July 13, 2020

Wow!

It's been quite a few weeks since my last post. I haven't really changed my thoughts since then, but maybe the economic impact of this will have more than a blip on the long term charts after all.

So far, the economy seems to be doing much worse (or will soon) than the stock market. The initial decline was shocking, but not at all unexpected. The recovery rally is kind of incredible too.

As I watch all these commentators, I realize nobody really has any idea. The commentators / pundits that survive a long time are masters at saying things that will make them look 'correct' in hindsight later on. You make enough calls and predictions, you will at least be able to pick one and say you were right. Also, they are very careful to word their comments so that they can't be called out for being wrong. 'If this happens, then this will happen, if that happens, then that might happen...' etc. You say enough of that, and you will be right about something, eventually... It's kind of a joke, but whatever.

Buffett and Airlines
A lot of things have happened since my last post, including the virtual BRK annual meeting. Nothing really new or unexpected, as usual, but one thing that may have shocked people was how Buffett dumped all his airline stocks. We are supposed to be long term investors, and are not supposed to be reacting to headlines, however scary.

But if you look at their income statements and realize that their revenues are down 90% and may be down for a year or more, it's hard to imagine them surviving. Most of them will be out of business by the end of the year or long before that. The government will have to bail them out, but that will be costly. Either they will have to take on a lot of debt that will take years to pay off, or they will have to issue a lot of equity, basically wiping out current shareholders.

Many businesses will not survive this, and even if they do, there will be big losses to equity investors.

A lot of restaurants will go out of business too, but mostly the independent ones. Major chains, especially fast food and fast casual should be fine.

Retailers are out too, for the most part. A lot of retailers should probably not even exist, and this pandemic is just accelerating what is going to happen anyway. The Micrsoft CEO, Nadella, said that there was two years worth of virtualization in two months since the pandemic. I think that's the case with retailers. This will just accelerate the demise of retailers with flawed (or out of date) business models.

No Bargains?
One thing Buffett said was that he didn't really see any bargains during the decline in March. We know from the 2008-2009 crisis that Buffett is not really a trader, so he is not going to be buying the lows on big down days, necessarily. So on fast declines with quick rebounds, he is not going to get much done.

If you look at what's going on, the stocks that were really hit are the ones that you don't really want to own, necessarily. Airlines, real estate, retail, travel-related stocks etc. And the ones you want to own didn't really get cheap. I can see Buffett piling into things like Amazon or Google if they were dumped with the bath water, but they weren't, really. Neither was Microsoft. Not sure what he thinks of Netflix, but that wasn't dumped either.

So crappy stocks got cheap, but as Buffett said, the way to succeed in the stock market (or at least not lose money) is "don't buy crummy businesses". And there are a lot of them out there now.

People also view Buffett as being 'bearish' because he sold stocks, and he is still sitting on a growing cash balance. He did mention during the meeting that he has a lot of cash, but he has a lot of equity exposure too. I wrote about it a while back, but his equity exposure is not limited to his listed equity portfolio. Kraft is not included in his list of stock holdings, but he still owns it. Same with Burlington Northern, and his many other operating companies (some of which were listed until recently).  If you add it all up, BRK is still fully exposed and is not as conservative as it seems if one were to look only at his listed equity portfolio and cash balance.

Which leads to the next thing being talked about a lot these days (as it has been for the last few years).


Value Investing is Dead?
One thing people need to keep in mind about value investing is that the way the general press talks about it and the way investors talk about it are completely different. The press just looks at nominal valuation and that's it. There is no concept of what something should be worth, and whether it is trading above or below that. They don't understand the concept of intrinsic value. Indexes split between growth and value don't help either.

Value investing used to be about low P/E's and things like that, I suppose, but the more modern approach is what something is trading at versus intrinsic value. This is not that modern, actually, as Buffett has been saying that for many decades.

Here is something from the second edition of Graham's Securities Analysis. This is in the section where he discusses the difference between investment and speculation.

It may be helpful to elaborate our definition from a somewhat different angle, which will stress the fact that investment must always consider the price as well as the quality of the security. Strictly speaking, there can be no such thing as an “investment issue” in the absolute sense, i.e., implying that it remains an investment regardless of price. In the case of high-grade bonds, this point may not be important, for it is rare that their prices are so inflated as to introduce serious risk of loss of principal. But in the common-stock field this risk may frequently be created by an undue advance in price—so much so, indeed, that in our opinion the great majority of common stocks of strong companies must be considered speculative during most of the time, simply because their price is too high to warrant safety of principal in any intelligible sense of the phrase. We must warn the reader that prevailing Wall Street opinion does not agree with us on this point; and he must make up his own mind which of us is wrong.
Nevertheless, we shall embody our principle in the following additional criterion of investment:
An investment operation is one that can be justified on both qualitative and quantitative grounds

I would look at the opposite of this example and say that many cheap stocks may not necessarily be safe. Would you buy junk bonds just on yield? Nope. Someone showed me years ago a quantitative report basically showing that the valuation of a stock is pretty much determined by it's credit quality (I don't know if there was an adjustment for long-term growth or returns on capital), but it made sense to me. The industrial cyclicals were always 'cheap', like steel, auto manufacturing etc. And consumer stocks were always expensive.

Anyway, today, I think a lot of this gap between value and growth just may be reflecting huge secular changes in the economy. You can say AMZN is overpriced and BBBY is cheap. But really, who would short AMZN and go long BBBY?


MKL Dumping Stocks
On the 1Q earnings call, MKL said they dumped a few stocks they thought would be hugely affected by Covid-19. Here are the stocks they dumped:

Anheuser-Busch Inbev ADR 0    0.00%13,000-13,000-100%
CDK Global Inc 0    0.00%176,897-176,897-100%
Discovery Communications 0    0.00%117,000-117,000-100%
Dollar Tree Inc 0    0.00%123,100-123,100-100%
Hasbro, Inc 0    0.00%364,000-364,000-100%
Kraft Heinz Co 0    0.00%68,000-68,000-100%
Rockwell Automation Inc 0    0.00%140,100-140,100-100%
Scotts Miracle-Gro Co 0    0.00%422,000-422,000-100%
Unilever PLC ADR 0    0.00%1,527,600-1,527,600-100%
United Health Group Inc 0    0.00%599,000-599,000-100%

This is as of end the March, and they may have dumped more things in April. Buffett dumped airline stocks in April, so that dumpage doesn't show up on his 13-F, which is here, by the way:

