Good blog post on FFH

[giofranchi]

Gio: at what point would you reconsider your investment in Fairfax? Since your thesis is relying on excellent management have you set any rules for judging that? And aren't you afraid that you will develop a positive bias regarding Fairfax since you spend so much time defending it? :)

 

Well, I wouldn’t like to see some move that is inconsistent with their way of doing things. Listen, I don’t think there is only one way to achieve great results. What matters is that you get to be the best at what you are doing and what you are doing is sensible, and you have the temperament and strength to follow your strategy till completion. If, on the other hand you are too much affected by temporary failure, and therefore you change course without a true reason, that would worry me… For instance, I decidedly wouldn’t like them taking the equity hedges off right now! ;)

 

On the contrary, one of the reasons I try to answer all your doubts about FFH (and other investments of mine) is that this forces me to constantly revisit potential weaknesses of the businesses I own, and to write down the reasons why I think they still might do fine in the future. It is a continuous monitoring that I like a lot! :)

 

Gio

 

[giofranchi]

I generally agree, although in the last 5 years they have not, and in the last 10 years they barely did.  I don't consider 5 and 10 years to really be all that short-term.

 

Joel,

How do you know this? Do you have their results on a 5 and 10 years basis without equity hedges? If so, could you please post them and tell us where you have found them? If they weren’t better than the indices, a long/short strategy (while waiting for some great opportunities to present themselves) would be sheer folly… Why do you think Mr. Watsa would have done that, if not convinced their stocks selection could beat the indices?! ::)

 

Gio

 

[giofranchi]

Your whole argument about “the long-term” is very misleading. If Mr. Watsa’s defensiveness today is proven right, those numbers will change dramatically in a matter of just a few years…

 

How do you know that, though? Someone could have written the same thing a couple years ago. What if the market goes up another 30% in the next few years and the real economy picks up a lot? That's the problem with trying to time macro. Over the past 100 years, there were always reasons to think the sky was about to fall, yet our economy mostly keeps driving forward. How many points was the dow jones 100 years ago?

 

Markel and Berkshire will participate fully in a good economy, but they'll also do well if things go to hell.

 

If things go well, FFH will create value more slowly than they would otherwise because the hedges are like a huge weight tied to their ankles, but if things go to hell, they'll just rewind the tape a bit and get back some of the money they lost in the past few years. On the long-term net, I don't think they'll come out ahead unless there's something just as bad or worse than 2008 that happens soon, in which case their other equity holdings would probably suffer more than the average company since they tend to be somewhat distressed situations (how would Blackberry do in a collapse? probably worse than Wells Fargo and Johnson & Johnson, I'd guess).

 

I would rather have seen them reduce their leverage or raise minimum cash to 2b at the holdco level or something like that. That reduces risk, but it's less directional, so that if things don't go the way you think, you still move in the right direction.

 

Don’t confuse the short-term with the long-term: in the long-term FFH equity portfolio has always outperformed the indices. In the long-term they will make money, not lose it!

 

Gio, what do you think of FFH's performance if you remove the first few years when they were really small? It looks like both BRK and MKL have done better for quite a long time despite not having successfully bet on CDS in the GFC and such. Again, I think FFH could just reduce its leverage a bit and it would make them have to be a lot less paranoid about macro, which is never a position you want to be in anywyay...

 

Liberty,

I don’t see it that way… and I suspect neither Mr. Watsa does… though I wouldn’t presume to know what he thinks…

 

Just let me tell you how I see things:

All these market prices going up and up are sustained basically by two facts: the printing of an unprecedented amount of money, and the no mark to market policy huge financial institutions are able to employ worldwide. In some way, market prices going up and up are themselves a macro bet! An optimistic bet, not a pessimistic one, but still a macro bet they are!

In other words, they are not supported by a significant difference between prices and values. They weren’t in 2012, nor in 2013, certainly not today!

This is not an environment in which FFH is finding great opportunities. Therefore, they wait: huge amount of cash, and a long/short equity portfolio.

But, and this is key, they have constantly one finger on the trigger, always ready to shoot in case the environment changes for the better! As soon as there is evidence values are much higher than what they think they are today, almost by definition great opportunities will abound, and that will be the time to drop the long/short policy, and to deploy all that cash.

What I mean is people assume their long/short policy and their cash burden will go on, unless some market crash comes along… But I don’t think it is true! Absolutely not true! As soon as they see great opportunities, they will seize them. And their asset allocation strategy will change accordingly. They have began doing so with the acquisition of private businesses. But, as I have always said, not in a hurry! You must get comfortable with doing things, unless you risk committing serious mistakes…, and you get comfortable only gradually. But, as they go on acquiring private businesses, the whole process will accelerate! Also their view of the stock market might change, without the need of a market crash, if things develop for the better, and values much higher than prices start to appear once again.

