ERICOPOLY

At 2009 year end FFH had an equity worth $7,619 million, with common stocks, investments in equity, and preferred stocks worth $5,621.3 million, or 73.8% of equity. Did they stretch their investment into equities to the upper limit? I cannot say… Gio 73.8% after they appreciated off the March bottom.

I live in California. I will pay 50+% tax on selling puts -- they are taxed as regular income. There is no point taking on risk if I can't keep the money as compensation. Instead, I purchase the underlying stock and hedge with a put. The put expires worthless (as a short-term capital loss) and the underlying stock keeps on compounding tax deferred. The expired put shields my tax bill elsewhere (allowing me to keep some profit for myself, which is a novel concept). After the first year or two, the underlying stock should have appreciated quite a bit. Then the additional cost of puts (at the same strike) will go down (due to skewness). That's when I begin to make money. Then there is risk profile -- I am taking the downside risk when I write a put. I am putting the downside risk on someone else when I buy a put. I want to keep all of the profits while letting others shoulder the bulk of the risk 8) EDIT: Take for example BAC. I bought the common for $12 in March and hedged with $12 strike put (about $1.10 cost). The stock is up a bit since then. Now the 2016 $12 strike put (to replace the 2014) costs only $1. So for a total outlay of roughly $2.10, I can get three years of BAC's upside. During this time, the gains compound tax-deferred and the puts expire worthless (offsetting dividends and realized capital gains). Then for 2017 expiry, I expect the next round of $12 strike puts to cost maybe 20 cents a year. Then I'm keeping nearly all the profit. So costly at first, then after a few years extremely cheap! So the leverage gets cheaper and cheaper -- it's like adjustable rate non-recourse loan that adjusts lower (at least for the puts it does). I expect the interest rate to move up over time (on the margin loan). What happens when I get more dividend income from BAC than the puts cost me? I buy shares of something that doesn't pay a dividend -- like Berkshire. I hedge that with puts. That gives me more write-offs to charge against my BAC dividends. I'm hoping this is the solution to California's nasty tax situation. It's like my Australian heritage is coming to light -- using leverage for negative gearing (isn't that the Australian way?).

No, but only because I wanted to make a quick trade in SHLD. Otherwise, I wouldn't have traded out of it.

So if they were running an all-equities fund, it's reasonable to conclude that they would have only invested 50% into equities in March 2009? I think that ludicrous, personally. That's just an opinion and everyone has one.

Higher than 0%. Almost certainly higher than 10%. I have no idea how much higher. Could be 30%, or 40%, or 50%, or 20%! Absolutely no clue.

That depends on how much their float leverages their equity. You have a certain amount of equity that services the float (not sure "services" is the right term), and beyond that the equity would be free to use for anything you wish. I don't know what the amount is. I've asked the board before and nobody knew. Common sense tells me there is a limit to how much an insurance regular can tolerate.

Without it impacting their ratings? Nope, I don't. They dropped their hedges when the market was at S&P 800. Let's say they are 100% (of shareholder equity) invested at that point in equities. Then let's say the market drops to S&P 400. So they're now taking a 50% haircut on their equity. Is that okay with their regulator?

Suppose you took out a loan from your family paying 7.5% interest rate. You invest it into BAC for 12 months. You break even if your total return from BAC (including dividends) is 7.5%. 7.5% is your cost of leverage -- that's the hurdle rate. So embedded within the warrant is a synthetic loan. The point where the returns from the warrant match the returns of the common is the cost of leverage. It's where the costs from the leverage merely equate to the total return from the stock. Anything above that total return "cost of leverage" rate, the leveraged approach will outperform the unleveraged common. Anything less, and it will underperform. So the whole point of a warrant is to earn leveraged returns. Not leveraged losses! So it's intelligent to think about how much the leverage in the warrant costs before deciding on that particular tool to drive your leveraged strategy.

What happened to preferring lumpy returns? Of course, insurance returns will generally be SMOOTHER due to the income from (a forced allocation into) bonds and (potential) underwriting profit. They say they are all about lumpy results though, and total returns over long periods -- so they're not in it for smoothness. That's not the attraction. So I ask why they are in insurance, and in return you ask if I would bet against them? I don't see the connection. Would you bet against HWIC running an equities-only fund without insurance? There, does that question mean anything?