BERKSHIRE HATHAWAY INC

Filing Date: 2020-05-15

Namedollar amt%port#shareschange%chg
APPLE INC 62,340,609    35.52%245,155,566

BANK AMER CORP 19,637,932    11.19%925,008,600

COCA COLA CO 17,700,001    10.09%400,000,000

AMERICAN EXPRESS CO 12,979,391    7.40%151,610,700

WELLS FARGO & CO NEW 9,276,210    5.29%323,212,918

KRAFT HEINZ CO 8,056,205    4.59%325,634,818

MOODYS CORP 5,217,658    2.97%24,669,778

JPMORGAN CHASE & CO 5,196,030    2.96%57,714,433-1,800,499-3%
US BANCORP DEL 4,563,233    2.60%132,459,618

DAVITA HEALTHCARE PARTNERS I 2,897,549    1.65%38,095,570-470,000-1%
BANK OF NEW YORK MELLON CORP 2,686,487    1.53%79,765,057

CHARTER COMMUNICATIONS INC N 2,367,684    1.35%5,426,609

VERISIGN INC 2,307,964    1.32%12,815,613-137,132-1%
DELTA AIR LINES INC DEL 2,050,935    1.17%71,886,963976,5071%
SOUTHWEST AIRLS CO 1,910,218    1.09%53,642,713-6,5000%
VISA INC 1,701,823    0.97%10,562,460

GENERAL MTRS CO 1,551,872    0.88%74,681,000-319,0000%
LIBERTY MEDIA CORP DELAWARE 1,446,433    0.82%45,711,345-240,000-1%
COSTCO WHSL CORP NEW 1,235,572    0.70%4,333,363

MASTERCARD INC 1,192,040    0.68%4,934,756

AMAZON COM INC 1,039,786    0.59%533,300-4,000-1%
PNC FINL SVCS GROUP INC 880,431    0.50%9,197,984526,9306%
UNITED CONTL HLDGS INC 699,073    0.40%22,157,608218,9661%
SIRIUS XM HLDGS INC 654,149    0.37%132,418,729-3,857,000-3%
KROGER CO 570,475    0.33%18,940,079

M & T BK CORP 556,665    0.32%5,382,040

AMERICAN AIRLS GROUP INC 510,871    0.29%41,909,000-591,000-1%
GLOBE LIFE INC 457,278    0.26%6,353,727

LIBERTY GLOBAL PLC 434,229    0.25%26,656,968-481,000-2%
AXALTA COATING SYS LTD 415,689    0.24%24,070,000-194,000-1%
TEVA PHARMACEUTICAL INDS LTD 384,248    0.22%42,789,295-460,000-1%
RESTAURANT BRANDS INTL INC 337,782    0.19%8,438,225

STORE CAP CORP 337,425    0.19%18,621,674

SYNCHRONY FINL 323,860    0.18%20,128,000-675,000-3%
STONECO LTD 308,410    0.18%14,166,748

GOLDMAN SACHS GROUP INC 296,841    0.17%1,920,180-10,084,571-84%
SUNCOR ENERGY INC NEW 236,195    0.13%14,949,031-70,0000%
OCCIDENTAL PETE CORP 219,245    0.12%18,933,054

BIOGEN INC 203,440    0.12%643,022-5,425-1%
RH 171,638    0.10%1,708,348

JOHNSON & JOHNSON 42,893    0.02%327,100

PROCTER & GAMBLE CO 34,694    0.02%315,400

MONDELEZ INTL INC 28,946    0.02%578,000

VANGUARD INDEX FDS 10,183    0.01%43,000

SPDR S&P 500 ETF TR 10,155    0.01%39,400

UNITED PARCEL SERVICE INC 5,549    0.00%59,400

PHILLIPS 66 0    0.00%227,436-227,436-100%
TRAVELERS COMPANIES INC 0    0.00%312,379-312,379-100%
Total175,485,996


Insurance Companies
By the way, insurance companies are going to hurt for a while. People keep saying that business disruption doesn't cover pandemics, or that it requires physical damage etc. But the way things work in this country, that doesn't matter. We have enough lawyers with a poorly structured incentive system so insurance companies can get bogged down in years and years of lawsuits. Even if insurance companies win, who knows how much all of that is going to cost.

Plus, interest rates are now 0% all the way out to 5 years, and 1% to 20 years. That's going to be painful, and makes BRK's float basically worthless. Yes, this may be temporary, but we have been saying that for more than 10 years now. I have always suspected we will follow Japan in terms of interest rates. I didn't expect a pandemic to cause rates to go to zero, though.

I still think BRK, MKL and others are great investments for the long haul, but there are serious issues for them out there for sure.

Banks
JPM and other banks are going to take some huge credit losses. There is no way around that. One rule of thumb is that credit card losses will follow the unemployment rate. Unemployment got up to 10% during the financial crisis, and sure enough, JPM's credit card charge-offs peaked at 10% or so. Total charge offs were 5%, I think, back then.

Unemployment is now over 15%, and headed to 20%. JPM has $160 billion in credit card loans, so credit card charge-offs can get over $30 billion. Total credit losses may get to 10% and they have around $1 trillion in loans outstanding. Who knows, really.

JPM is still the best managed big bank and they will get through this for sure, but they face some very serious problems. I think the view expressed during the 1Q conference call (expecting rebound in second half of the year) is way too optimistic.

Even if we start to reopen the economy, we can't really have a real recovery as a lot of events won't come back, and restaurant / bars / retailers will run at 30-50% capacity.

An interesting thing to look at is Sweden. They didn't have a hard lockdown like the U.S. and European countries, but their economy is taking a hit anyway. Reopening the economy doesn't mean we are all going to go back to the way we were right away. Many people tell me that they won't change anything even if the economy reopens until they get a vaccine. This could be years away.

I tend to believe things will normalize when we get a treatment that makes Covid-19 far less fatal. If we take that off the table, people will start to get back to normal.

I have no idea about these things, but I tend to think the odds of us finding a treatment is far higher than us finding a vaccine (there is a chance we may never find a vaccine).

Anyway, the mitigating factor to the above bank credit disaster is the amount of money being injected into the economy. I don't know if people are going to use their stimulus / Covid-19 help checks to pay off their credit card (they seem not to be paying their rent), but it will have some positive impact on bank credit, I assume (and hope).  Well, but don't assume because...

Is the Market Being Rational?
So, people are saying that the market is being too optimistic about a return to normal, but it's hard to tell. The market is full of stocks with different exposure. If the airline stocks got back to their highs, I would agree that the market is being too optimistic. But that hasn't happened; not even close. Same with retailers. And restaurant stocks.  OK, Amazon, Netflix, and others are going to new highs, but I doubt that is reflective of the market's optimism about a return to normal.

So when the markets move, I think we have to look by sector, and by stock, to see what they're expecting. It makes no sense to look at the index itself.

What to do?
When this started, I told people the same thing I always told them. Ignore the headlines and just think 3-5 years ahead. This works, though, for people with diversified portfolios. I wouldn't know what to say if they owned a lot of airlines, hotel and other travel related businesses, or other areas that may not recover so quickly. I have no idea.