After all, if you don’t see a clear difference between values and prices, everything else is “macro”, one way or the other… right? ;)

I wouldn’t talk about WFC, because I don’t really know it nearly enough, but I have owned JNJ in the past and I continue to follow it: my idea is that at current prices it is a mediocre investment at best!

 

Like I have already said, take away the first year, ok, but try and take away the last three years too! And compare FFH to BRK and MKL in the remaining 24 years… My guess is FFH would compare favorably. During the last three years Mr. Watsa has been waiting. :)

 

Gio

 

[giofranchi]

My issue with the cash argument is that I've not found any evidence that it works out.  For example, Sam Neil very confidently said that he thinks most money could be made by doing nothing until the opportunity arose and then stepping in.  While I think that is true on an individual stock basis, and perhaps that was what he was referring to, based on all the modeling an studying I've done, it is not true for the market as a whole (which is the context of his answer).  I was completely taken aback when he said that, as I've found absolutely no evidence that it is true and he seemed to be implying that it was for the market.  The opportunity cost of having cash is extremely high, on a market level basis.  For an individual stock picker, the opportunities have to be compared against what you have in front of you, so the opportunity cost is what you normally get, or would get in that period, which I still believe to be high.  It is much harder to model that though, so there's lots of variables. 

 

The problem with this argument is that it looks foolish.  I feel like value investors, because they are so contrarian, like to hold cash and call it being "prudent".  It feels good right?  People get to say they held cash when the market was high and redeployed it at the bottoms, but they very rarely test to see if they would have done better just investing it with the rest of their picks the whole way through.  Incidentally, this can be tested without too much effort:

 

1) Figure out your ex-cash returns on a per year basis:

2) model holding a percentage of cash and redeploying it at the bottom (assume you have excellent timing)

3) figure out what percentage of cash gives you the highest returns over your time period

 

For every investor I've done this for (except for Pabrai's second and third funds), the ideal cash percentage was 0, and that was over recent time periods, including the 2008 drop. 

 

Side note: I really wanted to find out that holding cash was prudent and the right thing to do.  It made sense in my head.  I wanted to be contrarian and hold cash as the market went up and deploy it on the bottom.  I've just not been able to confirm that it works better.  I really don't like the fact that if you are 100% invested, that crash is going to hurt, and you likely won't be able to buy at the bottom, but that's what everything I've tested has said, unless your portfolio volatility is very very high (like Pabrai's was in 2008, and even with that, it was better for him to be 100% invested for his longer run, first fund).

 

Joel,

I don’t know which studies you have performed… But it seems very unlikely that in every situation possible the best percentage of cash to hold, by a strictly mathematical point of view, is always zero! How is this possible? Zero, always?! In 1929 as in 1933?! In 1937 as in 1950? In 1950 as in 1968?! In 1982 as in 2000?! In 2003 as in 2007?! In 2009 as in… today?! I am no mathematician, but as an engineer I know some of math and statistics… and your conclusion seems at least unexpected to me!

 

Let alone the fact that in investing math and logic count only up to a certain point. It is psychology that counts the most. All the great capital allocators of the past knew this very well. And they all managed to always keep strong with a substantial cash reserve. Because that gives you calmness, and calmness gives you clear thinking, and clear thinking leads you to better decisions. Either we like it or not, we are all dealing with the future… math imo cannot get you very far. ;)

 

Personally, I try to manage my cash reserve, and let it grow when I see frothy behavior around me, while shrinking it when some great opportunities come along.

 

Gio

 

[giofranchi]

In 2013, Fairfax's book value went down by 10% while the stock went up by 18%, a difference of 28%.  Today it trades at around 1.25x book value.  The highest multiple it has ever traded is 1.44x (according to GuruFocus).  I think that Fairfax stock is significantly overvalued, which is both a good time for them to issue shares and a good time for Fairfax shareholders to be cautious.

 

This makes absolutely no sense. Simply because you cannot judge FFH by BV today. As is always the case, you must know what you own.

