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A template for understanding what's going


Eric50
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I read last night a paper from Ray Dalio on how the economic system works. This is really interesting and it provides a great background on the current crisis and what we can expect next. The part I enjoyed the most is his description of the long term debt cycle.

 

http://www.hedgefundletters.com/wp-content/uploads/2011/03/a-template-for-understanding.pdf

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This analysis is excellent -- consistent with assertions (but obviously much more expansive) I made in debate with some on this board over 1 year ago.  For those of you who get turned off by his reference to a "long wave cycle," ignore the terminology and understand the dynamics.

 

One can argue about whether the economy operates as precisely as he suggests (although Dalio admits he has simplified the analysis) but the dynamics he explains are very real.

 

Investors who fail to understand the analysis are "like a one-legged man in an ass-kicking contest" (to borrow a favorite from the real Munger).

 

Based Berkowitz public comments, I'm inclined to believe he is/was ignorant of the realities presented in this analysis.  He'll never make as much money as he originally anticipated in BAC, with returns relative to alternative common stock opportunities not so good.  Although at $6, maybe BAC is a great investment -- I personally don't know either way but I'm still cautious about investing in banks that are still heavily levered, even if "only" 10:1.  And the only way Berkowitz will make meaningful money in his BAC investment is if the Fed induces significant inflation through money printing but even then the returns in real terms will be paltry relative to the alternatives.  Buffett, on the other hand, stands to do quite well under almost any scenario except complete armageddon.

 

On a positive note -- good to see preseason hockey games have begun.  Will be tougher for the Canucks to get out of the West this year -- biggest team specific question mark is how much of a role Schneider will be asked to play?  Will be interesting to see if the Kings take a big step forward this year -- lots of talent.   

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This analysis is excellent -- consistent with assertions (but obviously much more expansive) I made in debate with some on this board over 1 year ago.  For those of you who get turned off by his reference to a "long wave cycle," ignore the terminology and understand the dynamics.

 

One can argue about whether the economy operates as precisely as he suggests (although Dalio admits he has simplified the analysis) but the dynamics he explains are very real.

 

Investors who fail to understand the analysis are "like a one-legged man in an ass-kicking contest" (to borrow a favorite from the real Munger).

 

There are no dynamics behind the "long wave cycle".  It's just nonsense.  You can fit any argument into almost any set of statistics.  For example, when you made the original argument around September 1, 2010, the S&P500 was at 1,100.  It then rose to well over 1,300, before correcting back to slightly above where it was. 

 

You can make two arguments here from one set of statistics...either you were wrong, and the market rose to 1,300, or you were right and it corrected to where it was.  What is the correct answer?  Neither, because the market does not make sense in the short-term and none of us are buying the market.

 

Based Berkowitz public comments, I'm inclined to believe he is/was ignorant of the realities presented in this analysis.  He'll never make as much money as he originally anticipated in BAC, with returns relative to alternative common stock opportunities not so good.  Although at $6, maybe BAC is a great investment -- I personally don't know either way but I'm still cautious about investing in banks that are still heavily levered, even if "only" 10:1.  And the only way Berkowitz will make meaningful money in his BAC investment is if the Fed induces significant inflation through money printing but even then the returns in real terms will be paltry relative to the alternatives.  Buffett, on the other hand, stands to do quite well under almost any scenario except complete armageddon.

 

I asked Mohnish what he thought of Buffett's investment and if Buffett was simply making a preferred bet like GE or GS.  He said, no definitely this time Buffett is making a bet on BAC stock.  He's protected through the preferreds, but the warrants aren't simply a kicker this time, but were integral to the investment.  Why?  Because with GE and GS he was getting interest comparable to quality equity investments he could make.  With BAC, he's tied that capital up now at a 6% return for 10 years.  The opportunity cost of this investment indicates that he is making a bet on BAC recovering, but he is protected on the downside if he is wrong.

 

On a positive note -- good to see preseason hockey games have begun.  Will be tougher for the Canucks to get out of the West this year -- biggest team specific question mark is how much of a role Schneider will be asked to play?  Will be interesting to see if the Kings take a big step forward this year -- lots of talent.

 

About the only thing we'll agree on.  Although Canucks will win the cup!  Cheers! 

 

 

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There are no dynamics behind the "long wave cycle".  It's just nonsense.  You can fit any argument into almost any set of statistics.

 

I continue to be surprised by the unwillingness of some to learn.  By reading/understanding the analysis, anyone would realize that the debt dynamics discussed are far from nonsense.

