Berkshire Subsidiaries Update

[txlaw]

 

Buffett's consistently optimistic view of the US economy is a major disconnect from the more cautious views of other highly respected gurus (Watsa, Klarman, Grant, Rodriguez, Grantham, Gross and El-Arian, Soros) and ECRI's recession call.

 

It's hard to ignore Buffett given his track record and his unique ability to take the pulse of the economy through BRK's operating companies. On the other hand (if I am not mistaken), he has been on the record saying that he missed the housing bubble and it seems he did not see the 2008 recession coming either.

 

Just wondering how good his economic forecasting record has really been and whether the pulse he holds on the economy is only a coincident indicator and not very useful in forecasting?

 

I think WEB has gone on record saying that he missed the severity of the housing bubble, not the fact that there was a bubble.

 

I'm glad that WEB, who has access to lots of real data, thinks that there won't be a recession, but the fact that all those smart guys are worried about a recession means that it's probably a good idea to build a recession into your outlook when determining whether there is a margin of safety in your investments.

 

 

[i accidentally removed my previous post.  Don't think there's a way to undo that.]

 

One other thing that I find interesting. 

 

Buffett has said that he doubts we will go into recession.  Fred Smith of Fedex doesn't see a recession.  Jack Welch thinks we will have 1 to 2% growth. 

 

Notably, it is mostly finance types (other than WEB of course) and economists who believe that there will be a recession or that we are in a recession right now.

 

That's a little cause for optimism, I guess.

[twacowfca]

Personally, I think that 9% book value increase you cited is a questionable way to look at Prem's returns on investments. The 9% net compounded annual number you cite for Fairfax is comprised of 1) excellent investment returns relative to book far greater than 9%, and this multiplied by 2) horrible underwriting losses relative to book due to the 7 lean years of the TIG and Crum acquisitions. Fairfax breaks out their earnings into these two big categories, the first category is the investment side. I think if you worked through those numbers, the returns would be at least 10% higher compounded annually than the 7% Francis got. So I am looking at the numbers before speaking, I am just not looking at them the same way you are.

 

You can't pick and choose.  Francis' numbers are significantly higher historically as well.  You can't take away Francis' losses, and you can't take away Prem's losses during the lean years...they don't just disappear...and it's also not fair to exclude from one and not the other. 

 

TIG & C&F were the equivalent of stock picks, and they killed Fairfax because they were so underreserved.  That's no different than me investing say in AIG and getting killed.  And they hurt Fairfax more because of the leverage. 

 

If Fairfax had the same asset to equity as Berkshire, the combined losses from 9/11, TIG & C&F and hurricane losses, would not have hurt as much.  Thus the reason Fairfax NEEDS to use hedges to protect themselves from massive swings in their equity, which would result in downgrades and possibly loss of ability to underwrite property-casualty insurance.  I would prefer to see Prem get the leverage down further...maybe 2.5 or 3-1.  Cheers! 

 

Great summary, Sanj.  This puts relative performance in perspective.  :)

[EdWatchesBoxing]

interesting discussion. This all tells me that people will have their preferences, but it can't hurt to look at things outside of your comfort zone. I believe in the fundamental approach, but work shows me the trading side of things. Interesting, but can be complicated at times.

 

I see how Soros and WB can be viewed highly. They are both very competitive people. WB was thinking about his partners when he rolled everything into berkshire. Soros makes me think about the renaissance fund. That fund seems to have done really well long term, but haven't looked into it for a while.

[moore_capital54]

Parsad,

 

"None of the people you mentioned are leveraged.  Prem is leveraged.  I think Francis can ignore macro for the most part, because it would be nearly impossible to wipe him out." 

 

Sure Parsad, Francis can ignore macro all he wants because he is not leveraged, so can you. You can ignore the fact that the Canadian dollar went from 66 cents to par with the US, you can ignore the financial system collapsing in 2008, and governments and/or the monetary system collapsing now, but you are both going to be getting much worse returns during the 2000 to 2015 period relative to Prem who, poor guy, is leveraged and therefore has to pay attention to macro.