 

Gio

 

[giofranchi]

Ok, guys! Sorry… I have tried to answer all your points, but it is too daunting a task! I give up. Let me conclude by saying this: in the past FHH has averaged a return on their portfolio of 8.9% annual. Given the amount of float they manage today, a 7% return on their portfolio is enough to compound BV at 15% going forward. Which is 21% worse annually than what they have achieved in the past. I asked Mr. Watsa at the AM my long term concern n.1, which is that in the past FFH has benefited much from a secular bull market in bonds that is now over and won’t probably be repeated for a very long time. He answered they will be opportunistic and they might invest more in equities, in private businesses, or in high-yield bonds. Basically what I had hoped to hear. He didn’t know I was asking him such a question. Therefore, he hadn’t had the time to put together a more elaborate answer. Yet, it seems to me he was very prepared.

No one knows the future, but I decidedly like what I see. :)

 

Gio

 

[vinod1]

Ok, guys! Sorry… I have tried to answer all your points, but it is too daunting a task! I give up. Let me conclude by saying this: in the past FHH has averaged a return on their portfolio of 8.9% annual. Given the amount of float they manage today, a 7% return on their portfolio is enough to compound BV at 15% going forward. Which is 21% worse annually than what they have achieved in the past. I asked Mr. Watsa at the AM my long term concern n.1, which is that in the past FFH has benefited much from a secular bull market in bonds that is now over and won’t probably be repeated for a very long time. He answered they will be opportunistic and they might invest more in equities, in private businesses, or in high-yield bonds. Basically what I had hoped to hear. He didn’t know I was asking him such a question. Therefore, he hadn’t had the time to put together a more elaborate answer. Yet, it seems to me he was very prepared.

No one knows the future, but I decidedly like what I see. :)

 

Gio

 

Thanks for detailed and thoughtful responses. Your patience is amazing!

 

Fairfax is one of my first investments and following Prem has taught me a lot. So regardless of our difference in expectations regarding Fairfax, I would be rooting for both Fairfax and your investment.

 

You mention frequently and it is something I have not been able to make the same leap of faith as you do, is the return expectation of 7% vs the 9% historical rate. How can you just lop of 2% off historical record and say that is conservative and provides us with a margin of safety?

 

Take the example of a 10 year bond,  as the yield went down from 5% to 2% over 5 years, the returns on that bond would be 8% annual (roughly). We cannot just say, I would chop off 4% or half of the return and conservatively expect just 4% over the next 5 years. It is not going to happen. We would just get 2% returns.

 

The math for Fairfax bond portfolio is very similar to the example above. I think Fairfax is one of the best if not the very best bond investors, but without a major dislocation in bond markets, I just cannot make the leap where Fairfax would be able to make 7% on their overall portfolio given where the bond yields are. Bond market is probably more important to Fairfax than the stock market given how they are forced to invest their portfolio due to insurance requirements. This is just not Fairfax specific, it is endemic for the P&C industry.

 

Vinod

[vinod1]

I think the fairest way to do these comparisons is to make rolling 3, 5, 10 year periods (perhaps quarterly) and show the distribution of those periods against the benchmark.  For good managers, I would expect something like: 65% outperformance for 3 years, 85% outperformance for 5 years, and 99% percent outperformance for 10 years, or something along those lines.

 

Anyone happen to have the data for that?

 

Edit: I'm also curious if anyone disagrees with measurement in that fashion or thinks there is a better way.  It seems to me to be the fairest since it is agnostic to particular time frames and the initial years.

 

Take 1990 to 2002 period. I am guessing, that the worst of the tech stock funds would have had pretty high rolling outperformance but would have had very large permanent loss of capital in the end.

 

I understand you are trying to come up with a mathematical way but I do not think this is the solution.

 

Vinod

 

Ah, good point, I think if we add a requirement that this is only done for long term outperformance company/investors, then it would remove the permanent loss issue.  (I would generally only want to do this for something I was interested in investing in, which would only include something that is outperforming).

 

The main difficulty is style differences impact your returns depending where you are in the cycle. Given a sufficiently long time period covering multiple cycles this effect would be reduced but still not be accurate. Why not measure at similar points in a cycle? That would take away the biggest error term in measuring performance.

 

Vinod

[giofranchi]

The math for Fairfax bond portfolio is very similar to the example above. I think Fairfax is one of the best if not the very best bond investors, but without a major dislocation in bond markets, I just cannot make the leap where Fairfax would be able to make 7% on their overall portfolio given where the bond yields are. Bond market is probably more important to Fairfax than the stock market given how they are forced to invest their portfolio due to insurance requirements. This is just not Fairfax specific, it is endemic for the P&C industry.

