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Grantham Urges Shift to Stocks Before "Rigor Mortis"


Parsad
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This article looks like it could have been written by FFH (or BRK). As they continue to invest their cash hoard we likely will hear many complaints about how they are too early... It will be instructive to see what moves they make quarter to quarter. The big changes in Q4 were:

1.) exiting US Treasuries

2.) moving into tax exempt municipal bonds

3.) removing the equity hedges

4.) purchasing more common stocks

What opportunities will Mr Market provide in 2009?

 

Quotes I liked from Grantham's article:

"Sensible value-based investors will always sell too early in bubbles and buy too early in busts."

"Life is simple: if you invest too much too soon you will regret it; “How could you have done this with the economy so bad, the market in free fall, and the history books screaming about overruns?” On the other hand, if you invest too little after talking about handsome potential returns and the market rallies, you deserve to be shot."

 

Here is the link to the Grantham article...

[ftp=ftp://http://www.gmo.com/websitecontent/JG_ReinvestingWhenTerrified.pdf]http://www.gmo.com/websitecontent/JG_ReinvestingWhenTerrified.pdf[/ftp]

 

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You could have said this last year and invested, not knowing where the bottom was, especially after Lehman.

But then your portfolio would have dropped another 30% or so.

 

There's no harm looking at the top down aspects.

 

Nonetheless for me, buying BRK-B at 2280 was just pure faith a week ago, with the hope that the market wouldn't get too irrational, but it can go down further (or it may stay at these healthy levels).

Margin of safety as a principle is fine and all, but it's much harder to implement and not as straightforward as it looks. Often the margin of safety will fluctuate, especially if the stock in question has assets that fluctuate in value with the market, like WEB's derivative contracts (especially the CDS ones).

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You could have said this last year and invested, not knowing where the bottom was, especially after Lehman.

But then your portfolio would have dropped another 30% or so.

 

There's no harm looking at the top down aspects.

 

Nonetheless for me, buying BRK-B at 2280 was just pure faith a week ago, with the hope that the market wouldn't get too irrational, but it can go down further (or it may stay at these healthy levels).

Margin of safety as a principle is fine and all, but it's much harder to implement and not as straightforward as it looks. Often the margin of safety will fluctuate, especially if the stock in question has assets that fluctuate in value with the market, like WEB's derivative contracts (especially the CDS ones).

 

 

Unless there is some chance of liquidation at current prices, it is not the smartest thing in the world to think of liquidation value as intrinsic value. 

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Viking, the reason it resembles FFH is because Grantham, and Grant (of Grant's interest rate observer) are the two people that FFH follow most ardently.  The macro ideas that FFH utilizes comes from these two men.  FFH just happens to be very good at grasping and applying the concepts. 

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Depending on what you call liquidation value.  It has different means for different people.  If you are using liquidation as a sum of the parts, then Berkshire has trade at range of its sums for years.  Some times it is near 100% and sometimes it is 150%.  It is what do you value the parts at that matter.

 

I don't think Berkshire Hathaway is a ton cheaper than the general market.  Entry price has to be evaluated against all possible options.

 

X can be 50% of IV, but Z might be at 10%.  Then again Y might be 150%.  So it is all up in the air now like it always is.... You make your "bets" and hope for the best.

 

=SFWUSC

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You know - its worth emphasizing that in this current note Grantham is saying he moved in October to somewhere between minimal and moderate exposure to equities.  This current note also seems to say he has not added to that minimal to moderate exposure as of yet. 

 

Sure, certain individual securities are cheap and should be bought, but the general market IS NOT the opportunity of a lifetime as confirmed by Buffet yesterday on CNBC - i.e. these are not 1974 or 1981 valuations.  Grantham also echoes these views explicitly stating in this note that this is NOT 1974 and that is why he still believes that there is a 50/50 chance the market drops below S&P 600.

