Why did so many smart investors miss making a killing on BRK stock?

[gfp]

On the subject of Buffett and debt and Berkshire board members making well timed moves with the stock...

 

In 1976 Warren convinced his Mother to sell her 5,272 shares of BRK.A to his sisters Doris & Bertie for $5,440 plus a $100,000 note (to Mom, not the bank or margin).  They each got 2,636 A-shares at about $40/share while coming up with only about $2/share in cash.  95% leverage.  Kind of puts his stories from this year's annual letter about his sister being one of the greatest investors of all time all on her own into perspective.

 

Charlie Munger did a similarly well-timed masterstroke of estate planning near the absolute bottom of stock prices in the GFC - he got 2,000 A-shares out of his estate, sold to family members in exchange for a promissory note.  On 11/20/2008, with BRK.A at $77,500.

https://www.sec.gov/Archives/edgar/data/1067983/000118143108063602/xslF345X03/rrd224408.xml

[Munger_Disciple]

57 minutes ago, gfp said:

The first Laguna beach house was $150k and I think Warren paid in cash.  He had recently shut down the partnership and that gave him $16 million cash but he pretty quickly spent every dime of it buying shares of stock (and presumably the Laguna house).  Then he ran out of cash and had to live on only the $50k annual salary Berkshire paid him and some fees he earned from running a pension fund for FMC Corporation (a sort of favor for a friend).

 

A few years later, Warren paid $300k cash for Howie's first farm in Nebraska.  Howie paid Warren rent.  I'm not sure if that farm was mortgaged or not.

 

 IIRC Warren called his broker and instructed him to sell a few Berkshire shares to raise cash saying that Susie wanted to buy a house. He probably bought back those and more later after getting a mortgage. 

[Munger_Disciple]

15 minutes ago, gfp said:

On the subject of Buffett and debt and Berkshire board members making well timed moves with the stock...

 

In 1976 Warren convinced his Mother to sell her 5,272 shares of BRK.A to his sisters Doris & Bertie for $5,440 plus a $100,000 note (to Mom, not the bank or margin).  They each got 2,636 A-shares at about $40/share while coming up with only about $2/share in cash.  95% leverage.  Kind of puts his stories from this year's annual letter about his sister being one of the greatest investors of all time all on her own into perspective.

 

Charlie Munger did a similarly well-timed masterstroke of estate planning near the absolute bottom of stock prices in the GFC - he got 2,000 A-shares out of his estate, sold to family members in exchange for a promissory note.  On 11/20/2008, with BRK.A at $77,500.

https://www.sec.gov/Archives/edgar/data/1067983/000118143108063602/xslF345X03/rrd224408.xml

 

This is very different from margin debt; mom wasn't going to call on the loans even if daughters didn't make a payment on the note  for a few months.

 

But a great strategy to keep in mind. 

Edited March 9 by Munger_Disciple

[Munger_Disciple]

I also think Berkshire is a totally different company now compared to the eighties and seventies to state the obvious. The ROE on Berkshire SH Equity in 70s and 80s was off the charts unlike today. So levering up BRK with debt is more dangerous now than before, especially given that the markets are quite bubbly.  

 

[gfp]

Yeah, I am definitely not advocating for borrowing against Berkshire or any other stock with margin debt (despite the fact that I sometimes do it - but I'm a big boy and I understand the risks).  There are other ways to add leverage to your financial life that are far less dangerous for those that are impatient or whatever.

[Munger_Disciple]

4 minutes ago, gfp said:

Yeah, I am definitely not advocating for borrowing against Berkshire or any other stock with margin debt (despite the fact that I sometimes do it - but I'm a big boy and I understand the risks).  There are other ways to add leverage to your financial life that are far less dangerous for those that are impatient or whatever.

 

I also used a relatively minor amount from time to time but ideally it is better to borrow non-recourse like Buffett did with a 30-year mortgage for those who are inclined to lever-up with any stock.  

