What a Lovely Frickin' Day!

[Uccmal]

parsad says:  What is gold's price going to do from where it is right now? 

 

maybe down?  All indicators are that gold is in a bubble.  At the local old persons mall (we all have one of these near our house) I noticed a cash for gold stall set up the other day.  If I owned some gold, other than my golden personality, I would be selling.  I have contemplated shorting gold but figure it has a ways to run, yet.  Gold does not generate cash, and having a piece of paper saying you own an ounce, or a Gold ETF defies the logic of safety.  If the shit hit the fan in the worst way, your ETF will be as worthless as the electronic screen it shows up on.  You actually have to hold the piece of metal in your hand to spend it for food, or gas and that assumes the owner of the gasoline even wants your gold.  He may prefer your rifle or some good buckshot.

 

Sanj., People dont get FFH.  They assume that Prem is making macro calls when he isn't.  He has hedged his equities 20% below market to avoid a catastrophic loss.  At the same time they have hedged they have bought Rim, Dell, CWB, IRE, JNJ, MB, SD,numerous insurers, and sent capital for expansion to existing insurers.  The cost of the hedges is magnitudes cheaper than the upside value of their business holdings. 

 

Some things are clearly macro bets borne out of their association with Jim Grant, Michael Burry, et al, but these are cheap bets made at a time of minimum distress, with huge potential payouts such as the CDS, or the deflation bet.  To my knowledge they have not touched Gold and have stayed out of Oil, exactly as Prem has stated. 

[biaggio]

"If I owned some gold, other than my golden personality, I would be selling. "

 

Uccmal, price of gold $1888/oz, price of golden personality...priceless.

 

Have a great labour day everybody.

[ERICOPOLY]

Ericopoly it is posts like this that make me think your success in the mkt has more to do with smarts than luck.

 

I told my wife that even if it just amounts to a good bedtime story, it keeps me from staying awake all night.  And perhaps that in it's own right will improve my success.  Forrest Gump (if he had enough smarts) would not have led such an interesting life as what he did.  "something just stung me in the buttocks"  Had he a full grasp on reality in Vietnam, then perhaps no trip to China to play table tennis.

 

So then there is Buffett (who original Mungerville alluded to) who has another view, that we will see substantial inflation.  His view is predicated upon a rebound in employment.  He sees the economy coming back eventually, and when it does these new reserves will create inflation.  I don't disagree.  You will then have more dollars chasing the goods -- that's when the reserves make it into the hands of ordinary people, when they get raises, get their old jobs back, work more hours, and lastly just a larger labor force.

 

So this brings me to the banks.  Will the stock price of BAC rise in the face of improving employment and credit expansion?  I'd say it has room to quickly triple in the Buffett inflation scenario.  So the question is, does BAC represent a decent hedge against the kind of inflation Buffett predicts?  I'd say yes.  The same thing that's holding down the bank stocks (employment and credit contraction) is holding back consumer inflation. 

 

[Santayana]

What a great thread this has become.  I had been wondering where Mungerville went.

 

I sure don't know what is going to happen economically, even if I could predict the individual events.  But I do think that what's going on with EU sovereign debt and the EU banks is going to be a factor in where we go from here.  Given how things are looking the amount of risk I see is way to high to be long without significant hedges.  I may be passing up on some awesome future gains, but I sure do sleep better at night.

 

For those who think it's not 2008 all over again, are any of you buying the Greek 1yr bonds yielding 80%?    Or do you see a scenario where Greece can fail and the whole system doesn't implode again? 

[Liberty]

Macronomic forecasting is a very dangerous thing for the average investor.  If the best economists in the world can never get it right, what advantage do we have?  The only advantage the value investor has is the intellectual framework that allows us to come to some estimate of an investment's intrinsic value, and then apply a margin of safety before buying.  That's the single greatest advantage we have.  I do not know of any other aspect of finance where we have such opportunity or probabilities.  Cheers!

 

I agree with this. As Claude Shannon would say, you need to stick to where you have an edge.

 

Maybe some people here are macro geniuses, but even these people seem to only get it right an awfully small percentage of the time (it's not a binary outcome thing where you start with 50% odds, in macro forecasting there are thousands of variables interacting with each other in unpredictable ways, so you start with very low odds of being right), so I'm not sure that provides much of a margin of safety...

[ERICOPOLY]

For those who think it's not 2008 all over again, are any of you buying the Greek 1yr bonds yielding 80%?    Or do you see a scenario where Greece can fail and the whole system doesn't implode again?

 

The longer it takes them to fail, the smaller the event will be (CDS contracts have a maturity date).

