Hey, Mr. Market! Do I really have to make FFH 50% of my portfolio?

[LakesideB]

Let me put it to you differently...

 

They dropped all hedges at 800 because:

 

A)  They thought the market would continue to fall

B)  Margin of safety at 800 and time to make some big money

 

I'm worried if you answer "A".  ;)

 

While they benefited tremendously by being able to deploy large amount of capital to take advantage of 40%+ drop in valuation levels, its the time it took to reach from 800 to 1050 that caused to them to become concerned about the legitimacy of the recovery. While the stock market basks in sun is reaching all time highs, the US GDP languishes even after Fed has spent all its bullets. So yeah they are concerned something is a definitely amiss here .... and best thing to do is to protect your capital and back your skill to add value well and over the market returns in the long run.

[Guest wellmont]

 

Whether the global crises happens or not in the long run enterprise need for security is not doing to go down.

 

so guns ammo and mobile security?  ;)

[LakesideB]

 

BBry is about 3% or so of their portfolio so not that significant from their portfolio allocation prespective.  Its a balance sheet play .. you could perhaps arrive at a liquidation value that is closer to $18 to $20. This ancors the downside. There is a transformation in the business happening where handset business will be less relevant as they become focused on deploying QNX as a security toll road for the enterprise and charge a recurring fee to get on this toll road. If they are successful this think could be worth substantially more. Whether the global crises happens or not in the long run enterprise need for security is not doing to go down.

 

so guns ammo and mobile security?  ;)

 

wellmont lets keep your massive blackberry love to the BBry thread  ;) ?

[ERICOPOLY]

While they benefited tremendously by being able to deploy large amount of capital to take advantage of 40%+ drop in valuation levels, its the time it took to reach from 800 to 1050 that caused to them to become concerned about the legitimacy of the recovery.

 

I highly doubt it.  They claimed specifically that it was the runup in stock prices, and gave no other reason other than continued "economic uncertainly in US and Europe".  There was plenty of that uncertainty at S&P 800 in 2008 as well.  I checked both the Q3 2009 transcript and the Q2 2010 transcript (can't find the ones in between those two).

 

Given their reasons, they would not have hedged if the market had stayed at 800.

[ERICOPOLY]

Question:

 

How much did the earnings of the Nikkei decline from 1990 to the present?  Not the prices of the stocks, but the level of the underlying earnings.

[giofranchi]

I find that not making 25% gain due to fear is numerically identical to losing 25% due to crash.  With Fairfax at 50% of book value equities weighting, this 25% loss is one arising from 50% decline in the markets.

 

Going back to 1060 on the S&P500 when they first put on the full hedge, you're talking about 530 on the S&P500.  Way lower than where they dropped their hedges in 2008, and quite a bit lower than the 2009 absolute bottom of 666.

 

You find yourself in the present with a given degree of capital that came from the past years of compounding.  Did you make mistakes that you are unaware of (errors of omission), that cost you 50% of your capital?  Or are you only counting losses that you are aware of, where it is obvious (errors of commission).

 

Eric,

 

1) As I have already said the average level of their hedges must be higher than 1060. So that a 30% decline in the market will be enough to recoup all their losses. They will have then a huge amount of capital to scoop up bargains. And don’t forget they have also hedged against the Russell2000, which, if a correction comes, I see falling like a stone!

 

2) Most important, don’t assume that just because you are shrewd and nimble enough to get in and out of the market, everyone can be as successful as you… to paraphrase Mr. Klarman, the market is a “revolving door”: if the market drops 40%, the great majority of people will see their wealth go back to where it was, when the market was 40 percent points lower… And this also applies to organizations like BRK, MKL, and FFH: what’s the duty of those organization is to be careful when others are greedy, and to be greedy when others are fearful. The exact time when people stop being greedy, and the exact time when people stop being fearful, are things you might be able to time much better that practically everyone else!

 

3) At the end all that matters is the CAGR in BVPS 10 years from now: and I think FFH’s will be higher than both BRK’s and MKL’s (choose any time frame you prefer!).

 

giofranchi

 

[Parsad]

I personally would have reduced operational leverage of FFH so that they can be more like other insurance companies and don't need to live in fear of getting wiped out. On the other hand, FFH wouldnt have the returns they did without the kind of leverage they built up.

