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Cash option is priceless


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David Tepper said the same thing on PlanMaestro 's video i kept it in my mind for awhile.

 

I think it was a one line at the end of the video "cash is the best hedge" I did not understand it completely.

 

David Tepper at Carnegie Mellon

http://variantperceptions.wordpress.com/2010/11/20/1627/

 

I guess it is a high level skill to understand the basic element of investing and melt it into my thinking Completely. There much more to be done. 

 

Can some more seasoned investors add some more context, experience and wisdom to help me understand this better visually ?

OR is this a trial and error time thing ?

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For someone driven by a quest to find things that are undervalued, as Mr. Buffett is, knowing the

price of cash as a call option is the key. The “call premium” on the cash option is essentially the

opportunity cost. It is the difference between what he can earn somewhere else and the nil return

on holding cash, said Ms. Schroeder, addressing the crowd at the annual Investment Industry

Association of Canada conference, after which she sat down for a Canadian exclusive interview.

“There are times when he feels like that option premium is really cheap, compared to the intrinsic

value of the option itself,” she says.

 

One thing I was confused about is:  how is the intrinsic value of the option calculated for cash when the future for investment opportunities is uncertain?  How do you handicap this?  What is a reasonable time horizon?

 

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For someone driven by a quest to find things that are undervalued, as Mr. Buffett is, knowing the

price of cash as a call option is the key. The “call premium” on the cash option is essentially the

opportunity cost. It is the difference between what he can earn somewhere else and the nil return

on holding cash, said Ms. Schroeder, addressing the crowd at the annual Investment Industry

Association of Canada conference, after which she sat down for a Canadian exclusive interview.

“There are times when he feels like that option premium is really cheap, compared to the intrinsic

value of the option itself,” she says.

 

One thing I was confused about is:  how is the intrinsic value of the option calculated for cash when the future for investment opportunities is uncertain?  How do you handicap this?  What is a reasonable time horizon?

 

It's a profound concept, but simple to understand.  When bargains are few the price (lost opportunity cost) of cash as a call option is cheap.  When WEB's AUM were relatively small compared to now, he would shift investing to workouts and away from being exposed to market risk when he couldn't find good bargains. That was like a cash option, but with better returns if done very well.  That was what Graham did after the rebound from the 1929 1932 crash.  He stuck to workouts almost exclusively to earn steady returns for his investors no matter what the market level, althought he bought a gem, Geico, as a long term hold for his own account.

 

Now, with BRK's being a mega cap, holding cash itself is mostly necessary.

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When WEB's AUM were relatively small compared to now, he would shift investing to workouts and away from being exposed to market risk when he couldn't find good bargains.

 

Quick question: What do you mean by "shift investing to 'workouts'"?

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When WEB's AUM were relatively small compared to now, he would shift investing to workouts and away from being exposed to market risk when he couldn't find good bargains.

 

Quick question: What do you mean by "shift investing to 'workouts'"?

 

Warren has gone through phases when he would buy generally undervalued companies and then sell them a few years later as they appreciated.  This works when the investment climate is bullish.  However, when there were few bargains to be found, Warren would stop buying these and invest the proceeds of their sales in recaps, reorganizations, merger arb, and other special situations that did not require a rising market to do well.  :)

 

These situations would provide cash as they "worked out" to pick up bargains if the market fell.

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When WEB's AUM were relatively small compared to now, he would shift investing to workouts and away from being exposed to market risk when he couldn't find good bargains.

 

Quick question: What do you mean by "shift investing to 'workouts'"?

 

Primarily Arbitrage style deals. Some good examples for Buffett are the Rockwell & Co. Cocoa bean deal (pre partnerships) and the Arcata Timber deal (Berkshire), those two of my personal favorites. The Rockwell story is great IMO because of how he handled it vs how he handled it for the firm.

 

 

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When WEB's AUM were relatively small compared to now, he would shift investing to workouts and away from being exposed to market risk when he couldn't find good bargains.

 

Quick question: What do you mean by "shift investing to 'workouts'"?

 

Primarily Arbitrage style deals. Some good examples for Buffett are the Rockwell & Co. Cocoa bean deal (pre partnerships) and the Arcata Timber deal (Berkshire), those two of my personal favorites. The Rockwell story is great IMO because of how he handled it vs how he handled it for the firm.

 

Yeah.  Graham Newman had a near perfect arbitrage buying Rockwell shares, shorting cocoa bean spot or near dated futures at the time of the share purchases to lock in their profit and then taking the Rockwell shares to Rockwell to exchange for cocoa bean warehouse slips that more than covered their short position. 

 

Warren noticed that the controlling shareholder was happy to skip the arbitrage and hold his shares as the book value per share of Rockwell went up up up as their share count went down down down.