 

That doesn't really answer the question, but it does explain perhaps why kicking it down the road isn't so dumb.

 

[moore_capital54]

My thinking for myself on gold goes like this...

 

1)  There isn't much of it in absolute total value if you take the total known supply and price it in dollars at the current market price.  Thus, if we go back to a gold standard it will need to go sky-high in price (so that the total value of it will begin to make sense).  This will be a big win for gold owners, but to everyone else it really won't matter.  Prices of bread in dollars will be the same, it's just that those dollars will be backed by gold all of a sudden.  Life would go on.

 

My reasoning to support this ho-hum scenario is that the world was already flooded in dollars over the past 40 years since taken off the gold standard.  And so pricing already reflects the flood of printed money.  The thing that would need to catch up is gold prices.

 

Meanwhile there are other ways of finding value instead of betting on a rebasing in gold of the USD.  So I'm playing that game instead.

 

And I agree with Watsa on the idea that goods are priced by the amount of dollars chasing them.  A car for example is going to be priced (all other things being equal) on the wages of the person interested in buying one.  If a person doesn't get a raise, he can't bid up the price of that car.  So just because the Fed inflates reserves, it doesn't actually push up prices in the real world unless that money gets into the wages of ordinary people who buy things.  And why would it get into their hands if they are not in demand (wages stagnant)?

 

Eric I really don't want to engage in another gold argument because we have already been there and done that, and at this point everyone surely knows I am biased, and where I stand on this topic.

 

But I just wanted to point out a major flaw in your post, (there are others but will point out the major one).

 

Under scenario #1 you assume the world will just go on and you can still buy bread and butter etc, it'll just be priced in gold. What you are missing here sir, is that under this scenario all your previous wealth will have been significantly eroded. Sure if you have an occupation that is in demand you will continue to earn a salary that will provide you with comparable purchasing power (Think Buffet response to african student) but all the wealth you had accumulated under the fiat money system that was not fully invested in assets which, under a gold standard system would command the same valuations, would be basically worthless.

 

There are no free lunches, this is a zero sum game and if we went back to the gold standard, a significant portion of the world's current wealth would be erased. But don't worry:  We won't go back to the gold standard. Western Society does not have the discipline to do so. There are also major flaws in your argument of not having enough gold to support a gold standard but I plan on enjoying this Labor Day and will just leave it at that, just remember a gold standard is a system based on ratio's.

 

What is going to happen under the most optimistic scenario is that we get QE3 here, and thing's chug along until we are back to growing again. We will see some type of inflation but it will be contained and the world goes on. This is the scenario I am hoping for and have invested in equities accordingly. But even under this scenario, I see gold as fundamentally transformed in terms of a financial asset. Many people are not realizing that gold rising from $250 to 1,800 has done something from a historical perspective that is much more meaningful than whatever happens next (even a drop back to 250, which is highly unlikely as only jewellery demand is 2,000 tonnes vs 2,500 tones of mine supply). It has proven to all the doubters that gold is in fact, an alternative currency. And as a financial asset, it is an extremely useful and important tool for investors.

 

How many value investors who would have never  touched gold will be all over it on a decline to 500 an ounce. In my opinion, a lot. You can already see in the arguments of a lot of value investors today lines such as (@ 250 I thought it was great, @ 500 fairly valued, but now it's crazy) I think those lines are nonsense and that the guys writing stuff like that never liked gold or had a meaningful portion of their assets in gold even @ 250 or 500. But you can bet your arse, that if gold ever goes back to 250 or 500, a lot of new value investors, contrarian or not will think of it as a potential buy.

 

What I am saying here is that even in the most rosy world scenario where things get back to normal ala 2004-05-06... and gold is less than 1,000, there will be substantial investor interest and rightfully so. Mathematically, even if it does what it did from 2001-2011 once every 3 decades, it's worth holding 1-2% of your aum in it.

 

Under a pessimistic scenario, Gold becomes 5-10% of an investors portfolio because of a global eruptions of hyperinflation. But after sustaining significant losses in my european portfolio today, I do not feel like exploring the pessimistic scenario any further :(

 

A little anecdote is in order: My father owned bullion for many years, my grandfather left him some, and he had accumulated a few hundred ounces in his lifetime as well. Two weeks ago we were having dinner and got to speaking about the 1970-80's gold market. I asked my father if he ever felt like selling his gold back then, or how he felt after the gold price collapsed in the late 80's and early 90's. His answer really put everything into perspective. He said something like this:

 

"When gold was rising, the economy was truly in bad shape, so as business slowed it was great to know that I owned gold and was somewhat shielded from the macro environment. And when thing's picked up business wise, the value of my gold declined but things got better in terms of the real fiat-based economy so I enjoyed the fruits of my labor."