I haven't owned any retail stocks in a long time (except BRK, which is the closest thing to a retailer I own), and the only restaurant stocks I own are CMG, QSR and SHAK.  Well, SHAK was never cheap so it's a token position that is not significant; it's more of a moral support, I like this company, kind of position. CMG was a large position that I scaled back and had to do again as it went over $1,000. It's not a cheap stock, and I have no idea why it's above $1,000; maybe they are going to take market share after many of their competitors go out of business within a few months). Oops, after writing this, I just realized I do own Costco. So I lied. I own Costco and have no problem with it. I will hold on to it. Yes, it's expensive, but I really like the business for all the reasons we've all heard already a gazillion times.

If you own the S&P 500 index, it doesn't really matter. Many companies will go bust, but that happens all the time. Some big banks, AIG and FNM went bust (or was massively diluted) during the financial crisis and yet the S&P 500 index was fine. It should be fine over the long term this time too, but many of the components won't be.

As usual, just don't invest based on the headlines. OK, evaluating your holdings on long term potential incorporating Covid-19 might not be a bad idea (like Buffett's dumping of airlines), but I would be careful about that too.

One thing is for sure. You really don't want to go chase Covid-19 stocks. You can buy AMZN, NFLX, MSFT thinking these are the pandemic-proof stocks, but the worst time to buy stocks is when everyone piles into them for the same reason (I wouldn't short them either!). For example, I wouldn't touch Zoom stock, of course.


Things are Interesting
I have to admit I have sort of been lazy about my investments over the past few years, kind of just let it go... Looking for things to do wasn't all that interesting as things got expensive.

But things are getting interesting again. I haven't read through so many conference calls and 10-Q's in a long time, and it's been fun. I have to say, though, that the 10-Q's only reflect a small portion of what's happening as the 1Q included the relatively healthy January and February. NYC shut down in mid-March. So there was only 2 weeks of really bad data included in 1Q. The 2Q reports are going to be really scary, but I can't wait to sift through that stuff.

Maybe this will lead to more blog posts. That would be fun, as I do enjoy this process. Until now, though, things are more interesting, but nothing really stands out to me. The really devastated industries are just 'too hard' for now, like cruise lines, airlines, casinos, and the solid businesses that you want to own are not cheap (AMZN, MSFT, COST etc...).

So to those who feel that ETFs and the indexing bubble has lead to a lack of differentiation in the evaluation of individual stocks, it is quite obvious that this is not the case at all. I've always maintained that this is not the case. Sure, there may be excess valuation in some large cap index stocks where index funds are 'forced' to buy regardless. I think overall, crummy stocks are cheap and higher quality stocks are expensive.

OK, banks and insurance companies are cheap now, and not all of them are crummy. But there are massive uncertainties they are facing now. The market is probably wrong and these stocks are probably too cheap.


Why BRK?

Every now and then, BRK comes up in conversations with people (and often with people not in the business) and the topic becomes, what to do with BRK post-Buffett. I tell them I own BRK and plan to own it for a long time, and sometimes I wonder why myself.

Too Big
First of all, it's really big now so it's going to be hard to grow the way they used to. With a market cap of more than $500 billion, it's going to be hard to keep growing at a high pace. This used to be sort of the cap in big company capitalizations; a lot of the bit techs went to $500 billion in 1999/2000 before they all came crashing down. The barrier today seems to be $1 trillion; Maybe these $1 trillion companies hit that wall and come crashing down. Who knows.

In any case, BRK is just too big to get too much alpha going forward.

Buffett
Buffett is not so young anymore, so the historical performance is getting increasingly less relevant; Buffett created the performance of the last half a century, but he is clearly not going to lead the charge for the 50 years. This doesn't mean BRK can't outperform.

Buffett hired some great managers to help manage the equity portfolio, but their historical performance is sort of irrelevant too.  Those guys posted great returns with a much, much smaller capital base. They will eventually inherit a $200 billion+ equity portfolio. If they want to stay focused, they will need to invest in companies they can buy $10-20 billion worth of. And there aren't a lot of those. Their universe will be no bigger than the one Buffett is fishing in now, so it's hard to imagine they will improve on what Buffett can do with this size.


Returns Not So Great Lately
And people say that BRK hasn't even been performing all that well lately, underperforming in the past five years. The rolling five-year BPS growth vs. the S&P 500 index total return has been negative for the last five years in a row (through 2017):

2013  -4.0%
2014  -3.9%
2015  -2.3%
2016  -3.2%
2017  -2.7%

People often point to this to show that the era of BRK outperformance is over.

But this sort of misses the fact that back in 2008, the S&P 500 was down -37% while BRK's BPS declined only -9.6%. So in a sense, the S&P 500 index had a lot of catching up to do compared to BRK. Looking only at the above table of the last five years misses a lot of crucial information.

Having said that, it's true that the supergrowth of BRK ended back in 1998, but has been a steady grower since then.

Check out the below log chart since 1980. You can see two clearly different eras in terms of performance. 1980-1998 was just amazing, but 1998-2018 has been much more modest (data just happened to be available since 1980 as I was playing with daily data; no cherry-picking start/end points. Good enough for this analysis).

BRK, Log Scale Since 1980


BRK's BPS grew +28%/year from 1980 through 1998 vs. +18%/year for the S&P 500 index for an outperformance of 11%/year. BRK's stock price rose +33%/year in that period, beating the index by 15%/year.

Since then, things have flattened out a little, but the returns aren't that bad at all. 

BRK vs. S&P 500
I haven't updated this table in a while, but let's take a look at BRK's performance against the S&P 500 index (total return) in various time periods.


BRK vs. S&P 500: Various Time Periods


Of course, we know how great the performance has been since 1965. But check out the past five years. On a BPS basis, BRK underperformed the S&P 500 total return, but outperformed based in BRK's stock price.

If you look at all the time periods, though, BRK has outperformed both on a price and BPS basis in most time periods.

This year, it just so happens that the 2007-2017 is the same as the 10-year comparison so be careful to not double count...  

But to me, more interesting than looking at the past 5 and 10 year returns (which are no doubt important), is to look at 'through-cycle' performance.

The lower part of the above table shows returns from various market peaks (year-end basis). You will see that on a BPS basis, BRK has outperformed the S&P 500 index since the 1989, 1999 and 2007 market peaks, and also on a price basis in most of those time periods.

The 1998-2018 BRK log price shows a more modest pace of growth than the 1980-1998 period, but you will see that BRK has still grown 10%/year since then, bettering the S&P 500 index (including dividends) by 3%/year on a BPS basis and 2%/year on a price basis. Not like it used to be, but not bad! (How many funds can you name that has done as well?)

So all this talk of Buffett not performing well is not so relevant to me.

It looks funny to have both 1998 and 1999 in there, but 1999 is there as a market peak, and 1998 for sort of a momentary peak in relative performance of BRK, and sort of the end of the high-growth era for BRK.

