Ask Kraven!

[txitxo]

 

May I suggest that we all do a gut check and ask ourselves if we're really as good as we think we are?  If the guy who is writing scientific papers on how the galaxy works is saying he can't figure out the Buffett method that speaks volumes.  I know I can't, but I understand Graham.  So far no one has successfully emulated Buffett's success in buying the same times of companies and becoming as wealthy as him. Many have followed Graham and using his own methods have surpasses the master himself, Buffett included.

 

Thanks, oddball, I will send you 40$. Praising Kraven is much easier... :)

 

Let me be a more specific about why I say that Buffet's method is magic. If you start looking at correlations between stock characteristics (P/B, P/E, F-score) etc. and future returns you quickly find that it is quite simple to generate  samples of stocks which will produce a large overperformance over the market (see Quantitative Value Investing for many examples). But most of those stocks are nano or micro caps. If you start increasing the amount of money you have to invest, you will find fewer and fewer of those things. At the megacap level markets get quite efficient, and the statistical "premium" is basically gone. I don't know of any value-based algorithm or recipe that will produce a sizeable overperformance for large companies. That's why getting 15% and even 20% a year from them is sheer magic to me.

 

  And don't talk to me about Security analysis, etc. You get guys like Einhorn shorting the hell out of JOE and Berkowitz betting the farm on it at the same price level. Great value investors are often in opposite camps regarding the same company. And that is because  there are no univocal rules which tell you what the intrinsic value is for them. There are just a few guys in the world who look at the numbers and know that a company is a good bet, in the same way as you have guys who know how to compose the Well Tempered Clavier or know how to paint Las Meninas, and what they do cannot be reduced to a fixed set of rules or probably even taught to others.

 

 

 

 

 

[txitxo]

Leonard is an experimentalist.

 

That's right, and working with lasers at that. I thought he was a theoretician from the few times I've seen the series, he certainly doesn't fit the experimentalist principal investigator (the guy who gets all the money to build all those expensive lasers and runs the lab) archetype...

[twacowfca]

 

May I suggest that we all do a gut check and ask ourselves if we're really as good as we think we are?  If the guy who is writing scientific papers on how the galaxy works is saying he can't figure out the Buffett method that speaks volumes.  I know I can't, but I understand Graham.  So far no one has successfully emulated Buffett's success in buying the same times of companies and becoming as wealthy as him. Many have followed Graham and using his own methods have surpasses the master himself, Buffett included.

 

Thanks, oddball, I will send you 40$. Praising Kraven is much easier... :)

 

Let me be a more specific about why I say that Buffet's method is magic. If you start looking at correlations between stock characteristics (P/B, P/E, F-score) etc. and future returns you quickly find that it is quite simple to generate  samples of stocks which will produce a large overperformance over the market (see Quantitative Value Investing for many examples). But most of those stocks are nano or micro caps. If you start increasing the amount of money you have to invest, you will find fewer and fewer of those things. At the megacap level markets get quite efficient, and the statistical "premium" is basically gone. I don't know of any value-based algorithm or recipe that will produce a sizeable overperformance for large companies. That's why getting 15% and even 20% a year from them is sheer magic to me.

 

  And don't talk to me about Security analysis, etc. You get guys like Einhorn shorting the hell out of JOE and Berkowitz betting the farm on it at the same price level. Great value investors are often in opposite camps regarding the same company. And that is because  there are no univocal rules which tell you what the intrinsic value is for them. There are just a few guys in the world who look at the numbers and know that a company is a good bet, in the same way as you have guys who know how to compose the Well Tempered Clavier or know how to paint Las Meninas, and what they do cannot be reduced to a fixed set of rules or probably even taught to others.

 

Benjamin Graham came to much the same conclusion by the mid 1970's as markets had generally become more efficient with two exceptions: The first exception was that buying a group of companies that were extremely statistically cheap by the method he outlined and then selling the ones that went up 50% or selling the ones that didn't go up  in a couple of years would work satisfactorily, provided that emotions or other factors didn't result in deviation from that plan.  Walter  Schloss was one of the few who was able to stick with that plan successfully, and he experienced underperformance for periods when investing was pushed aside in bubbles.

 

The other method that Ben said that could work was when an investor had deep and profound knowledge of a particular company that had uncommon strengths. 

