LEAPS, margin, and higher returns

[scorpioncapital]

This article's conclusions I found extremely interesting why 2:1 leverage is actually a good thing for young investors: http://islandia.law.yale.edu/ayres/Life-Cycle%20Investing%20Working%20Paper.pdf

 

I especially found the idea of LEAPS interesting. Consider the case where an investor receives a marginc all on stock. If they roll-over the remaining stake in 3 year LEAPS, they can now wait out a recovery, in 3 years they can buy back exactly the same amount they had leveraged 3 years before. If the depression continues or worsens, they can roll over the leaps. Given this logic, why not buy the deep in the money LEAPS initially, assuming the spread to market price is small AND the stock pays little to no dividends.

 

 

[Liberty]

I'm curious, who are some of the current 'gurus' that have used leverage when they were younger?

 

For the record: I'm genuinely asking because I don't know, and because I think looking at how very smart people who've proven they can do it decided to manage their money can tell us something about this. This isn't a hidden message (I know some people love to never actually say what they mean, but I always strive for clarity).

[ERICOPOLY]

Well Buffett and Watsa still use leverage.  It's called float, but it's leverage.

 

They are rich enough to just sit in their underlying equity portfolios without any float to juice it.  Why reach for that extra couple of points?  Well, they like it I suppose.

 

[Liberty]

Well Buffett and Watsa still use leverage.  It's called float, but it's leverage.

 

They are rich enough to just sit in their underlying equity portfolios without any float to juice it.  Why reach for that extra couple of points?  Well, they like it I suppose.

 

To be more precise, do you know of any 'superinvestor' that used margin on a personal account (not float in a company or whatever) when they were young? I can think of many leveraged companies, but I'm drawing a blank when it comes to these investors borrowing in their name to invest. I'm sure some did, though..

[ERICOPOLY]

Well Buffett and Watsa still use leverage.  It's called float, but it's leverage.

 

They are rich enough to just sit in their underlying equity portfolios without any float to juice it.  Why reach for that extra couple of points?  Well, they like it I suppose.

 

To be more precise, do you know of any 'superinvestor' that used margin on a personal account (not float in a company or whatever) when they were young? I can think of many leveraged companies, but I'm drawing a blank when it comes to these investors borrowing in their name to invest. I'm sure some did, though..

 

I read The Davis Dynasty.  It claims he used the "maximum" amount of margin.

 

[vinod1]

I'm curious, who are some of the current 'gurus' that have used leverage when they were younger?

 

For the record: I'm genuinely asking because I don't know, and because I think looking at how very smart people who've proven they can do it decided to manage their money can tell us something about this. This isn't a hidden message (I know some people love to never actually say what they mean, but I always strive for clarity).

 

I do not know of any of the Super Investors of (G&D ville) who used leverage other than via float. It could be because non-callable leverage like LEAPS are a relatively recent phenomenon. I think the key is non-callable.

 

Vinod

[west]

According to Schroeder's Snowball, when Munger ran his partnership and had a really good idea he would not just put in all the money he and his partners had, but all of the money he could borrow as well.  I would've never expected that myself :).

[Uccmal]

Charlie Munger - borrowed money back in the day when he was running his fund.  1 million to buy BC Power Bonds back in the day when 1 million was closer to 10 million.

 

Fairfax - had GE options about a year ago according to their 10k. 

 

Buffett - has a side bet on the S&P -  I wonder how that is doing?

 

Joel Greenblatt - I cannot confirm but I seem to recall something to that effect.

 

Thought not a super investor I use Call Leaps as a proxy for blue chips.  This time of year I work out if I want to roll them out for another year as the 2014s come out.  i.e) 2013s while they still have time value for 2014s.  I hold nothing less than 2013s right now.  Since Leaps do not count for margin you cannot get called on them.

 

To the article - I dont know where you get 3 year Leaps unless you write your own.  2.3 years is about the max.

 

[Myth465]

The Cornwall capital guys from the Big Short used leaps. I would call them super investors. Honestly I think Leaps are quite popular now because of low rates. Not sure how they were priced before rate went under 4-5%

[mevsemt]

Depends on how you define leverage, right?  Even before the days of Berkshire, I'd say the comp structure of Buffett's investment partnership could be called leverage.