 

Your logic of relating the need for attention to macro, to the use of leverage escapes me.

 

Exactly how much better did Prem do than Francis from 2000 to 2010.  Francis return 7% annualized, while Fairfax's book value increased by 9.9% annualized...using leverage and hedges!  Check the numbers before shouting from the rooftops!  Yes, their actual equity holdings did better on an annualized basis, but what is that position relative to the total assets within Fairfax? 

 

In my own personal portfolio, I've returned better than 20% annualized over the same period...no hedges, no leverage, no shorts.  Over the last five years, MPIC Fund I, LP has returned 12.5% annualized, when the S&P500 returned about 1%...no hedges, no leverage other than the occasional use of options.  Corner Market Capital's own portfolio is up about 12% this year...no hedges, no leverage, no shorts.

 

So feel free to do what your conscious is telling you, but don't extrapolate your use of hedges and macro views as a necessity when trying to invest successfully...even in volatile times.  Cheers!

 

Parsad that is a fantastic YTD return +12%... What positions contributed to this outperformance? Most value investors I know are down this year or up in the single digits.

[original mungerville]

Parsad,

 

Picking and choosing? OK, let's do it another way then: what do you think Prem 9% annualized would have looked like without the CDS bet and equity shorts, and while you are at it without the big long-bond gains - those are all "macro" type bets? Pretty shitty I would guess.

 

In any case, you are totally missing my point: My point is that your strategy is optimal for say 85 years out of 100, but you are not realizing that when you get 15 years where things are so out of wack your strategy of no hedges is suboptimal. Like I said, after 2015, I'll be investing like you - when it will be optimal again. That's the point. So yes, you are right, but only in the very long-term - ie 10 years plus.

 

So it doesn't matter if your fund made 12% annualized or whatever, or if you made 20% plus personally - my point is its suboptimal for this unique period of time - ie your fund could have made 16% and you 28%.

[Kiltacular]

Kiltacular,

 

Fair points although leverage (from float) and negative cost float are non-investment factors that helped Buffett's returns and offset the drag from taxes. Also, Buffett would not have been able to do everything he did if he did not have permanent capital - didn't he or Munger say something to the effect that BRK would not have been so successful if their capital was not permanent?

 

As for taxes that investors have to pay, while they do affect net returns, they should not really matter in a discussion on investor ability E.g. Should our evaluation of Soros's investing skills be arbitrarily dependent on whether the govt abolishes capital gains taxes or raises it to 80% tomorrow? Alternatively, you shouldn't have a situation when A, who is not subject taxes, conclude that Soros is great while B, who pays high taxes, concludes that Soros is bad simply because of their individual net returns.

 

Anyway, there are too many variables pulling in different directions for us to be able to say one is better than the other and this is not the issue. They are both 6-sigma investors who have achieved their results by taking different routes and I feel, that as students of investing, we should absorb whatever lessons we can from whomever we can.

 

The Buffett-only people seem to think this is wrong and that it's either Buffett's way or the highway, as though we already know everything that we can about investing from Buffett/Graham and that there is nothing else to be learned. How is saying that "All we need to know about investing can be found in Security Analysis" different from saying that "All we need to know about life is in a particular religious book and we don't need to do science?" Would Buffett have been so successful if had stopped his learning at Graham?

 

Just makes me wonder how the "Buffett-only people" would have reacted if they had been investors in Burry's fund when he started buying CDS. They would probably have berated Burry, as many of his investors did, for straying away from value investing instead of listening to his rationale for his actions.

 

Oec,

 

As I said before, you make good points.  I've noticed that most people aren't used to being agreed with so let me say that I think your reasoning and logic are sound on most subjects I've seen you discuss -- including this one!

 

My comment was just a nitpick about Buffett not a refutation of your points about Soros.

 

If you look at Berkshire's BVPS growth before the corporate taxes (which you "can't" since book is after taxes), one would see that his "gross" returns -- as a hedge fund would report -- are just INSANELY high over a very long period.  If Berkshire's real tax rate averaged 30%, Buffett's "hedge-fund-comparable returns" were over 30% even when one considers that Buffett's capital base exploded in size in the later years.