 

Don't get me wrong, I am investing, but I am not going "all in" at this point.  Furthermore, I am selling my gains - I believe there is an 80% probability that the market girates between S&P 500 to 1000 and it is just as likely to go below 500 as it is to go above 1000.  I believe there is almost no possible way we will see S&P 1500 (Oct 07) highs anytime in the next few years.

 

KO and JNJ at 4% dividend yields look like they can provide decent returns even in a depression.  ORH to me looks like a no-brainer double in 5 years even in a depression and within 3 to 4 years if we don't have a depression.  I think there is a 33% chance of a depression at this point.  So we have non-depression lows in the stock market with a decent chance of a depression and a 90% probability of a deep recession followed by very meager growth thereafter for a few years (this is consistent with Buffet's view).  Things can get a hell of a lot cheaper but we can also get a hell of a market rebound.  Not to 1500 though - that is for sure.

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Unless there is some chance of liquidation at current prices, it is not the smartest thing in the world to think of liquidation value as intrinsic value. 

 

No, not the puts ... but maybe the losses on CDS that WEB has to fork up each time the market drops.

Same things goes with the banks. Each time the market drops, the value of balance sheet mortgage assets (on or off Balance sheet) falls, and then the bank has to raise capital, thereby diluting shareholders.

This is what has been happening to the banks the last 6-12 months, and WFC is not immune to this either. If consumer credit losses and CRE loan losses blow out, then they'll have to raise capital too. Who knows where unemployment is going.

 

It's not the smartest thing in the world to think that leveraged institutions will never have to liquidate assets to meet funding requirements.

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I want to add more to my point and pay attention, I am giving you pearls here. :P

 

Grantham talks about minimizing the regret function.  I brought some of this up on a recent thread with Ericopoly where I said that if ORH's equities (1.6 billion as at Dec 31) in 2009 dropped by another 50%, the bond yields (note a $400M yield with no M-to-M loss due to CDS held protecting principal as well as market fluctuations) would make up for half of that equity loss over the course of 2009.  They would therefore get nailed with 400M in pre-tax losses or 280M after-tax.  Their book value is $2.9 billion.  So they take a hit of slightly less than 10% of book.  Book value falls from 45 per share to $40 per share in this scenario.  Guess what else happens though?  Competitors can not write business and they double market share in 3 years.  So, bring on the 50% equity market decline I say.  I WANT that loss.  Bring it.  ORH benefits depression or not.

 

So understand that no one has a crystal ball and to Grantham's point we all want to minimize the regret function.  Well how stupid would ORH be if they DID NOT invest in equities in October.  Answer: very stupid.  Its the same answer even if the market drops another 50% in 2009.  It was the right move.  If the equity market surges from here, we may not get that rock hard P&C market and there will not be as great an expansion in the business but at least we get the gain in equities.  So, to summarize, ORH's bet on the equity markets does not mean everyone should be "all in".  They are minimizing the regret function as per Grantham or in other words maximizing the probability of adjusted returns given no one has a crystal ball and no one can pick the exact bottom and that equation has a different curve when your underwriting profits and market share are inversely relate to the equity and bond markets.  This is likely NOT your situation.  Remember what Prem said in that National Post article in the Fall of 2008: the first 50% hurts, its the next 50% decline in the stock market that can kill you.  He, like all of us, understands that the bear market rallies can be furious and large - Buffet reminded us of as much in his October missive - and going in in October was a good move given his regret function.  Going into equities in October/November was the right move.  Its too bad about the timing, but no one is going to get the timing perfect.

 

Pay attention, re-read it, I'm giving you pearls here! :)

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Unless there is some chance of liquidation at current prices, it is not the smartest thing in the world to think of liquidation value as intrinsic value. 

 

No, not the puts ... but maybe the losses on CDS that WEB has to fork up each time the market drops.

Same things goes with the banks. Each time the market drops, the value of balance sheet mortgage assets (on or off Balance sheet) falls, and then the bank has to raise capital, thereby diluting shareholders.

