How to hedge a global depression?

[SharperDingaan]

Re asymmetric bets:

 

For maybe 80% of PMs ?, a short is one side of a pair trade - done to extract alpha, & executed via options to extract leverage and avoid the possibility of an inopportune loan call. The different dynamics drive the typical response.

 

Most see the asymmetric bet as a small (but certain) realized outflow against a high (but very uncertain) REALIZED inflow. EG. Long a marginally out-of-the-money put option on XYZ Coy. Easy to understand, intuitively obvious, but most don’t get that the magnitude of the payoff x its probability is key (Taleb)

 

... But an asymmetric bet can ALSO be as a small (& certain) realized inflow against a high (but less uncertain) UNREALIZED inflow. EG. Long a T-Bill & short a put on XYZ coy - or - selling existing XYZ coy & repurchasing later (synthetic short). Not so easy to understand is that the intent is to get called (to the get the stock cheaply) & THEN HOLD IT, & it is not intuitive that Mr Market is going to pay you to do it (premium + T-Bill interest).  Examples might be BAC, RIM, etc.

 

We use variations of the synthetic short extensively, & find that in a concentrated portfolio it materially reduces month-to-month volatility. Given that the risk is that the stock could run while you’re short, we don’t sell more than 50% of our position.

 

Hope it works for you.

 

SD

 

[alertmeipp]

the problem i see with hedging is most of those - u need to pay time value on the hedge.. i.e. as the time goes and the event u hedge for didn't happen, ur hedge value will go down. (like options.)

[JSArbitrage]

Maybe I'm a bit paranoid about money but does anyone else find it silly to discuss trying to hedge such an outcome?  What I mean by that is I can't see any other other viable alternative other than cash and lots of it.  If we hit a TRUE depression, then most of the pros on here will have clients hit them with redemptions up the wazoo, in which case I hope you have tons of household savings (again, in cash.) If you aren't a professional money manager, then you owe a duty to your family to have the cash needed to survive such a downturn.

 

In a true depression, you'll have to muster up everything you have (financial, emotional, etc.) just to survive.  So I think trying to generate alpha in that period is a lost cause.  It's no different than those e-warriors on the internet that make threads about how they would win a fight against a group of attackers.  Let's face the facts: you either run or get your assed kicked.

 

That's how investing in a depression really is.  Pissing in a tornado and trying to stay dry.  Good luck with that.

 

 

[alertmeipp]

Maybe I'm a bit paranoid about money but does anyone else find it silly to discuss trying to hedge such an outcome?  What I mean by that is I can't see any other other viable alternative other than cash and lots of it.  If we hit a TRUE depression, then most of the pros on here will have clients hit them with redemptions up the wazoo, in which case I hope you have tons of household savings (again, in cash.) If you aren't a professional money manager, then you owe a duty to your family to have the cash needed to survive such a downturn.

 

In a true depression, you'll have to muster up everything you have (financial, emotional, etc.) just to survive.  So I think trying to generate alpha in that period is a lost cause.  It's no different than those e-warriors on the internet that make threads about how they would win a fight against a group of attackers.  Let's face the facts: you either run or get your assed kicked.

 

That's how investing in a depression really is.  Pissing in a tornado and trying to stay dry.  Good luck with that.

 

 

 

Wish there is a recommend feature here!

[bmichaud]

So the fact that one of my largest holdings, Pepsi, has not gone down as much as the market means I don't know how to find value? I explained to you over PM that I believe it's worth $115 and it's currently selling for $63. IMO, that is no different than you buying BAC at $6 when it's worth $10 (or whatever). What has really stuck with me from studying WEB is buying wonderful businesses, and when I get the chance as I have with Pepsi, I load up - REGARDLESS of the macro environment.

 

FYI - Loeb is less than 30pc net long right now. He is VERY concerned about the macro and is hedging like crazy all the while loading up on YHOO. There is room for both.

 

Best of luck being 100pc long with leverage in this environment.

[Guest misterstockwell]

Cardboard here is a freebie we have been working on. I am currently vetoing the idea for this trade but its my partners idea and qualifies as a "hedge" as I believe you are looking for, and as far as hedges are concerned its damn good.

 

The crux of the thesis revolves around M&A Arbitrage. As you know there is a list of companies that are in between M&A Activity , those companies will trade at or near their buyout price. Generally in a very good market, the buyouts will come to fruition smoothly or better yet a second suitor will emerge and a bidding war will ensue.

 

Well, in depressions or even bad recessions, such as the one we witnessed in 2008-2009, 1 out of 3 of these deals breaks. As financing is not there or a multitide of reasons. The risk reward is very asymmetric.