Why BRK?
Despite the size, and the potential risk of a post-Buffett BRK, why do I still like BRK? First of all, the recent performance, I don't think, is as bad as people make it out to be. They are still outperforming in most time periods, especially from various market peaks.

There is something about BRK that makes me more comfortable than owning the S&P 500 index, even with the post-Buffett risk. The first thing is that BRK will probably not do anything irrational or stupid. This is not an assurance we get when investing in the S&P 500 index. The index committee will add bubble-ish stocks at bubble-ish prices. BRK will not be 'forced' to buy stocks just because they are 'big'. They will only buy stuff when it is high quality and is priced rationally. These are two things that the S&P 500 index committee do not seem to care about too much.

Sure, this inflexibility with regard to price and quality will be a drag on performance during certain time periods (like now, and back in the late 1990s), but I would feel more comfortable when my money manager is not chasing big stocks.

Also, check out the below chart. It's just the S&P 500 index since 1980 along with the BRK/S&P 500 index ratio. I just wanted to see, visually, how BRK has performed (price-wise) versus the index over time.

And what I see is kind of interesting.

S&P 500 Index and BRK/SP500 Ratio Since 1980

BRK seems to not do too well in late periods of raging bull markets (like the late 1990s) but seems to pick up a lot of relative performance during rocky times. This is kind of important for conservative investors. Whatever you think of the stock market now, there are pockets of bubbliness, and if that pops, it wouldn't surprise me if BRK has another big step up in relative performance like in the two circled periods above.

This sort of makes sense, right? As BRK doesn't have a whole lot of exposure to FANG/FAANG stocks. And if the market does decline a lot, that will provide a lot of opportunities for BRK to deploy cash so you are kind of sitting on cash optionality by owning BRK.

Yes, BRK declined 50% during the crisis, no better than the S&P 500 index, but if you look at the above table and charts, you will see that BRK does ratchet up relative performance during tough times. So just comparing peak-to-trough drawdowns sort of misses some important information.

By the way, here are some large declines in BRK stock over their history (from the 2017 Letter to Shareholders):


Stunning Discovery
OK, maybe not. But I just noticed something. Look at the above chart again; BRK price / S&P 500 index ratio. If you look at this chart, you will notice that the uptrend is pretty consistent and linear. OK, I am not going to go back and put a regression line on it (too lazy), but you can sort of imagine a straight line going through it from the mid-90's even through today.

Here is the chart again with the line I sort of see (this is not a regression line, but one I just drew by hand). The lower chart is the BRK/S&P index ratio:



And, importantly, there is no kink, bend or flattening after 1998!.

What does that mean?! It means the rate of BRK's outperformance against the index has been pretty consistent and hasn't tapered off at all! 

The ratio will measure the 'rate' of outperformance, not the absolute difference.

Here's what I mean. The above chart is based on prices, but I will look at BPS growth instead as the prices data is a little too spikey (and too sensitive to start/end points). As we saw above, in the period 1980-1998, BRK's BPS grew at a rate of 28.2%/year versus 17.7%/year for the S&P 500 index (total return), for an outperformance of 10.5%/year.  Since then, BRK's BPS grew 9.5%/year vs. 6.2%/year for the index for an outperformance of 3.3%/year. Looks like big degradation in relative performance.

But the linearity of the above ratio chart made me look at this another way. The 1980-1998 28.2%/year is 1.6x the index return, and the 1998-2017 BPS growth of 9.5%/year is 1.5x the index return! 

So, from now on, I am inclined to answer the question, "How do you think BRK will perform vs. the S&P 500 index in the future?" with, "I think it will do 1.5x better!".

Nonsense? Maybe. But it looks interesting to me. This is the danger with playing with charts.

Optionality at Low Cost
Moving on. This is not a new idea, but we can see all the cash at BRK as optionality (even though I have long said that the cash is matched pretty closely to float so wonder how much of the cash is actually immediately deployable. Some of the float might be 'fast', meaning maybe they actually can deploy a lot of that cash and run down the float if necessary).

A lot of funds held a lot of cash since the crisis and have severely underperformed the index. The worst fund managers have actually been net short since the crisis and have catastrophically posted negative returns for years on end. Sure, these guys had plenty of opportunity because they were short; if the market went down, they could profit on the decline and then use the profits to go long and make even more money! But, those guys were neither prudent nor rational, and it is unlikely they will ever be able to make up the damage as it is just too big to overcome.

And yet, here, we have BRK with all that cash and it seems like they haven't sacrificed all that much in terms of performance. That is really amazing when you think about it.

Leverage
By the way, BRK has $97 billion of cash/cash equivalents on the balance sheet just looking at the Insurance and Other segment.  This makes people say that Buffett is bearish the stock market. Well, it's true that Buffett has been having trouble finding stuff to buy, but that doesn't necessarily make him 'bearish'. There is a difference between not finding things to buy, and being bearish (and expecting a market decline).

One thing that occurred to me when thinking about this huge amount of cash and short term investments on the b/s is how small the investment in fixed maturity securities is: $18 billion.

So first of all, the amount of cash/cash equivalent sort of seems to me like more of a bearishness or unwillingness to buy bonds than stocks. There is only $18 billion worth of bonds in the insurance segment versus, what, $200 billion in stocks? That's not bearish stocks to me, that's more like, bearish bonds!

Not to mention BRK has been net purchasers of stocks; not the act of a bear.

Here's the other thing. When we look at insurance companies, we often look at investment leverage. For me, since I like risk, I look at the percent of shareholders equity invested in stocks. Markel looks at and talks about that, as it's a big source of their expected BPS growth.

So I think about BRK in the same way. Forget about cash vs. float and all that stuff for now.

Let's just look at how levered BRK equity is to 'equity'.

First of all, the portfolio (including KHC) is $219 billion at the end of 3Q 2018. That's against $379 billion in total shareholders equity (including minority interest). So the ratio of shareholders equity invested in stocks is 58%.  That's a lot higher than any other insurance company, and I think higher than MKL has been recently (maybe they are much higher now; too lazy to check now).

Of course, this is not like the old BRK, but not at all overly conservative either.

Now, keep in mind that BRK has a lot of unlisted businesses. For example, the various businesses in the railroad, utilities and energy used to be listed companies. If these were still listed, they would be included in equities. As far as growth potential is concerned, other than not having to mark to market, these businesses are basically no different than the equity portfolio (ignore the advantages of wholly owned businesses etc.).

So from the 'leverage' point of view, we can add this to the equity portfolio. The book value of this segment is $96 billion. With a similar argument for the Finance and Financial Products segment, we can add another $24 billion.

Sum that up and you get 'equity investments' of $339 billion.  That's against total shareholders equity of $379 billion. So that's already like 90% of BRK's shareholders equity invested in equity of businesses. That's really not all that bearish!