 

You see, there is simply no other asset, that functions like that, so perfectly and is completely removed from the financial system. You sit down and talk to any human being that owns physical gold, and you will get the same response. Nobody likes to sell gold, because nobody buys gold with all their money. I am absolutely sure that if yout ake the average household that owns physical gold and compare the cost basis to the value of their vehicles. The vehicles are worth more.

 

Here is another interesting statistic. Annual Gold Supply is 93mm ounces. Of which industrial demand (including jewellry) is 70mm ounces. So we are left with 23mm ounces a year of available investment supply. That means 23 million people can buy one ounce a year.

 

This is not a bubble. Last month the US Mint sold 160,000 ounces of gold, it was their highest month since january 2011. Do you think that 160k ounces were purchased by one person each on average? Heck no, one multi-millionaire or billionaire may have purchased 1k ounces each. I bet those 160,000 ounces went to less than 20,000 end users. This is not a bubble, this is an investment for intelligent, able, and historically conscious gentleman.

 

 

[turar]

... all the wealth you had accumulated under the fiat money system that was not fully invested in assets which, under a gold standard system would command the same valuations, would be basically worthless.

 

Just out of curiosity, which assets would command the same valuations? If one has a portfolio of businesses producing everyday goods and providing everyday services -- Cokes, P&Gs, etc., how much worthless can it really become?

[moore_capital54]

I know ive posted this before but it's just so "poetic" that I have to again:

 

http://www.fame.org/pdf/buffet3.pdf

 

I hope we see the day, where someone asks buffett point blank about this article, and it is televised.

 

Buffett thus far has been able to escape the question and answer with half arse answers, by comparing gold to equities and such. The people posing the question have been too stupid to know what to ask.

 

The question I would ask buffett would be:

 

1) Do you prefer a fiat money system to a gold standard system?

2) Don't you agree that gold has intrinsic value as a currency and medium of exchange, as it has served as such for thousands of years.

3) If not explain the position of your father and where you disagree with him?

4) When you buy and sell shares of Exxon and Walmart would you rather have the proceeds priced in fiat money or gold-backed money?

 

 

[moore_capital54]

Turar, they can become worth less but not worthless, because under gold-standard system aggregate demand would only be derived from true economic activity.

 

You would be surprised how much demand even for COKE and Gillette shavers would decline in a hard money system. Thats why it'll never happen.

 

The system we are in today is truly frankenstein money travels so fast, its absolutely crazy. I sit with people every day and nobody is content, nothing is ever enough. Long gone are the savers, this generation has produced very little households that have acted in a fiscally responsible manner. And I blame that solely on the system that rewards debtors and punishes creditors.

[Liberty]

The question I would ask buffett would be:

 

1) Do you prefer a fiat money system to a gold standard system?

2) Don't you agree that gold has intrinsic value as a currency and medium of exchange, as it has served as such for thousands of years.

3) If not explain the position of your father and where you disagree with him?

4) When you buy and sell shares of Exxon and Walmart would you rather have the proceeds priced in fiat money or gold-backed money?

 

Even if he answers 'yes' to all these, it's still not the system we have, and under the system we have, he obviously prefers to own productive businesses rather than currency, whether that currency is cash or gold. You might disagree with him, but his position is pretty clear and logically explained, IMO.

 

What's your opinion of gold as an investment?

 

We’re not enthused about gold. People say it’s a hedge against inflation, but that’s also true of oil, land, Coca-Cola, See’s Candies, etc. I’d much prefer to own land in Nebraska or an apartment house or an index fund as a store of value. We’d rather own an asset that will be useful even if the currency drops to 10 cents on the dollar. People will always need to drink and eat [referring to Coke and See’s]. We wouldn’t trade ownership of businesses for a hunk of yellow metal.

 

[CM: If you have the opportunities of Berkshire, an investment in gold is dumb.]

 

Gold would be way down my list as a store of value. I’d much rather own 100 acres of land in Nebraska or an apartment house or an index fund.

 

The Dow went from 66 to 11,000 or 12,000 during the last century, and you got paid a lot of dividends along the way. Gold went from $20 in 1900 to $400 in 2000, plus you’d have to pay insurance and storage costs, so it’s not a good store of value.

 

I’m not advocating paper money – it’s good to worry about this. But I’d rather sell one pound of candy. That will retain its value even if the currency is seashells.