 

I can only conclude that the phrase "long wave cycle" immediately turns some away.  I personally don't like the phrase either -- "long wave cycle" would seem to suggest the macro economy evolves according to an easily predictable timeline, which I am highly doubtful.  However, the analysis unquestionably captures the dynamics currently affecting the economy. I guarantee Buffett and Prem understand these realities and factor them into their decisions.

 

 

none of us are buying the market.

 

I agree.  But understanding the analysis conveyed by Dalio would provide insight into the risk to E and consequently why a much higher than usual margin of safety should be required for any investment during these times, which has been my primary assertion.  Further, no one in their right mind would invest a meaningful portion of their capital in the common equity at previously prevailing valuations (e.g. BAC $11-15/sh) of a highly levered bank if they understood the analysis.  Berkowitz got it wrong -- very wrong.

 

On Buffett -- he secured equity upside at a valuation some have argued is at .3-.5 of tangible book value without any corresponding downside risk while getting paid 6% in a world of record low interest rates.  Enough said.  I personally see no problem with Buffett cashing in on the well deserved reputation he established over the course of a lifetime.

 

About the only thing we'll agree on.

 

The principles of Buffett/Munger/Graham have governed every meaningful investment decision I have ever made.  So I presume we agree on much re investing.  The difference is that I expanded my knowledge base to understand what the hell (and why) was going on during the 2007/2008 credit crisis -- it was a worthwhile endeavor.

 

 

I unf don't have time to go back/forth today -- usually enjoy the debates.  Any really -- it is up to each one of us to decide to learn or not.  You don't want to be a "one-legged man in an ass-kicking contest."

 

 

 

 

 

 

 

 

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Based Berkowitz public comments, I'm inclined to believe he is/was ignorant of the realities presented in this analysis.  He'll never make as much money as he originally anticipated in BAC, with returns relative to alternative common stock opportunities not so good.  Although at $6, maybe BAC is a great investment -- I personally don't know either way but I'm still cautious about investing in banks that are still heavily levered, even if "only" 10:1.  And the only way Berkowitz will make meaningful money in his BAC investment is if the Fed induces significant inflation through money printing but even then the returns in real terms will be paltry relative to the alternatives.  Buffett, on the other hand, stands to do quite well under almost any scenario except complete armageddon.

 

I asked Mohnish what he thought of Buffett's investment and if Buffett was simply making a preferred bet like GE or GS.  He said, no definitely this time Buffett is making a bet on BAC stock.  He's protected through the preferreds, but the warrants aren't simply a kicker this time, but were integral to the investment.  Why?  Because with GE and GS he was getting interest comparable to quality equity investments he could make.  With BAC, he's tied that capital up now at a 6% return for 10 years.  The opportunity cost of this investment indicates that he is making a bet on BAC recovering, but he is protected on the downside if he is wrong.

 

This is exactly what I argued when Buffett made his investment.  Clearly, the equity exposure was integral to the investment.

 

 

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There are no dynamics behind the "long wave cycle".  It's just nonsense.  You can fit any argument into almost any set of statistics.

 

I continue to be surprised by the unwillingness of some to learn.  By reading/understanding the analysis, anyone would realize that the debt dynamics discussed are far from nonsense.

 

I can only conclude that the phrase "long wave cycle" immediately turns some away.  I personally don't like the phrase either -- "long wave cycle" would seem to suggest the macro economy evolves according to an easily predictable timeline, which I am highly doubtful.  However, the analysis unquestionably captures the dynamics currently affecting the economy. I guarantee Buffett and Prem understand these realities and factor them into their decisions.

 

 

none of us are buying the market.

 

I agree.  But understanding the analysis conveyed by Dalio would provide insight into the risk to E and consequently why a much higher than usual margin of safety should be required for any investment during these times, which has been my primary assertion.  Further, no one in their right mind would invest a meaningful portion of their capital in the common equity at previously prevailing valuations (e.g. BAC $11-15/sh) of a highly levered bank if they understood the analysis.  Berkowitz got it wrong -- very wrong.

 

On Buffett -- he secured equity upside at a valuation some have argued is at .3-.5 of tangible book value without any corresponding downside risk while getting paid 6% in a world of record low interest rates.  Enough said.  I personally see no problem with Buffett cashing in on the well deserved reputation he established over the course of a lifetime.

 

About the only thing we'll agree on.