 

You find a group of companies that are trading at a very small spread to their announced buyout (we have already done this) and you short them. IF you are wrong you only lose the spread which is generally 1-2%, but if you are right they will drop like stones, most likely 50-60% as they did in 2008-2009.

 

The risk reward is asymmetric, and it is a damn good hedge.

 

I have not put the trade on because I don't think we are entering a depression, but there is a freebie for you guys!

 

I decided to provide our list as I am in a good mood today :) Enjoy!

 

I found 2008/9 to be the exact opposite--rich with merger arb opportunities. I remember calling a judge that was ruling on an insurance merger in their state. A phone call was worth a double digit return in a few weeks. There is an opportunity in everything. Your method should work as well. Many of the poorly constructed mergers would fail. The good ones will see their spreads widen to a worrying degree, but the deal will eventually close. You will have to put your hedge on now as even the higher probability deals will have huge spreads when/if financial mayhem comes.

[twacowfca]

If you believe that this is a meaningful risk, then the most straightforward way is to take a long position in cash.  Unfortunately the precise allocation to cash that is optimal is not easily divined, but in the 1930s those who were able to rebalance between de-valued equities and cash/treasuries did just fine.

 

Personally, I'm running about 5% cash at the moment, so a depression scenario would be a real kick in the teeth for me.

 

 

SJ

 

It can be shown mathematically that the optimal balance between cash and equity for regular portfolio rebalancing in a trendless market is 50:50.  This assumes that a portfolio manager doesn't have an edge on the market.  In a bear market the optimal rebalancing ratio is more toward a higher percentage of cash, depending on how bearish the market is.  :)

[twacowfca]

Here's an interesting hedge.  Buy BRK when it hits $70/SH or perhaps 1% or2% below $70/SH.  Hold it if you think the market is set to become bullish.  Otherwise, sell it when it bounces X%.  In a bearish market X might be 8 to 10%.

 

Alternatively, stay in cash until BRK hits the trigger point; then buy it and write a covered call or stay in cash to cover writing a put on BRK.  :). Then adjust the trigger point regularly for changes in BRK's BV/SH.

 

This worked for us a few years ago when WEB was supporting USG's stock price at @ $45/SH.  We had three round trips on this trade until we stopped when USG's management did something stupid and we thought WEB would stop supporting their stock price.  That's what happened.

 

There is far less risk on this trade.  I think BRK will continue to buy BRK at <110% of BV even after WEB steps down.  :)

[original mungerville]

Hedging:

 

1) All my long stock positions have been converted to 15-20% in the money long-term calls (my downside is therefore limited to 15% or less, maybe 10% rather than 50% if the market drops in half);

 

2) I also have puts - again 15-20% in the money - on IWM (Russell 2000) so if the market really drops, I'll make money on a net basis with my longs being limited on the downside

 

Either way, I can't lose 100% of my capital and am limited to a 10-15% loss. (Note, I am willing to give up liquidity in getting these deep in-the-money puts and calls and that willingness reduces the cost of these things in terms of the time-value premium paid relative to options that are closer to the money.) Now, that makes me essentially

 

A) earning a value investing spread, but

B) I am long cash

 

I do not think cash is good to hold as monetary authorities could be forced to double or triple the money supply (and if they do, the announcement will be globally coordinated and on a Sunday night). So, to remedy that, I am long long-term out-of-the-money calls in silver and also hold physical gold.

 

The day of reckoning continues to get closer and I have not and will not expose myself to market risk or risk of hyperinflation, however, the value investing machine remains on full throttle in my above convoluted portfolio. 

 

If the situation continues to deteriorate and monetary authorities do not double the money supply (or triple it ), I will start moving out of these derivative positions as things continue to spiral downward (as the global financial system will collapse) into a combination of cash and precious metals and maybe some equities. If monetary authorities act, I will make big money on calls on silver and the financial system will hold together.

 

I sleep very well at night whether the market goes up or down, whether the Eurozone troubles get better or worse like they have over the last couple days.

 

 

 

[ubuy2wron]

So the fact that one of my largest holdings, Pepsi, has not gone down as much as the market means I don't know how to find value? I explained to you over PM that I believe it's worth $115 and it's currently selling for $63. IMO, that is no different than you buying BAC at $6 when it's worth $10 (or whatever). What has really stuck with me from studying WEB is buying wonderful businesses, and when I get the chance as I have with Pepsi, I load up - REGARDLESS of the macro environment.

 

FYI - Loeb is less than 30pc net long right now. He is VERY concerned about the macro and is hedging like crazy all the while loading up on YHOO. There is room for both.

 

Best of luck being 100pc long with leverage in this environment.