 

Gold has done very badly [as an investment] in the past and I see no reason why it will work well in the future. All that happens is that it is taken out of the ground in South Africa and put back in the ground in Fort Knox. (Laughter)

 

[CM: Gold was good to have if you were a well-to-do Jewish family in Vienna in 1935 because of the situation [just before the Nazis took over]. But if you’re in our position, gold has no interest.

 

Source: BRK Annual Meeting 2005 Tilson Notes

URL:

Time: 2005

 

When would you exchange shares for gold?

 

The idea of exchanging a producing asset for a non-producing asset seems foreign to me.

 

Source: BRK Annual Meeting 2000

URL:

Time: April 29th 2000

[moore_capital54]

Liberty I fully agree with you, and I personally prefer to buy shares as well, than to buy gold. But you have to agree that the average investor can more easily protect his nest egg with gold than picking stocks.

 

Also I don't like Buffet's response of comparing gold from 1900. That is flawed, he has to compare gold from 1971 when it was demonetized. Only then can you actually refer to gold as an "investment" or "financial asset".

 

As we are on the subject, let's now compare the returns:

 

In 1971 gold was $35 now it's $1,850

 

In 1971 the dow was at 830 now it's at 11,240

 

Since 1971 buffet is wrong and gold has kicked the arse out of the dow. Moreoever, his comment about Nebraska land is too wrong, as I am sure he would not repeat such a statement today.

 

All this proves to us all is that Buffett is only human, and hes good when he stays within his circle of competence.

[ERICOPOLY]

Moore_capital, 

I didn't say there is not enough gold.  I said it doesn't make sense to me at current prices if used as the basis for the world's currency.

 

Put differently, if you were to price it at $1 per ounce maybe Buffett could just buy all of it and be the world's banker (and of course on a fractional reserve basis as you day).

 

How would you be able to extract it from private hands?  You'd have to pay a suitable price that is scaled to at least sensibly match the private wealth of the people in the world.  What if people refuse to redeem the gold?  Ultimately, I think the price would need to be scaled to match the dollars already out there in order to make sellers happy.

 

But consumer priced are already scaled to match the dollars out there held by the people who demand those goods.

[moore_capital54]

Eric,

 

The way to do it is on the Central Bank Level. It's just a matter of fixing a ratio of base money to the gold hoard. Making it redeemable is where it get's tricky.

 

I will make a prediction here though that I believe at least one country (it could be the smallest one) will revert to a gold standard in the future. The US can't do it niether can major western economies. I hope China doesn't do it as it would be terrible for the rest of us, but China could theoretically do it.

 

My bet is that someone like Chavez does it or Lichtenstein, a smaller nation with could easily manage a gold standard given their current gold hoard to base money ratios.

 

You should also know that right now, by accident, 25% of CHF base money is backed by gold. Switzerland stopped selling their gold in 1999 and as a result still have a large hoard as compared to their base money.

[Myth465]

And so goes the thread to freedom, liberty, and glorious gold....

[Guest Hester]

"fiat" money: No utility, has worth because we all agree it has worth, can be printed in infinite amounts.

 

Gold (which is also fiat by the way): No utility, has worth because we all agree it has worth, is very finite.

 

Copper/Silver: Much utility, has worth because it is vital for civilizations, finite.

 

Arable Land: Much utility, has worth because man cannot survive without making use of it, very finite.

 

Value producing companies: Much utility, has worth because the goods/services that it produces are necessary/vital/enriching for humans, finite.

 

 

 

Some look at that list and conclude that gold is the best asset to own. Puzzling.

[Parsad]

parsad says:  What is gold's price going to do from where it is right now? 

 

maybe down?  All indicators are that gold is in a bubble.  At the local old persons mall (we all have one of these near our house) I noticed a cash for gold stall set up the other day.  If I owned some gold, other than my golden personality, I would be selling.  I have contemplated shorting gold but figure it has a ways to run, yet.  Gold does not generate cash, and having a piece of paper saying you own an ounce, or a Gold ETF defies the logic of safety.  If the shit hit the fan in the worst way, your ETF will be as worthless as the electronic screen it shows up on.  You actually have to hold the piece of metal in your hand to spend it for food, or gas and that assumes the owner of the gasoline even wants your gold.  He may prefer your rifle or some good buckshot.

 

Sanj., People dont get FFH.  They assume that Prem is making macro calls when he isn't.  He has hedged his equities 20% below market to avoid a catastrophic loss.  At the same time they have hedged they have bought Rim, Dell, CWB, IRE, JNJ, MB, SD,numerous insurers, and sent capital for expansion to existing insurers.  The cost of the hedges is magnitudes cheaper than the upside value of their business holdings. 