 

That's doesn't reduce what Soros has done!

 

Finally, you're correct that both the permanent capital and the "float" are large contributors to Buffett's results through Berkshire.

 

Good stuff and keep it up.

 

kiltacular

[vinod1]

In any case, you are totally missing my point: My point is that your strategy is optimal for say 85 years out of 100, but you are not realizing that when you get 15 years where things are so out of wack your strategy of no hedges is suboptimal. Like I said, after 2015, I'll be investing like you - when it will be optimal again. That's the point. So yes, you are right, but only in the very long-term - ie 10 years plus.

 

Mungerville,

 

I am following you comments with much interest as it seems to be somewhat in line with my own thinking. If I may restate or summarize you point as below, would you agree?

 

Most of the time it makes sense to ignore the macro because it is really difficult for one person to be able to assess with any degree of confidence how the economy and stock markets would fare. However, there are few occasions, very few and far between maybe once or twice in an investor's lifetime where it does make sense to pay attention to macro. These could be for example, extremes of valuation (say using Shiller's PE) or some other form of excess (say very high leverage among companies, consumers, governments). In these few cases it would make sense to take this into account and position once's portfolio appropriately - higher levels of cash, active hedges, etc. We take these precautions not because we predict or know something is going to happen, but because we learned from history that such occassions have led to severe losses. We fully understand that such precaution would necessarily penalize returns if such a risk does not actually materalize. 

 

Vinod

[twacowfca]

In any case, you are totally missing my point: My point is that your strategy is optimal for say 85 years out of 100, but you are not realizing that when you get 15 years where things are so out of wack your strategy of no hedges is suboptimal. Like I said, after 2015, I'll be investing like you - when it will be optimal again. That's the point. So yes, you are right, but only in the very long-term - ie 10 years plus.

 

Mungerville,

 

I am following you comments with much interest as it seems to be somewhat in line with my own thinking. If I may restate or summarize you point as below, would you agree?

 

Most of the time it makes sense to ignore the macro because it is really difficult for one person to be able to assess with any degree of confidence how the economy and stock markets would fare. However, there are few occasions, very few and far between maybe once or twice in an investor's lifetime where it does make sense to pay attention to macro. These could be for example, extremes of valuation (say using Shiller's PE) or some other form of excess (say very high leverage among companies, consumers, governments). In these few cases it would make sense to take this into account and position once's portfolio appropriately - higher levels of cash, active hedges, etc. We take these precautions not because we predict or know something is going to happen, but because we learned from history that such occassions have led to severe losses. We fully understand that such precaution would necessarily penalize returns if such a risk does not actually materalize. 

 

Vinod

 

Good advice. :)

[original mungerville]

Vinod1,

 

Yes, that's right.

 

Also, an investor has to understand what his neutral position is. In 85 of the 100 years, my neutral position would usually be, you know, something like 75% value stocks, 25% cash on average with the 75% going up and down depending on how many opportunities I find but 75% would probably end up being my average percentage invested over some period - probably similar to those arguing currently that hedges are not required for the unlevered investor. Well, I don't want that in THIS 15 years (2000-2015) as my neutral position (and the good news is there are probably only a few years left to go).

 

A counter-argument is that when you are not hedged, you are effectively betting on the market going up, and value investors should not bet on the direction of the market. When you don't buy CDS like Prem did, you are betting on the financial system not breaking down. So many inverse the logic used by the average value investor and state that when you don't hedge, you are in fact making a macro bet. Although this inverse logic makes sense to me to prove a point, I am not sure I would take it quite that far... but I thought I would throw it out there because there is some truth to it.

 

And I am not saying everyone needs to be hedged. I am saying that not hedging is suboptimal in this particular period which is far different that saying everyone needs to be hedged.