 

It's interesting to note that Warren's two new investment managers reportedly spend at least 500 hours studying a company and its industry before making a decision to invest.  :)

 

It's also interesting to note that Ed Thorp, the most successful hedge fund manager ever, risk adjusted, was acquainted with Ben Graham, Warren Buffett, and especially with his colleague and close relative of Graham, Dr Girard.  Thorp says he has never bought a common stock personally in his life, except one in the mid 1980's.  He still holds that stock which has compounded about 20%+ per annum since then. :)

[infinitee00]

Thanks Race for starting the thread and Kraven for answering the question patiently and honestly.I would like to start an AMA thread ( reddit style !) on Packer as well ( from the prince Alwaleed thread, I learned that he also has quite an enviable long term record) but not sure if he would be interested.

 

Kraven's 'box' and 'store' analogy definitely struck a chord with me. My style of investing is a bit different ( not super concentrated or diversified either) but I do believe that pretty good returns can be achieved with a lot of diversification.

 

I think the debate about whether to be concentrated or diversified is moot because the choice depends on the investor’s personality and expectations rather than some objective data point. In this matter, I agree with Peter Lynch who once opined that “The key organ for investing is the stomach, not the brain.”

 

IMO, assuming one has a good process of identifying undervalued stocks, the choice of capital allocation for an investor boils down to 3 most important considerations – stomach for volatility, risk of permanent loss of capital and return expectation (yes, there may be other considerations like time horizon, use of leverage etc, but most of them are related to these 3 or have a smaller significance in capital allocation decisions).

 

If an investor is uncomfortable with large swings or volatility and is unable to put a finger on management’s intentions or the company’s future prospects, it makes sense to be hugely diversified. One may still be able to achieve a very respectable rate of return but it will seldom be (say) 75% annualized - like Eric.

 

On the other hand, if one can handle large swings, have a moderate level of faith in management , have a decent understanding of that business it may make sense to have a more concentrated portfolio. Yes, the risk of permanent loss of capital is higher than a diversified portfolio, but there is also the hope of retiring at 40 !!

 

The trade-off is personal and no amount of data or objective analysis is going to convince the investor otherwise.

 

 

 

[ERICOPOLY]

If I KNEW that FFH would compound in the way you describe, I would probably make it a large position, maybe very large.  But how can I know that?  Just because something has happened, doesn't mean it will continue to do so.

 

It takes a good deal of managerial magic for FFH to grow tangible book at 15%. 

 

I know a lot about FFH and I think about this a lot.  However every time I wind up reaching the conclusion that I'd rather be invested in the company that can generate 13% to 15% returns from operational earnings... provided it too is priced such that I'm getting in at tangible book value.

 

The market more reliably puts an earnings multiple on operational earnings.  So it's not just about the returns on tangible equity, but the more likely path to an eventual multiple on the earnings themselves (a bonus tailwind of upwards valuation adjustment).

 

And so basically that's why I still keep my oversized BAC position rather than move some to FFH.  Not yet!  Not yet!  In due time...  First the easy money.  Later, I hope FFH can keep the magic going when it's time to buy back into it.

 

 

 

 

 

[infinitee00]

OK looking at this thread again, I wanted to voice a minor quibble regarding a comment. Sorry, Nate this is nothing personal.  I read your blog regularly and know that you are a smart guy but I have seen this line of reasoning being used time and time again on this board and other msg boards, so I couldn’t help myself.

 

 

May I suggest that we all do a gut check and ask ourselves if we're really as good as we think we are?  If the guy who is writing scientific papers on how the galaxy works is saying he can't figure out the Buffett method that speaks volumes.  I know I can't, but I understand Graham.  So far no one has successfully emulated Buffett's success in buying the same times of companies and becoming as wealthy as him.  Many have followed Graham and using his own methods have surpasses the master himself, Buffett included.

 

 

The statement above has at least 2 fallacies that I can identify. The 2nd sentence is a variation of "argument from authority" or " appeal to authority". Just because someone is a brilliant sociologist, astrophysicist or musician, does not necessarily mean that his/her insights or opinions about finance or investing should also be brilliant or any more valid than any ordinary Joe.

 

My background is in Electrical Engineering and I surmise that if I were to send some of my books to Buffett, he will probably have a tough time understanding the concepts (not because it’s tough, but because he has not spent years learning the subject as thoroughly as he did his own subject). But it would be clearly fallacious if I were to claim  " If the guy who compounded his capital at 20 something % per year and is one of the richest persons in the world, cannot understand these EE concepts, it should tell you volumes about how tough EE is". I think the validity of an observation should be judged independent of someone’s opinion.

 

Moreover, I don't quite agree with the implication that Buffett's method ( I am assuming you mean that of concentrated portfolios) is somehow inferior, complex or impractical just because "no one has successfully emulated Buffett's success in buying the same times of companies and becoming as wealthy as him". But no one has become as rich as Buffett by following Graham's method either. Does that mean Graham's method is also somehow inferior? Such line of reasoning is a 'non-sequitur' or can also be a fallacy of causal oversimplification. I have seen similar fallacies repeated numerous times - "Technical analysis is for idiots since I do not know any technical analyst who is in the Forbes list of richest people" or "Company A made record profits, so the CEO must be a terrific manager". These may very well be true but the conclusions do not necessarily follow from the premise.