 

Vinod

 

Vinod,

I asked Mr. Watsa my question exactly because of that concern I share with you. As they keep buying more operating businesses, and building earning power, they might be able to transition to a balance sheet more similar to BRK’s today (where bonds amount to barely 8% of total assets). That way regulatory constrains will become less and less significant. And they have time: interest rates might not come down much more from present levels, but it is not likely they are going up soon either. Also Mr. Watsa’s answer tells me they will find good value propositions wherever they might be (more equities and/or high yield bonds): it might be done and I don’t have any reason to believe he was not in earnest while replying to my question. :)

 

Gio

 

[vinod1]

The math for Fairfax bond portfolio is very similar to the example above. I think Fairfax is one of the best if not the very best bond investors, but without a major dislocation in bond markets, I just cannot make the leap where Fairfax would be able to make 7% on their overall portfolio given where the bond yields are. Bond market is probably more important to Fairfax than the stock market given how they are forced to invest their portfolio due to insurance requirements. This is just not Fairfax specific, it is endemic for the P&C industry.

 

Vinod

 

Vinod,

I asked Mr. Watsa my question exactly because of that concern I share with you. As they keep buying more operating businesses, and building earning power, they might be able to transition to a balance sheet more similar to BRK’s today (where bonds amount to barely 8% of total assets). That way regulatory constrains will become less and less significant. And they have time: interest rates might not come down much more from present levels, but it is not likely they are going up soon either. Also Mr. Watsa’s answer tells me they will find good value propositions wherever they might be (more equities and/or high yield bonds): it might be done and I don’t have any reason to believe he was not in earnest while replying to my question. :)

 

Gio

 

Thank you!

[giofranchi]

The math for Fairfax bond portfolio is very similar to the example above. I think Fairfax is one of the best if not the very best bond investors, but without a major dislocation in bond markets, I just cannot make the leap where Fairfax would be able to make 7% on their overall portfolio given where the bond yields are. Bond market is probably more important to Fairfax than the stock market given how they are forced to invest their portfolio due to insurance requirements. This is just not Fairfax specific, it is endemic for the P&C industry.

 

Vinod

 

Vinod,

I asked Mr. Watsa my question exactly because of that concern I share with you. As they keep buying more operating businesses, and building earning power, they might be able to transition to a balance sheet more similar to BRK’s today (where bonds amount to barely 8% of total assets). That way regulatory constrains will become less and less significant. And they have time: interest rates might not come down much more from present levels, but it is not likely they are going up soon either. Also Mr. Watsa’s answer tells me they will find good value propositions wherever they might be (more equities and/or high yield bonds): it might be done and I don’t have any reason to believe he was not in earnest while replying to my question. :)

 

Gio

 

Thank you!

 

My pleasure!

 

We will see. :)

 

Gio

[Packer16]

My issue with the cash argument is that I've not found any evidence that it works out.  For example, Sam Neil very confidently said that he thinks most money could be made by doing nothing until the opportunity arose and then stepping in.  While I think that is true on an individual stock basis, and perhaps that was what he was referring to, based on all the modeling an studying I've done, it is not true for the market as a whole (which is the context of his answer).  I was completely taken aback when he said that, as I've found absolutely no evidence that it is true and he seemed to be implying that it was for the market.  The opportunity cost of having cash is extremely high, on a market level basis.  For an individual stock picker, the opportunities have to be compared against what you have in front of you, so the opportunity cost is what you normally get, or would get in that period, which I still believe to be high.  It is much harder to model that though, so there's lots of variables. 

 

The problem with this argument is that it looks foolish.  I feel like value investors, because they are so contrarian, like to hold cash and call it being "prudent".  It feels good right?  People get to say they held cash when the market was high and redeployed it at the bottoms, but they very rarely test to see if they would have done better just investing it with the rest of their picks the whole way through.  Incidentally, this can be tested without too much effort:

 

1) Figure out your ex-cash returns on a per year basis:

2) model holding a percentage of cash and redeploying it at the bottom (assume you have excellent timing)

3) figure out what percentage of cash gives you the highest returns over your time period

 

For every investor I've done this for (except for Pabrai's second and third funds), the ideal cash percentage was 0, and that was over recent time periods, including the 2008 drop. 

 

Side note: I really wanted to find out that holding cash was prudent and the right thing to do.  It made sense in my head.  I wanted to be contrarian and hold cash as the market went up and deploy it on the bottom.  I've just not been able to confirm that it works better.  I really don't like the fact that if you are 100% invested, that crash is going to hurt, and you likely won't be able to buy at the bottom, but that's what everything I've tested has said, unless your portfolio volatility is very very high (like Pabrai's was in 2008, and even with that, it was better for him to be 100% invested for his longer run, first fund).