Warren went long Rockwell shares for his own account and made a killing many times the percentage gain of his mentor who was happy to get paid to dance to Rockwell's tune.

 

That's the type of operation that could not take place without a certain amount of cash or credit.

 

The young CEO of Rockwell was a member of a Chicago family that was among the first to push Barak Obama forward as a candidate for The US Senate and then for US President.  Who was that young man, and what was the other important connection he had with Warren?

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One simple way to think about it, is to use your track record as a rule of thumb. If you were able to generate say 10% over a period of more than 5 years then that is the potential return you can ascribe to your cash.

The longer the time frame the higher the probability; put another way, the more certain you can be.

 

If you are being paid 1% to tie up your cash for a year you are leaving 9% on the table. If you are paid 4% then 6% are left on the table, etc.

 

Using that you need to consider the general opportunity set and the less it is (which will happen as the market gets more and more overvalued) the closer a "crash"/revaluation. In this case the option value of the cash increases the closer you get to the point of the "crash"/revaluation.

 

Having said all of that, for me at least, in reality cash is a residual of my ability to find things on my terms. So cash builds in general as the market goes up, not because I take a view on the market, but because I cannot find things that fit my criteria anymore mainly because it is too expensive.

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The young CEO of Rockwell was a member of a Chicago family that was among the first to push Barak Obama forward as a candidate for The US Senate and then for US President.  Who was that young man, and what was the other important connection he had with Warren?

 

I my memory serves me, that would be Pritzker would assembled the Marmon Group comglomerate which was later sold to BRK.

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The young CEO of Rockwell was a member of a Chicago family that was among the first to push Barak Obama forward as a candidate for The US Senate and then for US President.  Who was that young man, and what was the other important connection he had with Warren?

 

I my memory serves me, that would be Pritzker would assembled the Marmon Group comglomerate which was later sold to BRK.

 

Yes. Jay Pritzker was the young CEO that sat on their family's shares, despite the obvious guaranteed profit in arbitrage.  :)

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  • 3 weeks later...

One simple way to think about it, is to use your track record as a rule of thumb. If you were able to generate say 10% over a period of more than 5 years then that is the potential return you can ascribe to your cash.

The longer the time frame the higher the probability; put another way, the more certain you can be.

 

If you are being paid 1% to tie up your cash for a year you are leaving 9% on the table. If you are paid 4% then 6% are left on the table, etc.

 

Using that you need to consider the general opportunity set and the less it is (which will happen as the market gets more and more overvalued) the closer a "crash"/revaluation. In this case the option value of the cash increases the closer you get to the point of the "crash"/revaluation.

 

Having said all of that, for me at least, in reality cash is a residual of my ability to find things on my terms. So cash builds in general as the market goes up, not because I take a view on the market, but because I cannot find things that fit my criteria anymore mainly because it is too expensive.

 

This makes sense, but at the same time, Schroeder says that Buffett literally quantifies the option value, and that he assumes no strike price and no expiration date. If we assume a certain CAGR we believe we can achieve over a lifetime (say 10%), is there a way to use binomial option pricing or Black Scholes to actually quantify the option price relative to the opportunity cost? Or am I thinking too much about this and it really is a simple comparison between the opportunity cost now and what I believe I can generate over time?

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One simple way to think about it, is to use your track record as a rule of thumb. If you were able to generate say 10% over a period of more than 5 years then that is the potential return you can ascribe to your cash.

The longer the time frame the higher the probability; put another way, the more certain you can be.

 

If you are being paid 1% to tie up your cash for a year you are leaving 9% on the table. If you are paid 4% then 6% are left on the table, etc.

 

Using that you need to consider the general opportunity set and the less it is (which will happen as the market gets more and more overvalued) the closer a "crash"/revaluation. In this case the option value of the cash increases the closer you get to the point of the "crash"/revaluation.

 

Having said all of that, for me at least, in reality cash is a residual of my ability to find things on my terms. So cash builds in general as the market goes up, not because I take a view on the market, but because I cannot find things that fit my criteria anymore mainly because it is too expensive.

 

This makes sense, but at the same time, Schroeder says that Buffett literally quantifies the option value, and that he assumes no strike price and no expiration date. If we assume a certain CAGR we believe we can achieve over a lifetime (say 10%), is there a way to use binomial option pricing or Black Scholes to actually quantify the option price relative to the opportunity cost? Or am I thinking too much about this and it really is a simple comparison between the opportunity cost now and what I believe I can generate over time?

 

No. This is a most important topic.  I agree with what you have both said.  The same questions apply to the Buffett Put on BRK stock: not the absence of a strike price, but one that adjusts to 110% of BRK's BV over time in perpetuity. I think that transforms BRK stock into a quasi zero coupon bond with a very high yield to maturity which never comes.

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