 

Not true.  I think if they had used the same sort of leverage as MKL, they would have had as good, if not better returns, than they have had since inception.  They are very good equity investors, and Brian is probably one of the best bond investors over the last 25 years.  Combine that with the likelihood they would not have suffered as badly over the "7 lean years", and they would be ahead of the game right now.  As well, they would not have had to hedge so completely and would have enjoyed investment returns as good, if not better, than anyone else.  I'm not a proponent of significant amounts of leverage...be it as an investment manager, or within Berkshire or Fairfax.  Cheers!

[giofranchi]

I personally would have reduced operational leverage of FFH so that they can be more like other insurance companies and don't need to live in fear of getting wiped out. On the other hand, FFH wouldnt have the returns they did without the kind of leverage they built up.

 

I don’t think FFH is all that leveraged! Look at the picture in attachment: FFH has a portfolio of investments worth circa 300% its surplus. Therefore, while certainly more leveraged than the average insurance or reinsurance company, it is just a little bit more leveraged!

 

Another point is that, before the merger with Alterra, MKL had a portfolio of stocks larger as a percentage of equity than FFH’s. So, troubles with the stock market would have entailed a more serious hit to MKL’s equity than to FFH’s. Even without taking into consideration the equity hedges put in place by FFH! Things changed with the acquisition of Alterra, because a huge amount of cash and short term bonds suddenly became available to MKL, and that’s why I invested in MKL also, as soon as the merger was announced (the drop in share price also helped!).

 

giofranchi

Insurance_Leverage.bmp

[giofranchi]

Correct.  But they have to do this because of the leverage.  The 1 in 100 investor's not surviving "The Crash" is somewhat of a fallacy.  That number would be 1 in 100 if the investor used leverage or were on margin.  An investor who owned their stocks outright, or had the equivalent of a cash account, would have survived perfectly well as long as the underlying brokerage didn't go under because of fraudulent use of the investor's assets.  The same would have been true in 2008/2009. 

 

Even when Buffett said that everything would have gone under, including Berkshire, but they would have been the last to fall, is because of the use of debt, leverage and especially counterparty risk.  An investor who owned Coca-Cola outright would have no problem surviving a 1929 style crash.  Leverage is great when things work, but it can kill you when things go wrong.  Cheers!

 

Well, of course “not surviving” is euphemistic… but it surely was not pleasant at all! Take, for instance, Mr. Keynes: his net worth in 1936 was £506,522 and he had loans worth £299,347. So, though he used a certain amount of debt, he surely wasn’t too leveraged! And yet his net worth declined to only £171,090 in 1940, and in 1945 at £411,238 it was sill well below its peak of 1936.

And the reason we know what happened to Mr. Keynes is because he undoubtedly was one of the shrewdest investors of the first half of the last century! I seriously doubt a lot of people fared as well as he did!

 

So, I am sure he “survived” those times, but try to imagine what it is to suffer a decline of 66% in your net worth over the course of 4 long years… think about the psychological drama… anyone would be forced to question his/her beliefs… And that’s why, like Yogi Berra said:

In theory there is no difference between theory and practice, in practice there is!

 

giofranchi

 

[Packer16]

I think you need to put in context the losses of Mr. Keynes.  1936 was the top of the market for the UK in 1920s and 1930s and 1940 was the evacuation of Dunkirk and it was not unreasonable to think the Germany would have taken over the UK, like it had done France in 1940.  If that happened many of the UK cos would have been 0s.

 

Packer 

[giofranchi]

I think you need to put in context the losses of Mr. Keynes.  1936 was the top of the market for the UK in 1920s and 1930s and 1940 was the evacuation of Dunkirk and it was not unreasonable to think the Germany would have taken over the UK, like it had done France in 1940.  If that happened many of the UK cos would have been 0s.

 

Packer

 

Of course! And far from me saying we will repeat such dramatic events!

 

Anyway, nothing so dramatic happened in Japan during the last 20 years, right? Now, let me ask you a question: do you know of some deep value investor, who invested solely in the Japanese stock market from the early ‘90s until today, and reaped significant returns?