 

Joel,

I don’t know which studies you have performed… But it seems very unlikely that in every situation possible the best percentage of cash to hold, by a strictly mathematical point of view, is always zero! How is this possible? Zero, always?! In 1929 as in 1933?! In 1937 as in 1950? In 1950 as in 1968?! In 1982 as in 2000?! In 2003 as in 2007?! In 2009 as in… today?! I am no mathematician, but as an engineer I know some of math and statistics… and your conclusion seems at least unexpected to me!

 

Let alone the fact that in investing math and logic count only up to a certain point. It is psychology that counts the most. All the great capital allocators of the past knew this very well. And they all managed to always keep strong with a substantial cash reserve. Because that gives you calmness, and calmness gives you clear thinking, and clear thinking leads you to better decisions. Either we like it or not, we are all dealing with the future… math imo cannot get you very far. ;)

 

Personally, I try to manage my cash reserve, and let it grow when I see frothy behavior around me, while shrinking it when some great opportunities come along.

 

Gio

 

I think what Joel has shown which I think makes sense is the opportunity cost of cash on average is negative.  Look at cash/bonds today.  Cash yields 0% so you are losing about 2.2% to inflation (based upon the 5 year TIPs treasury spread) per year just being in cash.  Now for a short period that is OK but over time it accumulates (just like the hedge losses for Fairfax).  There just has not been periods of time when the cash anchor has been able to overcome this headwind.  This does not mean you should be a 100% in stocks all the time.  You have to determine your volatility tolerance then develop an asset allocation based upon that.

 

WRT to the 7% investment return, I think it will be very hard to obtain going forward unless interest rate spike soon.  Just look at the current bond yield for BND at 2.2% and lets assume the FFH can outperform the bond market by 2.8% per year that is 5% yield going forward.  These types of instrument are about 80% of FFH's portfolio.  So the implies a 15% return on hedged equities and even more if FFH cannot outperform the bond market by 2.8% per year.

 

Packer 

[giofranchi]

These types of instrument are about 80% of FFH's portfolio.  So the implies a 15% return on hedged equities and even more if FFH cannot outperform the bond market by 2.8% per year.

 

Packer

 

I agree. But they don't have to stay at 80% indefinitely. And, if it makes sense to change, things will change. Gradually, of course, never in a hurry. But things are not carved in stone. And the transition to acquiring more and more operating businesses will certainly help a shrinking of their bonds portfolio.

Also, equity hedges are not here to stay. They will be removed, even at a substantial loss, if they finally are not justified anymore.

 

Gio

 

[racemize]

I generally agree, although in the last 5 years they have not, and in the last 10 years they barely did.  I don't consider 5 and 10 years to really be all that short-term.

 

Joel,

How do you know this? Do you have their results on a 5 and 10 years basis without equity hedges? If so, could you please post them and tell us where you have found them? If they weren’t better than the indices, a long/short strategy (while waiting for some great opportunities to present themselves) would be sheer folly… Why do you think Mr. Watsa would have done that, if not convinced their stocks selection could beat the indices?! ::)

 

Gio

 

Well, why does it matter what it is without hedges?  They did hedge, and those are their results over that period.  I'm sure they beat it without hedging as they are good at investing, but they did choose to hedge, so why would I give them credit as if they didn't?

[racemize]

My issue with the cash argument is that I've not found any evidence that it works out.  For example, Sam Neil very confidently said that he thinks most money could be made by doing nothing until the opportunity arose and then stepping in.  While I think that is true on an individual stock basis, and perhaps that was what he was referring to, based on all the modeling an studying I've done, it is not true for the market as a whole (which is the context of his answer).  I was completely taken aback when he said that, as I've found absolutely no evidence that it is true and he seemed to be implying that it was for the market.  The opportunity cost of having cash is extremely high, on a market level basis.  For an individual stock picker, the opportunities have to be compared against what you have in front of you, so the opportunity cost is what you normally get, or would get in that period, which I still believe to be high.  It is much harder to model that though, so there's lots of variables. 

 

The problem with this argument is that it looks foolish.  I feel like value investors, because they are so contrarian, like to hold cash and call it being "prudent".  It feels good right?  People get to say they held cash when the market was high and redeployed it at the bottoms, but they very rarely test to see if they would have done better just investing it with the rest of their picks the whole way through.  Incidentally, this can be tested without too much effort:

 

1) Figure out your ex-cash returns on a per year basis:

2) model holding a percentage of cash and redeploying it at the bottom (assume you have excellent timing)

3) figure out what percentage of cash gives you the highest returns over your time period

 

For every investor I've done this for (except for Pabrai's second and third funds), the ideal cash percentage was 0, and that was over recent time periods, including the 2008 drop. 