 

Some things are clearly macro bets borne out of their association with Jim Grant, Michael Burry, et al, but these are cheap bets made at a time of minimum distress, with huge potential payouts such as the CDS, or the deflation bet.  To my knowledge they have not touched Gold and have stayed out of Oil, exactly as Prem has stated.

 

100% agree Al!

 

"If I owned some gold, other than my golden personality, I would be selling. "

 

Uccmal, price of gold $1888/oz, price of golden personality...priceless.

 

Have a great labour day everybody.

 

Also 100% agree with this!  Cheers!

[moore_capital54]

"fiat" money: No utility, has worth because we all agree it has worth, can be printed in infinite amounts.

 

Gold (which is also fiat by the way): No utility, has worth because we all agree it has worth, is very finite.

 

This is where the argument ends Hester, Once you establish gold is better than fiat than you make a conscious decision to use it to price everything else including these --->

 

It is not a competition between these other assets and gold, it is a competition between what you are using in between your investments. And I don't agree with the "fiat" statement relating to gold.

 

Copper/Silver: Much utility, has worth because it is vital for civilizations, finite.

 

Arable Land: Much utility, has worth because man cannot survive without making use of it, very finite.

 

Value producing companies: Much utility, has worth because the goods/services that it produces are necessary/vital/enriching for humans, finite.

 

 

 

Some look at that list and conclude that gold is the best asset to own. Puzzling.

[Josh4580]

Moore capital, the best book to read about how a functional gold peg would work is Gold: The Once & Future Money by Nathan Lewis

 

Here is the Amazon link.  I read this book when it came out in 2007 and have been bullish on gold since.  (It was around $650/oz than)

 

http://www.amazon.com/Gold-Future-Money-Nathan-Lewis/dp/0470047666/ref=sr_1_1?ie=UTF8&qid=1315253085&sr=8-1

 

[moore_capital54]

I own the book and it is definitely a good one.

 

I have recommended it to several posters here privately when asked for recommendations. I also suggest this book by Shayne Mcguire published very recently:

 

http://www.amazon.com/Hard-Money-Taking-Higher-Investment/dp/0470612533/ref=pd_sim_b_4

 

I also highly suggest: Extraordinary Popular Delusions and the Madness of Crowds

 

http://www.amazon.com/Extraordinary-Popular-Delusions-Madness-Crowds/dp/1463740514/ref=sr_1_1?s=books&ie=UTF8&qid=1315253415&sr=1-1

 

I personally find it very helpful to read a wealth of nations every few years as well. Very hard to read Adam Smith's work without realizing how important gold is as a medium of exchange. I find it fascinating how modern economic theory can disregard the amount of "weight" placed on gold in Mr. Smith's teachings.

 

 

[moore_capital54]

The Great Adam Smith:

 

The values of goods depend on the demand for them and the difficulty of acquiring them. Values must be measured by some common standard, and this standard must be something generally desired, so that men may be generally willing to take it in exchange. To secure this it should be something portable, divisible without loss, and durable. Gold and silver best fulfil these requirements. At first they were used by quantity or weight, without coinage, but eventually the state vouched for quantity and quality by its stamp. The stamp being 'easy workmanship' adds no considerable value. 'Coin is ever valued as a commodity in commerce as well as other goods; and that in proportion to the rarity of the metal, for the demand is universal.

[rranjan]

I think we should not have gold discussion in this thread. We should have it in gold or currency related threads. That way all related things will be together.

[original mungerville]

1) Stock Market Valuation

 

I am not as optimistic as my friend Uccmal whose views I respect very much. For example, I think the US stock market has been significantly over-valued for the last 14 years (roughly the entire period I have been investing), with only very brief periods of fair valuation (eg March 2009). There have been longer periods in those 14 years where stocks have not been outrageously /dangerously priced (just “high”), however, in no time in these 14 years have these “high” prices been accompanied with governments and central banks both “doing the right thing” at the same time from a long-term perspective in order to give me the confidence to fully take off the hedges. Rather, its been high prices accompanied by kicking the can down the road one more time.

 

The methods of other smarter people than me also indicate stocks are “high” (assuming price stability that is): Buffet’s Fortune articles in 2000/2001 go over how to value stocks to GDP (although he was being somewhat optimistic in those analyses so adjustments are necessary, and one can track Munger’s comments from the period to get a sense of the adjustments necessary), Grantham’s valuation methods for the S&P 500 have been very good over the last decade. 

 

My conviction on valuation leads me to continue my hedging …

 

You are assuming investors are only buying the market. No - I am and we are long-term value investors. I actually don't buy more than 1 to 5 stocks at a time, you probably buy a few more than me at a time. In any case, we don't buy the market - clearly then that is not my assumption.