[merkhet]

Uccmal, where did you get the info re $1 million to buy BC Power Bonds?  I knew Charlie used margin, but I didn't know specifics.

 

Greeenblatt definitely used LEAPs and warrants -- he mentions it in his first book.

[Uccmal]

Snowball - Alice Shroeder - somewhere in the first thousand pages :-).

[merkhet]

 

Snowball - Alice Shroeder - somewhere in the first thousand pages :-).

 

 

Ah, found it -- I love the Kindle.

 

Also, for those that are interested, re-reading Greenblatt's "You Can Be A Stockmarket Genius" provided some insight on how Greenblatt valued LEAPS -- he goes into detail on Wells Fargo (a coattail on Berkowitz's 1992 OID interview, actually).

[alwaysinvert]

I don't remember for what investments but I have a strong memory that Buffett took out bank loans early in his career (says so somewhere in Snowball?). I guess the key is flexibility, nothing wrong with leveraging up a bit when you could buy strong cash-flow generating large caps for p/e 3-5 in 2009, for example. Most people, among them me, just aren't good enough at this to gain the conviction to lever up, though.

[Rabbitisrich]

The Cornwall capital guys from the Big Short used leaps. I would call them super investors. Honestly I think Leaps are quite popular now because of low rates. Not sure how they were priced before rate went under 4-5%

 

Those guys seemed a bit hasty, or perhaps Lewis simply didn't portray them in a flattering light. Michael Burry was the only character who seemed to think matters through before acting, and he was the only guy who demanded mark-to-market collateralization for the CDSs.

[twacowfca]

Well Buffett and Watsa still use leverage.  It's called float, but it's leverage.

 

They are rich enough to just sit in their underlying equity portfolios without any float to juice it.  Why reach for that extra couple of points?  Well, they like it I suppose.

 

To be more precise, do you know of any 'superinvestor' that used margin on a personal account (not float in a company or whatever) when they were young? I can think of many leveraged companies, but I'm drawing a blank when it comes to these investors borrowing in their name to invest. I'm sure some did, though..

 

I read The Davis Dynasty.  It claims he used the "maximum" amount of margin.

 

Yup.  But he was a NYSE member, US  Ambassador, and he wasn't apparently subject to the same automatic margin calls as retail investors were in the unpleasantness of 1973 1974.  :)

[twacowfca]

Uccmal, where did you get the info re $1 million to buy BC Power Bonds?  I knew Charlie used margin, but I didn't know specifics.

 

Greeenblatt definitely used LEAPs and warrants -- he mentions it in his first book.

 

Charlie, as a Pacific Coast Stock Exchange member also wasn't subject to automatic MTM margin calls.  :)

[Myth465]

The Cornwall capital guys from the Big Short used leaps. I would call them super investors. Honestly I think Leaps are quite popular now because of low rates. Not sure how they were priced before rate went under 4-5%

 

Those guys seemed a bit hasty, or perhaps Lewis simply didn't portray them in a flattering light. Michael Burry was the only character who seemed to think matters through before acting, and he was the only guy who demanded mark-to-market collateralization for the CDSs.

 

Where is the line for hast, I want some of that stuff. I mean making a few hundred million while starting out of a garage with 100k has to show some sort of competence inmo. I found them fascinating and really liked the ways they thought about things. Being young and inexperienced makes anyone look hasty.

[Rabbitisrich]

The Cornwall capital guys from the Big Short used leaps. I would call them super investors. Honestly I think Leaps are quite popular now because of low rates. Not sure how they were priced before rate went under 4-5%

 

Those guys seemed a bit hasty, or perhaps Lewis simply didn't portray them in a flattering light. Michael Burry was the only character who seemed to think matters through before acting, and he was the only guy who demanded mark-to-market collateralization for the CDSs.

 

Where is the line for hast, I want some of that stuff. I mean making a few hundred million while starting out of a garage with 100k has to show some sort of competence inmo. I found them fascinating and really liked the ways they thought about things. Being young and inexperienced makes anyone look hasty.