[Munger_Disciple]

BTW we all know the famous story about Rick Guerin, friend of Warren & Charlie who levered up a bit too much in the 70s and was forced out of all of his Berkshire A stock at something like $40 a share due to a margin call. 

[Dynamic]

Margin debt can be very risky especially if your dealer offers you more margin that Regulation T. In times of major decline they then tend to increase the margin requirements which is more likely to lead to forced sales at the worst time.

 

However, I could imagine that right now with Berkshire B shares over $400 and A shares over $600,000, you could withdraw on margin about 5% of the market value with very little risk, so $20 against each B Share or $30,000 against each A share. If it fell 75% it would still only be a 20% loan to market value and I don't think it's ever fallen to a quarter of a previous high.

 

If Berkshire compounds at say 8% or better in the long run your percentage loan would reduce over time making it even safer so long as the margin interest isn't too expensive. So there are ways it could be done pretty safely so long as you're strict about keeping your limits a very long way from a margin sale in the worst case scenario.

[keegomaster]

35 minutes ago, Dynamic said:

Margin debt can be very risky especially if your dealer offers you more margin that Regulation T. In times of major decline they then tend to increase the margin requirements which is more likely to lead to forced sales at the worst time.

 

However, I could imagine that right now with Berkshire B shares over $400 and A shares over $600,000, you could withdraw on margin about 5% of the market value with very little risk, so $20 against each B Share or $30,000 against each A share. If it fell 75% it would still only be a 20% loan to market value and I don't think it's ever fallen to a quarter of a previous high.

 

If Berkshire compounds at say 8% or better in the long run your percentage loan would reduce over time making it even safer so long as the margin interest isn't too expensive. So there are ways it could be done pretty safely so long as you're strict about keeping your limits a very long way from a margin sale in the worst case scenario.

Berkshire has dropped 50% in a few instances. One of those during 2008

https://www.cnbc.com/2008/11/21/berkshire-hathaway-down-almost-50-from-alltime-high-as-stock-sinks-again.html

[Dynamic]

Yes, and I would want to plan for an even bigger drop to be survivable if I took out a margin loan against it. A 25% loan against a $400 stock would become a 50% loan against the same stock when cut in half to $200, so that's clearly too risky. It could easily fall 60% or 70% in extremis compared to it's current fairly lofty levels, albeit still below IV. Imagine extreme insurance loss events (Pandemic, event like 9/11, or a major war) coupled with rising interest rates and a big recession hitting big names like Apple really hard, perhaps two or three of those at the same time. The worst drop Berkshire has seen is probably not the worst it will ever see. Anything now than about 12.5% loan to value would make me nervous.

[Jaygo]

What about just borrowing from a line of credit?. Possibly not worth it at the current rates or the expected performance of brk. 

[Cigarbutt]

On 3/13/2024 at 2:03 AM, Dynamic said:

Yes, and I would want to plan for an even bigger drop to be survivable if I took out a margin loan against it. A 25% loan against a $400 stock would become a 50% loan against the same stock when cut in half to $200, so that's clearly too risky. It could easily fall 60% or 70% in extremis compared to it's current fairly lofty levels, albeit still below IV. Imagine extreme insurance loss events (Pandemic, event like 9/11, or a major war) coupled with rising interest rates and a big recession hitting big names like Apple really hard, perhaps two or three of those at the same time. The worst drop Berkshire has seen is probably not the worst it will ever see. Anything now than about 12.5% loan to value would make me nervous.

Interesting.

Just in case this is useful, here's a short discussion with a picture.

