Tuesday, November 25, 2008

Certifiably Crazy

The recent sell-off in Berkshire Hathaway's (NYSE: BRKB) stock has been nothing short of astonishing. But it is perhaps another sign of fear creeping into investors' psychology. Hand in hand with that decline has been a dramatic rise in the value of the company's credit default swaps implying the AAA-rated conglomerate's credit should be considered junk. Whitney Tilson's article published by Seeking Alpha is a great read on this subject. He calls the stock's dramatic decline "certifiably crazy".

Mr. Buffett himself warned of the derivative time-bomb in his 2002 letter to shareholders. Who in their right mind would think that one of the best investors of our lifetime would ignore his own words of wisdom and enter into such perilous contracts? The equity index put options written against 4 indexes appear to be causing the most angst for Mr. Market. Never mind that the contracts do not require him to post barely ANY collateral even in the event these indexes decline dramatically and that any losses recorded on the books are merely paper losses and nothing more. Never mind that the first contract won't expire until 2019 and that they have an average life of 13.5 years. Never mind that according to a just released email from Mr. Buffett, the value of the indexes would have to decline to ZERO for Berkshire to incur a loss equal to its maximum exposure of $35.5 billion. And never mind that he has gotten paid $4.85 billion in premiums for those contracts which he may invest as he wishes.

Mr. Buffett has indicated that he will provide much greater detail about these contracts in his 2008 shareholder letter and that he will provide "all aspects of valuation" and "deficiencies in formula" for pricing the derivatives. He goes on to say that he uses the formula despite the deficiencies. Classic Buffett to point out the shortcomings of the formula. This should make for some fascinating reading.

In a sign of the times we live in, Berkshire's stock has already rallied 28% from the lows they hit last week. They closed today at just over $3,200. Something is not right when you witness this kind of volatility in Berkshire. But it is precisely in the midst of this confusion that you should be taking advantage of the buying opportunities being presented by Mr. Market. Mr. Tilson has. He has doubled his holding in Berkshire by committing 20% of his fund to the stock.

Saturday, November 15, 2008

Burnt Hedges

Fancy suits, designer glasses and a personality that perhaps stood out a bit from the crowd. Back in 2007 as the Dow was marching its way to a record 14,000, these were apparently some of the prerequisites for launching a fund according to some folks. Oh yes, there was one more prerequisite: a secret sauce or ‘black box’ strategy to go along with the fanciness. The Hedgies could do no wrong with returns exceeding 25% a year over the past 5 years or so, justifying their exorbitant fees. Bland looking, boring value investors were out of style.

Well, a
Black Swan has swooped in and ripped the Armani suits and the black boxes to pieces. Hedge funds are closing up shop at a rapid pace and more carnage probably lies ahead as redemptions pour in at a furious pace and losses mount. Our own Globe and Mail newspaper has had recent articles about ‘high-profile’ Lawrence Asset Management and Salida Capital which have suffered heavy losses.

To be sure there are those who will come out of this stronger and bigger than before. Steven Cohen’s SAC Capital has managed to raise capital in this environment, a testament to his staying power and superior performance relative to peers. John Paulson’s Paulson & Co. has posted impressive gains amid the turmoil. But the ranks of the Hedgies will be thinner come 2009. Here is a sampling of Canadian hedge funds’ performance as reported by the Globe and Mail in October 2008.

Thursday, November 13, 2008

Time to Buy

It has been a while but life can get busy sometimes. I last posted on Margin of Safety in January 2008 and discussed the possibility of a recession and outright Armageddon. Well, both of those are upon us with a vengeance. I have been investing for a little over ten years and the tech bubble and ensuing recession pale in comparison to what is happening right now.

Meanwhile, I have been behind on updating you on the Model Portfolio but have been posting trades I would have executed during that time. I have just posted an update of the portfolio’s performance for the twelve months ending September 2008. Please visit that section of the blog for more color on the portfolio’s performance. Of course the carnage began in October and the Model Portfolio has not been spared. But I plan to add new positions and add to existing holdings as the market experiences these wild convulsions.

These are scary times for investors. I feel especially bad for those who have been saving to go to college or those who may have been contemplating a retirement. The joke is that 401(k)s are now 201(k)s. Predictions range from a short recession to a long and hard economic slowdown that may last through 2011. One article I read used the expression “contained depression” to describe the environment we will face over the next few years. Others are calling this a bottom while others think we may see Dow 7,000. Regardless, we have given up a decade of gains in the stock market. How this will end and when the markets will begin a turn around are anyone’s guess.

There is no question we have some hard times ahead of us. The number of people losing their jobs is mounting every day. The world’s consumption appears to be screeching to a halt. Oil has lost more than half its value and other commodities have been battered as well. Wall Street has been reshaped forever. Bear Stearns, Lehman Brothers and Merrill Lynch are gone. Goldman Sachs (NYSE: GS) is trading at levels not seen since its IPO in 1999 and is now a bank holding company. Even the most revered investors have not been spared. Buffett, Icahn, Kerkorian, Eddie Lampert and Bill Miller have all lost billions. Many prominent mutual funds that have been closed to investors for years are reopening heir doors. Meanwhile, many hedge funds are reeling from Mr. Market’s wrath and succumbing to the high volume of redemptions forcing them to sell assets at any cost. There is no doubt the recent volatility and severe decline in the valuation of various companies are in part due to investors demanding their capital forcing funds to liquidate in anticipation of upcoming redemptions.