This is what has been happening to the banks the last 6-12 months, and WFC is not immune to this either. If consumer credit losses and CRE loan losses blow out, then they'll have to raise capital too. Who knows where unemployment is going.

 

It's not the smartest thing in the world to think that leveraged institutions will never have to liquidate assets to meet funding requirements.

 

Why think of the cds as being any different from the other types of insurance Berkshire writes?  No one suggest that writing hurricane insurance decreases intrinsic value, even if they end up paying out more than they receive on a given year. 

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So, bring on the 50% equity market decline I say.  I WANT that loss.  Bring it.  ORH benefits depression or not.

 

 

... I don't ... I want to buy it when it falls 50%, and then see it go up 50% and then some.

 

Ah ... the [glow=red,2,300]ELUSIVE[/glow] bottom ...  :)

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I dont know Arbitragr,  There is actually signs of life out there.

 

The dividend cuts and writedowns are starting to flow cash into those banks, and GE capital.  And the stimulus hasn't even begun to take effect.  If Citi, and BAC, and JPM actually reports a profit in a few weeks all hell will break loose on the upside. 

 

 

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I agree.  Although the market essentially has - i.e. other than a little 20% bounce in December - it doesn't usually go just straight down.  So my view is why not buy some things that should do OK fundamentally over 4 years with a portion of the portfolio regardless of the economic and market environment.  I think ORH qualifies as an unhedged position.  And I don't mind hedging and going long KO and JNJ at 4% yields.

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Be cautious of the impending 'bump' as there are a lot of logic flaws.

 

-An awfull lot of people need a big rally in order to recover cover losses YTD, but the intent is to hedge/sell into it so that further drops will not be as damaging. It can only happen if the money on the sidelines is dumb; & much of it is far from dumb.

-We rally because 1-3 months of profit at certain key banks clearly indicates that the turnaround is working. But at any other time this would not be seen as a 'trend', especially when the underlying problems are still there. In the 1930's it was Morgan proclaiming in the pit, how is todays 1-3 months of profit not the same?

- It is implied that only existing participants will sell/hedge, & that somehow dumb money will not short or write puts in any major way. Dumb & dumber is not a great way to sustain a rally.

 

The opportunity may well be very short lived

 

SD

 

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SD,

 

I agree with what you are saying, but I don't understand what opportunity you are talking about ("the opportunity may well be short lived").

 

I think you are dead on that lots of people will sell if they recover their losses, but politely, who cares?

 

People on this board have been wondering recently if we go down to 600 or even 500 as Grantham posits . .. .  who cares?

 

We are talking about a 10-20% downside in a market that will likely double over the next 3-5 years. Inflation has become a "when" not "if" question . . . stocks will certainly outperform cash and bonds over the long term. The short term is scary, but that is why you buy with a margin of safety. Most stocks discussed on this board have an adequate margin of safety at this point so that things can get worse than we expect in the short term, and the investment will still work out.

 

Buffett always says that no matter how smart you are, you have to realize that even if you know exactly where the economy is going, you still have no idea where the stock market will go.

 

I have always been very against the efficient market theory, but I have to agree with Warren and Charlie; the weak form of the EMT almost always holds (other than in the midst of a crash of mania). There are a lot of very smart people on this board, and a lot of very smart people managing money out there - arguably the percentage of money that is "smart" is a lot higher than in the past. I think we all have roughly the same information: this board, Ben Bernanke, John Paulson, Warren Buffett, and most of our intelligent non-financial friends and relatives.

 

In short, I think a lot of this stuff is priced in. All that is left in my opinion is being greedy while others are fearful. We could debate all day about what will happen this year . . ..  but if you want to talk about whether or not FFH will outperform stocks, bonds, and cash over the next four years that will be a very short conversation. There are "sure thing" winners sitting around at unheard of prices . . . I think Grantham and others are right that it doesn't make sense to wait.

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T-Bone

 

I agree.  I think it is more difficult to act that way if you manage OPM, thats why FFH or BRK can do it as they see fit.

