LEAPS, margin, and higher returns

[twacowfca]

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.

 

 

Float has the huge advantage in a down market that funding keeps coming as markets decline enabling bargain purchases when deleveraging from other sources of funds is causing forced sales.

[S2S]

I'm writing just to say that the two posts directly above mine are awesome. Thanks  ;D

[twacowfca]

I'm writing just to say that the two posts directly above mine are awesome. Thanks  ;D

 

You're very welcome.  :)  And thank you for complimenting the two cents worth I added to the nice summary by oec2000.

[oec2000]

I'm writing just to say that the two posts directly above mine are awesome. Thanks  ;D

 

Thank you!

[Uccmal]

OEC, that is definitely the "post of the year".  You have given me alot to think about in one short summary.

 

BTW, Prem wanted the same P&C type float as Buffett because there is no chance of a run on the bank when things turn sour, like right now.  Whenever he has been asked about getting into the Life Business, every other AGM or so, he says the same thing.  Life is subject to sudden withdrawals. 

[JAllen]

Didn't Buffett say one time that Berkshire's return would be about 13% if Berkshire didn't have float?  Quite sure I remember that, not sure where I read it though.....

[AZ_Value]

Didn't Buffett say one time that Berkshire's return would be about 13% if Berkshire didn't have float?  Quite sure I remember that, not sure where I read it though.....

 

Lol... It's crazy, we read so much about Buffett that it seems we all suffer from information overload and can no longer exactly recollect where and when we read a specific quote from him. I know I suffer from it, and I blame Alice Schroeder and her 50,0000 pages of nonsense that I read and didn't take away much other than the term "Bathtub memory" that makes up 1/2 of the book; I so wish Lowenstein would update his earlier work and Buffett drops his bias towards pretty blondes and gives him access to his files.  ;)

 

Anyways, I think this is an interesting discussion that extends the one board members had about using home equity loans or any leverage against your house and investing in dividend paying stocks because the subject of leverage was also at the center of that one.

We've all heard Buffett say things like "if you're smart you don't need it and if you're dumb you shouldn't be using it" when discussing leverage and I can't remember who the board member was that said with Buffett one needs to learn to look at what he does  and not necessarily what he says because he tends to speak in "generalities" maybe because he is aware that his audience ranges from big time money managers to regular folks so he maybe feels the need to convey the wisdom that will keep the most people out of trouble, but his mind is full of caveats, and these "ifs" and "buts" usually don't make it into his public statements.

 

To answer Liberty's question earlier in the thread regarding gurus that used leverage, I was going to post "Didn't Buffett himself talk about using leverage to offset partnership funds that were tied-up in what he used to call "work-outs" so that he would still have enough capital to take advantage of opportunities... I can't remember where I read that..." But instead of posting that I decided to do some work and spent some time going through my "Buffett files" and here is a direct quote from his 1962 partnership letter that answers it best:

 

"Over the years, work-outs have provided our second largest category. At any given time, we may be in five to

ten of these; some just beginning and others in the late stage of their development. I believe in using borrowed

money to offset a portion of our work-out portfolio, since there is a high degree of safety in this category in

terms of both eventual results and intermediate market behavior. For instance, you will note when you receive

our audit report, that we paid $75,000 of interest to banks and brokers during the year. Since our borrowing was

at approximately 5%, this means we had an average of $1,500,000 borrowed from such sources. Since 1962 was

a down year in the market, you might think that such borrowing would hurt results. However, all of our loans

were to offset work-outs, and this category turned in a good profit for the year. Results, excluding the benefits

derived from the use of borrowed money, usually fall in the 10% to 20% per annum range. My self-imposed

standard limit regarding borrowing is 25% of partnership net worth, although something extraordinary could

result in modifying this for a limited period of time."

 

And he talks about this in many of his partnership letters. So Buffett has always used leverage before and after he started collecting the float that his insurance operations provide him with; the idea is obviously how you use it and if you're smart about it but this goes without saying of course. But we sometimes get so hung up on his direct quotes and forget to look beyond them and look at what he actually did to be so successful.

