bmichaud

Thanks Moore.

That's exactly what I'm saying - he has basically set up BRK to be a massive version of BPL, where the "total portfolio" if you will is invested in A) Controlled Businesses, B) Equities, and C) a safety cash position. When he's buying equities, he doesn't care about the market because the rest of the "BRK Portfolio" is invested defensively. If Buffett was just investing equities (i.e. did not own controlled businesses), my guess is that it would not be 100% invested in the market - if it was, then I would be dead wrong about how he views general market valuation. Perhaps there is no difference. If there isn't, then I would wonder why BPL Buffett would bother buying a control stake in companies when other opportunities were available in the open market (particularly when you consider the small amount of capital he ran). AMEX is a great example. Buffett is buying a business that is attractively priced regardless of what the general market is doing or what the macro outlook looks like. In other words he thought the "bottom" was in for business specific risk, or that he was being compensated for any potential business risk at the price he was paying. But he also acknowledged that even if you buy something at 12 times earnings, in a general decline that PE can drop to 8 times. Thus he engaged in "pairs trading" - i.e. buying a 10x business and selling short a like business going for 20x - in order to offset the risk of a general decline. AMEX was part of his category "Generals - Relatively Undervalued", which was his "pairs trading" category. I have no idea "why" he was worried about market risk - but if he truly wasn't, I don't see what the need was for offsetting the AMEX position with a short. Semantics. When I say he couldn't find a place to invest I am implying he couldn't find a good deal. Buffett is constantly saying how there are always unknowns and uncertainties out there, and if you pay the right price you shouldn't worry about them. Obviously I am the only one with this opinion (which probably means I should strongly re-evaluate my thinking), but given how small $500MM is relative to $13T and his penchant for concentrating his bets, I would think he should have been able to find something.... On an individual company basis I agree 100%. I'm thinking about it from a total portfolio perspective. Monish is the best example - he's a master at finding 50-cent dollars, but he went from a cumulative return of 365.2% as of 12/31/2007 down to 90.1% as of 12/31/2008, and now back up to 451.2% as of 12/31/2010. If you look at the graph on the attached letter, it took over 3 years (from June 2007 to December 2010) to make up for the losses in 07/08/09. That entire rollercoaster he was finding 50-cent dollars. What if by chance the Fed hadn't come in to manipulate the market? All I'm trying to point out is that from a total portfolio perspective, it's difficult to make up losses. Yes, someone could have put 100% of the portfolio in McDonalds back in the fall of 2008 and doubled his/her money while the market flat-lined, but nobody only invests in one stock or has the ability to anticipate such a return with such accuracy. Perhaps Berkowitz can come back - he probably will. But let's say his hurdle rate of return is 15% over 5 years (I'm making this up, so bear with me) - he just lost let's say 30%, now he has 4 years left to achieve his goal and he is now starting with $70 versus $100 at the beginning of 2011. So $100 compounded at 15% over 5 years is $201 - in order to get to a 15% average return, he now has to compound at 30% over the next 4 years in order to reach $201. I'm not saying it's not doable, it just gets very difficult to hit a particular rate of return when starting from such a low base. 12.31.2010.pdf

BRK Buffett invests behind a corporate veil, and as a result, has a natural hedge in the form of free cash flow pouring in the door on a daily basis as well as the ability to keep operating businesses marked at book value as oppose to book value. Let me explain....If you own 100% of Burlington Northern, it's on the books at $20 billion and you earn $2B, your ROE is 10% regardless of what general market is doing. Now let's say you only own 10% of BN common, or $2 billion worth of the company - further, let's say you receive 50% of your share of annual earnings ($200 million) in the form of dividends. If your investment stays flat, you earn 5%, or $100 million on a $2 billion investment. Well if the market re-values your investment down to $1.5 billion, your return for the year is then -20% including dividends. Yes over the very long run the investment, whether 100% or 10% owned, should generate the same return - but one must admit there is a rather stark difference between the two types of operations. BPL Buffett didn't try to allocate toward "Controls" for no reason..... Perhaps BPL Buffett allocated to "Workouts" in order to appease clients (i.e. for "business risk" purposes), but I think not. He specifically says in his letters that "Generals" were at risk of declining "in sympathy" with the market in the event of a general market decline. Also - leading up to his October 2008 op-ed "Buy American. I Am.", Buffett was 100% in US treasurys. If the greatest investor on the planet did not care about the general market, isn't it likely that he would be able to find a place to invest $500 million in a $13 trillion equity market? Even though I do manage OPM, I don't care one bit about their tolerance or lack thereof for volatility. All I care about is the math of generating superior long-term returns by losing less in market declines - i.e. one must generate a 100% return in order to break-even after losing 50%. As a simplistic example - I'd rather return 50% of the market return on the upside in order to generate 50% of the market return on the downside. So if the market returns 10% and I return 5%, then the next year the market declines 20% and I decline 10%, I've returned -2.8% per annum versus -6.2% for the market. Going a step further, it would be my hope that coming off a low such as after a 20% decline, I would be able to strongly outperform the market on the upside because the starting point would be from attractive general valuations. In hindsight, the 2011 low would have been the perfect opportunity to get very aggressive and outperform through now - I just did not think that was the opportune time due to the reasons I've cited ad nauseum. My strategy worked to a T last year, as I strongly outperformed on the downside, and kept up decently in the rally due to increasing net exposure at the bottom (I just was not aggressive enough as I said earlier, in order to really outperform).