 

Could your observation be a case of too small a sample size or a case of 'availability bias'- a possibility if majority of your friends and peers are Graham/Schloss 'fans' and you don't know too many people who have maintained concentrated portfolios for very long periods of time? Could it also be due to confirmation bias - seeking out people or examples that support your premise? Could it be that the reason no one has successfully emulated Buffett's method and become as rich as him is because of the time and age they were born in - not being able to take advantage of the post-WWII raging bull market ? Is it possible that the advent of computers in the last 30 years has made markets more efficient and bargains that the young Buffett could find are no longer available? Could it have anything to do with Buffett's personality - charm, initiative, marketing skills? Could this also be a function of political changes, securities regulation or technological innovation ? What about plain old lady luck ? I am sure you can find numerous such factors if you sit down and think about it.

 

I know it's difficult to judge a person's tone from a message so let me assure you that I am not trying to be confrontational here. But, just trying to point out that a person's investment returns or ability to outperform the market ( or contrarily others' inability to achieve significant alpha) may be a function of several factors many of which have nothing to do with the investment methodology.

[no_free_lunch]

Kraven,

 

I just don't understand how you can have the time to invest this way. I mean it certainly follows my line of thinking, diversify as much as you have good ideas, but how can you research 100 stocks?  You spoke a bit about looking at financials and getting into conference calls and that sort of thing, that takes a significant time investment.  Most of the time you end up not wanting to buy the stock so the investment goes up further.  I guess I am just trying to figure out if you have some sort of trick for speeding up the process or if you have an exceptionally long holding period that you only need a few every month.

[giofranchi]

If the guy who is writing scientific papers on how the galaxy works is saying he can't figure out the Buffett method that speaks volumes. 

 

This is funny… because I think I know personally some of the most renowned Italian university professors in engineering… and, believe me, they have really great minds! They are extremely clever under a myriad of different points of view! Many times, when I hear them talk, I don’t even understand what their topic of conversation actually is! … and yet … I wouldn’t entrust a single dime of my firm’s equity to anyone of them! They just don’t get how business works! Probably, because they just don’t really care… txitxo is very brilliant, no doubt about it, and he is very interested in making money, and is a wonderful trader, not a single doubt about it either. But, imo, to run a business is something completely different. (txitxo, please, don’t get upset with me! :) )

 

giofranchi

 

Don't worry,  Gio, I won't get upset, but I think you are wrong there, I don't know about Italian University Engineering professors, but I have met quite a few scientists who could be excellent business managers, and the best example is probably your compatriot and Nobel Prize Winner, Riccardo Giaconni. Have a look at his bio, among other things he led the effort to put "glasses" on the Hubble Space Telescope, what probably saved NASA from very big budget cuts or even a worse fate. The person who came up with the "glasses" idea told me that, if he hadn't been an Astrophysicist, Riccardo would probably have ended up running a big US firm. Some scientists do actually own and run companies in their spare time, I know personally of three cases, an software engineering company, a food import business and a translation agency. And they make much more money from them that they do with their academic jobs. A significant fraction of the Russians who have made the Forbes list at some point have Science degrees, for instance in Physics (Deripaska), Chemistry (Khodorkovsky) or used to have one in Math (Berezovsky; he did publish many math papers and books before he turned oligarch). 

 

  The thing is that once you get to a certain level in science, you don't get to sit in an office and speculate about how many angels fit in a pinhead. You have to compete to get grants (selling), you have to hire people with them, make sure that they do their work, you have to get papers out (products), you have to make sure that the largest possible amount of people read these papers and then reference them in their own work (selling again), and then the cycle starts anew, applying for grants  based on the prestige these papers brought you, etc.  In the experimental sciences, any successful scientist has to be at least a part time entrepreneur. That's why Sheldon and Leonard are theorists; they would not last 5 minutes in a lab.

 

  And this does not happen in a vacuum, you are competing with extremely smart people, who will resort to all kind of dirty tricks, steal your results or your people, try to stop you from publishing, etc. You have to maximize the return you get from your resources, allocate physical and human capital to your best ideas, etc. Probably not so different from running an engineering firm...:)

 

  And if you fail, you are screwed. You won't get any more grants, you will lose your tenure, you will only be offered academic jobs at places like Bumblef*ck College, and once all hope is lost, you will be forced to get a quant job in Wall Street to feed your children...

