Tuesday, March 25, 2008

Call of the wild

An interesting lesson/case study in economics.


Monday, March 24, 2008

Old Pros Size Up the Game

WSJ interview with Ed Thorp and Bill Gross.
On a related note, I've been meaning to do a write-up one weekend on the Kelly Criterion, how I use it and how I believe it should be used in investing. Many opinions have been given on this topic but I believe a simplified, expected value approach that still involves the art behind valuation work is the correct one. Until then (or in case there is no then), here are a few related links:
Mauboussin: Size Matters
William Poundstone site page (author of Fortune's Formula)

Friday, March 21, 2008

Jean-Marie Eveillard Interview

Great interview with Jean-Marie Eveillard on Bloomberg News: VIDEO

Monday, March 17, 2008

Excerpt from Buffett's 2002 Annual Letter

Excerpt from Mr. Buffett's 2002 Letter to the Shareholders of Berkshire Hathaway that is worth reviewing in light of recent market developments:

When we purchased Gen Re, it came with General Re Securities, a
derivatives dealer that Charlie and I didn't want, judging it to be
dangerous. We failed in our attempts to sell the operation, however, and
are now terminating it.

But closing down a derivatives business is easier said than done. It
will be a great many years before we are totally out of this operation
(though we reduce our exposure daily). In fact, the reinsurance and
derivatives businesses are similar: Like Hell, both are easy to enter
and almost impossible to exit. In either industry, once you write a
contract - which may require a large payment decades later - you are
usually stuck with it. True, there are methods by which the risk can be
laid off with others. But most strategies of that kind leave you with
residual liability.

Another commonality of reinsurance and derivatives is that both generate
reported earnings that are often wildly overstated. That's true because
today's earnings are in a significant way based on estimates whose
inaccuracy may not be exposed for many years.

Errors will usually be honest, reflecting only the human tendency to
take an optimistic view of one's commitments. But the parties to
derivatives also have enormous incentives to cheat in accounting for
them. Those who trade derivatives are usually paid (in whole or part) on
"earnings" calculated by mark-to-market accounting. But often there is
no real market (think about our contract involving twins) and
"mark-to-model" is utilized. This substitution can bring on large-scale
mischief. As a general rule, contracts involving multiple reference
items and distant settlement dates increase the opportunities for
counterparties to use fanciful assumptions. In the twins scenario, for
example, the two parties to the contract might well use differing models
allowing both to show substantial profits for many years. In extreme
cases, mark-to-model degenerates into what I would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but
that's no easy job. For example, General Re Securities at yearend (after
ten months of winding down its operation) had 14,384 contracts
outstanding, involving 672 counterparties around the world. Each
contract had a plus or minus value derived from one or more reference
items, including some of mind-boggling complexity. Valuing a portfolio
like that, expert auditors could easily and honestly have widely varying

The valuation problem is far from academic: In recent years, some
huge-scale frauds and near-frauds have been facilitated by derivatives
trades. In the energy and electric utility sectors, for example,
companies used derivatives and trading activities to report great
"earnings" - until the roof fell in when they actually tried to convert
the derivatives-related receivables on their balance sheets into cash.
"Mark-to-market" then turned out to be truly "mark-to-myth."

I can assure you that the marking errors in the derivatives business
have not been symmetrical. Almost invariably, they have favored either
the trader who was eyeing a multi-million dollar bonus or the CEO who
wanted to report impressive "earnings" (or both). The bonuses were paid,
and the CEO profited from his options. Only much later did shareholders
learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble
that a corporation has run into for completely unrelated reasons. This
pile-on effect occurs because many derivatives contracts require that a
company suffering a credit downgrade immediately supply collateral to
counterparties. Imagine, then, that a company is downgraded because of
general adversity and that its derivatives instantly kick in with their
requirement, imposing an unexpected and enormous demand for cash
collateral on the company. The need to meet this demand can then throw
the company into a liquidity crisis that may, in some cases, trigger
still more downgrades. It all becomes a spiral that can lead to a
corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run
by insurers or reinsurers that lay off much of their business with
others. In both cases, huge receivables from many counterparties tend to
build up over time. (At Gen Re Securities, we still have $6.5 billion of
receivables, though we've been in a liquidation mode for nearly a year.)
A participant may see himself as prudent, believing his large credit
exposures to be diversified and therefore not dangerous. Under certain
circumstances, though, an exogenous event that causes the receivable
from Company A to go bad will also affect those from Companies B through
Z. History teaches us that a crisis often causes problems to correlate
in a manner undreamed of in more tranquil times.