 

Side note: I really wanted to find out that holding cash was prudent and the right thing to do.  It made sense in my head.  I wanted to be contrarian and hold cash as the market went up and deploy it on the bottom.  I've just not been able to confirm that it works better.  I really don't like the fact that if you are 100% invested, that crash is going to hurt, and you likely won't be able to buy at the bottom, but that's what everything I've tested has said, unless your portfolio volatility is very very high (like Pabrai's was in 2008, and even with that, it was better for him to be 100% invested for his longer run, first fund).

 

Joel,

I don’t know which studies you have performed… But it seems very unlikely that in every situation possible the best percentage of cash to hold, by a strictly mathematical point of view, is always zero! How is this possible? Zero, always?! In 1929 as in 1933?! In 1937 as in 1950? In 1950 as in 1968?! In 1982 as in 2000?! In 2003 as in 2007?! In 2009 as in… today?! I am no mathematician, but as an engineer I know some of math and statistics… and your conclusion seems at least unexpected to me!

 

Let alone the fact that in investing math and logic count only up to a certain point. It is psychology that counts the most. All the great capital allocators of the past knew this very well. And they all managed to always keep strong with a substantial cash reserve. Because that gives you calmness, and calmness gives you clear thinking, and clear thinking leads you to better decisions. Either we like it or not, we are all dealing with the future… math imo cannot get you very far. ;)

 

Personally, I try to manage my cash reserve, and let it grow when I see frothy behavior around me, while shrinking it when some great opportunities come along.

 

Gio

 

Well, that's the issue with this whole discussion.  The answer is 0 in every study I've done.  However, from your comments, I'm not sure if you are understanding what I'm doing. 

 

Here's the issue--many people on the board post articles about CAPE or market P/Es and indicate that they are holding a lot of cash.  However, I've not seen anyone show that this behavior is prudent.  If it is prudent, then it should be easy to show that getting in and out of the market based on CAPE (or whatever metric being used) beats the market.  I've tried over and over again to get those to work, and they simply don't.  Being fully invested all of the time over time has higher overall returns than any system I've come up with, when tested over decently long periods.  Now, if you pick small periods, you can show outperformance with a timing system, but if it doesn't work over all sample periods or out of samples, then I think the result is noise and cannot be relied upon.

 

Saying it another way, what I'm testing is quite simple, if you hold cash over time, consistently, and then deploy it at the bottom, are your returns better than they would have been if you had been 100% invested the whole time?  I have found no system that beats being fully invested over decently long periods.  I have tested perfect hindsight bias investing 100% at the bottom (but holding cash until the bottom hits), metrics based on CAPE, differences between spreads, and a bunch of other timing strategies--none of them give higher returns than just being 100% invested, on a market level.  I've also tested it for multiple investors, since picking stocks is different than the market.  The way to do the test is outlined above--again, the answer is 0, unless your portfolio returns, as an investor, are much, much more volatile than the market.

 

Taking it a step further, what you just said is "Personally, I try to manage my cash reserve, and let it grow when I see frothy behavior around me, while shrinking it when some great opportunities come along."  This appears to be prudent on its face, and I would love for it to be true--I wanted it to be true when I started looking at this.  The issue is, I can't show that the returns are better when cash is held consistently.  Do you have your overall returns, ex-cash, calculated?  I'm happy to do the test for you to see if your returns holding the cash are better than they would have been if you had just been fully invested the whole time.  I strongly suspect you would have done better with no cash reserves (ignoring any business concerns and the need to have cash on hand for that).

 

[giofranchi]

I generally agree, although in the last 5 years they have not, and in the last 10 years they barely did.  I don't consider 5 and 10 years to really be all that short-term.

 

Joel,

How do you know this? Do you have their results on a 5 and 10 years basis without equity hedges? If so, could you please post them and tell us where you have found them? If they weren’t better than the indices, a long/short strategy (while waiting for some great opportunities to present themselves) would be sheer folly… Why do you think Mr. Watsa would have done that, if not convinced their stocks selection could beat the indices?! ::)

 

Gio

 

Well, why does it matter what it is without hedges?  They did hedge, and those are their results over that period.  I'm sure they beat it without hedging as they are good at investing, but they did choose to hedge, so why would I give them credit as if they didn't?

 

No, no… I didn’t explain myself correctly… There is no denying they have been waiting! While everybody else is rushing to make money, they have made none. Instead they have been waiting. You might say it is wrong to wait. You might even say it is ALWAYS wrong to wait. I don’t know… I clearly think it is not so… but I might be wrong.