 

They didn't take care of counterparty risk, and, according to Lewis, they didn't understand the contractual details of their bets. Burry also seemed to be the only character to justify the timing of his bets.

 

Given the severity of the market dips, and all the second and third chances it provided to investors, I'm skeptical of any young investors who made a ton of money with a limited track record. In March of 2009, you could have invested in Gymboree or DineEquity and enjoyed a 7-bagger in each case. But focusing on the return ignores the that one bet was much smarter than the other. Short track records might not expose the difference.

[Liberty]

They didn't take care of counterparty risk, and, according to Lewis, they didn't understand the contractual details of their bets. Burry also seemed to be the only character to justify the timing of his bets.

 

Given the severity of the market dips, and all the second and third chances it provided to investors, I'm skeptical of any young investors who made a ton of money with a limited track record. In March of 2009, you could have invested in Gymboree or DineEquity and enjoyed a 7-bagger in each case. But focusing on the return ignores the that one bet was much smarter than the other. Short track records might not expose the difference.

 

This is a smart way to look at things, IMO, and not only in the abstract. Over the long-term, being right for the wrong reasons (and not entirely realizing it) can throw you off the correct path and later punish you because your mental model is flawed. We control the process, not the results, so we have to focus on process.

[Myth465]

From where I sit their results and process were both quite good.

 

Based on the book most of the money was made prior to the bet / 2009 (capital one and a few other leap situations), and they were right on the bet despite missing a few details you cant win em all. Also the Cornwall guys, made the best bet of the three (I am working from memory of the book here). We could nit pick anything to death, but in my opinion for 2 kids inmo they did rather well. We cant all aspire to be Prem Watsa or Mike Burry, but I will take what the Cornwall guys accomplished and be pretty happy, but thats just me.  ;D

[stahleyp]

I think I remember this article appearing in 2007. haha.

 

I also agree with Myth. While luck may have played a bit factor, the Cornwall guys certainly have a different way of looking at things.

[meiroy]

 

My impression from the book was that these guys did a lot of investigative work and sought out experienced people to assist with their research.  If I'm not mistaken at some point they actually hired a professional, paying him a nice sum of money each month.  No doubt though that what they did, at least in the beginning was speculative.

[ERICOPOLY]

I think the theme here is that the only investors that survived to be rich and famous did so with margin only if it was non-callable (like with Davis and Munger).

 

[oec2000]

1) We should not ignore survivorship bias when identifying successful investors who used leverage. The unsuccessful ones are "dead" and not known - we don't know how many unsucessful Cornfalls :) there were for every supremely successful Cornwall.

 

2) While it is true that Buffett and Watsa have leverage from the use of float, I ownder whether the leverage from float added significantly to their compounded returns. While I haven't looked at numbers from their earlier years, if you look at BRK's and FFH's exposure to equity-type investments, they are not materially larger than their underlying shareholders' equity. So, the leverage from float is in effect mostly invested in "safer" investments like bonds.

 

With their investment prowess, Buffett and Watsa would likely have been able to achieve returns of around 20% without leverage if they had been running closed-end funds - this are the returns they have achieved for BRK and FFH. It seems like the leverage from float merely offsets the taxes they have to pay in the insurance company structure.

 

I suspect that a key reason for the use of float is that it gives them access to permanent OPM capital. In Buffett's case, it is also a source of profit (to the extent that his cost of float is negative).

 

3) Most here are thinking of using leverage for equity type investments which is why there should be a stronger focus on risk. Callable margin is definitely much riskier than what Buffett and Watsa are doing. A 30-year fixed rate mortgage taken out on a fully paid home is much less risky. LEAPs can be risky or risk reducing depending on how they are used. Before employing leverage, it is useful to ask why we need to use it; do we really need to get to our destination a few years earlier?

 

While not the same, I see some similarities to the Sino-Forest discussion here when some justified taking the risk by using the examples of how others made it big by taking risk. It is not a good idea to use 20-20 hindsight to find examples that justify your view.