This, by the way, doesn't even include the other unlisted businesses, the Manufacturing, Service and Retailing Operations (MSR), which is the 'other' in the Insurance and Other segment. BRK doesn't disclose the balance sheet in detail for this segment, but in 2016, BRK equity in the MSR segment was $92 billion or so. Add this to the above $339 billion and you get $431 billion worth of equity investments at BRK against it's shareholders equity of $379 billion.

This is why you get equity-like returns on BRK despite BRK having so much cash/cash equivalents on the balance sheet. This is hardly the balance sheet of a bearish CEO.

Conclusion
I haven't even touched valuation here, but from all of the above, I like BRK a little more now than I have liked it in recent years.

I don't want to time the market and call a peak or anything. I have made it clear that even though we may enter a bear market or have a severe correction at any time, there doesn't seem to me to be a strong case to be made for an extended bear market in the U.S. at the moment (famous last words... I know!)

But the more frothy things seem (well, less so now with the October/November corrections), the more interesting BRK becomes for the above reasons.

AND, it is possible that you won't give up much in terms of performance to buy this 'optionality', with, of course, the greatest investor of all time ready to pounce if we have any big disruption in the market. And we can't forget that BRK has a lot more levers to pull than most conventional funds or even hedge funds; they can buy private businesses too, or do add-on deals to augment the many businesses they already own.

Plus, all that cash on the balance sheet doesn't mean it's as much a drag on BRK's performance as people make it out to be.

As for a post-Buffett world, I think what we need is intense rationality and discipline not to do stupid things. We know BRK is not going to jump into Bitcoin, or buy into bubble stocks (I fear we may find AMZN in the 13-F at an entry price of $3000 some day; that may be a sell signal!), panic and sell out stocks during a crisis or anything like that. And they will not be subject to quarter-to-quarter performance pressure in fear of redemptions. Many of these (and other) advantages are enough to keep me comfortable with BRK for a long time.

Also, even though BRK is not growing the way it used to, and it doesn't look like they are outperforming as much against the index, it looks like a lot of this is due to lower returns in the market in general as the rate of outperformance has been remarkably consistent even after 1998.

By owning BRK, you sort of get paid at least market performance while you wait for the optionality to be exercised!



BRK Corporate Governance, MSFT, Market Volatility etc.

So Buffett finally buys some JPM. He owned a bunch in his PA years ago and said it would be a conflict to own both JPM and WFC within BRK, or some such thing. I guess recent events (WFC scandals) have made him change his mind (as he may be starting to dump WFC). I've been a big fan of JPM for years, so naturally, I like this move. I wonder if Jamie Dimon would ever make it onto BRK's board; he would be a great fit there and would give the board some real, hands-on expertise in the financial industry (there is plenty of talent there, but noone with Dimon's experience/background).

This is the 13-F that was just filed (includes only positions over $1 billion):




Market Cap to GDP
Someone asked in a comment the other day what I thought about the market cap to GDP ratio, Buffett's once favorite stock market valuation indicator. This, like many other valuations measures, is really dependent on interest rates. If you believe (like I do) that interest rates drive the valuation of assets, then prices are high when rates are low and vice versa. So, of course, if interest rates are low, the market cap to GDP ratio will be high. But that tells us nothing about the valuation of asset prices as it has to be compared to interest rates. Plus, it doesn't really tell you anything about interest rates either. (A lot of bears like to point to 'overvalued' indicators, like this market cap to GDP, P/E, CAPE, EVITDA/EV, Dow-to-Gold ratio etc. But often, it's all the same thing, so it's like double counting. They all point to one thing: asset levels are high because interest rates are low. But, people still think of these above factors as separate, discrete pieces of evidence to show the market is overvalued.)

Not to mention, many U.S. companies are growing globally, so their sales and earnings from non-U.S. business will be capitalized in the U.S. stock market while the GDP will not include those new territories. If a U.S. company merges with a European company, the stock market valuation may well increase (while GDP does not). Also, when Yahoo owned Alibaba as Alibaba took off, the U.S. market cap of Yahoo (and therefore the U.S. stock market) increased (with no increase in GDP).

So in that sense, I don't think it's a relevant measure of anything these days. I still like to adjust interest rates to what we might think is a normalized rate, and then price assets off of that.

BRK Corporate Governance
Again, from the comment section, someone mentioned an analyst or author that is comparing BRK to fraudulent companies; BRK's corporate governance standard is comparable to historical frauds (ENR etc.).

Well, I am preaching to the choir here, and maybe I am just an ignorant, blind, cool-aid drinking BRK groupie, but every time I read these comments, I think it's ridiculous. It just takes a little bit of common sense to figure out the difference between BRK and the big corporate frauds in the past.

First of all, just for fun, I took a quick look at the corporate governance score of BRK on the Yahoo Finance page, and was surprised at the high score: 9 out of 10!
Corporate Governance
Berkshire Hathaway Inc.’s ISS Governance QualityScore as of November 1, 2018 is 9. The pillar scores are Audit: 1; Board: 10; Shareholder Rights: 8; Compensation: 6.
Corporate governance scores courtesy of Institutional Shareholder Services (ISS). Scores indicate decile rank relative to index or region. A decile score of 1 indicates lower governance risk, while a 10 indicates higher governance risk.
Not bad! But then, reading further, I realized that 10 means high risk, lol... Oops. So it is, in fact, the way I thought it would be. Just to be sure, I checked this at the ISS website.

From the ISS website:

THE METHODOLOGY BEHIND THE SCORES
Governance QualityScore uses a numeric, decile-based score that indicates a company’s governance risk relative to their index or region. A score in the 1st decile (QS:1) indicates relatively higher quality governance practices and relatively lower governance risk, and, conversely, a score in the 10th decile (QS:10) indicates relatively higher governance risk. Companies receive an overall QualityScore and a score for each of four categories: Board Structure, Compensation/ Remuneration, Shareholder Rights, and Audit & Risk Oversight.

WFC, by the way, with all it's scandals, has a QualityScore of 1.

Out of curiosity, I looked at MSFT and check this out: 
Microsoft Corporation’s ISS Governance QualityScore as of November 1, 2018 is 1. The pillar scores are Audit: 1; Board: 1; Shareholder Rights: 1; Compensation: 3.
Amazing!

MSFT
OK, and check this out from the proxy:
The vast majority of our global employees participate in an annual anonymous poll. Here is a selection of results:


LOGO


That sounds crazy too, for a large corporation. I don't know how 'real' this is, as we all know how people may be 'nudged' to fill out surveys in ways favorable to management. Well, they say it's anonymous, so OK, maybe it's legit. 

I have become in recent years a big fan of MSFT, both as a user and an investor.

My MSFT Experience
I have been tied to MSFT for most of my career as company PC networks were usually run on Microsoft and desktops were usually Windows NT or whatever. Of course, we also had Unix machines running the serious stuff, but most office work, spreadsheet work and whatnot were done on Windows machines. 