Anyway, what I meant is there are basically two ways of waiting: the first is to sit on cash, the second is to employ a long/short strategy, which earns some alpha but is more volatile. Either way you are supposed to “be waiting”, and to be waiting means to make no money, but neither to lose it (like the post I commented was suggesting instead!).

 

Gio

 

[racemize]

Ah, good point, I think if we add a requirement that this is only done for long term outperformance company/investors, then it would remove the permanent loss issue.  (I would generally only want to do this for something I was interested in investing in, which would only include something that is outperforming).

 

The main difficulty is style differences impact your returns depending where you are in the cycle. Given a sufficiently long time period covering multiple cycles this effect would be reduced but still not be accurate. Why not measure at similar points in a cycle? That would take away the biggest error term in measuring performance.

 

Vinod

 

Well, what I'm trying to measure is whether an investor could get good returns by buying at any point in the cycle (assuming a good price in FFH's case, but this can generally be applied to asset managers).  I.e., I don't want to have to force the investor to only invest at the "right" time, which is the result of measuring only cycle to cycle.  If focusing on 5 and 10 year periods, this should be sufficiently long term that the manager should do well, in my opinion.  If the manager only does well over specific 5 and 10 year periods (e.g., based on the cycle), then that means that the buyer has to be extremely careful about when they buy.  I want the manager to do well in virtually all time periods given a long enough horizon (5-10 years, with the understanding that 5 years may be something like 85% outperformance and not 100%).

[racemize]

I generally agree, although in the last 5 years they have not, and in the last 10 years they barely did.  I don't consider 5 and 10 years to really be all that short-term.

 

Joel,

How do you know this? Do you have their results on a 5 and 10 years basis without equity hedges? If so, could you please post them and tell us where you have found them? If they weren’t better than the indices, a long/short strategy (while waiting for some great opportunities to present themselves) would be sheer folly… Why do you think Mr. Watsa would have done that, if not convinced their stocks selection could beat the indices?! ::)

 

Gio

 

Well, why does it matter what it is without hedges?  They did hedge, and those are their results over that period.  I'm sure they beat it without hedging as they are good at investing, but they did choose to hedge, so why would I give them credit as if they didn't?

 

No, no… I didn’t explain myself correctly… There is no denying they have been waiting! While everybody else is rushing to make money, they have made none. Instead they have been waiting. You might say it is wrong to wait. You might even say it is ALWAYS wrong to wait. I don’t know… I clearly think it is not so… but I might be wrong.

Anyway, what I meant is there are basically two ways of waiting: the first is to sit on cash, the second is to employ a long/short strategy, which earns some alpha but is more volatile. Either way you are supposed to “be waiting”, and to be waiting means to make no money, but neither to lose it (like the post I commented was suggesting instead!).

 

Gio

 

Well, my point is, 5 and 10 years are pretty long time periods.  Their results are not good over those two time periods right now, in my opinion.  I realize that this may be a special endpoint period for 5 and 10 years, but if they don't beat the market over 10 year periods somewhat regularly, then that is very dangerous for investors--you don't get many 10 year investing periods in your life!  This is why I'm talking about measuring the percentage of outperformance for rolling 3, 5, 10 year periods so that we can be sure about what we are getting.  Perhaps I'll make a spreadsheet for it. 

[giofranchi]

Taking it a step further, what you just said is "Personally, I try to manage my cash reserve, and let it grow when I see frothy behavior around me, while shrinking it when some great opportunities come along."  This appears to be prudent on its face, and I would love for it to be true--I wanted it to be true when I started looking at this.  The issue is, I can't show that the returns are better when cash is held consistently.  Do you have your overall returns, ex-cash, calculated?  I'm happy to do the test for you to see if your returns holding the cash are better than they would have been if you had just been fully invested the whole time.  I strongly suspect you would have done better with no cash reserves (ignoring any business concerns and the need to have cash on hand for that).

 

Joel,

I understand pretty well what you are saying. But probably the heart of the matter lies in the fact I am trying to run a business, not a portfolio. My portfolio of investments is just a part of my business. A very important part, but still only a part. And I look at and try to imitate great entrepreneur of the past. As far as I know, they have never talked about models nor spreadsheets… Instead, they all agree on one simple truth: they all have repeatedly said never to regret the time when cash was not enough. ;)

 

Gio

 

[giofranchi]

Taking it a step further, what you just said is "Personally, I try to manage my cash reserve, and let it grow when I see frothy behavior around me, while shrinking it when some great opportunities come along."  This appears to be prudent on its face, and I would love for it to be true--I wanted it to be true when I started looking at this.  The issue is, I can't show that the returns are better when cash is held consistently.  Do you have your overall returns, ex-cash, calculated?  I'm happy to do the test for you to see if your returns holding the cash are better than they would have been if you had just been fully invested the whole time.  I strongly suspect you would have done better with no cash reserves (ignoring any business concerns and the need to have cash on hand for that).