Basically what this entire debate comes down to is some investors worry about the general level of the market (myself, Grantham, Hussman, BPL Buffett) and those that do not (Moore, Peter Burke, Berkshire Buffett). Whenever the general valuation level of the market comes up in discussion, it turns into a "macro" debate b/c those who do not like to worry about the general market level believe worrying about the general market level is a "top-down" exercise, and thus is a macro discussion. Further, I believe the debate comes down to those who believe we operate in a central-bank manipulated world where there is a perpetual put under the market and thus general market corrections are not to be of concern, versus those who believe while central banks can kick the can and manipulate in the short term ultimately long-term valuations exert their power over the market. This is where Moore's experience and monetary expertise has been a phenomenal lesson, at least for me, in taking the power of the central bank into consideration. I grossly underestimated the power of the ECB to manipulate the market's perception of the underlying deflationary pressures currently ravaging the Eurozone economy and the risk posed to the global economy, and as a result, I reduced risk in the portfolio far too early. With regard to whether general market valuations matter - as always, I cite BPL Buffett who intentionally allocated capital to "workouts" based on where the general market was trading. This point isn't really up for debate, as he explicitly writes about it in his early letters, and it is discussed in the "Snowball". What is up for debate is whether or not his early approach is relevant to us as portfolio managers - this point brings about some pretty heated debates, but as some have said in this thread, it's a matter of personal preference both for whether or not to hedge and how to hedge. For example, those holding big positions in Fairfax are in fact quasi hedging their portfolios since it is largely deemed an inversely correlated security due to hedges and treasuries in place at the corporate level. With regard to central bank manipulation - ultimately, I believe long-term valuation measures will win out, as evidenced by the fact that while the "greenspan put" has been in place since the 1998 "asian contagion" Lehman Brothers still collapsed and valuations ultimately fell to fair value and BELOW in the fall of 2008 and in early 2009. The "Schiller PE" using 10-year median real earnings is currently around 20 times and back at the end of September got as low as 17.53 times. The long run median Schiller PE is approximately 15.61 times - so back at the 2011 low, the market never got THAT cheap, especially considering the low/no-growth environment, European risk, and the supposed oncoming recession per the ECRI - thus I did not become THAT aggressive outside my normal market exposure parameters. And FWIW, Buffett packed up shop in the late 1960s at around current Schiller PE levels (see attached spreadsheet). Current valuations are only cheap within the context of the credit-fueled/Fed-manipulated bubble of the last 15 years. So yes I was dead wrong to "reduce risk" back in October at Dow 11,800 - at least for now. However, that does not mean I am capitulating on my long-term outlook for valuations and the current hideous macro outlook. Biggest lesson learned for me over the past 5 months is to be more aggressive while still maintaining market exposure discipline - hopefully I'll have a chance to implement that lesson at some point in the near future 8) Schiller_Data_January_2012.xls

Wells Fargo had a good note on this topic back in December. See attached. Page 6 outlines the required primary surplus in order to achieve debt stabilization under various interest and growth rate scenarios. EuropeRenaissanceDarkAges_12192011.pdf