 

The principles of Buffett/Munger/Graham have governed every meaningful investment decision I have ever made.  So I presume we agree on much re investing.  The difference is that I expanded my knowledge base to understand what the hell (and why) was going on during the 2007/2008 credit crisis -- it was a worthwhile endeavor.

 

 

I unf don't have time to go back/forth today -- usually enjoy the debates.  Any really -- it is up to each one of us to decide to learn or not.  You don't want to be a "one-legged man in an ass-kicking contest."

 

 

 

 

 

 

 

Munger - while I don't agree with your former assertions regarding bank capital and how it relates to the equity market, I am 100% on board with your approach to expanding knowledge beyond ignoring the macro economic realities of the current environment. I give 100% credit to Cullen Roche of pragcap.com for greatly assisting in that regard, as my view of the world has changed entirely, and I have made much wiser capital allocation decisions with the macro in mind. You are 100% right regarding Berkowitz being wrong on the banks - it is a fools errand to invest in banks based on post-depression recession history b/c we are simply in a completely different environment. The private sector is deleveraging and will be for a long time unless the government actually pulled their heads out of their as$es and ran huge deficits. The banks aren't going anywhere anytime soon - yes they are more attractive here at $7 for BAC than when Berkowitz purchased at $15, but only now is BAC starting to resemble an attractive entry point considering the environment we're in.

 

We're in a slow-growth (if not a low-growth) environment even assuming China doesn't crap the bed, AND the market is still above Grantham's 950 FV. I would argue qutie vehemently in this environment the market belongs below if not well below FV. Considering my view of the world, I am probably way too aggressive with my portfolio, but I just can't help buying really cheap individual securiteis. That being said, I am scared to death that we will end up below 950 and stay there for a long time, which would drag down nearly all of our holdings here on this board. If we have a negative GDP print, I will gladly be picking up BAC and WFC at $4 and $18, respectively.

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Based Berkowitz public comments, I'm inclined to believe he is/was ignorant of the realities presented in this analysis.  He'll never make as much money as he originally anticipated in BAC, with returns relative to alternative common stock opportunities not so good.  Although at $6, maybe BAC is a great investment -- I personally don't know either way but I'm still cautious about investing in banks that are still heavily levered, even if "only" 10:1.  And the only way Berkowitz will make meaningful money in his BAC investment is if the Fed induces significant inflation through money printing but even then the returns in real terms will be paltry relative to the alternatives.  Buffett, on the other hand, stands to do quite well under almost any scenario except complete armageddon.

 

I asked Mohnish what he thought of Buffett's investment and if Buffett was simply making a preferred bet like GE or GS.  He said, no definitely this time Buffett is making a bet on BAC stock.  He's protected through the preferreds, but the warrants aren't simply a kicker this time, but were integral to the investment.  Why?  Because with GE and GS he was getting interest comparable to quality equity investments he could make.  With BAC, he's tied that capital up now at a 6% return for 10 years.  The opportunity cost of this investment indicates that he is making a bet on BAC recovering, but he is protected on the downside if he is wrong.

 

This is exactly what I argued when Buffett made his investment.  Clearly, the equity exposure was integral to the investment.

 

Buffett's betting on the frickin government would step in and save the system if need be - that's what he did back in 2008 and that's what he's doing now. If you go back and look at his Gillette, US Air, Salmon preferreds in the Forbes Buffett interview compilation I posted within the last couple of weeks, he clearly made those investments b/c the actual equity was too risky. Even if the equity is an integral part, by definition, buying something higher up on the capital structure (unless restricted by policy) means an investor deems the lower position is too risky.

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Based Berkowitz public comments, I'm inclined to believe he is/was ignorant of the realities presented in this analysis.  He'll never make as much money as he originally anticipated in BAC, with returns relative to alternative common stock opportunities not so good.  Although at $6, maybe BAC is a great investment -- I personally don't know either way but I'm still cautious about investing in banks that are still heavily levered, even if "only" 10:1.  And the only way Berkowitz will make meaningful money in his BAC investment is if the Fed induces significant inflation through money printing but even then the returns in real terms will be paltry relative to the alternatives.  Buffett, on the other hand, stands to do quite well under almost any scenario except complete armageddon.

 

I asked Mohnish what he thought of Buffett's investment and if Buffett was simply making a preferred bet like GE or GS.  He said, no definitely this time Buffett is making a bet on BAC stock.  He's protected through the preferreds, but the warrants aren't simply a kicker this time, but were integral to the investment.  Why?  Because with GE and GS he was getting interest comparable to quality equity investments he could make.  With BAC, he's tied that capital up now at a 6% return for 10 years.  The opportunity cost of this investment indicates that he is making a bet on BAC recovering, but he is protected on the downside if he is wrong.