Anyways, over on the SHLD thread people are arguing that the retail business detracts from the value of the assets. I'm simply asking if the insurance operations detract from the value of HWIC -- they would not have the float, but they could go heavier into equities when the opportunity is ripe. And I don't mean Kraft and Johnson and Johnson when American Express is trading at tangible book value!

I agree with that -- however keeping all this cash around costs money. You have to knock that off the underwriting results to account for the true cost of insurance operations.

Common sense tells me "B" that I would rather buy insurance from: A) a company that invests the premiums in short-duration treasuries B) a company that puts 50%+ in stocks Just kidding! It's "A". So, to what degree does the investment portfolio influence the underwriting results? It must work (to some degree) in favor of Mr. Brindle's underwriting result and against Mr. Barnard's. Don't the ratings agencies care? And don't the customers care about the insurance ratings? To answer Giofranchi -- it's not that I believe insurance is less risky than investing, rather I believe the risks are additive. In other words, you can have a major cataclysmic underwriting result during a major stock market panic (and bond market panic). They can all happen at the same time -- a perfect storm. You just have equity market risk if you only invest in equities. You just have bond market risk if you only invest in bonds. You just have insurance market risk if you only invest in short duration T-bills.

Doesn't the Sears square footage need to be converted to suitably sized mall space first before getting leased out at similar rates to what SPG is getting across it's portfolio? I mean, presumably you don't just get full market lease rates in existing Sears big-box format. It has to go renovation -- planning, permitting, construction, etc... So if that process takes a couple of years (planning, permitting and construction) you would want to discount the real estate for a couple of years. Then if it takes dollars to pay the people for the planning, permitting and construction, then you'll need to knock those dollars off of the value as well. Yes, of course. It just gives an idea that there is real value in SHLD's portfolio, not a precise value. Exact weight vs the guy is fat. I don't want exact weight. But is it a 30% slimming? Oh, it might be 25%, or 35% -- roughly right is good enough. Putting no discount at all just seems like pumping the value of the stock. A 200lb woman can look fat, but if she loses 30% of bodyweight she might be hot at 140 lb.

Doesn't the Sears square footage need to be converted to suitably sized mall space first before getting leased out at similar rates to what SPG is getting across it's portfolio? I mean, presumably you don't just get full market lease rates in existing Sears big-box format. It has to go renovation -- planning, permitting, construction, etc... So if that process takes a couple of years (planning, permitting and construction) you would want to discount the real estate for a couple of years. Then if it takes dollars to pay the people for the planning, permitting and construction, then you'll need to knock those dollars off of the value as well.

That's interesting that JPM warrants are 5.22%. They are currently trading in-the-money by roughly the same amount as BAC will be when BAC is trading above $18. BAC warrant premium costs more today but today BAC is closer to strike price (and skewness has an effect on that embedded put premium).

What would FFH's returns be if they relied solely on insurance? Now we're getting to the meat of my argument.

Well, let’s just forget for a moment about this board, which is filled with genius investors! ;), and look at the statistics about hedge and mutual funds around the world… To outperform the S&P500 by 3% annual you probably must be in the top 1%. If the S&P500 is priced to achieve something like 3% annual for the next 10 years, like a believe, you have to be able to choose one fund among the top 1% performers to get a 6% return, and you won’t benefit from leverage. If you want a 12.2% return (an outperformance of 9 percentage points each year) probably you must be able to pick one fund among the top 0.1% performers… and maybe that won’t still be enough! Or else, you buy FFH. Gio Seriously though, I looked in an annual report back around 2007 or so, and HWIC's annualized return (since inception) on equities was over 17%. This is why I merely ask how much more they achieve by having all the risk of insurance added to the fold. They could lose 20% of book value later on today if their luck is bad. Or it could be the worst case of 10% or so that they have modeled. The reason you've heard of Alexander Hamilton is that he was a young boy living in the West Indies on a day that they were hit with a huge hurricane and a huge earthquake on the same day! He wrote an account of this experience that circulated in worldwide newspapers. Some wealthy businessmen were impressed by his intellect and funded his studies at Kings College in the US -- the rest is history.