Longs are flat, shorts are up - do the math. Long portfolio is chock-full of good event stocks that won't necessarily participate in a month-long, low volume rally. Just recently swapped out of a multi-year holding that the market is getting a bit too excited about (including Mr. Cramer) into a name that is trading at less than 7 times FCF to equity, has a 12% total payout yield and is a potential takeout candidate at a market cap of $10 billion. All that said, the portfolio is in phenomenal shape for any environment going forward with good hedges in place, "events" set to transpire within the year, and a huge position in a severely undervalued business that has a balance sheet I can understand. Mr. Hamilton made a wonderful call on the market rocketing above its 200dma. What's curious to me however, is why someone that claims his stock picks have averaged over 50% annualized returns over the past ten years is writing free essays on the direction of the market as oppose to keeping his "secret sauce" to himself and making billions running a hedge fund. I remain skeptical - however, after giving his essays a "trial run" if you will, I will certainly take his opinion into stronger consideration when putting on hedges. His analysis has absolutely obliterated Hussman's outrageous weekly perma-bear musings.

http://www.examiner.com/international-trade-in-national/greece-plans-orderly-exit-of-the-eurozone

The rally in EURO gov bonds was expected because the ECB is extending credit to bankrupt banks by allowing them to post their high yielding sovereign debt as collateral to receive low interest ECB loans . . . That can then be used to buy more high yielding bad sovereign debt. . . . Repeat. :o Doesnt make sense to me since non-ECB funding has dried up and Euro banks have one trillion euros coming due in the next year. How do they refi that funding while simultaneously buying additional SD? Perhaps that is happening on the short end while banks wait to refi, but for long term SD? ....

Moore, wonderful call on the market, government support and LTRO. I'm literally in shock at the rally in Euro gov't bonds in the face of a deteriorating economy - the austerity measures being instituted over there will not work regardless of LTRO, but I guess in the short-run market perception is the most important factor....

WLI growth rate at -6.5% versus -8.6% two weeks ago. http://www.businesscycle.com/reports_indexes/allindexes

Hussman is beginning to capitulate on his recession call (http://www.hussman.net/wmc/wmc120123.htm) and the ECRI WLI improved from -8.6% two weeks ago to -7.5% last week. I must admit the timing of ECRI's emphatic recession call was pristine given the recent decline in initial jobless claims and other economic data....

Tremendously helpful Parsad. Thanks a lot. Uccmal - great point here. In thinking about it more last night, the fact that earning power after cost reductions is more in the realm of $2 per share would support tangible book value per share somewhere between actual BVPS and tangible BVPS. Thus in a liquidation scenario, the SOTP would probably be higher than current prices.

Tremendously helpful Parsad - love hearing how great managers think through tough situations. So with Steak & Shake, Fairfax, WFC back in 2008, and your most recent undisclosed acquisition, I'm assuming you had determined in one way shape or form that your investment had a very low probability of permanent impairment, as should all value investors with all investments. IDK anything about Fairfax, but I'm assuming when it was distressed, you were able to readily determine that in a worst case scenario, such as a liquidation, that your investment would be made whole, no? Same with Steak & Shake - worst case scenario, perhaps the real estate, cash, and receivables would cover your investment while any upside from operational improvements would be pure upside. This is where I struggle with BAC. The upside case is very obvious - IMO, the downside protection in a worst case scenario is NOT. We can argue all day long whether or not a worst case scenario will actually materialize, but assuming there is a greater than 0% chance of one, where is the downside protection? Asset valuations are stretched to the max, are they not? In a liquidation scenario, how is BAC's "Other Asset" category going to hold up? How are the "trading account" assets going to hold up? How are NPAs going to hold up? At 10x leverage, there is only a small margin for error. This is where I am struggling - I can't determine the downside protection. It's not a matter of having the guts to buy something distressed, it's a matter of being able to determine what the downside is. That's where Yacktman's quote comes into play - how do you trust asset valuations that can be created with the stroke of a pen? I hate to "LVLT" this thread, but one could make the argument with LVLT that in a worst case liquidation scenario, the highly valuable "fat pipes" could be auctioned off for at least as much as the current TEV. I can't reliably make that determination with BAC - you can't tear apart its balance sheet and come up with a worst-case liquidation scenario that comes out favorably for equity holders. That's what I'm trying to get a feel for on this thread is how folks here are looking at the worst case scenario - what is the downside protection people are looking at? Simply saying "the Fed will just print" or "WEB bought a preferred stake" aren't valid margins of safety, IMO. There is in fact a scenario out there that another global credit crisis will impair the asset side of BAC's balance sheet and it will be forced to raise expensive equity - so the earning stream stays the same over the long-term, but the share count doubles, rendering the investment very if not permanently impaired. This line of thinking isn't Zero Hedge-derived either - it's being careful to avoid investing in the next WaMu, Fannie, Freddit, Bear, AIG, Merrill Lynch, etc... etc... Just curious how others look at the downside given the opacity of the balance sheet.