There exists no perfect hedges, in a serious depression just losing money slower than the next guy is somewhat of a hedge. That said I have a higher than normal cash position I own corporate bonds in particular FFH bonds I am long a little gold  have a pretty concentrated portfolio and my BAC position is thru in the money leaps and I run a pretty active hedge through inverse etf,s. Someone said that no one rings the bell at the bottom when Prem removes his equity hedge I will remove mine if I have any, his mkt timing has been pretty fricken amazing for a guy who doesn't time the mkt.

[bmichaud]

His so called timing has been amazing because he does not time - he values. Back I'm the fall of 2008 prem, buffet, klarman and hussman sounded the all clear almost at the exact same time. It is not by accident that the market fell to a level where the expected return was 10% per year for the next ten years. The market continued to fall, proving they were not trying to time. They didn't care what the market would do going forward they just knew it had fallen to a level that would yield the average return the market has generated over time.

[oddballstocks]

Well Moore, as a fiduciary for your clients money, I am a little disappointed by your answer. Your defense seems to be that if things go to hell that anyway you did as well as Einhorn, Buffett and others. It may work for your situation and I can appreciate that you are following your mandate, but if you have a chance to do something then it would also be to your advantage.

 

Basically, I am in the same situation as you are currently except that I don't manage OPM. I am fully invested and I have a small short position which may not make much of a difference if things go really nasty. I see value out there and trust me I have bought it. However, I do stress test my companies and wonder what would happen if different events occur. I can tell you for certain that some will not survive a depression.

 

So what I have been searching for is an hedge with asymmetric payout. To date I have not found that instrument. The other thing that I am moving towards is income. My portfolio has allowed me to live comfortably by being able to sell winners once in a while. This year has been tough and disappointing with many deals not occuring. So being forced to sell your cheap stocks to live is unfortunate. I would imagine that it would be similar for you if you face redemptions.

 

In essence, I don't care about volatility. However, I do care very much about permanent losses due to companies going bankrupt or facing events that will dramatically lower their value for real. A really bad economy can do that, but I have no way to predict it.

 

So here are the solutions that I have been thinking of:

1- Increase income: dividend paying companies, corporate bonds with something special

2- Increase the quality: eliminate cyclical and companies having a fair bit of leverage

3- Shorting: have to be very selective. A problem is that you are speculating as to when to cover. No bell will ring, no value will be more right than another unless you are lucky and it hits your target before rebounding.

4- Some asymmetric hedge?

5- Reduce my expectations: I have always invested mostly in smaller cos since my goal was to find companies with very high upside or very large deviation from intrinsic value. If you are wrong on 1 or 2, it is fine since the rest will more than make up, but if you lose 10 because of a calamity, you are back to square one.

 

In essence, I would appreciate if you could share how you approach risk in your portfolio. That is what my original post was about. A BP would have a much better chance to survive IMO than say BAC which would survive, but not likely its current shareholders.

 

Cardboard

 

Cardboard, the way I have always approached risk mitigation is through capital allocation. If you looked at my portfolio it would be very similar to Mr. Kahns, whos 13F I recently uploaded or Pabrai's. It is a concentrated portfolio of not more than 20 names, and each name, as you mentioned has different risk profiles.

 

I can look through my holdings and say just as you just did that some may or may not survive a depression, but that is conjecture. How do I know if a depression is truly coming, and if it is how do I know what the ultimate reality will be in such depression. To say BP survives and BAC doesn't is conjecture, how do you know that? How do you know oil doesn't drop to 40$ on a depression but banks get flooded with deposits, in which case BAC survives and BP goes to hell.

 

All I am trying to accomplish with my posts, is to provide a consistent tone from an investor that is following the principles of graham & dodd. In a few years some of you will look back and realize that while many emotions were thrown around, there were a core group of investors on this board that maintained their confidence and kept following the principles we are all supposedly adhering to.

 

Regarding your "disappointment", I think you need to realize that investors allocate risk capital to hedge fund, and our job is to see through the forest and look for returns while focusing, as you say on prevention of permanent losses of capital. I do not feel that any of my positions will deliver such losses. The difference is that you may change your mind due to the moods of Mr. Market while I retain conviction.

 

It has only been 3-4 months of this BS. Last year at this time markets were truly roaring, and that is the name of this game. Its all very reflexive. Today there is an overwhelmingly amount of negative data, and tomorrow there could be just the opposite.

 

Take a look at my post history, you will see that I get very active when the market is down, because I find myself able to contribute more given the incremental increase in non-sense on the board. In October when things were roaring I had nothing to contribute and most of the posters that delivered this nonsense were gone as well.