 

It seems many good value investors just don't see this. If I remember correctly, for example, the guys at LUK pre-crisis made a remark about Watsa's hedges that was not too flattering. In any case, most value investors just seem to continue to value invest because it has worked so well for all these years while not seeing that it didn't work so good in the Depression or in Japan... and they just go on with this we can't-hedge-because-that-is-macro-betting attitude view of optimal portfolio structure even in this 1:100 year crisis. I think that is a bit silly and sub-optimal.

 

 

[moore_capital54]

I don't agree with Mungerville, I am in the Parsad camp that a value investor need never to delta hedge. What you can do is construct a portfolio in a manner that has hedges built in IE: larger cash and different securities (Fixed Income, Preferreds) but to sit there and say that in 2015 you will jump in the market is a little insane.

 

Nobody knows what tomorrow will bring, and nobody is putting a gun to our heads to deploy capital. But if you deploy according to the principle that price is what you pay, value is what you get, there is no need to hedge as that will hurt your compounding over the long-term. All that hedging does to a value investor is provide the weak minds with the ability to stomach volatility or temporary paper losses.

 

If you have done your research on a business, and understand the fundamentals, no hedging is required.

 

Cheers!

[original mungerville]

"to sit there and say that in 2015 you will jump in the market is a little insane"

 

That's what I have done for 12 years: I bought US value stocks 100% long fully hedged for most of the time (say 80%). So I was rarely taking market risk for those 12 years.

 

12 years ago, the S&P was at 1500 and now is at 1150 (25% lower in nominal terms and if you assume there has been 2% inflation a year, knock off another 25% or so to get to real purchasing power loss)...and that is in $US terms. As a Canadian investor, the $ Canadian was at 66 cents or something and has been at par recently (so another 50%). In real terms, the US market has been completely horrible for the last 12 years, and that over a period when government debt mushroomed to support the real economy. Now we have to go through debt destruction in real terms, so this ain't over by a long shot.

 

In general, taking on market and currency risk over that 12-year period seems a bit insane to me. Similarly, not having deflationary and hyper-inflation hedges in place for the coming 3 years seems a little insane to me.

[moore_capital54]

Sir with respect, any professional investor that has been around for the last 12 years has gotten rich. Some may have given some back over the last few years, but for the most part, and take this with a grain of salt if you like, but there is no doubt in my mine 2000-2011 has been a better investment environment than 1990-2000, No doubt about that and I have been through both periods, as a professional investor.

[twacowfca]

Hedges are great when they are cheap, but the cost of most hedges now is such a drag that cash would be a better alternative. 

 

Our four significant holdings have internal hedges or ultra low beta characteristics with good upside potential.  One is a speculative Cpt 11 workout that has lots of risk, but no general correlation with the market.  Another is LRE with an ultra low duration AA+ portfolio.  Practically all their earnings are returned to shareholders, so it makes little difference to long term holders if the price should drop.  If their stock price should drop 25% or so, that would merely provide another opportunity to repurchase shares in the zone of up to 110% of BV as they have done with gusto in the past. 

 

Our third holding, FFH is almost entirely hedged internally.  Last, but not least, BRK now has a free put for anyone who owns the stock.  :)

[Valuebo]

A counter-argument is that when you are not hedged, you are effectively betting on the market going up, and value investors should not bet on the direction of the market.

 

No, you are betting that your personal stock picks will reach estimated intrinsic value over time, not the general market. A lot of money was made by value investors in the last decade and a 100% hedge would probably only have been a drag on their performance unless they were lucky buying insurance at the 1500 high and/or had favorable currency-valuation changes. It is a form of timing I doubt many people can do correctly for 10 years. In that regard I think it is odd that you claim others, who are not hedging, are betting on the market's direction.

[original mungerville]

Yes, I agree that it is a form of timing and a drain and so I do not advocate doing it other than when things are out of wack from a 1:100 year perspective - like the last decade. In any case, at this point its getting expensive to hedge the market so I also agree FFH and BRK now  have built in value/market hedges which is just one more reason I think both a great investments in this environment.