 

My point is: I know that value investing empowers you with the strength to swim against the tide, but could exist a tide so strong that even value investing stops being very effective? By “stops being very effective” I mean that, although you surely do much better than the average, you’d still fail to build wealth at a satisfactory compound rate.

 

I am not saying I know the answer… all I am saying is that historically the answer is not very clear… what is clear from history is only that the tide doesn’t matter 95% of the times.

 

giofranchi

 

[jay21]

So if you consider that they dropped their hedges at 800 in 2008, and then put them back on at 1060, were they merely stressing out over a 20% drop back down to 800?  That's only a 10% hit to their book value.  In saving themselves from that 10% hit, they've suffered an even large hit looking at where they would be today verses where they actually are today.

 

They were worried about it going much much lower than 800.

 

No they were completely unhedged at 800.  I forget where, but it was somewhere in the 800 range that they dropped ALL of their equity hedges.

 

And yes, they made all those "1in100 year storm" comments, and "very few survived the great depression" comments a long time beforehand.

 

Then the market rallies 25% and they go completely hedged again?  It's not like 20% is a terrifying amount of market swing.  That kind of decline can happen in any market.

 

And then if it happens, it's only a 7% loss to them due to their 50% exposure and the tax thing.  I mean, come on, I eat 7% losses for breakfast!  (happens at least a couple of times a year).

 

As Lakeside pointed out, unlike us, insurers need to worry about MTM losses unfortunately. 

[Packer16]

There may be a tide (such as letting zombie companies stay alive, not clearing the system and poor governance - that in my mind is Japan's biggest issue and what makes the US and the UK different than Japan).  The premise of value investing is the market will realize the value of assets held but if those assets are used for other purposes (enriching management or others in control) then the market is correct for not valuing them at their actual value thus leading to a permanent discount.  The other danger value investing cannot save you from is expropriation.

 

Packer

[Uccmal]

Gio,

 

I dont see any evidence that the equity hedges were put in much above 1060.  In statements since they seem to reaffirm the 1060 number. 

 

The lack of losses on equity hedges in the last Q reflects the marginal change between March 31, and June 31.  Losses will have been booked after the Q end, so far. 

 

The CR for NB and major losses will be reported in September.  My numbers may still be a little pessimistic, and I acknowledge that. 

 

Al

[benhacker]

Interesting discussion.

 

For reference, I don't see it stated so I'll do it:

 

1) FFH unhedged fully in Nov '08.

2) FFH hedged up to 25-30% of equities from 2H '09 to end of Q1 '10.

3) FFH hedge up to 92% (call it 100%) by end of Q2 '10. During Q2 '10, the S&P reached above 1200 (not sure where the 1060 number came in, but maybe I missed something)

 

--

I think Eric's points lead us back to an argument that these hedges, are indeed "hedges".  FFH was adding to their shorts in the mid of '08, but a few things changed between then and Nov '08.  Namely, their CDS windfall grew by >$1B which likely changed their desire / need for "hedges".

 

Yes, equities were cheaper and I'm sure that is part of why the hedge was removed, but they were on much more sound financial footing, were in the process of buying billions of BHAC muni bonds, and likely felt that the hedge while becoming less effective was also not quite as necessary.

 

Now the resumption of the hedge does seem early (to me), but I think a market neutral strategy (short the US) with a lot of international, convertible, and other special situation / private placement stuff is a good long term direction; with the US markets at >20x GAAP EPS, seems logical.  But I agree that the ~1200 or so level was probably only marginally overvalued at the time.  Seems like there could have been better hedges (I guess they were also short a lot of global miner and commodity names around this time as well so perhaps it was just a size issue.... shorting $6B worth of individual names is a challenge.)

 

FFH's hedging does look off in hindsight, but honestly, if you would have asked me in 2010 if by 2013 the market would be trading for 20x+ GAAP earnings on a 10% profit margin, a Shiller PE of 24, and 2.3x book value with a sub 2% yield I probably would have laughed at you.  If you would have told me that the valuation of EAFE stocks was going to be 30-40% lower I also wouldn't have believed it.

 

Yet with anemic revenue growth, and limited net buyback of shares, the S&P / Wilshire trade up to fairly elevated levels while other countries shares (at least in many situations) trade much cheaper.