 

I am just trying to provide balance, I don't need anyone to think I am right or wrong, and I definitely don't need anymore AUM. This is not an attempt at self marketing, just an attempt to provide in real time, my thoughts and actions in a market that most feel is "unprecedented". Almost every time I dug into the person behind the computer screen I found that the nervous posters were either new to the game, or had very little invested in the market. And that corroborates with what I have seen my whole life.

 

You guys think Buffett sits there and contemplates whether the world is going to end every day.. nope not a chance, he spends his time looking for opportunities.

 

And for a value investing board, some of you come off as real sissies, as I see an obvious increase in threads relating to Shorts, and Hedging Strategies when stocks are at 52 week lows, instead of seeing threads relating to incredible bargains, of which there are SO MANY right now.

 

Cool post, if I can boil down the essence, you're saying invest with a margin of safety, and I mean a real margin of safety.  To me this is investing in companies with slugs of cash that have been proven to survive past recessions.  A margin of safety isn't estimating that a DCF values the stock at $80 and it's trading at $50.  A margin of safety is that the company can take a 35% hit in sales and still operate cash flow positive, or they have enough of a war chest to last a few years of down earnings.  Another margin of safety is a bonified moat.  When I think of moats I think of something like Mastercard or Visa, even in a depression people will choose to pay with plastic.  Sure maybe volume declines, but MA and V have such a simple cost structure even in the more dire situation they will be profitable.

 

After reading this post I thought about some of the companies in my portfolio and how they qualify.  I own one company that's operated since 1931 in Europe, they lasted the depression, WWII, and the past 80 years while earning a return for investors.  The company is operated conservatively with shareholders in mind, I bought at a significant discount to tangible book, to me I have a margin of safety.

 

I also own some net-net's, classic net cash companies that in a depression I would actually do well if they liquidated since they have more assets than market cap. 

 

And thirdly I own some moat type companies, I own Mastercard as mentioned above.  I also own America Movil, the largest wireless carrier in Latin America.  If the world enters a depression I can't imagine things would get any worse than the last 20 years in Latin America where America Movil (and TelMex before) has been able to turn solid profits.  Even in the worst of times people need to make calls.

 

I recognize that if the market drops 50% my portfolio might drop my 50% as well, but I'm confident in the companies that I own, I'm confident in their financing and that they'll be around on the other side, and through it all I'll do ok.  I do hold between 5 and 10% of dry powder so I have some ammunition at all times.  I try to keep this at a steady level, and I haven't had a problem deploying cash recently.

 

Best of luck!

[alertmeipp]

seriously, with every gov looks around each other trying to boost growth.. do u guys really expect a depression will hit?

[Packer16]

If you look at what did the best in the last Depression (1930s), it was gov't bonds or even better gold-backed bonds.  There was a competitive devaluation after the sterling crisis (1931) and the US dollar devaluation in 1933.  So given these were hedges in the last depression, they maybe again. 

 

Packer 

[alertmeipp]

Would someone define Depression here? I am not even sure if our definition would be the same?

 

25% unemployment worldwide?

60% of global trade vanished?

What would be the interest rate?

 

 

[Cardboard]

I used the term global depression, but really I have no idea what it would like exactly or where it would hit the worst.

 

Today, we have Europe entering a recession, it seems to me like China will have a hard time orchestrating a soft landing (has it ever worked?), the U.S. is improving very slowly and Japan is still in deflation. So we have the largest economies at best flat overall and this is in a time of peace where no big shock has occured yet. Things are kind of moving a bit and we already have OWS. What happens if unemployment creeps up and it is starving people now showing up on the streets? What happens if there is war with Iran? What happens if the terrorists resurface? What happens if a major earthquake destroys L.A.?

 

I was running a bit on callable margin and then I started to wonder about the impact of such catastrophes. Even if I had modest leverage, there was a chance of wipeout. Then you combine this with what Oddballstocks as mentioned:

 

"Cool post, if I can boil down the essence, you're saying invest with a margin of safety, and I mean a real margin of safety.  To me this is investing in companies with slugs of cash that have been proven to survive past recessions.  A margin of safety isn't estimating that a DCF values the stock at $80 and it's trading at $50.  A margin of safety is that the company can take a 35% hit in sales and still operate cash flow positive, or they have enough of a war chest to last a few years of down earnings.  Another margin of safety is a bonified moat."

 

I realized that seeking the highest potential returns likely lead me to the highest potential risks in my portfolio. Howard Marks explains it well in The Most Important Thing with his modified chart of risk vs return.