In banking, the recognition of a "linkage" problem was one of the
reasons for the formation of the Federal Reserve System. Before the Fed
was established, the failure of weak banks would sometimes put sudden
and unanticipated liquidity demands on previously-strong banks, causing
them to fail in turn. The Fed now insulates the strong from the troubles
of the weak. But there is no central bank assigned to the job of
preventing the dominoes toppling in insurance or derivatives. In these
industries, firms that are fundamentally solid can become troubled
simply because of the travails of other firms further down the chain.
When a "chain reaction" threat exists within an industry, it pays to
minimize links of any kind. That's how we conduct our reinsurance
business, and it's one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that
participants who can't bear certain risks are able to transfer them to
stronger hands. These people believe that derivatives act to stabilize
the economy, facilitate trade, and eliminate bumps for individual
participants. And, on a micro level, what they say is often true.
Indeed, at Berkshire, I sometimes engage in large-scale derivatives
transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and
getting more so. Large amounts of risk, particularly credit risk, have
become concentrated in the hands of relatively few derivatives dealers,
who in addition trade extensively with one other. The troubles of one
could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer
counterparties. Some of these counterparties, as I've mentioned, are
linked in ways that could cause them to contemporaneously run into a
problem because of a single event (such as the implosion of the telecom
industry or the precipitous decline in the value of merchant power
projects). Linkage, when it suddenly surfaces, can trigger serious
systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a
single hedge fund, Long-Term Capital Management, caused the Federal
Reserve anxieties so severe that it hastily orchestrated a rescue
effort. In later Congressional testimony, Fed officials acknowledged
that, had they not intervened, the outstanding trades of LTCM - a firm
unknown to the general public and employing only a few hundred people -
could well have posed a serious threat to the stability of American
markets. In other words, the Fed acted because its leaders were fearful
of what might have happened to other financial institutions had the LTCM
domino toppled. And this affair, though it paralyzed many parts of the
fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return
swaps, contracts that facilitate 100% leverage in various markets,
including stocks. For example, Party A to a contract, usually a bank,
puts up all of the money for the purchase of a stock while Party B,
without putting up any capital, agrees that at a future date it will
receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements.
Beyond that, other types of derivatives severely curtail the ability of
regulators to curb leverage and generally get their arms around the risk
profiles of banks, insurers and other financial institutions. Similarly,
even experienced investors and analysts encounter major problems in
analyzing the financial condition of firms that are heavily involved
with derivatives contracts. When Charlie and I finish reading the long
footnotes detailing the derivatives activities of major banks, the only
thing we understand is that we don't understand how much risk the
institution is running.

The derivatives genie is now well out of the bottle, and these
instruments will almost certainly multiply in variety and number until
some event makes their toxicity clear. Knowledge of how dangerous they
are has already permeated the electricity and gas businesses, in which
the eruption of major troubles caused the use of derivatives to diminish
dramatically. Elsewhere, however, the derivatives business continues to
expand unchecked. Central banks and governments have so far found no
effective way to control, or even monitor, the risks posed by these

Charlie and I believe Berkshire should be a fortress of financial
strength - for the sake of our owners, creditors, policyholders and
employees. We try to be alert to any sort of megacatastrophe risk, and
that posture may make us unduly apprehensive about the burgeoning
quantities of long-term derivatives contracts and the massive amount of
uncollateralized receivables that are growing alongside. In our view,
however, derivatives are financial weapons of mass destruction, carrying
dangers that, while now latent, are potentially lethal.