 

Joel,

I understand pretty well what you are saying. But probably the heart of the matter lies in the fact I am trying to run a business, not a portfolio. My portfolio of investments is just a part of my business. A very important part, but still only a part. And I look at and try to imitate great entrepreneur of the past. As far as I know, they have never talked about models nor spreadsheets… Instead, they all agree on one simple truth: they all have repeatedly said never to regret the time when cash was not enough. ;)

 

Gio

 

For as long as I can remember, veteran businessmen and investors – I among them – have been warning about the dangers of irrational stock speculation and hammering away at the theme that stock certificates are deeds of ownership and not betting slips… The professional investor has no choice but to sit by quietly while the mob has its day, until the enthusiasm or panic of the speculators and non-professionals has been spent. He is not impatient, nor is he even in a very great hurry, for he is an investor, not a gambler or a speculator. The seeds of any bust are inherent in any boom that outstrips the pace of whatever solid factors gave it its impetus in the first place. There are no safeguards that can protect the emotional investor from himself.

-J. Paul Getty

 

 

Gio

 

[giofranchi]

Joel,

I have really a very hard time to believe in models and spreadsheets. Usually in all the models I have seen, put in the slightest of changes, and you get completely different results.

To imitate great entrepreneurs of the past and their behavior, or at least try to, is still the most sensible policy I have come up with. ;)

 

Gio

 

[ERICOPOLY]

I have really a very hard time to believe in models and spreadsheets. Usually in all the models I have seen, put in the slightest of changes, and you get completely different results.

 

Isn't it still a model if you don't write it down in a spreadsheet as such?

 

Market is high, go to cash -> redeploy after crash.

 

Isn't that a model?

 

[racemize]

Joel,

I have really a very hard time to believe in models and spreadsheets. Usually in all the models I have seen, put in the slightest of changes, and you get completely different results.

To imitate great entrepreneurs of the past and their behavior, or at least try to, is still the most sensible policy I have come up with. ;)

 

Gio

 

These are extremely simple "models".  All I'm doing is assuming that a certain amount of cash is held (or a variable amount of cash, based on a metric (such as CAPE or something else)) and then deployed at the bottom and it tells me what the results are.  I've changed assumptions over and over again, and it pretty much always says that the higher returns come in when you are fully invested.  The cost of cash is very high, generally.

 

My issue is that you appear to just be assuming the people you quote are correct.  I don't like to assume anything, really, even it appears to make sense.  You are using a particular system, but how can you be sure it is the right one?  How can you be sure that holding cash will give you higher returns?  Perhaps you don't care about getting higher returns, but want to be conservative?  I don't really know.  I'm just trying to figure out what gives higher returns over the long term.

[Packer16]

My take from Joel's analysis is the on average there is an opportunity cost for holding cash.  In other words market timing doesn't work.  Right now I think it happens to be very high versus before the financial crisis.  Before 2008 10-yr treasury rates were seldom below 4% and was typically above 5% late in market rallies.  Now we are at 2.6% for the 10-yr treasury or 2.2% for BND (a diversified mix of bonds).  So in previous times you went from stocks to something that would retain purchasing power or grow slightly.  Now you have a situation where cash is a decaying asset where it is being debased every year.  Over short periods of time this is fine but if you hold cash for multiple years you are going backwards.

 

Packer

[giofranchi]

My issue is that you appear to just be assuming the people you quote are correct.  I don't like to assume anything, really, even it appears to make sense.  You are using a particular system, but how can you be sure it is the right one?  How can you be sure that holding cash will give you higher returns?  Perhaps you don't care about getting higher returns, but want to be conservative?  I don't really know.  I'm just trying to figure out what gives higher returns over the long term.

 

Who? Mr. Franklin? Mr. Vanderbilt? Mr. Sage? Mr. Baker? Mr. Mellon? Mr. Templeton? Mr. Getty? Even Mr. Buffett and Mr. Munger? No, I don’t think I am assuming anything… They have been the richest and most successful entrepreneurs in history. Period.

I certainly don’t know if studying their methods and imitating them might lead to the highest returns possible over the long term… But I am confident enough those returns will be satisfactory. ;)

 

Gio