 

This is exactly what I argued when Buffett made his investment.  Clearly, the equity exposure was integral to the investment.

 

Buffett's betting on the frickin government would step in and save the system if need be - that's what he did back in 2008 and that's what he's doing now. If you go back and look at his Gillette, US Air, Salmon preferreds in the Forbes Buffett interview compilation I posted within the last couple of weeks, he clearly made those investments b/c the actual equity was too risky. Even if the equity is an integral part, by definition, buying something higher up on the capital structure (unless restricted by policy) means an investor deems the lower position is too risky.

 

Orrr... Buffett just realizes he has the negotiation power to get more for his money than others can. This deal is in no way an indication that he finds common stock to expensive or risky.  I am in the group that doubts he would ever be willing to bet $5b in pure cash for a lean 6% with a speculative play attached.

 

The glass half full or half empty I guess.

 

Also, claiming Berkowitz is wrong because the price plummeted... That is just stupid. Even if all his bank investments went to zero you still couldn't simply claim it was stupid. There are odds involved that generate very favorable risk/reward scenario's and sometimes they don't turn out to well.

It is easy to call something stupid or risky in retrospect without actually having a clue what you are talking about Munger.  ;)

I guess a lot of value investors are terribly wrong today then...

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Based Berkowitz public comments, I'm inclined to believe he is/was ignorant of the realities presented in this analysis.  He'll never make as much money as he originally anticipated in BAC, with returns relative to alternative common stock opportunities not so good.  Although at $6, maybe BAC is a great investment -- I personally don't know either way but I'm still cautious about investing in banks that are still heavily levered, even if "only" 10:1.  And the only way Berkowitz will make meaningful money in his BAC investment is if the Fed induces significant inflation through money printing but even then the returns in real terms will be paltry relative to the alternatives.  Buffett, on the other hand, stands to do quite well under almost any scenario except complete armageddon.

 

I asked Mohnish what he thought of Buffett's investment and if Buffett was simply making a preferred bet like GE or GS.  He said, no definitely this time Buffett is making a bet on BAC stock.  He's protected through the preferreds, but the warrants aren't simply a kicker this time, but were integral to the investment.  Why?  Because with GE and GS he was getting interest comparable to quality equity investments he could make.  With BAC, he's tied that capital up now at a 6% return for 10 years.  The opportunity cost of this investment indicates that he is making a bet on BAC recovering, but he is protected on the downside if he is wrong.

 

This is exactly what I argued when Buffett made his investment.  Clearly, the equity exposure was integral to the investment.

 

Buffett's betting on the frickin government would step in and save the system if need be - that's what he did back in 2008 and that's what he's doing now. If you go back and look at his Gillette, US Air, Salmon preferreds in the Forbes Buffett interview compilation I posted within the last couple of weeks, he clearly made those investments b/c the actual equity was too risky. Even if the equity is an integral part, by definition, buying something higher up on the capital structure (unless restricted by policy) means an investor deems the lower position is too risky.

 

Well, I do think that the government would step in and save the system if the US banking system were to collapse again, but I think Buffett's assessment is that the US financial system is in much better shape versus the European and Chinese financial systems.  Europe, in particular, is a total mess.

 

I really think that WEB wouldn't make an investment like this where he thought the stock was not worth his strike price in a negative/worst case scenario.  Otherwise, he would have asked for a 10% yield and the strike price would have been at TBV or BV.  He has just tied up $5 billion of capital for ten years, knowing full well that he could have deployed into "safer" investments with a much better than 6% return, including buying up whole companies where it doesn't matter one bit what the market does. 

 

So why preferred + warrants versus a common investment at all then?  Because it's the best of both worlds.  He gets equity exposure and an immediate cash stream that can be deployed in a market that could easily trade sideways for a long time.

 

I'd do the same thing if I were WEB. 

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Well, I do think that the government would step in and save the system if the US banking system were to collapse again, but I think Buffett's assessment is that the US financial system is in much better shape versus the European and Chinese financial systems.  Europe, in particular, is a total mess.

 

I really think that WEB wouldn't make an investment like this where he thought the stock was not worth his strike price in a negative/worst case scenario.  Otherwise, he would have asked for a 10% yield and the strike price would have been at TBV or BV.  He has just tied up $5 billion of capital for ten years, knowing full well that he could have deployed into "safer" investments with a much better than 6% return, including buying up whole companies where it doesn't matter one bit what the market does. 