Simple answer, we were not comfortable. And we placed our bets accordingly. My initial bets on ffh leaps were quite small. It was only after the stock began to rally that it quickly became 80% of my portfolio and I stuggled with it the whole time, as did many I know. I lost more sleep when my Leap positions had become 10 baggers than when I bought them. I cannot say that I am ever comfortable with a new value investment. It often takes a couple of years, like Seaspan. The problem is that once an investment gets comfortable it no longer is a value investment. The only way to mitigate this is to not back up the truck on any one thing and try to have a margin of safety. There is MOS with BAC at this price. Maybe not so at $18/ share. Well said! It'd be interesting to take a poll of the average position size BAC is for board members. Perhaps that's my biggest hang up with BAC, since I usually take very large positions. I believe I've seen 30% for some people, but could be wrong on that. I just re-read BB's interview on BAC - phenomenally compelling and that was with BAC over $10 per share. Gosh, I'm so frickin close to pulling the trigger.

Great point. BB says tax savings are about $80B.... 2012 EBT: $13,240, Tax Savings = .35 x EBT = $4,634, PV @ 12% = $4,138 2013 EBT: $13,240, Tax Savings = .35 x EBT = $4,634, PV @ 12% = $3,694 2014 EBT: $32,980, Tax Savings = .35 x EBT = $11,543, PV @ 12% = $8,216 2012-2014 accumulated EBT = $59,460, so $20,540 remaining for 2015 ($80,000 minus 59,460). So 35% x $20,540 = $7,189, PV @ 12% = $4,569. Cumulative PV of tax savings = $20,617, or $1.84 per share. New EPV @ 12% cost of equity = $16.06

My apologies for my original post - pure laziness, as I had not yet looked at the latest financials in depth.... PTPP income excluding goodwill impairment and merger costs is $17 billion. Add back 90% of R&W provision, PTPP is $31.04B. Equity Investment Income, Gain on Sale of Debt Securities and Other Income total $17.6B. These are lumpy YOY, and given the large amount of asset sales this year, I'd say it's safe to deduct 25% of $17.6B from PTPP. So pro-forma PTPP is $26.64 billion. Loan loss provision of $13.4B seems reasonable at ~1.4% of FYE gross loans & leases. So EBT is $13,240, and Net Income is $8,606 assuming a 35% tax rate. Assuming 11.2B shares out (assuming 10.5B currently out plus WEB 700MM shares), current normalized EPS is $.77. Assuming a 12% cost of equity, EPV Is 8.3 x $.77 = $6.39. Assuming Phase 1 & 2 expense reductions of $7.5 billion (Phase 2 50% of Phase 1) and litigation/LAS expenses of $12.24B (90% of $13.6B in 2011) are achieved in full by 2014, FYE 2013 capitalized after-tax cost reductions are $106.5 billion (35% tax rate, 8.3x PE). Discounted back two years at 12%, present value of future cost reductions is $84.9B or $7.58 per share. WEB $5B conversion, $.45 per share ($5B / 11.2B) Total current EPV = $14.22 If a 10% cost of equity is used instead, current EPV is $17.62. As Donald Yacktman says, banks can create assets with a stroke of a pen. The balance sheet still kills me.... How did everyone here involved in the Fairfax restructuring get comfortable with its balance sheet at the time? Was it more of a trust in Prem given how familiar you all are with him? Or is it just a matter of sucking it up and banking (no pun intended) on the earning power of BAC to allow it to earn its way out of this mess and assuming there are no major skeletons on the balance sheet?

Given $.96 EPS, I'd say "Earning Power Value" is $8 assuming a 12% cost of equity (8.3x PE). If BAC can reinvest at a rate higher than 12%, then perhaps it warrants a PE of 10x, for a FV of $9.60. I hate the exploding share count. Earning power is supposedly there, but it's been severely diluted. And my weekly struggle with BAC continues....