 

If the market has been overvalued for 14 years, then how did I manage to quintuple my initial investment capital in that time? I think you know how you managed to do that: a) from 1997 to 1999 you benefited from your value investing and from a market rise, and then b) from 1999 to 2011 you benefited only from your value investing (ie the S&P500 has been more or less flat for 12 years). Now, as a Canadian probably investing like I did mainly in US stocks, like everything else relative to $US (ie ag, metals, precious metals, oil, other major currencies) the Canadian dollar is up and went up maybe 50% or so. So, you know the US stock market is actually down over that 14-year period when measured against most things other than the US dollar and certainly when measured against the Canadian dollar. But to answer your question: you did it by a combination of a) and b). I am not sure what point you are trying to make though other than to demonstrate your returns of 14% compounded annually - by the way congratulations, those are great returns especially given the market has been pretty flat over that period. (Even though we disagree on a few issues like heding and what Watsa is thinking, I have always thought that I would feel comfortable having you - as well as Uccmal, and a couple others on this board - invest my hard earned/saved capital.)

 

In fact, my initial investment in Corner Market Capital is up 4,000% over the last five years.  If you are searching for value, then you are buying individual investments...equities, bonds, entire private businesses, etc...not the market.  Like I said, I don't know why I do, but I only seem to buy 1 to 5 stocks - so you are preaching to not only the converted, but probably the priest.

 

 

2) Portfolio hedging and the kicking of the can

 

Watsa bet along with Buffett in late 2008 that the can would again get kicked, and kicked it was - big-time, and Watsa took off all the equity hedges. In no way had anything fundamental been fixed and he knew that when he did it (Watsa that is) – he bet on the stimulous having a huge effect (Grantham also called that – and exactly in March 2009 no less). Its one thing to bet on the can getting kicked and the effect – you have to be very wily to be sure the can will a) get kicked again, and b) of the effect of the kicking - however I would argue that that involves some degree of risk because the politics could somehow turn against you and then you get caught 100% in stocks in a depression. Both Buffett and Watsa – being wily enough though - took that calculated risk at the end 2008/2009 and were proved right.

 

Actually, although sometimes I thought I was nuts to do so, I have been hedged to at least some significant degree probably at almost every point since I started investing over a decade ago – because stocks have either been 1) way over-valued or 2) highly value accompanied by mismanagement of the economy at all points in that period (other than very brief points like March 2009 where we got to some level of fairish valuation). I was fully hedged going into the crisis, but I could only bring myself to take off 50% of my equity hedges at that same point Watsa took off 100% of his.  I have been 100% hedged through all of 2011 having fully transitioned up again from that 50% hedge.

 

If you contrast the last 4-5 years of my hedging with Watsa, he took off 100% of his hedges in 2009 … but they went back on in 2010 and he is again 100% hedged now – so he wasn’t long without them precisely because nothing has been fixed, the can keeps getting kicked and the stock market remains high.

 

But now what is changing is that they have kicked the can so damn far down the road, they got to the end of road, but that didn’t even stop them, they went out and got the dozers and built more road to kick it a couple more times.

 

So although I want to simply hedge 100% (ie basically 100% cash plus a value spread) like in 1997, I can’t be what is effectively 100% cash now (ie the financial system was going to collapse then and effectively 100% cash was great then, but now the threat has been shifting to the monetary system – and 100% cash is not good in that situation but nor do I want to be unhedged 100% long in stocks because nothing has changed on that front either - ergo Watsa is 100% hedged) …

 

This argument doesn't wash with me, and I have no idea why individual investors always reflect back on what Prem is doing.  Fairfax is an insurance company.  One that carries asset to equity leverage of 4-1 and about $2B in consolidated debt.  Their business absolutely exists based upon their credit rating and levels of statutory surplus.  If either goes down, they could be out of business. 

 

It is very likely that Fairfax's credit rating would drop significantly if they lost 10% of their assets, which would be roughly 35% of their equity.  If somehow the credit rating stays intact, the amount of business they could write would shrink enormously in such circumstances.  He has responsibilities to his employees, shareholders and customers.  Especially the customers who bought policies that need to be paid out in the most dire of circumstances.  Like Berkshire, or any other insurance company, Fairfax's check cannot bounce.  That's why Prem hedges.