 

So why preferred + warrants versus a common investment at all then?  Because it's the best of both worlds.  He gets equity exposure and an immediate cash stream that can be deployed in a market that could easily trade sideways for a long time.

 

I'd do the same thing if I were WEB. 

 

I happen to agree with everything you and Parsad and other BAC bulls are saying.  But, just one point of clarification -- can't they preferreds be paid back at any time by BAC.  I don't think they have a maturity date, IIRC.  He's tying up $5 billion indefinitely in the preferreds.  This is the same deal he got with GE and GS -- those preferreds also had no maturity date.  The companies simply chose to pay them back -- GS when it got approval from the FED and GE after 3 years have passed -- October of this year (those were the terms of the GE preferreds).  However, if either or both company chose not to redeem them, Buffett had committed the money to each company -- at 10% per year -- indefinitely and had not ability to force them to redeem, as I understand it.

 

Here's the relevant language from the BAC 8k on 8/25:

Subject to the approval of the Board of Governors of the Federal Reserve System, the Preferred Stock may be redeemed by the Registrant at any time at a redemption price of $105,000 per share plus any accrued, unpaid dividends. The Preferred Stock has no maturity date and will rank senior to the outstanding Common Stock (and pari passu with the Registrant’s other outstanding series of preferred stock) with respect to the payment of dividends and distributions in liquidation.

 

The warrants are a separate deal, as I understand it -- the fact that he got 10 years on the warrants makes this deal look far better to me than the GE and GS deals. 

 

Those deals had 5 years on the warrants -- they expire, IIRC, around October of 2013.  His strike on the GE warrants is $22.25 and on GS it is $115, IIRC. 

 

He said at the time that he wouldn't have done the preferred deals without the warrants -- this time around I think he's just facing the fact that he should have gotten more than 5 years.  I don't think he was expecting to be 3 years in and not well above the strike prices by this time.

 

All the above said, I think this deal means he is very bullish on the long term value of BAC equity and that he doesn't think BAC equity / balance sheet is a zero.  As Ben Graham has said (to paraphrase), you don't buy a preferred for par if you have any question about the company as a going concern. 

 

 

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I happen to agree with everything you and Parsad and other BAC bulls are saying.  But, just one point of clarification -- can't they preferreds be paid back at any time by BAC.  I don't think they have a maturity date, IIRC.  He's tying up $5 billion indefinitely in the preferreds.  This is the same deal he got with GE and GS -- those preferreds also had no maturity date.  The companies simply chose to pay them back -- GS when it got approval from the FED and GE after 3 years have passed -- October of this year (those were the terms of the GE preferreds).  However, if either or both company chose not to redeem them, Buffett had committed the money to each company -- at 10% per year -- indefinitely and had not ability to force them to redeem, as I understand it.

 

Here's the relevant language from the BAC 8k on 8/25:

Subject to the approval of the Board of Governors of the Federal Reserve System, the Preferred Stock may be redeemed by the Registrant at any time at a redemption price of $105,000 per share plus any accrued, unpaid dividends. The Preferred Stock has no maturity date and will rank senior to the outstanding Common Stock (and pari passu with the Registrant’s other outstanding series of preferred stock) with respect to the payment of dividends and distributions in liquidation.

 

The warrants are a separate deal, as I understand it -- the fact that he got 10 years on the warrants makes this deal look far better to me than the GE and GS deals. 

 

Those deals had 5 years on the warrants -- they expire, IIRC, around October of 2013.  His strike on the GE warrants is $22.25 and on GS it is $115, IIRC. 

 

He said at the time that he wouldn't have done the preferred deals without the warrants -- this time around I think he's just facing the fact that he should have gotten more than 5 years.  I don't think he was expecting to be 3 years in and not well above the strike prices by this time.

 

All the above said, I think this deal means he is very bullish on the long term value of BAC equity and that he doesn't think BAC equity / balance sheet is a zero.  As Ben Graham has said (to paraphrase), you don't buy a preferred for par if you have any question about the company as a going concern.

 

Kiltacular, I believe you're right.  Somehow, I got in my head that WEB could force redemption after 10 years. 

 

You definitely don't buy a preferred for par at a below market yield and for an indefinite period of time (no right to force redemption) if you have a question about the company as a going concern or if you don't get some sort of equity exposure out of the deal.

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