The cost of leverage in the warrant will be about 7.8% if the premium decays in straight-line fashion by the end of 2014. Your $18 price equates to a return on the common of 15%. So you have some advantage to owning the warrant under the straight-line decay assumption. However, the cost of leverage could drop to 5% (just picking a number). There would be 4 years left on the warrant. So 2.8% multiplied by 4 is 11.2%. Total cost of leverage over the next year would therefore be 19%. The hurdle rate becomes 19%, the common stock only appreciates by 15%, you wind up losing out versus the common. So it's still possible that the warrant could underperform the common as it rises to $18. The gain on the common is about 27.8% if it goes to $20. You should safely outperform the common in that scenario. One alternative approach is to buy the common and hedge it with a $15 strike put for $1.40. It only costs 10% in the worst-case plus your margin borrowing rate. IB has rates from 50 bps to 140 bps. So, 10.5%-11.4% total cost in the best case. Plus, you would sleep better having a higher strike price on the put ($15 vs $13.30). So in short, the warrant has a projected cost range of 7.8% to 19%. If you qualify for the lower IB margin rate, you could instead get a cost of only 10.5% (assuming short term rates remain steady). The higher strike price is nice too.

I understood you, the trouble is that the 12.2% is not a tough hurdle for guys like this to achieve running a plain vanilla equities fund. It's well below their historical equity returns actually. Suppose these guys come up with a really fancy system that takes a lot of their energy, and they merely achieve a return that Chou can achieve WITHOUT the fancy system and his job is easier because of it?

Operating profits from insurance and reinsurance operations as of September 2013 were $160 million, or 2.12% FFH’s equity at 2012 year end. This is a 2.8% ROE annualized. To get to 15%, you only need 12.2% from investments. Given their leverage, a return of more or less 5.7% from their portfolio of investments is needed. Historically they have averaged 9.4% annual on their portfolio of investments. If this is not a margin of safety, I have never seen one. :) Gio They are tremendous investors and can achieve much of what you talk about if they were to shut down the insurance operation. You say they only need 12.2% from investments. What, and they need to run an insurance operation for that... why? Insurance forces them into a lighter equity allocation during market cheapness periods (they have an insurance regulator and they have credit ratings to worry about). During periods of high interest rates and poor equity prospects, the bonds really shine -- but they don't shine so bright when there are low interest rates. Hasn't Chou Funds kicked the crap out their returns the last 5 years without an insurance operation to worry about? I mention Chou because he's about as FFH as you get without actual working there anymore (he used to be a VP there). So they should be able to achieve what he can achieve (he uses the same philosophy).

The puts can be viewed as a proxy for holding cash. Once the stock drops to $8, you can flip the put into a call (put/call parity). So it costs 30 cents today to have $8 of synthetic buying power (expiring in 2016) "just in case" the opportunity arises. For taxable portfolio margin account, it may be better to just purchase the common and hold onto the puts to hedge the loan used to buy the common. This way, you don't wind up with a potentially expensive short-term capital gain on the put (if you sell the put to buy a call, you have a realized gain on the put).

10 yr hit 3% yield mark today. It is absorbing some of the freshly generated capital. The way things turned out, they've absorbed much of the capital that people were screaming should have gone into a higher capital return for 2013. So I'm glad the way this worked out -- now there is one less risk in the stock (less to fear from future rate increases because a good part of the journey has already been travelled).