 

Well I agree with most everything you said. I don't think the thinking at Fairfax is that they would always hedge their equities - they hedge when there is potential for significant decline to their common equity book value which is a function of two things: 1) the ratio of their exposure to common stocks relative to their common book value and 2) their thinking on temporary or permanent percentage declines in the value of their common stocks. For example, in 1999, they had common equity book value of around $3 billion with less than half of that in common stocks and $US600M in hedges for a net exposure of less than $800M or less than 25% of equity book. They thought stocks were dangerously priced. Whereas at year-end 2009, they had common equity book of $7.4 billion with over $5 billion invested in equities (75%), and I think their hedging was limited - so they thought stocks were not dangerously priced especially given the stimulus in place. All I am saying is individual investors could also benefit by trying to understand when the overall market is over-priced and position themselves accordingly. I am not advocating throttling down on the value investing compounding machine, rather that should always be peddle to the metal for an exceptional value investor. I am advocating hedges (not cash) in order to be fearful when other people are greedy and vice-versa. Hedges are better than cash depending on your investment returns. If your investment returns are really outsized, you never want to throttle down. If they are just slightly better than the index, then maybe forget the hedging and increase your cash when others are greedy. This to me is optimal portfolio strategy for an exceptional value investor. Again, to be clear, an exceptional value investor does not need any help and could just value invest, however he/she could make more money using hedges to be fearful rather than cash. Looking at the change in stance Watsa took from 1999 versus a decade later at year-end 2009 can be informative in this regard. His comments from both periods are also informative and can help returns. That's my point.

 

 

3) The Right Dry Powder (precious metals versus cash?) and Optimal Hedging/Portfolio Construction in this Environment

 

As value investors, we have been content keeping our “powder dry” in cash in the past, or like Pabrai did before the financial crisis started, some have even kept it dry in Berkshire Hathaway. Like Pabrai questioned himself keeping his powder dry in Berkshire during the crisis, I question keeping powder dry in cash in these times.

 

Maybe this thinking came from my hedging, but I started thinking a couple years ago, if I am 100% hedged like Watsa, my net position is basically 100% cash with, hopefully, me earning my value investor stock picking spread. But its basically 100% cash plus a spread and do I want to be 100% cash now at this point. In the past decade that has been fine, stocks have gone nowhere overall so hedging 100% and being effectively 100% cash plus a spread has been fine, but not now because other forces are becoming increasingly prominent: one of the potential directions we are headed in seems to be towards a whole new monetary system (maybe the odds are 60% in my view). The others are a depression (maybe at 20%), and also the chance of just some sort of muddle through (20%) which eventually becomes inflationary/ stagflationary – this is what the central bankers are shooting for as it’s the most palatable option. I certainly don’t want to be 100% in cash if we go to a new monetary system, nor do I want to be 100% in highly valued stocks if we go into a depression, and I don’t think I want to be 100% stocks in stagflation. At a minimum, I want my “dry powder” to be “safe” in all situations and ready to deploy in undervalued stocks.  But forgetting the minimum, from an optimal portfolio perspective for the next 5 years, I want to make as much money as possible in a safe way without anyone robbing me of my value investor spread (that spread being the spread between the growth of the value of my portfolio measured against both i) the stock market performance, and ii) cash) by inflicting on my portfolio either 1) significantly higher price levels, or 2) a depression.

 

And if we see deflation, which is also one of Prem's hedges?  What is gold's price going to do from where it is right now? Macroeconomic forecasting is a very dangerous thing for the average investor.  If the best economists in the world can never get it right, what advantage do we have?

 

The only advantage the value investor has is the intellectual framework that allows us to come to some estimate of an investment's intrinsic value, and then apply a margin of safety before buying.  That's the single greatest advantage we have.  I do not know of any other aspect of finance where we have such opportunity or probabilities.  Cheers!

 

1) I don't know, and don't pretend to know what is going to happen to gold if we get deflation - it may depend on the response of authorities to that deflation and this is what gives me pause - we could get a new monetary system as a result more or less overnight if the response is a once in a century one and is global. I do know that sure as shit my Russell 2000 puts will be way in the money if we get deflation and nothing happens in terms of the inflationary response from authorities.

 

2) Yes, absolutely that is the only advantage we have as value investors. For this exact reason I am advocating always being fully invested, however, I am advocating hedging in certain times instead of going to cash. ie if you are a really good value investor, harness the value investing advantage at all times by hedging when others are greedy.

 

3) You might remember a guy by the name of Warren Buffet hedging, before he was in insurance and still at the partnership level - going around asking portfolio managers to lend him any stock they wanted so he could sell it short. Why did he do that? To make less money or more?

[original mungerville]

Liberty,

 

"The Dow went from 66 to 11,000 or 12,000 during the last century, and you got paid a lot of dividends along the way. Gold went from $20 in 1900 to $400 in 2000, plus you’d have to pay insurance and storage costs, so it’s not a good store of value."