After going out on my own, I stuck to Windows, but I got increasingly frustrated at how often Windows would crash/freeze. Some days, I thought I spent more time waiting for things than actually doing any work. And then they killed XP (which I had on some of my old machines).

A programmer friend suggested I look at Linux, so I did. I installed Linux on my old laptop and eventually one of my old PC's, and I loved it. It was rock-solid and stable, like the Sun workstations (Unix) I used to work with that you never had to reboot or restart. I was seriously contemplating switching everything over to Linux and ditching MSFT altogether. 

One thing holding me back was that a lot apps written for Windows is not available in Linux (well, you can still run Windows apps with Wine, but I was a little skeptical/worried that there would be issues if there was another layer). Otherwise, I loved everything about Linux. I use GIMP now all the time for photo processing (like the Buffett photo in my last post), Libre Office is great and is getting better etc. Plus my Linux machines never just randomly go into these long updates. 

Well, one of my favorite things is how easy it is to run cron jobs in Linux versus Windows; I really hate the Windows task manager. A lot of other things are just so much easier to do off the command line in bash (although Powershell is getting pretty powerful, but it's so clumsy/clunky, I don't feel like learning how to use it properly). 

Back to Windows
But OK, I never abandoned Windows. But what sucked me back in and made me abandon the idea of switching over completely to Linux was Windows 10. I was skeptical, but upgraded all my Windows machines to Windows 10 (forgot when), and I have been very happy. Yes, if you are not careful and don't set your 'active' time, it can go into long update cycles rendering your computer unusable until the updates are done. This is forced so you can't stop it. But you can tell Windows what hours of the day you will not be using the machine, so the forced updates will happen in those inactive hours. 

OK, small problem. 

But since switching to Windows 10, I have had very, very few problems I used to have. Random crashing, random freezing etc. I have not had that occur much at all and it's been a pleasant surprise.

Also, Windows 10 comes with Ubuntu bash so if you like Linux command line stuff, you can do it all in a bash terminal right on the Windows 10 machine and in those drives/folders that Windows runs on (goodbye cygwin?!). 

The other major thing that drew me back to Windows is OneDrive. I used to do work on my home desktop and my laptop, and I used to have to email files back and forth to work on them. You can use Google Drive, Dropbox, Box etc. to sync files on your various machines, but I never got around to doing that with the above, and I didn't like how Google Drive seemed to keep altering my files (especially programs) when I uploaded them. 

But OneDrive was so easy and is basically already set up from the get-go in Windows 10. Now my most active folders are on OneDrive, I never have to worry about syncing anything; it's all done automatically.  

I think this is one of the big things that got me tied to Windows now. 

Plus, I am playing with Azure now and it is very easy to create Linux instances (basically virtual machines in the cloud) so you can write bots and set them up to run as cron jobs and your tasks will be done whether your PC/laptop is on or not. Plus they have databases and many other cloud services (I use Amazon too, but mostly for fun/experimenting). 


So when you think about how all of this is integrated and everything works great with each other, you can see how excited I am about MSFT. A programmer relative told me a few years ago that MSFT sucked for most of their existence, but that with C#, Azure and other cool things, they are becoming a really incredible company. (I am also experimenting with C# but haven't created anything for actual use). Of course, at the time, I didn't really look into it or understand. 

Anyway, this is sort of relevant, right? As IBM just bought Red Hat, which is a Linux business. Anyway, I still love Linux and have a Linux box sitting next to my main Windows 10 machine. Linux will continue to grow, and behind the scenes, Linux runs everything, and will run even more going forward.

And check this out. I just recently noticed that Stanley Druckenmiller is big into MSFT: 



So he is probably seeing and hearing the same things I am talking about. Well, OK, I have no idea why Druckenmiller is long MSFT. But I would assume it has something to do with what I'm talking about.

Oh yeah, and I really enjoyed Nadella's book: Hit Refresh.

With the FANG/FAANG stocks so popular, who knows, maybe MSFT is the tortoise that surprises everyone!


Back to BRK
OK, so there is probably not much I need to say on how silly it is to criticize BRK's corporate governance. Check this out from the BRK 2018 proxy: 


This list doesn't show a group of people who really need the money. I think the average compensation for a big company director is something close to $300,000. If you wonder why so many board members seem to be yes-men to the CEO, this may be one reason why; it's good money! Don't rock the boat, keep quiet and keep cashing your checks!

It's clear from the above table that BRK directors are not there for the money. And sure, they are friends with Buffett so are they really independent? I would rather have directors that understand Buffett and BRK well, and have enough of a spine to express themselves if they see something they don't like.

There is a lot more to say on this but one of the biggest arguments in support of BRK's structure is that Buffett himself is the largest shareholder of BRK, so if this was a fraud, who is he defrauding? Himself? That's laughable. He takes a $100,000 salary but the bulk of his wealth is created by BRK's stock.

This is the opposite of most situations, where managements own token amounts of stock (and dump their stocks whenever they exercise their options) and pay themselves massive amounts of money. When you own very little stock but pay yourself huge amounts, I think that incentivises fraud more. Don't you think?

When a CEO has 99% of their wealth tied up in a stock, that is stronger than any corporate governance factor I can think of.

But corporate governance specialists, critics and academics don't seem to understand that. They would rather check the boxes on what they inflexibly think of as good corporate governance practice and that's it. I guess part of it is laziness, and part of it is just practicality.

Institutions that own a large number of companies can't possibly evaluate that many CEOs, BODs, etc. so they need some simple measure to save time. Like P/E ratios, maybe. Those that don't know how to evaluate businesses may have to depend on P/E ratios to evaluate cheapness, but if you know how to evaluate businesses, P/E ratios often don't really matter (as they don't tell the whole story, like, in the case of BRK!). 

Abdication/Transparency
I mentioned this in the comments section of another post, but the other issue is that Buffett is so hands off the businesses to the point of abdication. But this is misleading. We all know Buffett watches numbers like a hawk. He said he gets faxed sales figures every day from various businesses and he looks at them carefully every day.

What he means when he says he is hands off is that he doesn't micromanage. He doesn't insist on seeing every ad before airing. He doesn't want to interview and approve every new hire. He is not going to approve every paint job of a store, or pricing/marketing strategy of each business. He is not going to approve each detail of every budget for every line of business.

But this doesn't mean that he isn't watching every penny that goes in and out of the businesses. We all know that all of the free cash of a business is sent to Omaha, so if something is wrong, he will know right away.

For the businesses where things may get funky, like the insurance businesses, those are highly regulated, and Buffett is very closely monitoring those businesses and is very involved as he says, with big blocks of business (talks to Jain several times a day etc...).

As for transparency, I don't know. I never thought BRK lacked transparency. It could disclose more, of course, but I never thought of BRK as a complete black box or anything like that. Major business lines are presented clearly and in detail. Some of the non-insurance businesses might be opaque, but each of them are just too small to disclose separately.