 

Well, of course I can tell you only what my experience is. Mark Twain was used to saying: “All generalizations are false, this one included!” So, no doubt there might be very entrepreneur-like university professors out there… the simple truth, though, is I have still to meet one!

 

Take for instance Professor Antonio Migliacci: he is among the best known living professor in civil engineering in Italy today. Three generations of professional engineers have studied on his books. And he has founded “MSC Associati”, which in the ’80 and ’90 was among the largest engineering firms in Italy. My experience with him could be summarized as follows: “First I had the greatest of fortunes to be his pupil, later I had the greatest of misfortunes to be his partner!” Believe me, he was extremely more successful as an entrepreneur that the great majority of his ex-colleagues inside the Politecnico of Milan, yet I think he will behave like a child, when it comes to capital allocation, until the very end… by now I have given up all hopes!  ::)

 

My father is another good example!

He is very brilliant. He was among the first ones to write software for reinforced concrete structures design in the late ’70, early ’80, at the University of Waterloo with Professor Cohn, Professor Grierson, and Professor Gladwell (yes, Malcom Gladwell’s father). He became Full Professor at the age of 32. He has published a lot. Etc.

Though, when it comes to capital allocation, he is just like his friend Professor Migliacci… a spoiled kid!!  ;D ;D

 

Then, of course my experience is limited, so it is never wise to generalize.  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

 

[giofranchi]

If I KNEW that FFH would compound in the way you describe, I would probably make it a large position, maybe very large.  But how can I know that?  Just because something has happened, doesn't mean it will continue to do so.

 

It takes a good deal of managerial magic for FFH to grow tangible book at 15%. 

 

I know a lot about FFH and I think about this a lot.  However every time I wind up reaching the conclusion that I'd rather be invested in the company that can generate 13% to 15% returns from operational earnings... provided it too is priced such that I'm getting in at tangible book value.

 

The market more reliably puts an earnings multiple on operational earnings.  So it's not just about the returns on tangible equity, but the more likely path to an eventual multiple on the earnings themselves (a bonus tailwind of upwards valuation adjustment).

 

And so basically that's why I still keep my oversized BAC position rather than move some to FFH.  Not yet!  Not yet!  In due time...  First the easy money.  Later, I hope FFH can keep the magic going when it's time to buy back into it.

 

Eric,

As I have written in this thread, going forward FFH must achieve an average return of 6.6% on its portfolio of investments to grow BV per share at a 15% CAGR. Historically FFH has achieved an average total return on portfolio of 9.6%.

Sincerely, I don’t understand the required “managerial magic” you are talking about…

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

[writser]

Kraven: I believe you mentioned you were something like a corporate laywer in a previous life (could be mistaken). If so, how long did you do this? Did you enjoy it? How did you end up being a full-time value investor? Was there any particular event that triggered you (like earning a windfall bonus)?

[oddballstocks]

OK looking at this thread again, I wanted to voice a minor quibble regarding a comment. Sorry, Nate this is nothing personal.  I read your blog regularly and know that you are a smart guy but I have seen this line of reasoning being used time and time again on this board and other msg boards, so I couldn’t help myself.

 

 

May I suggest that we all do a gut check and ask ourselves if we're really as good as we think we are?  If the guy who is writing scientific papers on how the galaxy works is saying he can't figure out the Buffett method that speaks volumes.  I know I can't, but I understand Graham.  So far no one has successfully emulated Buffett's success in buying the same times of companies and becoming as wealthy as him.  Many have followed Graham and using his own methods have surpasses the master himself, Buffett included.

 

 

The statement above has at least 2 fallacies that I can identify. The 2nd sentence is a variation of "argument from authority" or " appeal to authority". Just because someone is a brilliant sociologist, astrophysicist or musician, does not necessarily mean that his/her insights or opinions about finance or investing should also be brilliant or any more valid than any ordinary Joe.

 

My background is in Electrical Engineering and I surmise that if I were to send some of my books to Buffett, he will probably have a tough time understanding the concepts (not because it’s tough, but because he has not spent years learning the subject as thoroughly as he did his own subject). But it would be clearly fallacious if I were to claim  " If the guy who compounded his capital at 20 something % per year and is one of the richest persons in the world, cannot understand these EE concepts, it should tell you volumes about how tough EE is". I think the validity of an observation should be judged independent of someone’s opinion.