 

Whether or not FFH has made all the right or wrong moves, the magnitude of how bad they "look" and how many folks on this board are questioning them is probably more important than the FFH specific discussion.

 

The US markets are priced right now as if low rates are here to stay "forever" *and* that those same low rates of capital won't lead to companies lowering their required rates of returns when competing and thus driving margins down dramatically for everyone.  To me, this is strange.  Or maybe investors are now truly willing to accept much lower returns on equities going forward and are ok with that.

 

We'll see.

 

Ben

 

 

[giofranchi]

Interesting discussion.

 

For reference, I don't see it stated so I'll do it:

 

1) FFH unhedged fully in Nov '08.

2) FFH hedged up to 25-30% of equities from 2H '09 to end of Q1 '10.

3) FFH hedge up to 92% (call it 100%) by end of Q2 '10. During Q2 '10, the S&P reached above 1200 (not sure where the 1060 number came in, but maybe I missed something)

 

--

I think Eric's points lead us back to an argument that these hedges, are indeed "hedges".  FFH was adding to their shorts in the mid of '08, but a few things changed between then and Nov '08.  Namely, their CDS windfall grew by >$1B which likely changed their desire / need for "hedges".

 

Yes, equities were cheaper and I'm sure that is part of why the hedge was removed, but they were on much more sound financial footing, were in the process of buying billions of BHAC muni bonds, and likely felt that the hedge while becoming less effective was also not quite as necessary.

 

Now the resumption of the hedge does seem early (to me), but I think a market neutral strategy (short the US) with a lot of international, convertible, and other special situation / private placement stuff is a good long term direction; with the US markets at >20x GAAP EPS, seems logical.  But I agree that the ~1200 or so level was probably only marginally overvalued at the time.  Seems like there could have been better hedges (I guess they were also short a lot of global miner and commodity names around this time as well so perhaps it was just a size issue.... shorting $6B worth of individual names is a challenge.)

 

FFH's hedging does look off in hindsight, but honestly, if you would have asked me in 2010 if by 2013 the market would be trading for 20x+ GAAP earnings on a 10% profit margin, a Shiller PE of 24, and 2.3x book value with a sub 2% yield I probably would have laughed at you.  If you would have told me that the valuation of EAFE stocks was going to be 30-40% lower I also wouldn't have believed it.

 

Yet with anemic revenue growth, and limited net buyback of shares, the S&P / Wilshire trade up to fairly elevated levels while other countries shares (at least in many situations) trade much cheaper.

 

Whether or not FFH has made all the right or wrong moves, the magnitude of how bad they "look" and how many folks on this board are questioning them is probably more important than the FFH specific discussion.

 

The US markets are priced right now as if low rates are here to stay "forever" *and* that those same low rates of capital won't lead to companies lowering their required rates of returns when competing and thus driving margins down dramatically for everyone.  To me, this is strange.  Or maybe investors are now truly willing to accept much lower returns on equities going forward and are ok with that.

 

We'll see.

 

Ben

 

Thank you Ben!

1200 is much more consistent with the math that leads me to think a 30% decline in the market should be required to recoup all the losses from the equity hedges (1700 x 0.7 = 1190).

Maybe Al is right and my math is wrong, but I still don’t understand where my error lies…

 

Other very good points as well. :)

 

giofranchi

 

[ERICOPOLY]

Interesting discussion.

 

For reference, I don't see it stated so I'll do it:

 

1) FFH unhedged fully in Nov '08.

2) FFH hedged up to 25-30% of equities from 2H '09 to end of Q1 '10.

3) FFH hedge up to 92% (call it 100%) by end of Q2 '10. During Q2 '10, the S&P reached above 1200 (not sure where the 1060 number came in, but maybe I missed something)

 

--

I think Eric's points lead us back to an argument that these hedges, are indeed "hedges".  FFH was adding to their shorts in the mid of '08, but a few things changed between then and Nov '08.  Namely, their CDS windfall grew by >$1B which likely changed their desire / need for "hedges".

 

Yes, equities were cheaper and I'm sure that is part of why the hedge was removed, but they were on much more sound financial footing, were in the process of buying billions of BHAC muni bonds, and likely felt that the hedge while becoming less effective was also not quite as necessary.