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i recently used that concept with one of my daughters who's more into math and statistics and not into investing. She wonders if, going forward, she should invest her excess earning power into an index (which is great in a lot of ways) and she wonders (the downside part in her) how long her initial investment could be under water after the initial period. i used the graph below which is a typical potential catastrophe loss graph (exceedance probability graph) showing the likelihood of loss and the 'modelled' loss per return period with, in this specific picture, how present undiscounted factors could be integrated to shift the graph line, in this case, for example, how the use of specific mitigation measures could bring down the potential loss and the potential likelihood of loss, such as improved building codes and wildland management versus wildfire costs. Anyways, the graph was used in a way to show the likelihood of marked-to-market loss sufficient to remain underwater on the y-axis against time on the x-axis (1yr, 5yrs, 10yrs, 20 yrs? etc). One can then figure out the time it would take to "recover" from a sentimental and fundamental point of view given a relatively low likelihood of loss following the initial phase. With her, several factors were discussed including present valuation levels which could influence the loss curve especially for the lower duration period ie 10 years or less. Anyways, if you can weather the loss, it's not really an issue. Or is it?

-----

Anyways, for the topic at hand (use of leverage to buy BRK), a similar concept can be applied with the likelihood of margin calls on the y-axis and time duration on the x-axis. The loss curve can be approximated from history (previous BRK drawdowns, frequency of such drawdowns and other factors etc). Many underlying assumptions do not follow the stationarity principle and could be used to 'adjust' the curve for different potential foresight scenarios. Of those assumptions, one has to consider the trend that BRK's market returns have been becoming more and more correlated with the S&P index (no longer such an uncorrelated pillar of strength in time of uncertainty). Another factor to consider is the growing proportional revenue and net income/cash flow streams coming from energy, a sector not appreciated for these qualities presently in an environment that is causing various degrees of transitory 'regulatory (un-)friendliness'.

Bottom line, your approach to avoid becoming nervous appears reasonable and does not require fancy models and all but i've spent some time recently on the potential for catastrophe results to impact targeted investments and this post required 5 minutes to share so..

[backtothebeach]

The most prudent approach is to make the leverage uncallable.

 

If you own 1000 shares of a stock, and want to control, for example, 1100 shares, you could sell 100 shares and buy 2 option contracts of the longest expiration and lowest strike price possible from the proceeds, for even money. That way you don't have margin loan and have zero risk of a margin call.

 

The implied interest rate  for BRKB deep ITM LEAPs currently is around 6%, not too different from any other cost of leverage. (Probably a bit high for the expected return of Berkshire at the moment).

 

Jim (mungofitch) on the old Fool boards did a lot of great work on this.

 

Eplanation of implied interest rate:
http://www.datahelper.com/mi/search.phtml?nofool=youBet&mid=34391366
http://www.datahelper.com/mi/search.phtml?nofool=youBet&mid=31996045

 

One nuance: During a steep drop in stock price, you might be able to lock in some gained time value by rolling the strike price further down, as explained here:
http://www.datahelper.com/mi/search.phtml?nofool=youBet&mid=31899968

 

Another nuance: If the stock goes absolutely nowhere, or down, or up less than 6% p.a., you would have to roll those options forward (a few more years out), in order to maintain the leverage. This may require fresh funds, suitable strike prices may not always be available, or implied interest rates could be even higher.

[Munger_Disciple]

13 minutes ago, backtothebeach said:

The most prudent approach is to make the leverage uncallable.

 

If you own 1000 shares of a stock, and want to control, for example, 1100 shares, you could sell 100 shares and buy 2 option contracts of the longest expiration and lowest strike price possible from the proceeds, for even money. That way you don't have margin loan and have zero risk of a margin call.

 

The implied interest rate  for BRKB deep ITM LEAPs currently is around 6%, not too different from any other cost of leverage. (Probably a bit high for the expected return of Berkshire at the moment).

 

Jim (mungofitch) on the old Fool boards did a lot of great work on this.