 

Moreover, I don't quite agree with the implication that Buffett's method ( I am assuming you mean that of concentrated portfolios) is somehow inferior, complex or impractical just because "no one has successfully emulated Buffett's success in buying the same times of companies and becoming as wealthy as him". But no one has become as rich as Buffett by following Graham's method either. Does that mean Graham's method is also somehow inferior? Such line of reasoning is a 'non-sequitur' or can also be a fallacy of causal oversimplification. I have seen similar fallacies repeated numerous times - "Technical analysis is for idiots since I do not know any technical analyst who is in the Forbes list of richest people" or "Company A made record profits, so the CEO must be a terrific manager". These may very well be true but the conclusions do not necessarily follow from the premise.

 

Could your observation be a case of too small a sample size or a case of 'availability bias'- a possibility if majority of your friends and peers are Graham/Schloss 'fans' and you don't know too many people who have maintained concentrated portfolios for very long periods of time? Could it also be due to confirmation bias - seeking out people or examples that support your premise? Could it be that the reason no one has successfully emulated Buffett's method and become as rich as him is because of the time and age they were born in - not being able to take advantage of the post-WWII raging bull market ? Is it possible that the advent of computers in the last 30 years has made markets more efficient and bargains that the young Buffett could find are no longer available? Could it have anything to do with Buffett's personality - charm, initiative, marketing skills? Could this also be a function of political changes, securities regulation or technological innovation ? What about plain old lady luck ? I am sure you can find numerous such factors if you sit down and think about it.

 

I know it's difficult to judge a person's tone from a message so let me assure you that I am not trying to be confrontational here. But, just trying to point out that a person's investment returns or ability to outperform the market ( or contrarily others' inability to achieve significant alpha) may be a function of several factors many of which have nothing to do with the investment methodology.

 

Nothing personal taken, and you're correct my tone should be more of a curious observation rather than a "this is how it is"

 

Let me clarify, when I think of Buffett I'm not thinking his style is concentrated, I will willingly admit that being concentrated is a great strategy for getting rich.  I actually believe it's one of the best strategies, if you can find the best situations or companies and concentrate everything in them then do it.  If I had some level of control over the companies I was investing in I would make outsized positions as well.  This goes with my argument that the true path to being rich is owning your own company, and entrepreneurs are 100% concentrated in it, financially, and even in life.  It works for some, and blows up for others.

 

I look at Buffett's style now as buying larger companies with strong brand presence with consistent growth.  His value angle now appears to be buying growth cheaply, or at a reasonable price.

 

He will still do distressed investments like BAC, GS, but there aren't opportunities for things like that often.  I'm looking more at deals like Heinz.  The Heinz deal will turn out ok for him, but not because it's a great company, or a great price, but because of the financial engineering he pulled off on his position.

 

 

[ERICOPOLY]

Eric,

As I have written in this thread, going forward FFH must achieve an average return of 6.6% on its portfolio of investments to grow BV per share at a 15% CAGR. Historically FFH has achieved an average total return on portfolio of 9.6%.

Sincerely, I don’t understand the required “managerial magic” you are talking about…

 

giofranchi

 

That's exactly the magic I'm talking about.  It's not the norm!  This isn't a business that has a model of spitting out those returns from operations, they get it by being smarter than the market (booking capital gains).  That's hard, but they're very good at it.  That's their managerial magic that I'm talking about.  It does matter how the profits are made, because the market will reward operational earnings.  There is a good deal of logic to that -- the market would have to assume itself to be wrong in order for it to believe that FFH will reliably keep whipping it.

 

Take away HWIC and put an average investment management team in there -- now say that they "only" need to make 6.6%.

 

I do hold some FFH now though -- I bought some last week for my taxable account.  I hedged some BAC with puts and the idea is to manufacture some losses with the puts expiring worthless for offsetting future capital gains.  Just some tax laundering.  The FFH needs to build value at a single digit rate in order for this to come at no-cost to me.  Perhaps they'll do more than 15%!  Hope so, but not expecting it with fixed income yields the way they are.

[Yours Truly]

If I KNEW that FFH would compound in the way you describe, I would probably make it a large position, maybe very large.  But how can I know that?  Just because something has happened, doesn't mean it will continue to do so.

 

It takes a good deal of managerial magic for FFH to grow tangible book at 15%. 

 

I know a lot about FFH and I think about this a lot.  However every time I wind up reaching the conclusion that I'd rather be invested in the company that can generate 13% to 15% returns from operational earnings... provided it too is priced such that I'm getting in at tangible book value.

 

The market more reliably puts an earnings multiple on operational earnings.  So it's not just about the returns on tangible equity, but the more likely path to an eventual multiple on the earnings themselves (a bonus tailwind of upwards valuation adjustment).

 

And so basically that's why I still keep my oversized BAC position rather than move some to FFH.  Not yet!  Not yet!  In due time...  First the easy money.  Later, I hope FFH can keep the magic going when it's time to buy back into it.