 

Moore, I am not sure what you mean that any professional investor has made a killing from 2000 to 2010? The S&P is down probably 30-40% in real terms. What are you talking about exactly? Do you mean the mutual fund unit holders and pension fund were left holding the bag while hedge fund professionals made a killing? Surely you can't mean the average institutional investor made a killing?

[original mungerville]

I am also not sure how the average value investor made out in the Depression. Value is what you get but if you are not taking into account the potential for 10 years of deflation in your valuation, you are neglecting a key risk. Also, if you don't have some protection against hyperinflation/monetary system structure change, you are neglecting a key risk.

[Cardboard]

Thinking now about my experience, I believe that both Mungerville and Moore are right.

 

In a way, I have been hedging since 1999. At the beginning, I was almost all in cash due to the extreme valuation in the marketplace where very few bargains were available.

 

Then after that came good years until 2007 where plain vanilla value investing worked great. The hedging part is that I had to lower down my intrinsic value targets vs what worked from say 1995-1999. I used lower valuation metrics as fair value.

 

In 2008 and early 2009, I had to keep rotating my portfolio from cheap stocks to cheaper ones. Another form of hedging if you will by getting into more and more coiled springs.

 

From mid 2009 to today, I once again reduced my intrinsic value targets from the ones used from 2000-2007.

 

I guess that is one form of hedging. The market is simply not willing to pay the same multiple over time and that is due to macro. So while not entering a "true" hedge or short, I was in a way shorting the market as a whole by lowering the valuation metrics that I should use to buy and sell.

 

So if people are willing to pay around 16 times earnings today for Coca-Cola and were willing to pay 50 times in 2008, you know that something fundamental in the market has changed. So your cheap stock in 2008 at 8 times earnings might have had a good chance to reach 16 times, but it might not be the case today.

 

In any case, stocks should always be attractive on an absolute basis. If not, you should be out like I mostly did in 1999. But, other than for these extreme periods of overvaluation which seems to come about every 30 years, just adjusting buying and selling based on what the market has to offer at any given time seems to work out pretty well. You don't really have to think about it. It is just about continually looking for better bargains than what you currently own.

 

Cardboard

 

 

[original mungerville]

Cardboard,

 

That is exactly it. I agree completely.

 

Not to complicate things, but then the next step in the thinking is, in these types of frothy environments, is it a) better to hold greater amounts of cash (by requiring higher discounts to intrinsic value) or b) hedge in those times and be fully invested in stocks that are relatively cheap compared to the frothy market. I think its mainly the latter because you can have the value investing machine continuing to run full speed ahead even in frothy times, you don't have to reduce the throttle.

 

[Then finally, in practice, if you are not experienced doing b) thereby undertaking implementation risk of the strategy, optimally then you do some a) and ease into b) while you learn.]

[oec2000]

I've noticed that most people aren't used to being agreed with so let me say that I think your reasoning and logic are sound on most subjects I've seen you discuss -- including this one!

 

 

Kiltacular,

 

Thanks for the generous comments and I am sorry if I came across as "venting at" you. I did get the gist of your original post and while the first few paragraphs were in response to your post, the later paragraphs were more of me "venting to" someone I felt was open-minded enough to listen.

 

I have to learn to be less intense in my posts! While I try to focus on the issues, there have been occasions when my posts have been construed as personal attacks. Unfortunately, it's easy for this to inadvertently happen when you are challenging someone's view. (To clarify again, these comments are not aimed at you. It's just more of my general rambling.  :) )

 

Thanks for pointing this out.

 

oec

[oec2000]

I don't agree with Mungerville, I am in the Parsad camp that a value investor need never to delta hedge. What you can do is construct a portfolio in a manner that has hedges built in IE: larger cash and different securities (Fixed Income, Preferreds) but to sit there and say that in 2015 you will jump in the market is a little insane.

 

Nobody knows what tomorrow will bring, and nobody is putting a gun to our heads to deploy capital. But if you deploy according to the principle that price is what you pay, value is what you get, there is no need to hedge as that will hurt your compounding over the long-term. All that hedging does to a value investor is provide the weak minds with the ability to stomach volatility or temporary paper losses.