Some fuss is made about the Sokol incident, but those things will happen every now and then to any company. Goldman Sachs has a lot of legal and compliance infrastructure, is highly regulated and constantly audited, and yet we now have the 1MDB scandal. So I don't know that the Sokol incident proves anything about BRK either way. You have to look at the big picture and see the kinds of problems they've had over the years, and the record is pretty good. Will another scandal happen? Yes. These things will happen. It's how management deals with it that will determine the fate of BRK, and I have faith that they will deal with any issues in the future promptly.

As Munger says, it's all about incentives, and I think BRK people are properly incentivized.

Remember what Buffett said after the crisis. He said that there was a regulator who had one job, and that was to regulate FNM and FRE, I think. And they failed. So just because you have someone watching and regulating, if the incentives are not correct, you are going to have problems. 


Market Volatility
So, I was a little irked when the market was down 600 points the other day when I was on my way out of the house. I know I don't really care, but still, at the back of my mind, I think, is this it? Is this the end of capitalism? Are we going to go down 90% like we did in 1929-1932? OK, I wasn't that worried, actually.

But it made me curious. Why are we so scared of big market moves like this? 600 points is a little more than 2%. Back in the late 1980s and early 1990s, a 2% move would have been a 50 point move. 600 points is psychologically shocking because Black Monday was a 500 point drop. So it feels like Black Monday again (that was before my time!).

I tend to buy into narratives I don't really care about. The HFT/quants are making the markets more volatile. ETFs, especially leveraged ETFs are making the markets more volatile. More regulation in the markets and the resulting decrease in liquidity (thinner bid/ask from market-makers/specialists) are making the markets more volatile etc...

I go, hmm... OK. Probably true. But whatever. Doesn't matter to me.

But sometimes, I suddenly think, wait a minute. Is all of this true?!

Let's take a look!

First of all, let's just take a look at the market's volatility on a rolling 100-day basis. This is what derivatives traders would call the 100-day historical volatility. I looked at this going back to 1950. All of the following charts include data up to this past Monday (11/12/2018).




So, looks pretty normal. Even with the big moves in the past few weeks, nothing out of the ordinary here. In fact, I would have guessed things were pretty wild since Trump was elected, but if you look back to even 2012, 100-day vols have been in a normal range. It certainly doesn't feel that way.

OK, so maybe vols don't tell the whole story. Let's look at some other things.

We've had a few days where the market was down more than 2% recently. Or it feels like it happens a lot. So, I looked to see how often the market went down more than 2% on the day. To make it a readable chart, I just summed up how many times the market declined by more than 2% in the past 200 days.

Here's that chart:




So yes, it's a little elevated, but nothing really out of the ordinary. Look at the period during the crisis! Also, look at the mid to late 1990s, even before the bubble collapsed.

What about those days the market opens down 800 points and closes up 300, or some such crazy thing? It seems like that sort of thing happens a lot these days. If I had to guess, I would tell you that that happens more often these days than in the past.

To measure that, I just subtracted the day's high from the day's low and divided it by the day's close, and then took a 100-day average of that.

Here is that chart going back to 1962 (hi-lo data only goes back to 62):




...and surprisingly, this too is in a very normal range, and far below the levels of even the mid-90s (I guess the day traders used to make this really wide). Nothing out of the ordinary here.

And let's look at the number of days in the past 100 days that the day's range exceeded 2%. 



Totally normal range. Nothing out of the ordinary.

Conclusion
JPM is now a BRK stock. Get Jamie on the board! He would be the person I trust most next to Buffett.

BRK scores low on corporate governance, but so what? Look at the incentive structure, which is more important than committees, bureaucracies like compliance/legal departments etc.

People who write to complain about BRK are people who just don't understand, or just use BRK to grandstand and gain attention by making astounding claims against consensus (this is why people like to say "the market is going to crash 50%!", or "the market will get to 500,000!"). So ignore those people.

Microsoft is pretty awesome. I never made a post about it as an investment; I should have when I started to get interested, but oh well. Maybe eventually, but I don't really have anything to add to MSFT in terms of financial analysis/valuation.

And, the markets seem like they are crazy and more volatile than ever, but the above charts don't bear that out. People, the press, keep freaking out over 2% moves as if they are 10% moves. The markets, despite all the things that should make markets more volatile than ever, are just as volatile as they ever were and no more.  So relax! 

Is Buffett Bearish?!

This is going to be a short post. It's just another one of those things that hit me in the head, like, duh! 

I read all the time that even Buffett is bearish the stock market as he is stockpiling a ton of cash. He has close to $100 billion in cash (and equivalents) on the balance sheet now. The idea is that the market is so expensive he is not finding things to buy (even though he is still buying Apple).

I took it for granted and sort of agreed, thinking that maybe he is just saving up for a really huge deal.

Still, something about this bothered me and didn't sit well. I was catching up my 10-Q's and just read BRK's 3Q and saw these giant numbers on the balance sheet, and something else struck me too, right away. Loss and LAE is up to $100 billion

And that immediately reminded me of one of my old posts where I contended that Buffett never allows cash, cash equivalents and fixed income investments to fall very far below float (old-timers will remember this). In other words, the idea that the low cost "float" is invested in stocks and operating businesses, to me, is baloney. Well, cash/capital is fungible so you can't say float isn't invested in stocks. But still, I noticed this and made a big deal out of it. Well, sort of.

Anyway, I just created a new spreadsheet going back to 1995 to see if what I said is still true (well, there is no reason the historical data would change, of course).

And here it is:

Berkshire Hathaway Cash and Fixed Income vs. Float

I shouldn't be surprised at this as I noticed this myself a few years ago. But check it out. I think people think Buffett is bearish because he used to say that he wants $20 billion of cash on the balance sheet at all times for emergency liquidity. And when cash gets over that amount, it is assumed that this is 'firepower' for the next mega-deal.

By the way, my float is not the same float as Buffett's. For simplicity, I only include Loss/LAE and unearned premiums.

Anyway, check it out. All of that cash and cash equivalent increase is basically just matching the growth in float! And to the extent that cash and cash equivalents have grown quicker than float reflects the reduction in fixed income holdings (from $36 billion in 2009 to $22 billion now), which is more of an indication of Buffett's bearishness on bonds.

The column all the way to the right is just the cash, cash equivalents and fixed income investments as a percentage of my lazily calculated float. You will see that it has been close to 100% since 1995, and I think it was true going further back. The average over this period is the 105% you see at the bottom of the table.

Conclusion
Anyway, the next time someone tells you that Buffett is bearish; just look at his cash stockpile, you can say that is more reflective of his bearishness on bonds (bond balance down, cash up), and the rest is backing up the float, as he has been doing since at least 1995.