 

Eric,

As I have written in this thread, going forward FFH must achieve an average return of 6.6% on its portfolio of investments to grow BV per share at a 15% CAGR. Historically FFH has achieved an average total return on portfolio of 9.6%.

Sincerely, I don’t understand the required “managerial magic” you are talking about…

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

I don't follow FFH but how did you get up with 6.6% in the statement "must achieve an average return of 6.6% on its portfolio of investments to grow BV per share at a 15% CAGR." ?

[Packer16]

Kraven,

 

What sources of data do you use to find banks?  What do you use to determine if the bank is safe enough assuming it cheap?  TIA

 

Packer

[ERICOPOLY]

Kraven,

 

What sources of data do you use to find banks?  What do you use to determine if the bank is safe enough assuming it cheap?  TIA

 

Packer

If I KNEW that FFH would compound in the way you describe, I would probably make it a large position, maybe very large.  But how can I know that?  Just because something has happened, doesn't mean it will continue to do so.

 

It takes a good deal of managerial magic for FFH to grow tangible book at 15%. 

 

I know a lot about FFH and I think about this a lot.  However every time I wind up reaching the conclusion that I'd rather be invested in the company that can generate 13% to 15% returns from operational earnings... provided it too is priced such that I'm getting in at tangible book value.

 

The market more reliably puts an earnings multiple on operational earnings.  So it's not just about the returns on tangible equity, but the more likely path to an eventual multiple on the earnings themselves (a bonus tailwind of upwards valuation adjustment).

 

And so basically that's why I still keep my oversized BAC position rather than move some to FFH.  Not yet!  Not yet!  In due time...  First the easy money.  Later, I hope FFH can keep the magic going when it's time to buy back into it.

 

Eric,

As I have written in this thread, going forward FFH must achieve an average return of 6.6% on its portfolio of investments to grow BV per share at a 15% CAGR. Historically FFH has achieved an average total return on portfolio of 9.6%.

Sincerely, I don’t understand the required “managerial magic” you are talking about…

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

I don't follow FFH but how did you get up with 6.6% in the statement "must achieve an average return of 6.6% on its portfolio of investments to grow BV per share at a 15% CAGR." ?

 

 

I took giofranchi's math at face value, but now that I've done a bit of number crunching I don't get it.

 

They have:

$25b cash and investments

$3b LT debt  (I believe they paid about 6.9% interest on that debt in 2012)

 

So total return coming in the door at 6.6% on $3b of investments is effectively a wash against the 6.9% interest due on $3b of LT debt (money out the door).

 

So they have $22b of net cash and investments

 

There are 20.2m common shares.  That brings us to $1,089 net investments per share.

 

So 6.6% on that brings in $72 before taxes, 19% pre-tax return on $378 BV per share.

 

So 13.3% growth in BV per share at 30% tax rate.  More like 13.1% after including the non-controlling interests.

 

Then there is corporate overhead, but hopefully underwriting profits can overwhelm this and then some.

 

I believe they need about 7.5% total return on investments in order to achieve 15% growth in BV per share.  (assuming underwriting profit merely nets out against corp overhead)

[vinod1]

 

I took giofranchi's math at face value, but now that I've done a bit of number crunching I don't get it.

 

They have:

$25b cash and investments

$3b LT debt  (I believe they paid about 6.9% interest on that debt in 2012)

 

So total return coming in the door at 6.6% on $3b of investments is effectively a wash against the 6.9% interest due on $3b of LT debt (money out the door).

 

So they have $22b of net cash and investments

 

There are 20.2m common shares.  That brings us to $1,089 net investments per share.

 

So 6.6% on that brings in $72 before taxes, 19% pre-tax return on $378 BV per share.

 

So 13.3% growth in BV per share at 30% tax rate.  More like 13.1% after including the non-controlling interests.

 

Then there is corporate overhead, but hopefully underwriting profits can overwhelm this and then some.

 

I believe they need about 7.5% total return on investments in order to achieve 15% growth in BV per share.  (assuming underwriting profit merely nets out against corp overhead)

 

My numbers are pretty much in line with yours when I went through this exercise after the annual letter. A minor difference is that I also deducted $60 million for preferred debt.

 

To get a ROE of about 13%, I had to assume equity investments, preferred stock, and investment in associates return 12% (compared to a 15 year average for YE 2010 of about 17%) and bonds return 5% (15 year avg of 10%) with a 103 CR and 30% tax rate. Total portfolio return is 7.6%. To me the portfolio return seems to be pretty optimistic.

 

Vinod

[giofranchi]

 

I took giofranchi's math at face value, but now that I've done a bit of number crunching I don't get it.