 

If you look at Munger's history as a money manager the bear market of the mid 70s killed him sicologically as a manager of OPM.  Well, killed him in the scense that he went on to partner with WEB and become a billionaire..;)

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I agree with Tbone.  Rather than worry about where the market is going investors should consider the strength of their investments.  I would expect that any significant rally be met with selling pressure.  But if earnings of the companies I have invested in continue to grow who cares?

 

One company I identified for my portfolio is a monopoly level business.  It requires minimal capital investment to grow and operate.  Free cashflow even accounting for depreciation, taxes, and interest should come in around 65-70 million this year.  Been DECIMATED.  This company has a track record of doing well under nearly any economic circumstances and held their own last year.  Why was this priced at 185 million for a time?  They actually grew their customer base last year, albeit slowly.

 

Scrape the bottom of this market in the bombed out areas and it is amazing the deals you can find.  What is even more amazing is you will get mocked for buying them. 

 

 

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Maybe oldye, time will tell.

 

My thought with the overall market is that there are really two markets.  The big money market (pension funds, large mutual funds, endowments and foundations) and the small cap market.  In order to see a severe correction (dow 3000) we will probably have to see that type of money go running to the exits.  The weaker hedge funds have already been crushed and are selling to meet redemptions.  Any area they were heavily involved in is laying bloodied.  Of course much of their selling is meeting the redemptions of their not so happy institutional clients.

 

So the question in my mind is would Calpers, Ipers, Berkshire, ISU, etc go running?  If not we probably won't get the deal of a lifetime on McDonalds, Pepsi, etc.  But you can find companies with exceptionally strong fundamentals and market positions in the small cap space if you look hard enough.  You will probably be the only person looking at it.  Very little coverage and interest from the institutions.  The company I mentioned in the post above even if it were to increase 300% would do little to nothing for a major player.  They would literally need 100 such opportunities to move the needle, so they don't bother.

 

In the seventies pension funds were largely absent from the market having gotten stung in the great 'bull', I believe they didn't march back in till the eighties  bull was well underway.  They seem rather committed to this market still.  Same is true with the 1930's, mostly it was made up of individual investors. 

 

I haven't done a study on this, but are just general thoughts.  This is the first major wipe out since the emergence of large institutions as the predominant force in the overall market.  They could prove more rational or less rational, time will tell.

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Bit of a stretch but Canada may be a usefull example.

 

The big money are the pension funds and almost all of them were down 15%+ last year; some were down almost 25%. Most of the big DB plans are being reviewed, & there is real possibility of contribution increases & reduced benefits. The first wave of boomer retirees is in 5-10 yrs, the viability of the long term investment rate growth assumptions is being questioned, & there is rising concern that ALM mismatch volatility (averaging net gains/losses forward) is not being adequately addressed. ie: The climate is demanding that asset managers deliver reliable returns with minimal downside volatilty. Fail to deliver, & you're gone.

 

While most recognize that there are some terrific bargains, your career will not tolerate one of these bargains having an adverse credit event. It will also suffer some damage if you have a CDS to cover the downside risk, as you're only as good as that counter-party staying out of the bad press. ie: Dont touch unless absolutely positive (hedge), & keep each holding as small as possible to minimize exposure (career diversification)

 

So what ?

 

Pension funds will not go running, but they will very likely be super cautious. ie: Writing puts to acquire the underlying, cash + call combos to cover break-outs, quick to put on hedges to lock in a minimum level of gain, etc. Small repeat gains versus the big & widely dispersed gains of the past.

 

Long tail investment 'float' funds will very likely be less cautious simply because they can afford to be. Especially when convertible cash yields are so high, there is a hardening market (same premium, but lower payouts from higher deductibles), & you also have the ability to lower UW standards if neccessary. ie: WEBs & HWs shifts are no accident, but they are also at the aggressive end of the current spectrum.

 

The more pension $ in the institutional 'pool' the more caution - in Canada, pension $ dominates.

Small rallies, & choppy trading, untill the career risk goes down

 

SD

 

 

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