 

If you have done your research on a business, and understand the fundamentals, no hedging is required.

 

Cheers!

 

I am confused by your comments. Are you saying that you believe in applying "macro" (by "contructing a portfolio with built-in hedges") but just disagree with Mungerville's method of delta hedging? Parsad's view is that one should ignore macro unless you are highly leveraged.

 

In your comments on the gold threads, I got the distinct impression that you were bullish on gold. Even if you play this view by buying value-priced gold mines, it still amounts to taking a macro view on gold, not to mention that it contradicts your view that "nobody knows what tomorrow will bring."

 

Besides, isn't it the case that taking the view that "buying value and ignoring the future because we can't know what tomorrow will bring" the type of thinking that cause people like Bill Miller, Marty Whitman and the managers at AIC to lose permanent capital in their investments in financials? This are just a few examples of people who did much less well in the 2000s vs the 1990s.

 

Sir with respect, any professional investor that has been around for the last 12 years has gotten rich. Some may have given some back over the last few years, but for the most part, and take this with a grain of salt if you like, but there is no doubt in my mine 2000-2011 has been a better investment environment than 1990-2000, No doubt about that and I have been through both periods, as a professional investor.

 

Not sure how you define "professional investors" and what statistics you rely on but most people would say that professional investors (whom I define as people who invest full time as a profession on behalf of outside investors) had much better returns in the 1990s compared to the 2000s. I would include mutual funds, hedge funds as well as pension funds. Some dedicated sector funds, in particular the resource funds, have done very well in the 2000s but that is purely due to highly favourable macroeconomic factors.

[moore_capital54]

OEC, my views on gold, and central banking are in no way related to macro. They are related to what I view as structural issues, where gold is the ultimate solution. Moreover, I like gold for reasons that are pretty straight forward IE: Supply/Demand. Most of my arguments on this board relating to gold were against posters that tried to refute gold's validity as an investment or as having  "utility". I invest in gold because it is a scarce element that serves best as a medium of exchange. 

 

And you are correct, for the most part we invest in gold through the junior market and in effect are acquiring gold for pennies on the dollar, never once did we invest in gold for the fear trade or as a hedge against macro events.

 

With regards to Macro hedging via portfolio construction, Let me expand on that for a second. The way we do it is we ease into a position based on our assessment of how cheap it is. This has worked very well. In 2007 for example we were not finding many companies we felt were cheap and as a result had a substantial amount of our aum in cash. So in a way when you are constructing a portfolio and are not able to find anything that is cheap, hoarding cash is a sort of macro hedge. Because the reason you are not finding cheap securities is due to the market most likely getting ahead of itself.

 

But using that same methodology, we are able to deploy that cash when we see tons of opportunities, as we have been these last few months. But we don't attempt to time the market in any way, and we have definitely stomached some significant volatility and even paper losses but as we continue to deploy capital our cost average should reflect a price which in hindsight will be near the lows.

 

And yes I don't view cash as delta hedging. Think about it, cash is more like dry powder or ammunition.

 

Professional Investors

 

What I mean by professional investors are either investor that make a living from successfully deploying capital in their personal accounts or fiduciaries that have some type of a leveraged compensation schedule IE: 2/20 for hedge fund managers.

 

And in that regard I stick to what I said. the period between 2000-2011 has been a lot more profitable for such investors. This can be attributed to the fact that never before have hedge funds become more ubiquitous, more accredited investors than ever, and markets that have become global allowing to access efficiently securities from Korea to Australia with cheaper commissions. There are many many reasons, cheap money, ability to leverage, shorting, and substantial capital flows into smaller capitalization companies. Never before has a hedge fund manager been able to raise so much capital so quickly than now. This was not the case in 1990-2000.

 

Most of the investors from my vintage have made the majority of their gains over the last decade and not in the 1990-2000 decade. Some may have given some back, but for the most part the majority of their wealth has been derived over the major bull market of 2003-2007 and the Canadians I know have minted it from 2008-2010 in the junior space.