Franchises such as Goldman Sachs and General Electric have been left for dead by Mr. Market. I have been buying both in recent weeks. For all I can tell Mr. Market is assuming that companies such as Intel (Nasdaq: INTC), Cisco (Nasdaq: CSCO), Ebay (Nasdaq: EBAY) and Starbucks (Nasdaq: SBUX) will never grow again. It seems our beloved analysts are overshooting on the downside just as they did on the upside. The bearish mentality is pervasive and even the venerable Warren Buffett is being questioned for his recent moves.

Mr. Buffett has been putting a lot of Berkshire Hathaway’s (NYSE: BRKB) cash to work in recent months. He has financed the acquisition of Wrigley’s by Mars as well as Dow Chemical’s (NYSE: DOW) acquisition of Rohm and Haas for a total of more than $7 billion. He has purchased preferred shares in Goldman and GE to the tune of $8 billion as well as warrants to buy common stock within a 5 year period at $115 and $22.5 respectively. Many pundits are questioning his timing for these transactions. A recent Op-Ed piece in the New York Time also drew fire from critics. In that article Buffett declared: “Buy American. I am.”, and concluded with this paragraph:

"I don’t like to opine on the stock market, and again I emphasize that I have no idea what the market will do in the short term. Nevertheless, I’ll follow the lead of a restaurant that opened in an empty bank building and then advertised: “Put your mouth where your money was.” Today my money and my mouth both say equities."

As we were going through the tech bubble, the experts declared: this time is different, companies with no earnings are worth infinity. As the Dow worked its way toward 14,000 in recent years they declared: this time is different, China and India will grow indefinitely. Now the Dow is hovering near 8,000 and they have declared: this time is different, Buffett is wrong and he is making his bets too early. Early he may be but wrong he is not. Calling a bottom is a futile exercise but buying companies at attractive valuations is a game winning strategy. Buffett is still the richest man in the world and I am betting he is still the one and only expert to listen to.

Monday, January 21, 2008


In 2005, while an MBA candidate at Ivey, I was enthralled by David Conklin’s Global Environment of Business class. David is a fantastic professor and was kind enough to warn us on numerous occasions to sell any and all of our US dollars because it had nowhere to go but down. I did not heed his warning.

Fast forward to 2007. I spoke with David in December asking him about his availability to give a presentation on the credit markets to our team at DRI Capital. I confessed to David that I had not taken his advice on the USD. He gave me a second chance. He said Armageddon is upon us and to brace myself. Here we are in January and 2008 has begun with a bang. The Dow has swooned more than 15% from its high (earlier today stock markets around the world were pummeled and the Dow Futures don’t look pretty for tomorrow).

The R word is being thrown around like there is no tomorrow and financial stocks are in a free fall. Even strong results from IBM (NYSE: IBM) and Intel (Nasdaq: INTC) were not enough to calm the jittery crowd. Meanwhile, Bank of America (NYSE: BAC) seemingly took advantage of the turmoil and snatched Countrywide Financial (NYSE: CFC) for pennies on the dollar. At least 30 BofA analysts spent 4 weeks on their due diligence. Time will tell how real the diligence was and if this move was brilliance or stupidity. Countrywide shareholders will get 0.1822 BofA shares for every share they own. Countrywide shares are trading at least 20% below that exchange value creating what could turn out to be a fantastic arbitrage opportunity. The market believes BofA could still walk away or reprice the deal.

Meanwhile, Mr. Buffett is bouncing up and down with joy snapping up more Burlington Northern Santa Fe (NYSE: BNI) on a daily basis. He also figured he may as well start a bond insurance business while he is at it. Look no further than Ambac (NYSE: ABK) and MBIA (NYSE: MBI) to see why he smells blood. I hope you weren’t one of those unloading your Berkshire Hathaway (NYSE: BRKB) stock because according to many Mr. Buffett is apparently past his prime. Well not quite. The shares have all but ignored the downdraft and have rocketed to all time highs as Mr. Buffett works his magic and puts his cash hoard to work. There are also the Sovereign Funds of Kuwait and Singapore and the famous Prince Al-Waleed. All are salivating at the chance to own a piece of America’s behemoth financial titans.

One positive out of all this is that stellar businesses such as Moody’s (NYSE: MCO) are trading at half their peak valuations. And one of our favorites, Mr. Lampert’s Sears Holdings (Nasdaq: SHLD) has been cut in half. Ok, so retail is in the dog house especially since a recession is all but inevitable, if the US isn’t only experiencing one. But I believe Mr. Lampert will squeeze value out of Sears. The real estate and the Sears brands should provide ample downside protection. In the meanwhile, both Mr. Lampert and I thank Mr. Market for giving us the opportunity to buy more stock. Starbucks (Nasdaq: SBUX), the purveyor of my daily morning coffee has also been the subject of numerous analyst downgrades and doomsday scenario press coverage by the media. That is one to keep an eye on. And how about Intel? Robust results and the crushing below we predicted they would deliver to Advance Micro Devices (NYSE: AMD) have not prevented a 30% decline from 2007 peak valuations.

The magnitude of write-offs at the Citigroups (NYSE: C) and Merrills (NYSE: MER) of the world has been staggering. That may just be the tip of the iceberg. But don’t fret Mr. Market’s moodiness. To paraphrase Warren Buffett, be greedy when others are fearful. Yes, life will go on beyond Armageddon and will almost certainly be better than before.