Thursday, March 13, 2008

Annaly February Commentary

In this environment, we are reminded of a speech given by Ben Bernanke in November 2002 when he was still a Fed Governor. The speech, entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here,” laid out the rationale for lowering Fed Funds to an emergency rate in order to stave off deflation and its corrosive effects on the economy. The prescription, he said, could include bringing the target rates as low as possible, even zero. But beyond that, there are a variety of alternate tools it could use, including expanding the scale and menu of asset purchases, including Agency debt and MBS, making low interest-rate loans to banks or directly to the private sector (through the discount window, for example), working with fiscal policymakers, committing to holding short term rates at zero for a specified period (a la Japan), or establishing interest-rate ceilings on long-term Treasuries. As he concludes, even though these ideas are relatively unfamiliar, using them to prevent deflation is far preferable than having to cure it. “I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound.” To us, even though he was talking about general price deflation, he could have been referring to the possible toolbox for fixing the asset deflation/deleveraging that is currently plaguing the financial markets. Today, the title of that speech would be “Deleveraging-induced economic depression: Making sure ‘it’ doesn’t happen here.”

Tuesday, March 11, 2008

Prem Watsa's 2007 Shareholder Letter - Fairfax Financial

We have witnessed credit spreads widen dramatically for mortgage insurers, bond insurers and junk bonds, reflecting mainly the problems of the housing market. We remain vigilant for the spreading of these risks into all credit markets, because the same loose lending standards and asset backed structures have been applied to these markets. Also, as we have mentioned in the past, we remain concerned about the potential decline in record after-tax profit margins in the U.S. and its impact on stock prices. Of course, the potential impact of the U.S. economy and stock prices on the rest of the world’s economies and stock prices, particularly given that most of the world’s stock markets are trading at close to record highs, is why we continue to protect our portfolios from a 1 in 50 to 1 in 100 year financial storm.
Recently, we came across an interesting observation by the man who provided the intellectual underpinnings of “long term value investing” and to whom we are ever indebted. Ben Graham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932. If you didn’t see the risks in 1925 (very hard to do), it was very unlikely that you survived the crash! We think Ben’s observation may be relevant to what we have experienced in the past five years. We reminded you in our 2005 Annual Report that “Jeremy Grantham of Grantham Mayo said that of the 28 bubbles that they have studied in all asset categories (including gold, silver, Japanese equities and 1929), this recent bubble in the U.S. stock market is the only one that has not completely reversed itself (just as it was about to in 2003, it turned and rebounded).” Caveat emptor!!

Monday, March 10, 2008

Warren Buffett: How to Minimize Investment Returns

From Warren Buffett's 2005 Letter to the Shareholders of Berkshire Hathaway:

How to Minimize Investment Returns
It’s been an easy matter for Berkshire and other owners of American equities to prosper over the years. Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow rose from 66 to 11,497. (Guess what annual growth rate is required to produce this result; the surprising answer is at the end of this section.) This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments.
The explanation of how this is happening begins with a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.
Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.
To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.
But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.
After a while, most of the family members realize that they are not doing so well at this new “beat-my-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.
The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course.
It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.
The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”
The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with selfconfidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.
The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.
And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).
A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.
Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
* * * * * * * * * * *
Here’s the answer to the question posed at the beginning of this section: To get very specific, the Dow increased from 65.73 to 11,497.12 in the 20th century, and that amounts to a gain of 5.3% compounded annually. (Investors would also have received dividends, of course.) To achieve an equal rate of gain in the 21st century, the Dow will have to rise by December 31, 2099 to – brace yourself – precisely 2,011,011.23.

Oak Value Q4 Letter


Monday, March 3, 2008

A Portfolio Warren Buffett Would Love