 

They have:

$25b cash and investments

$3b LT debt  (I believe they paid about 6.9% interest on that debt in 2012)

 

So total return coming in the door at 6.6% on $3b of investments is effectively a wash against the 6.9% interest due on $3b of LT debt (money out the door).

 

So they have $22b of net cash and investments

 

There are 20.2m common shares.  That brings us to $1,089 net investments per share.

 

So 6.6% on that brings in $72 before taxes, 19% pre-tax return on $378 BV per share.

 

So 13.3% growth in BV per share at 30% tax rate.  More like 13.1% after including the non-controlling interests.

 

Then there is corporate overhead, but hopefully underwriting profits can overwhelm this and then some.

 

I believe they need about 7.5% total return on investments in order to achieve 15% growth in BV per share.  (assuming underwriting profit merely nets out against corp overhead)

 

My numbers are pretty much in line with yours when I went through this exercise after the annual letter. A minor difference is that I also deducted $60 million for preferred debt.

 

To get a ROE of about 13%, I had to assume equity investments, preferred stock, and investment in associates return 12% (compared to a 15 year average for YE 2010 of about 17%) and bonds return 5% (15 year avg of 10%) with a 103 CR and 30% tax rate. Total portfolio return is 7.6%. To me the portfolio return seems to be pretty optimistic.

 

Vinod

 

Well, I just used Mr. Watsa’s numbers… $378 per share of equity, $784 per share in float, $127 per share in net debt = $1,289 in investments per share.

 

$1,289 compounding at 6.6% for 10 years gets you to have $2,442 in investments. If at the end of the 10th year you give back what you owe, both the float and the debt, you must subtract $784 + $127 = $911. Therefore, you are left with a capital of $2,442 - $911 = $1,531. $378 compounded at 15% for 10 years gets you to $1,529.

 

Of course, this doesn’t take into account the yearly coupon FFH must pay on its debt… anyway, long term debt is just 9.8% of total investments.

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

[giofranchi]

Total portfolio return is 7.6%. To me the portfolio return seems to be pretty optimistic.

 

Even if it were 7.6%, why pretty optimistic? When historically FFH has achieved an average total return on portfolio of 9.6%?

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

 

 

[ERICOPOLY]

long term debt is just 9.8% of total investments.

 

That's a pretty large number -- it isn't like it winds up at 14.99% or something that you can just round up to 15%.

 

.902 * 15% = 13.53%.  The interest rate on the debt is higher than the 6.6% assumption you are making on portfolio total return -- so it needs to be stripped out.

 

As for using the "investments per share" number in the AR:

I believe in the past they put that number out there despite the fact that ORH and NB had substantial minority interests.  In other words, even though FFH didn't own a large chunk of those investments, they were still included in the "investments per share figure".

 

So since then I've never trusted that number again.

 

 

 

 

 

[giofranchi]

long term debt is just 9.8% of total investments.

 

That's a pretty large number -- it isn't like it winds up at 14.99% or something that you can just round up to 15%.

 

.902 * 15% = 13.53%.  The interest rate on the debt is higher than the 6.6% assumption you are making on portfolio total return -- so it needs to be stripped out.

 

As for using the "investments per share" number in the AR:

I believe in the past they put that number out there despite the fact that ORH and NB had substantial minority interests.  In other words, even though FFH didn't own a large chunk of those investments, they were still included in the "investments per share figure".

 

So since then I've never trusted that number again.

 

That’s why I like a margin of safety!! If it is actually 7.6%, instead of 6.6%, I think FFH can achieve a 15% CAGR in BV per share anyway. Even significantly trailing behind its past results! I have a double margin of safety here: one against some errors in my assumptions (as you have pointed out), and another against FFH not being able to replicate past achievements.  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

[ERICOPOLY]

long term debt is just 9.8% of total investments.

 

That's a pretty large number -- it isn't like it winds up at 14.99% or something that you can just round up to 15%.

 

.902 * 15% = 13.53%.  The interest rate on the debt is higher than the 6.6% assumption you are making on portfolio total return -- so it needs to be stripped out.

 

As for using the "investments per share" number in the AR:

I believe in the past they put that number out there despite the fact that ORH and NB had substantial minority interests.  In other words, even though FFH didn't own a large chunk of those investments, they were still included in the "investments per share figure".

 

So since then I've never trusted that number again.

 

That’s why I like a margin of safety!! If it is actually 7.6%, instead of 6.6%, I think FFH can achieve a 15% CAGR in BV per share anyway. Even significantly trailing behind its past results! I have a double margin of safety here: one against some errors in my assumptions (as you have pointed out), and another against FFH not being able to replicate past achievements.  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

They will meet my expectations if they achieve results that allow me to earn 10+% total return from their stock.  The main concern that drives my lower expectations is that:

1)  bond yields low

2)  bond yields can't go too much lower

 

Their storied history had this terrific tailwind from not only high bond yields, but those yields kept falling and that gave them sizable capital gains!