 

Now the resumption of the hedge does seem early (to me), but I think a market neutral strategy (short the US) with a lot of international, convertible, and other special situation / private placement stuff is a good long term direction; with the US markets at >20x GAAP EPS, seems logical.  But I agree that the ~1200 or so level was probably only marginally overvalued at the time.  Seems like there could have been better hedges (I guess they were also short a lot of global miner and commodity names around this time as well so perhaps it was just a size issue.... shorting $6B worth of individual names is a challenge.)

 

FFH's hedging does look off in hindsight, but honestly, if you would have asked me in 2010 if by 2013 the market would be trading for 20x+ GAAP earnings on a 10% profit margin, a Shiller PE of 24, and 2.3x book value with a sub 2% yield I probably would have laughed at you.  If you would have told me that the valuation of EAFE stocks was going to be 30-40% lower I also wouldn't have believed it.

 

Yet with anemic revenue growth, and limited net buyback of shares, the S&P / Wilshire trade up to fairly elevated levels while other countries shares (at least in many situations) trade much cheaper.

 

Whether or not FFH has made all the right or wrong moves, the magnitude of how bad they "look" and how many folks on this board are questioning them is probably more important than the FFH specific discussion.

 

The US markets are priced right now as if low rates are here to stay "forever" *and* that those same low rates of capital won't lead to companies lowering their required rates of returns when competing and thus driving margins down dramatically for everyone.  To me, this is strange.  Or maybe investors are now truly willing to accept much lower returns on equities going forward and are ok with that.

 

We'll see.

 

Ben

 

Thank you Ben!

1200 is much more consistent with the math that leads me to think a 30% decline in the market should be required to recoup all the losses from the equity hedges (1700 x 0.7 = 1190).

Maybe Al is right and my math is wrong, but I still don’t understand where my error lies…

 

Other very good points as well. :)

 

giofranchi

 

I think Ben is right as well -- it looks like it was only 25% hedged at 1060.

 

However I don't follow Giofranchi's reasoning.  Recouping all of the losses means losing a largely offsetting amount on equities -- what does that get you?  Why is that exciting?  The opportunity cost is baked in today.  Call it the real cost of float.

[giofranchi]

As you can see on page 15, Al is right about the S&P500 average level of the equity hedges. My math wasn’t right, because I arrived at a total original notional amount of 7,014.25 million, when it actually is worth $6,520.9 (see page 15).

Anyway, $3.5 billion are short the Russell2000 at an average level of 662.22, while at the end of Q2 2013 that index was at 977.48. So, more than half of the losses could be recouped with the Russell2000 declining little more than 30%. Only $1 billion is short the S&P500, with $1.6 billion short individual equities.

 

giofranchi

2013-Q2-Interim-Report-Final.pdf

[giofranchi]

However I don't follow Giofranchi's reasoning.  Recouping all of the losses means losing a largely offsetting amount on equities -- what does that get you?  Why is that exciting?  The opportunity cost is baked in today.  Call it the real cost of float.

 

Nothing to be exited about… do I give the impression of being exited about $billions in losses…?! If so, I am sorry: not my intention!  ;)

I just want to put the right numbers on the equity hedges.

 

giofranchi

 

[ERICOPOLY]

Regarding turning Japanese,

 

This guy says that in 2011 the Shiller PE was 37 for the Nikkei.  I wonder if anyone reading this knows where to find the underlying earnings data for the Nikkei -- I am interested in looking them, but my web searches are just getting nowhere.

 

http://www.rwroge.com/2011/06/world-equity-valuations-by-the-shiller-pe-ratio/

[tombgrt]

As you can see on page 15, Al is right about the S&P500 average level of the equity hedges. My math wasn’t right, because I arrived at a total original notional amount of 7,014.25 million, when it actually is worth $6,520.9 (see page 15).

Anyway, $3.5 billion are short the Russell2000 at an average level of 662.22, while at the end of Q2 2013 that index was at 977.48. So, more than half of the losses could be recouped with the Russell2000 declining little more than 30%. Only $1 billion is short the S&P500, with $1.6 billion short individual equities.