For instance, another thing that I've seen come up, usually when discussing why Watsa uses shorts to hedge his portfolio is that Buffett says that he doesn't short even as a hedge, here's the very next paragraph in the same letter:

 

"You will note on our yearend balance sheet (part of the audit you will receive) securities sold short totaling

some $340,000. Most of this occurred in conjunction with a work-out entered into late in the year. In this case,

we had very little competition for a period of time and were able to create a 10% or better profit (gross, not

annualized) for a few months tie-up of money. The short sales eliminated the general market risk."

 

So it looks like Buffett would short as a hedge to protect his portfolio against general market behavior just like the Fairfax team and maybe the answer is just that given his current position and the kind of balance sheet that BRK has (virtually bulletproof if you ask me), he just doesn't see the need but that doesn't mean that put in a different situation he wouldn't short. This is just an example of us taking his word verbatim, me included, and not thinking about the context that he doesn't expand on.

 

 

[Myth465]

I liked oec2000's post because it was done by a man who has thought for himself instead of telling everyone what Buffett says...

 

AZ_Value I have always said watch what Buffett has done and also for every Buffett quote there is an equal and opposite quote / action. I wish we had more independent thought though.

[AZ_Value]

I liked oec2000's post because it was done by a man who has thought for himself instead of telling everyone what Buffett says...

 

AZ_Value I have always said watch what Buffett has done and also for every Buffett quote there is an equal and opposite quote / action. I wish we had more independent thought though.

 

Alright so I guess it was you who said it then  ;D

 

I think this would make actually for an interesting thread/discussion about what we hear are Buffett tenets and what his actions actually tell us, stuff like buy and hold etc... would be fascinating I think.

[Myth465]

I think Buffett is fairly simple. He is telling you Joe Six pack not to do this or that for your own good, nothing more nothing less. Ever rule could or should be broken at some point depending on the circumstances. The key is knowing when to break said rules, and also knowing why said rules exist.

 

I wasnt smart enough to learn the leverage lesson, and went into 2008 with none callable short term leverage. I came out well enough, but it is something I wouldnt recommend anyone do. I wrote several new rules regarding Leap positions, based on the last few months of turmoil. I will survive and hopefully thrive going forward should I head those rules.

[Rabbitisrich]

I think Buffett is fairly simple. He is telling you Joe Six pack not to do this or that for your own good, nothing more nothing less. Ever rule could or should be broken at some point depending on the circumstances. The key is knowing when to break said rules, and also knowing why said rules exist.

 

I even feel the same way when I see people saying "That isn't value investing. This is value investing." At a certain point, it doesn't matter if you call it a hill or a mountain, just give me the topography.

[AZ_Value]

I think Buffett is fairly simple. He is telling you Joe Six pack not to do this or that for your own good, nothing more nothing less. Ever rule could or should be broken at some point depending on the circumstances. The key is knowing when to break said rules, and also knowing why said rules exist.

 

Agreed.

 

I wasnt smart enough to learn the leverage lesson, and went into 2008 with none callable short term leverage. I came out well enough, but it is something I wouldnt recommend anyone do. I wrote several new rules regarding Leap positions, based on the last few months of turmoil. I will survive and hopefully thrive going forward should I head those rules.

 

Now this is interesting, care to share with us, maybe I can learn something going into the next crisis, which seems to be toying with us and doesn't want to materialize. What in your situation constitutes non callable ST leverage? and what have the last few months of volatility taught you? Thanks.

[Myth465]

I think Buffett is fairly simple. He is telling you Joe Six pack not to do this or that for your own good, nothing more nothing less. Ever rule could or should be broken at some point depending on the circumstances. The key is knowing when to break said rules, and also knowing why said rules exist.

 

I even feel the same way when I see people saying "That isn't value investing. This is value investing." At a certain point, it doesn't matter if you call it a hill or a mountain, just give me the topography.

 

This is probably the second most annoying thing. LOL

 

AZ Value - Regarding short term leverage and options. I guess the risks are the same. You have invoked time into the equation. I believe most of my valuations / investment calls are correct, but that does not mean they will pay out correctly time wise, especially given whats going on. I had revamped my investment strategy though it will take time to get there.