 

So I think that asset quality is simply becoming more important to me. Accepting 20% a year may now be acceptable vs reaching for 30% and the famous "guaranteed" 50% by Buffett. I realize that these are high objectives, but I always thought that to achieve a certain result you had to aim for more.

 

So this whole discussion may be more about asset allocation and risk adjusted returns. Asking myself why guys like Buffett, Klarman and others go into distressed bonds while at the same time I am finding much better opportunities in stock? How is my portfolio structured to deliver risk adjusted returns? Is it that I have just been lucky in the past?

 

I could still invest a major chunk of my assets into cyclicals, turnarounds and levered asset plays if I had that perfect hedge to protect them against catastrophe, but I have not found it. So what are the options?

 

Cardboard

[moore_capital54]

If you look at what did the best in the last Depression (1930s), it was gov't bonds or even better gold-backed bonds.  There was a competitive devaluation after the sterling crisis (1931) and the US dollar devaluation in 1933.  So given these were hedges in the last depression, they maybe again. 

 

Packer

 

Actually Packer the best performing security par excellence in the great depression was Homestake Mining.

 

Have any of you guys ever even done any actual research on performance of individual equities from 1929-1940, or do you all just look at the DOW as a representative.. sounds like the latter.

 

Investment

Vehicle Investment

Date Amount Investment

Value @ Dec. 1935

DJIA Oct - 1929 $10,000 $3,600

DJUA Oct - 1929 $10,000 $2,100

Homestake Mining Oct - 1929 $10,000 $62,000

Note: For simplification cash dividends not taken into account

 

http://www.gold-eagle.com/editorials_98/djiave.gif

 

In those 6 years where the dow lost 80%, Homestake gained 520%.

 

http://www.gold-eagle.com/editorials_98/hmstkmng.gif

 

There is always a bull market somewhere...

 

 

[Packer16]

You are correct and the only other major stock to have prices greater than 1929 prices was Alaska Juneau Gold.  These firms mined the only asset that held its value as the devaluation occured.  The only question I have is it still valid today given the lack of a gold standard?  Seth Klarman appears to be betting that gold is good hedge against this devaluation as he has purchased some gold miners recently. 

 

Packer

[bookie71]

If it is a true depression, then the ins co's and brokerage houses could fail and we could lose it all.  I don't think there is anything Joe Blow can do to hedge, especially if the brokerage houses and the brokerage insurance companies fail.

 

[original mungerville]

Klarman gets it. Watsa gets it. Rodriguez at FPA gets it. Other value investors just seem to follow Buffet's generalisations about what you should do over the very very long-term.

 

The macro situation is not something to bet on at this point, and many value investors are by not hedging their non-value risks (eg market risk, currency risk, monetary system risk, systemic risk). By not hedging, they are betting that everything will work out on these four fronts which to me is an impossibility.

[alertmeipp]

Klarman gets it. Watsa gets it. Rodriguez at FPA gets it. Other value investors just seem to follow Buffet's generalisations about what you should do over the very very long-term.

 

The macro situation is not something to bet on at this point, and many value investors are by not hedging their non-value risks (eg market risk, currency risk, monetary system risk, systemic risk). By not hedging, they are betting that everything will work out on these four fronts which to me is an impossibility.

 

 

All these risks were around last 24 months... were u invested over that period?

[original mungerville]

tombgrt,

 

Re why you also need to adjust the 10-yr average PE for corporate earnings relative to GDP - I found a recent related article with a good graph and notice the last 10 years are above average.

 

http://www.nytimes.com/2011/11/26/business/for-companies-the-good-old-days-are-now.html?_r=

 

 

http://www.nytimes.com/interactive/2011/11/25/business/profits-are-high-wages-are-low-taxes-are-below-average.html?ref=business

 

 

 

[original mungerville]

Here is a link to Buffet's 1999 Fortune piece stating that corporate profits should be expected in the 4.5 to 6% range relative to GDP:

 

http://money.cnn.com/magazines/fortune/fortune_archive/1999/11/22/269071/index.htm

[twacowfca]

You are correct and the only other major stock to have prices greater than 1929 prices was Alaska Juneau Gold.  These firms mined the only asset that held its value as the devaluation occured.  The only question I have is it still valid today given the lack of a gold standard?  Seth Klarman appears to be betting that gold is good hedge against this devaluation as he has purchased some gold miners recently. 

 

Packer

.

 

Alaska Juneau Gold was a highly efficient operation set up to mine a low grade deposit.  It was exquisitely sensitive to the price of gold which had been fixed at $20/OZ for many decades.  Roosevelt Raised the price of gold to $35/OZ when he took office.  The mine which had become uneconomical had new life.  Profits went through the roof as the real price of gold more than doubled in that deflationary time.  :)