 

giofranchi

 

 

Losses recouped but equally lost in the long portfolio? As Eric said, how is that exiting? Why is holding FFH now as a full position better than holding out with some nice cash for that eventual crash that will keep FFH exactly at where it is now, only at a lower price to book because it will get dragged down along with the rest? In the meantime while you are holding you are taking on the risk that a major catastrophe hits FFH and others.

 

I don't find you silly Gio, not in the least. I like the discussions you bring and your way of standig up for what you believe in, keep it up! I just found that particular comment a bit weird because for me it was "upside down" to consider it good that they didn't lose anything on the hedges, especially with the market up 6% from Q2's end. I didn't mean to be offensive, sorry.

 

 

Edit: Sorry, I didn't refresh the page so didn't see the new comments on the whole "exiting" thing. Ignore that part. ;)

[DynamicPerception]

Equity Hedges

1) existing swap contracts referenced to the S&P 500 index

  (at an average S&P 500 index value of 1,062.5).

2) by entering into total return swaps referenced to the Russell 2000 index

  (at an average Russell 2000 index value of 646.5)

At June 30, 2010, these hedges represented approximately 93% of the company’s equity investment exposure.

[ERICOPOLY]

Three years from now that initial 1,200 S&P500 number will be 1,608 (growing it at 5% a year).

1,420 would be the equivalent mark where they can return to a 25% hedge position (dropping 75% of the hedges).

 

Of course, that's if the market bounces around for another 3 years instead of plunging sooner than that.

 

In summary, following their initial plan to hedge 25% at 1060, we can expect them to drop 75% of the hedges if the market is at 1,420 in 3 years (and not sooner).

 

EDIT:  And in 3 years time, the equivalent level for the 2009 low of 666 will be 1,069.  I'm using 7% a year growth in that 666 number to account for the market trading at a higher earnings yield at the bottom in 2009.

[giofranchi]

I don't find you silly Gio, not in the least. I like the discussions you bring and your way of standig up for what you believe in, keep it up! I just found that particular comment a bit weird because for me it was "upside down" to consider it good that they didn't lose anything on the hedges, especially with the market up 6% from Q2's end. I didn't mean to be offensive, sorry

 

Hey, no problem! After all, your are doubling your money with ALSK, while I am stuck with FFH... So, yes! Of course, I am silly!! ;D ;D ;D

 

Cheers!

 

giofranchi

[Parsad]

FFH's hedging does look off in hindsight, but honestly, if you would have asked me in 2010 if by 2013 the market would be trading for 20x+ GAAP earnings on a 10% profit margin, a Shiller PE of 24, and 2.3x book value with a sub 2% yield I probably would have laughed at you.  If you would have told me that the valuation of EAFE stocks was going to be 30-40% lower I also wouldn't have believed it.

 

I think a lot of the hard core Graham students, (HW, Klarman, Grantham, etc) underestimated exactly how active (correctly or incorrectly) the Fed and other governments would be.  Buffett knew that there was really no limit and thus the "peddle to the floor" quote.

 

Yet with anemic revenue growth, and limited net buyback of shares, the S&P / Wilshire trade up to fairly elevated levels while other countries shares (at least in many situations) trade much cheaper.

 

Whether or not FFH has made all the right or wrong moves, the magnitude of how bad they "look" and how many folks on this board are questioning them is probably more important than the FFH specific discussion.

 

The US markets are priced right now as if low rates are here to stay "forever" *and* that those same low rates of capital won't lead to companies lowering their required rates of returns when competing and thus driving margins down dramatically for everyone.  To me, this is strange.  Or maybe investors are now truly willing to accept much lower returns on equities going forward and are ok with that.

 

Well exactly, and this leads to the question of what sort of mess has all of that activity by policy makers created?  I think the Graham students, in particular HW, expected things to peter sideways for a considerable period of time...thus the hedges back in place in 2010.  But that did not happen!  So, exactly what is the situation like now with all of that government easing and stimulus? 

 

Well, HW is hedged 100%+!  So either governments can pull off an equally stellar coordinated withdrawal of capital, as they did when injecting it...or the shit hits the fan.  Will be interesting to see how Berkshire handles the situation if the hard core guys are the ones who are correct.  Cheers!