 

The strat is to focus on options, warrants, and deep deep value equity - but to also hold 50% cash unless investments are trading at 25% - 30% on the dollar. This allows you to double down a few times without getting killed. Options will be more of a way to hold more cash, and less of a way to juice returns. Also I will probably be taking positions around 5%-10% and will trim my winners a bit more. I have had stocks make up 25% of my port get cut in half 3-4 times. It gets old and one cant effectively double down on a 15% position no matter what their conviction is.

 

Those are some of the main changes, but as I said it will take quite a bit of time to get there. I plan to hold my cash now until things clear up a bit. We will probably rally Fri or Monday on some BS announcement, but I am holding until we get some market clarity.

 

[original mungerville]

I use LEAPS like Uccmal and also try and roll them forward at this time of the year. Sell the 2013s and buy the 2014s. In-the-money LEAP calls can provide leverage while limiting your downside if the market drops in half. I like using them because I take big notional positions in individual stocks (eg 100% of the value of my portfolio, so if I pay 15 cents for every 100 cents notional for deep in-the-money LEAP calls 2 years out and keep rolling I can take a big position while limiting my downside to less than 15% due to continual residual time-value...say 10% max downside). I do this with my own money. If I run other people's money, I cut that in half or so depending.

 

I plan on trying to make a killing again at some point over the year or two using LEAPS.

 

[Uccmal]

I bought a very small number of $25 - January 2014 WFC Leaps this morning.  I am very tentative at the moment.  Aside from SPY Leaps WFC are the only ones I have seen for 2014 that are out yet that I was interested in.  Biding my time a trying to be patient.

 

Others come out around October 14th - I think BBY, and the final ones November 14th - GE, BAC, JPM,

[Myth465]

Thats been my issue, rolling over leaps is very important. I hold a few 2012s which have me but mostly hold 2013s. I am waiting for 2014s to do any serious buying or tax selling. Adding time to the mix is quite interesting. You can even time your catalyst correctly but get killed because your leaps are up during a day like today.....

[SFValue]

"You will note on our yearend balance sheet (part of the audit you will receive) securities sold short totaling

some $340,000. Most of this occurred in conjunction with a work-out entered into late in the year. In this case,

we had very little competition for a period of time and were able to create a 10% or better profit (gross, not

annualized) for a few months tie-up of money. The short sales eliminated the general market risk."

 

So it looks like Buffett would short as a hedge to protect his portfolio against general market behavior just like the Fairfax team and maybe the answer is just that given his current position and the kind of balance sheet that BRK has (virtually bulletproof if you ask me), he just doesn't see the need but that doesn't mean that put in a different situation he wouldn't short. This is just an example of us taking his word verbatim, me included, and not thinking about the context that he doesn't expand on.

 

sounds to me the WEB was eliminating market risk for a specific work-out, maybe shorting the stock of an acquirer on a stock deal? 

 

I remember the story of WEB asking around (columbia?) for somebody to lend him shares to short, but have never heard any specifics about this, anybody more familiar with this story?

 

thanks,

[twacowfca]

"You will note on our yearend balance sheet (part of the audit you will receive) securities sold short totaling

some $340,000. Most of this occurred in conjunction with a work-out entered into late in the year. In this case,

we had very little competition for a period of time and were able to create a 10% or better profit (gross, not

annualized) for a few months tie-up of money. The short sales eliminated the general market risk."

 

So it looks like Buffett would short as a hedge to protect his portfolio against general market behavior just like the Fairfax team and maybe the answer is just that given his current position and the kind of balance sheet that BRK has (virtually bulletproof if you ask me), he just doesn't see the need but that doesn't mean that put in a different situation he wouldn't short. This is just an example of us taking his word verbatim, me included, and not thinking about the context that he doesn't expand on.

 

sounds to me the WEB was eliminating market risk for a specific work-out, maybe shorting the stock of an acquirer on a stock deal? 

 

I remember the story of WEB asking around (columbia?) for somebody to lend him shares to short, but have never heard any specifics about this, anybody more familiar with this story?

 

thanks,

 

I agree that WEB probably shorted out the risk of a specific stock, perhaps the stock of an acquirer in an acquisition for stock.