I have looked at this thing time and time again, and still continue to struggle.... For 2011, PTPP income was $17 billion, and if you add back the $12 billion of cost savings Parsad and Eric refer to, "normalized" PTPP is around $29 billion. Are you guys modeling higher PTPP due to future revenue increases, or does BAC becoming "lean and mean" involve a lower revenue base? Loan loss provision seems about at normalized levels, $13.4 billion, so pre-tax income is $15.6 billion, and net income $10.1 billion assuming a 35% tax rate. Shares out as of FYE were 10.5 billion, so normalized EPS is $.96. Curious what type of normalized EPS figure board members are looking at....

Fortunately for Yahoo! shareholders (myself included), the 33.33% of the "cash-rich transaction" price must be applied toward an operating asset, so the inevitable overpriced acquisition won't come out of cash available for a special dividend and/or buyback. If we can get Loeb on the board to inject some sense of financial engineering, Yahoo! could lever up 2x EBITDA of approximately $1.2B, and buyback over 10% of shares out at $18 per share - this doesn't even take into account the cash received from the CRT. I think the jig is up with these guys, and Loeb will receive full support. Obviously I'm biased....

If you have access to Capital IQ, there is a function called Blackline that does it for you. Super helpful.

Eric, The attached spreadsheet should have all the data you're looking for as far as payout ratios. The payout ratio column is my own construction, as Schiller does not provide in his spreadsheet. The highlighted box shows the median payout ratio since 1945, 1960 and 1980 to be, 51%, 48% and 43% respectively. Even more interesting, IMO, are the historical growth rates for EPS and DVPS. Dividend growth per share has stayed remarkably stable over time, stabilizing at around 5% per annum. EPS ont he other hand, has averaged 12% over the last 10 years, 6% over the last 30 years, and 7% over the last 50 years. These are unadjusted GAAP earnings for the market. IMO, if share repurchases were achieving their intended effect, we would see DVPS growth move higher over the last ten or twenty years. So the actual cash investors are receiving has stayed relatively constant on a growth basis for some time, which would indicate to me, reported EPS is for some reason overstating true sustainable FCF to equity holders. Perhaps the O&G industry is contributing to the profit margin bubble due to the fact that D&A in that industry understates the maintenance CAPEX needs for the industry to sustain current earning power. It certaintly would be interesting to analyze on a sector by sector basis. FWIW - sales per share as of Q411 were 1,018, and 10y median inflation-adjusted sales per share are 959. I went back and looked at what the market was trading at on a price-to-sales basis (using the 10y median inflation-adjusted sales figure) when WEB wrote his NYT op-ed - adjusted sales per share were 833, and the market was around 916, for an approximate 1.1x multiple. Applying that to the current 959, brings us to around 1,050. Schiller_December_2011.xls

Look at another way. Long term profit margins are 6%, and with current sales on the SP around 1000, normalized EPS would be $60. I'm being conservative using $70, IMO. I look at it another way too, adjusting ten years worth of sales for inflation and taking the ten year median. This alleviates the problem of having the majority of years at record high profit margins distort the EPS figure. I can get to a FV of 1000 using this method. But to your question on having two recessions in the data set, that is exactly the point, to have earnings spanning economic cycles. I use the median as oppose to average in order to account for the record low EPS in 2008/2009. Hussman for example uses the average which has $19 EPS in the calculation. IMO, his numbers are overly bearish.

I dont know if we will get down to 5x on the market (one can only pray for such an environment!), but taking a cursory look at past bear markets, they tend to last for 15 years give or take, and end at 7 or 8 times earnings on the market. If we can agree the secular bear we are currently in started in 2000, then we have the potential for a range-bound market for the next 4 years let's say. So right now the ten year median inflation adjusted EPS on the SP 500 is around $70, and if we assume a 6% growth rate for the next four years, 2015 EPS will be around $88. 10 times that is 880 on the market in 2015, so not only is it plausible the market is flat for the next four years, but could EASILY decline. Obviously that is a very crude forecast fraught with risks, but it is one way of looking at the general environment and giving yourself a rough time frame for when downside risk could materialize.

I am pretty sure bb can buy ultrashort ETFs and fpa crescent fund actually hold short positions. But I think I will just leave it here and let the thread speak for itself. :) Nice edit after the fact, BTW.

Hahaha. Well said.