 

Well, that's an excellent time period for Buffet to choose not adjusting for the inflated valuations of common equities. In 2000, stocks were over-priced by about 50% so cut that 12,000 to 6,000 for a fair price on equities.  Also unaccounted for were everyone's full 200% confidence in Greenspan - double gold to $800 for that. (we can argue about both adjustments, but my point is directional and that the comparison is weak given the time period chosen which just coincided with the annual report, so I am not blaming Buffett rather I am saying its not applicable to what we are going through today - see below) For 2000, on that adjusted basis, equities went up 100, and gold went up 40 times (I would say that that is  pretty close - only a 100% difference over 100 years or less than 1% compounded per year);

 

If you don't like my adjustments, currently, the Dow is at 11,000 and Grantham says its worth something like no more than 9,000. Gold is at 1,900. But lets just go with 11,000 - that's about 160-170 times from 66; gold is up about 100 times from 20 - damn close over a 110 years - now much less than a 1% annual difference compounded.

 

People still think the authorities can save the day and prevent deflation - otherwise stocks would not be at 11,000. If you take the gold bubble to be the inverse of the authority bubble, gold is not in a bubble because people still think the authorities can save the day.

 

But let's just stick with the numbers - I'll even give Buffett the less than 1% slippage a year (not that I am certain that that is the case). So you know, let me agree with him that in normal times, take the candy - take the productive asset, take the stocks, farm, etc and over time that is better than gold at the end of the century.

 

But I would say this: I am not concerned about who has slippage of 1% compounded over the next 100 years and who doesn't. I agree with Buffett there, either the other stuff is better than gold in this regard, OR its a wash - I would guess its a wash but maybe he is right.

 

What I am concerned with is keeping my powder dry over THIS PARTICULAR TRANSITION period where I am not smart enough to know if we get deflation (like Watsa thinks) or inflation (like Buffet thinks) and whether the latter is accompanied or not by a new monetary system and a one-time significant adjustment of the price level upwards. I am not smart enough to know that my Russell hedges are the right thing to do over these next 1 to 4 years anymore (I was certain they were the right thing over significant periods in the last 12 years though) but I am certain that "safe" is the way to go. And I am pretty sure that in the Buffett and/or new monetary scenarios, precious metals, after accounting for this less than 1-4% slippage (over the next 1 to 4 years, ie. I'll give that measly less than 4% away no problem) should outperform stocks dramatically. Actually for the record, I have been in this stuff for close to 1.5 years already, so make that from 2010 to 2015 inclusively, precious metals should outperform stocks as the financial crisis compounds the sovereign fiscal crises if we get significant inflation and/or a new monetary system.

 

Buffett and Munger in that quote are talking very long term, and saying stay focussed on the candy because in the END, the candy is just as good as precious metals. And I agree but I am talking in THIS TRANSITION PERIOD which could be brutal, add in-the-money calls (ie don't put your whole portfolio in) on precious metals to the mix with an equity hedge to ensure your dry powder doesn't get wet. This is the only way I can think of of being "safe" with my "dry powder" dry in all scenarios.

 

Having said all that, what sucks about thinking about this crap, is arguably that it may detract from you developing your stock-picking skills further while you focus on this stuff for this particular transition period. (But if worse comes to worse, after this is all over sometime in the next 4 years, I can give my money to one of the capable board members to invest purely bottom-up. But I guess even I can find three good stocks to hold at any one time.) I actually can't wait 'till the day comes when I will feed that the optimal portfolio strategy includes no equity hedges - and no currency/precious metal hedges - because its a real pain in the ass frankly.

 

 

 

 

 

 

 

 

 

 

 

[Parsad]

2) Yes, absolutely that is the only advantage we have as value investors. For this exact reason I am advocating always being fully invested, however, I am advocating hedging in certain times instead of going to cash. ie if you are a really good value investor, harness the value investing advantage at all times by hedging when others are greedy.

 

Sorry Mungerville, I mis-understood your original comment.  I thought you said you were 100% cash AND hedging.  Yes, I would agree that if you are fully invested, then hedging would be a rational way to protect your capital. 

 

Personally, I prefer cash in most circumstances, as the frictional costs from hedges can eat away at returns if you are wrong for a significant period of time.  We've moved pretty quickly in and out of cash over the last couple of years, simply due to the massive swings.  We were fully invested a couple of weeks ago, and a couple of our investments recovered rapidly where we averaged down significantly, so we built our cash position back up to about 15%.  Cheers!