 

Otherwise, nothing else to worry about.  I do hope their underwriting gets better -- it seems there is a trend in that direction with ORH becoming a bigger slice of the pie and the emerging markets businesses getting larger.  Should that trend continue, then perhaps underwriting will one day step forward to boost profits meaningfully.  But i don't count on it.

 

[giofranchi]

long term debt is just 9.8% of total investments.

 

That's a pretty large number -- it isn't like it winds up at 14.99% or something that you can just round up to 15%.

 

.902 * 15% = 13.53%.  The interest rate on the debt is higher than the 6.6% assumption you are making on portfolio total return -- so it needs to be stripped out.

 

As for using the "investments per share" number in the AR:

I believe in the past they put that number out there despite the fact that ORH and NB had substantial minority interests.  In other words, even though FFH didn't own a large chunk of those investments, they were still included in the "investments per share figure".

 

So since then I've never trusted that number again.

 

That’s why I like a margin of safety!! If it is actually 7.6%, instead of 6.6%, I think FFH can achieve a 15% CAGR in BV per share anyway. Even significantly trailing behind its past results! I have a double margin of safety here: one against some errors in my assumptions (as you have pointed out), and another against FFH not being able to replicate past achievements.  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

They will meet my expectations if they achieve results that allow me to earn 10+% total return from their stock.  The main concern that drives my lower expectations is that:

1)  bond yields low

2)  bond yields can't go too much lower

 

Their storied history had this terrific tailwind from not only high bond yields, but those yields kept falling and that gave them sizable capital gains!

 

Otherwise, nothing else to worry about.  I do hope their underwriting gets better -- it seems there is a trend in that direction with ORH becoming a bigger slice of the pie and the emerging markets businesses getting larger.  Should that trend continue, then perhaps underwriting will one day step forward to boost profits meaningfully.  But i don't count on it.

 

I think Mr. Watsa knows that bonds are not going to be a good investment for the next 10 years as well as anyone else! And I think he and his team will invest opportunistically somewhere else. I have always judged Mr. Watsa to be an “under promising and over achieving” kind of manager: if he says 15%, and the math is not completely crazy, I tend to believe him.

Then, of course, time will tell!  :)

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

 

 

 

[vinod1]

Total portfolio return is 7.6%. To me the portfolio return seems to be pretty optimistic.

 

Even if it were 7.6%, why pretty optimistic? When historically FFH has achieved an average total return on portfolio of 9.6%?

 

giofranchi

 

“As time goes on I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.” - John Maynard Keynes

 

Just based on the current market valuations,

 

1. The assumption of 12% equity returns imply beating the market by at least 8% (if you take Hussman and others expectations of market returns of 3-4% going forward)

 

2. At current bond market yields of 2-3% and 0% yield on cash/very short term credits, the expectation of 5% return on the fixed income portfolio implies a return nearly double that of the fixed income markets. I think they are by far the best bond investors on the planet and their performance in bond markets is even more impressive than their stock market performance. Even so a 5% return, given the constraints on the portfolio as a P&C insurer where they do not have complete flexibility, would be a not too easy goal.

 

I would give Watsa and Co more than a decent chance of meeting the above but these are some pretty difficult hurdles. To get these returns, markets have to be pretty volatile for Watsa to take advantage of. If we just muddle through, I do not think these are realistic hurdles. Conservatively these would be rather optimistic assumptions for me to bake into my estimates.

 

I would not put too much emphasis on the 15% target by Watsa as the starting base is not well defined. If we take start of 2007 as the starting point, then they have already achieved the 15% returns needed until end of 2014 if they just keep the book value at the current level. On the other hand it would be unfair to expect them to deliver 15% annual returns say from the beginning of 2010 when they just increased book value by 150% over the past three years.

 

Vinod

 

 

[vinod1]

Kraven - Apologies for the above digression. Thanks for taking the time to patiently answering questions on your investment approach. I found it very helpful.

 

Vinod

[Kraven]

Kraven - Apologies for the above digression. Thanks for taking the time to patiently answering questions on your investment approach. I found it very helpful.

 

Vinod

 

Ha ha, no worries.  Hijack away. 

 

FYI, at this point this thread has gotten long in the tooth, at least to me.  PM me if there are any other questions, but otherwise I think this thread has run its course.  I will make an exception for questions of higher importance on topics such as 80's pop culture and baseball (opening day!).