I didn’t mean that! You should know by now, if there is someone who buys insurance (maybe too much of it!), it is just me! Instead, what I meant is I don’t feel comfortable yet with the “technicalities” of options trading. That’s why I wouldn’t buy or sell options with much capital involved. Gio I see. Well, I can only say that it has been worth it for me to learn about them. It's sort of nice the way you can write the $25 strike call and use the proceeds to purchase two $8 strike puts. This way, you can put 100% of your present capital into the stock at $8 per share during a panic (by either purchasing the underlying common stock, or by flipping each $8 put into an $8 call). So if it goes from $16, down to $8, and then back up to $16 you can double your money even though the stock never appreciated from present levels. And instead if the stock doesn't go into a panic, but rather it goes from $16 to $25 over those same two years, you can make 56%. That's not a horrible thing either way -- panic or no panic. You get to preserve your buying power, and at the same time you don't have miss out on gains if there is no panic. And really it costs nothing at all -- only gets expensive if the stock goes over $25... but if that is to be considered an expense, then you have a much bigger expense if you are instead in cash all that time. Eric, I'm assuming you're talking about Jan 2014 BAC calls and puts. The $25 calls are 10-12 cents and the $7 (no $8) puts are 5-6 cents. Seems like tiny % of the common. Does seem to make sense to sell the upside here. If buying the $7 puts only cost 30bps, seems to make sense to just pay up for them. I really like the strategy of buying the commons and the ATM puts simultaneously. Seems like a great way to sleep well at night knowing that you've paid the cost of the fire insurance on your "house" even if it cost 10% annualized. It allows one to comfortably size a position at 20+% knowing that worst case downside is 2% of AUM. Sizing trades large in a fund is harder to do than in your personal IRA. This seems to resolve that issue. If you want to size something at 20+%, the CAGR on that idea is likley above 10% anyway. If you were to initiate a position in BAC today, which strike would you buy? Would it be the $15, 12, or a mix of both with some deep OTM thrown in? How do you think about the % premium vs OTM and duration? Regarding lending rates for shares like SHLD, can you implement a strategy where you can buy the ATM put and lend at a double digit rate that pays for the put? I recall the cost of borrow for SHLD being close to 100% at one point. Do you recall how much ATM BAC puts cost (% of common) when it was trading close to $5? Great discussion on this thread. I delayed the launch of my fund for 2 years because I couldn't figure out how to hedge a repeat of 2008/2009. I've decided to borrow a page from Buffet by investing in workouts/special sits as an alternative to holding cash. I believe that I can do >10% CAGR regardless how the market performs. But your long commons coupled with long ATM puts is a great addition to my tool box of hedging against 2008/2009. I was actually thinking of the 2016 expirations when I wrote that -- the short terms expiring in 2014 don't provide adequate time to recover to the upside. So if you get 2016 expiry $8 puts, and the shares crash back to that level, you can either buy more common (hedged at $8), or you can sell the put and buy the call. So the long-dated call here gives you a lot of time for market recovery. This is if you are willing to hold the BAC shares to expiration of the calls you write -- it will get annoying if the stock goes to $25 by end of next year and you have this (by then) really expensive $25 strike call standing in the way. But, that's the tradeoff if you want the $8 strike puts to come at "no" cost.

I didn’t mean that! You should know by now, if there is someone who buys insurance (maybe too much of it!), it is just me! Instead, what I meant is I don’t feel comfortable yet with the “technicalities” of options trading. That’s why I wouldn’t buy or sell options with much capital involved. Gio I see. Well, I can only say that it has been worth it for me to learn about them. It's sort of nice the way you can write the $25 strike call and use the proceeds to purchase two $8 strike puts. This way, you can put 100% of your present capital into the stock at $8 per share during a panic (by either purchasing the underlying common stock, or by flipping each $8 put into an $8 call). So if it goes from $16, down to $8, and then back up to $16 you can double your money even though the stock never appreciated from present levels. And instead if the stock doesn't go into a panic, but rather it goes from $16 to $25 over those same two years, you can make 56%. That's not a horrible thing either way -- panic or no panic. You get to preserve your buying power, and at the same time you don't have miss out on gains if there is no panic. And really it costs nothing at all -- only gets expensive if the stock goes over $25... but if that is to be considered an expense, then you have a much bigger expense if you are instead in cash all that time.

That sounds like a very good strategy. The problem is I don’t master options half as good as you do… Half?! Try 1/5! Much better! ;) And I wouldn’t dare following your strategy with much capital… Options clearly is a field where I still have a lot of room for growth and improvement! :) Gio People wouldn't dare purchase fire insurance for their homes right, because it's too risky? I mean, so far I've lost money on fire insurance every single time I've purchased it. Year after year, I've lost 100% of the premium. It's too risky! Fire insurance gets risky when you start purchasing insurance on homes that you don't own. Options work the same way.