 

Eplanation of implied interest rate:
http://www.datahelper.com/mi/search.phtml?nofool=youBet&mid=34391366
http://www.datahelper.com/mi/search.phtml?nofool=youBet&mid=31996045

 

One nuance: During a steep drop in stock price, you might be able to lock in some gained time value by rolling the strike price further down, as explained here:
http://www.datahelper.com/mi/search.phtml?nofool=youBet&mid=31899968

 

Another nuance: If the stock goes absolutely nowhere, or down, or up less than 6% p.a., you would have to roll those options forward (a few more years out), in order to maintain the leverage. This may require fresh funds, suitable strike prices may not always be available, or implied interest rates could be even higher.

 

The biggest issue with this approach is the capital gains taxes that are incurred (assuming the options are in the money) when rolling into new LEAPs just prior to expiration date. The only other alternative is exercising the options which involves taking on margin debt which was the original problem we are trying to solve. 

[sleepydragon]

14 minutes ago, Munger_Disciple said:

 

The biggest issue with this approach is the capital gains taxes that are incurred (assuming the options are in the money) when rolling into new LEAPs just prior to expiration date. The only other alternative is exercising the options which involves taking on margin debt which was the original problem we are trying to solve. 

also, if Brk suddenly starts paying dividends, long term calls will tank 

[Munger_Disciple]

4 minutes ago, sleepydragon said:

also, if Brk suddenly starts paying dividends, long term calls will tank 

 

You can exercise the calls before the ex-dividend date in this case but then it involves taking on margin debt again. So there is no easy solution.

[backtothebeach]

7 hours ago, Munger_Disciple said:

The biggest issue with this approach is the capital gains taxes that are incurred (assuming the options are in the money) when rolling into new LEAPs just prior to expiration date. The only other alternative is exercising the options which involves taking on margin debt which was the original problem we are trying to solve. 

Good points about taxes and dividends. I am not an expert on taxes, but if exercising the options does not trigger a tax event, this kind of leverage could be at least a good tool to pull investments forward two years during the accumulating phase of ones life. Particularly if you think you have identified an outstanding bargain, e.g., Berkshire trading below book value in 2020.

[charlieruane]

One more quick thought on the original topic of this thread, i.e. why many smart investors didn't make a killing off of Berkshire. I think part of it probably stems from a lack of intellectual humility. Berkshire has been the most well-known value investment option for decades now. It takes a certain amount of humility for a money manager to say, "honestly, I'm not likely to beat the risk-adjusted return this investment offers." Managers also have a mandate to "prove their worth" to their clients; it can be hard to justify earning fees on Berkshire even if that is the best choice. 

 

It's Buffett's one-foot-hurdles quote manifest... 

[Munger_Disciple]

47 minutes ago, charlieruane said:

One more quick thought on the original topic of this thread, i.e. why many smart investors didn't make a killing off of Berkshire. I think part of it probably stems from a lack of intellectual humility. Berkshire has been the most well-known value investment option for decades now. It takes a certain amount of humility for a money manager to say, "honestly, I'm not likely to beat the risk-adjusted return this investment offers." Managers also have a mandate to "prove their worth" to their clients; it can be hard to justify earning fees on Berkshire even if that is the best choice. 

 

It's Buffett's one-foot-hurdles quote manifest... 

 

Most brokers (A.K.A. wealth managers, but they are really glorified salesmen) at "full service" brokerages like Morgan Stanley, Goldman, JPM, etc generally hate Berkshire because they can't make money churning the account. I used to work with one of them and I got rid of them (and moved my account to a discount broker) after I started buying Berkshire stock 22+ years ago. 

 

I also think in the last 20 years, Berkshire roughly matched the S&P 500 index. So if one doesn't want to do any work on which stocks to buy & hold, she would have done just fine buying & holding the index (case in point: Astrid's portfolio as described by Warren). 

 

I think Berkshire is likely to just match the index results over the next 10-20 years. But I prefer holding Berkshire as opposed to the index even if that's the case. I like the culture, deep focus on risk, treatment of shareholders as true partners, no stock options for management, managers buying Berkshire stock in the open market like their fellow shareholders, and everything else at Berkshire. 

 

 

Edited March 18 by Munger_Disciple