickly. He has been more optimistic than the situation warranted at other times in the past as well. So nothing new here.
Vinod
-
Parsad,
sorry, today I am bothering you… But I don’t think my expectations that FFH can grow BVPS at a CAGR of 15% for many years into the future are completely extravagant and unfounded… People on the board say “I am living in a bubble”, yet no one has convincingly explained why FFH should fail to achieve that goal. They must return circa 7% on their portfolio of investments, when historically they have returned 9.4%. I am not saying it will be easy, I am not saying they will succeed. All I am saying is I think my expectations are reasonable and don’t see why I should temper them.
Here is, I think, something important: when you really want to invest in a business for the long-run, I mean you want to own a business for years, you can be neither too optimistic nor too conservative. Instead, you must be (at least vaguely) right. Why you shouldn’t be too optimistic is plain to see for everyone. Maybe, why you shouldn’t be too conservative, is less well understood. Yet, if you think of it, this also is clear enough: because, if you don’t know the true potential of a business, as soon as the stock rises, you will sell it.
giofranchi
Gio,
Here is what I see using 2013, Q3 balance sheet adjusted for investments in associates that are not carried at fair value
• $7000 million common stock holders equity
• 20.25 million shares outstanding
• $23,000 million of investments ($6 billion stocks, $17 billion cash/bonds/derivatives)
• $3200 million long term debt ($210 million in annual interest cost)
• $1200 million preferred stock (5% interest)
The best case return at this time would be
• $300 million Return on stocks (5% alpha as it is hedged)
• $700 million Return on bonds (4% yield, overall non stock portfolio is actually yielding about 2.3%)
• $120 million Underwriting income (98% CR on $6 billion of net premiums earned)
• -$200 million interest cost
• -$100 million corporate overhead
• $820 million pre-tax income or about $575 million Net Income
• -$60 million preferred dividends
• $515 million net income to common stockholders or about 7% ROE
Again the above are what I would expect Fairfax to earn if the present investment climate goes on for a few more years. My assumptions above are not something I would be comfortable making, they are the most optimistic estimates that I can stomach.
- 5% alpha in an environment when expected market returns are around 3-5% represents an alpha that is around 100% of expected returns.
- Bond returns of 4% are over 50% of what they are currently making. Note that I have included all non-stock portfolio so that includes cash and other assets that have been pledged short, etc.
- CR of 98% is 5% better that what their 25 year average.
If I assume all that I come up with 7% ROE. Absent a major stock market correction or further major drop in yields, I just cannot see Fairfax making 10%. Again, this is in the short term until there is a market correction. It might be one year or it might take another 3 years, I do not know. When it happens I would reevaluate investment in Fairfax. I came to this conclusion in late 2011 and got out of Fairfax.
I understand that you are taking a much more longer term view.
Vinod
-
I think you should be more concerned about asset class returns, since even the active funds within this list are mostly index huggers. So the investment you make in any of the above funds would be driven almost entirely by the performance of the relevant index. Given the expected returns of most broad asset classes seems to be truly horrible at current valuations (GMO, Hussman, etc) it might be prudent to just stick to cash if you are forced to invest in the above funds only.
Vinod
-
How about this to ease your concern:
1) Quit Job
2) Open Fidelity "self-employed 401k" -- perhaps you become a self-employed handy man for a few months between jobs
3) Roll your employee 401k assets (and perhaps other IRA accounts as well) to the new self-employed 401k.
4) start new job at new employer
There, now you have it all in a 401k, not in an IRA
Ah... there's a catch for solo-401k plans:
If your savings are in a 401(k) account, they are protected from all forms of creditor judgments, including bankruptcy, says Kyle Brown, a retirement counsel with Watson Wyatt Worldwide in Arlington, Va. Solo 401(k)s, however, don't necessarily have the same protections as other 401(k) plans; in some states, solo 401(k)s are protected from creditors, but in others they aren't.
http://online.wsj.com/news/articles/SB124181801239401917
Some states give good protection to IRAs (others don't):
Other states, such as Texas, Arizona and Washington, protect virtually everything inside an IRA from creditors. In Arizona, for example, only contributions made within the last 120 days can be subject to creditors' claims in a bankruptcy.
http://www.latimes.com/la-ira-story3,0,6977190.story#axzz2j51AkHYR
Thanks! This is something I need to look into in more detail.
#1 is complete. I did already leave my job earlier in the month. Just following the path you trail blazed :)
Vinod
-
You got lots of good advice. I would add asset protection as a consideration when choosing between staying in a 401k vs moving to an IRA. 401k has the most protection from creditors (as in someone suing you). The main things it would not protect are divorce and IRS. IRA is not as solid and varies by state. So if asset protection is important for you, you might want to keep it all or a portion of your assets in 401k.
Vinod
-
Markets are fairly efficient and most reasonable people would agree with that. But Fama goes much further. He practically denies there is such a thing as a bubble. Any time there is a factor that is identified that has shown historical outperformance, he turns it into a risk factor. Small stocks have higher returns, well small stocks are more risky, value has higher returns, value must be more risky and so on. According to him, the highest priced stocks (or as her prefers low Book to Price) have low risk. As Taleb like to say, he is a perfect example of an "equation solver" with Physics Envy.
Shiller on the other hand, is much much more reasonable and humble guy and fully deserves the prize.
Here is an interview with Fama:
http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1134
Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. The way I look at it, there were two crashes in the last century. One turned out to be too small. The ’29 crash was too small; the market went down subsequently. The ’87 crash turned out to be too big; the market went up afterwards. So you have two cases: One was an underreaction; the other was an overreaction. That’s exactly what you’d expect if the market’s efficient.
The word “bubble” drives me nuts. For example, people say “the Internet bubble.” Well, if you go back to that time, most people were saying the Internet was going to revolutionize business, so companies that had a leg up on the Internet were going to become very successful.
I did a calculation. Microsoft was an example of a corporation that came from the previous revolution, the computer revolution. It was hugely profitable and successful. How many Microsofts would it have taken to justify the whole set of Internet valuations? I think I estimated it to be something like 1.4.
Vinod
-
In the thread on Accenture PLC, one member stated a valuation method where the expected return on investment in a share = FCF Yield + Growth.
I stated that if you were to do it on a per-share basis, then you have to exclude the share repurchases from the FCF Yield as they do not flow to stockholders and are reinvested in the firm in order to increase future FCF/share, and counting them in FCF Yield would be double counting as it is already reflected in the rising earnings yield.
However, two other posters disagreed, what's your take?
Palantir,
You got it right. If you look at the dividend discount model, which is the simplest case of the discounted cash flow model, this becomes very obvious.
In DDM, value of a share of stock = Dividend next Year/(Cost of Equity - Growth rate of Dividends forever)
Growth rate of Dividend = (1 - Payout Ratio) x Return on Equity
To account for share buybacks, you would adjust the Payout Ratio and hence the Dividend next year. This automatically adjusts the growth rate down. Just as you noted, growth rate is adjusted down while the dividend for next year is adjusted up. It does not make sense to assume that both dividends go up and growth rate goes up.
Big Boss of valuation, Damodaran, has written about this quite a bit so you are on firm ground.
Vinod
LEAPS, Portfolio Cash and Leverage
in General Discussion
Posted
You also need to add the dividend yield to the cost of the LEAP.
Vinod