JP Morgan 2016 Annual Report (JPM)

I haven't posted much about JPM recently as it's still basically the same story. Great CEO building an awesome company performing really well etc.  After even a couple of posts, they are basically the same.

But since I haven't been too active here recently, I figured why not? Let's take a look at this. There is a lot to learn here, not just about banking and the economy, but about markets and investing too.

So first of all, let's look at how well JPM has done in recent years. And it's not just because of the huge bull market since 2008. If you look at the performance figures below, they go back to 2004, and the performance chart in the proxy is from 2007, which is the benchmark I use to get 'through-the-cycle' returns.

Anyway, Dimon's Letter to Shareholders is really good so go read it if you haven't done so already. I sort of look forward to this one even more than Buffett's lately.

Check out the total return of JPM stock over various time periods:



This is really crazy given what has happened since 2000 and particularly after 2007. Back in 2000, I don't think anyone would have guessed JPM stock would outperform the S&P 500 index over the next 16 years. People were bearish the financials after the collapse of the 1999/2000 internet bubble, especially JPM which had a large investment bank attached to it with trillions in notional derivatives outstanding. For years, JPM has been considered the first domino in the coming financial collapse.

And yet, look at that! Yes, bears will argue that JPM got bailed out during the crisis etc. I've talked about that a lot here so won't go into it too much, but I disagree. I agree that the government bailed out the whole system, which is what it should do (that's what the Fed is for, and that's what the government has the power to do in extraordinary situations).  But I don't think JPM was in any danger unless the whole system itself collapsed, in which case nothing would matter anyway. 

So let's look at the performance of the company itself:


This is just totally insane. TBPS has increased even more than the stock (total return).

Here's a chart from the proxy that is indexed to 2007:


That's a 10.5%/year return since 2007.  That's crazy. Let's say you knew that the worst financial crisis would come and almost destroy the country. People would have called you an idiot if you said, "Fine. I don't care. My stock will return 10.5%/year over the next 9 years!".  In fact, I did own JPM and didn't sell in front of it, even when cracks appeared. I didn't sell any during or immediately after either. 



Investment Lessons
And here's sort of the lesson on investing. It was widely known that Dimon was a super-competent manager when he took over Bank One. I think he was already considered at the time one of the best managers in finance. When he left Citigroup, many thought C would collapse because Dimon was the detail guy that made sure everything was OK.  Sandy was a big picture guy while Dimon chased after the details. No Dimon == noone looking at the details => eventual blowup. (I heard this from someone that was there at the time and watched how they worked up close too.)

But a lot of people didn't invest in JPM because it was a large money-center bank and banking cycles tended to be severe. Everyone remembers the banking crisis of the 1970's and the late 80's/early 90's.
So the thought was 'thanks, but no thanks'.  I confess I was one of those. I've owned Bank One since forever and JPM too, but never allowed it to become a huge position because of that. (On the other hand, I would not mind being 100% in Berkshire Hathaway, even though BRK has gone down 50% on a number of occasions).

In 2007, bank stocks were expensive and we were at the tail end of a very long credit cycle. Contrary to the claims of some best-selling books, the leverage built upon shrinking credit spreads was pretty well-known within the industry. It would have been wise to not be too exposed to financials at this point.

But, when you own a great business run by great people, it is often better off to ride out the cycles than to try to time them.  And that's another lesson here with JPM stock. This is not really hindsight trading either, as I would have told you back in 2007 (and I think I did even though this blog was not in existence back then) that JPM and GS would be the survivors in any crisis, and they would come out the other end bigger and stronger (as Charlie Munger says about how great companies grow; they grow in bad times, just like Rockefeller, Carnegie and everyone else did).

The argument back in 2007 really focused a lot on the notional derivatives outstanding at JPM. This was one of the major red flags that kept some investors away. I have managed derivatives before so understood that notional amounts outstanding is not a measure of risk. When you are a big banker and dealer, you end up with huge amounts of notionals outstanding because, for example, if you issue bonds for an issuer, you sometimes do interest rate swaps to accommodate the client's cash flow needs. Same with FX. As a major FX dealer, you often use swaps as a tool to help risk-manage clients' risk exposure.  Those 'straight' swaps often have very little risk.

Cyclical or Secular?
The other lesson is that markets have cycles. After the financial crisis and after JPM has shown its resilience and management competence, it traded cheaply for a long time. Even the most prominent bank analysts would say things like, "Yes, it's cheap, but there is no reason to own it as regulations make it hard for them to make money...". I've heard that argument over and over again post-crisis.

But these folks held a linear, static model in their heads. They didn't realize, or underestimated how the industry would adjust to new regulations and requirements. If the regulatory capital burden got too heavy in a line of business, they would drop it. They can cut expenses. They can reprice products as new regulations apply across the industry.  Sure, they may not get back to bubble-era returns, but banks don't need to to be good investments.

Maybe this was due to the short-term nature of Wall Street; with regulatory headwinds and low interest rates, bank stocks were simply not recommendable.

Either way, long term value investors look to invest in great businesses at reasonable (or cheap if available) prices.

And interestingly, now, hedge funds and others seem to be piling into banks.  Nobody wanted JPM at $20 or even $40, and now they are piling in at over $80!  And people say the market is efficient, picked over etc.?

I think all of this sort of just illustrates the cyclical nature of markets. The key in successful investing is being able to see the difference between cyclical and secular. It's true that this is very hard a lot of the time. But I never thought banking itself was in secular decline. Every year, Dimon has shown how much business needed to be done over the long term in banking.

Regulations tend to be cyclical too as the pendulum can swing wildly from one extreme to the other. We are now seeing the pendulum start to swing back the other way. As Dimon says, a lot of this can be done (simplify regulations) without congressional action.

By the way, I have a lot to say about this, maybe in future posts, but I do believe that this max exodus out of hedge funds too is cyclical, as is the move towards machines (vs. people) / indexing. I do believe that most hedge funds probably don't deserve to exist, and machines will more and more take over money management, but I think it will still be very cyclical.  We have seen this before in the past; move to quantitative money management, indexing vs. active, hedge funds vs. index etc...

Buffett and WFC
And this sort of thing explains why Buffett has been buying WFC for all these years, even right before the crisis. I always heard comments like, "doesn't Buffett see this big trouble brewing? This huge storm?  Doesn't he understand that the era of big banks is over?". He has been buying before, during and after the crisis at 'high' prices.

He focuses on what a business can earn on a normalized basis over time, so he doesn't care about the short term outlook. He doesn't care about what other people say. He doesn't worry about downturns as strong institutions should be managed to survive and grow in such situations. Trading in and out to avoid such dips is a loser's game.





2x Tangible Book
Dimon says it was a no-brainer to buy back stock at 1x tangible book, but says this year that it still makes sense to buy back stock at 2x TBPS. That would be over $100/share!

That sounds insane. Who would have even guessed JPM would be closing in on $100 just a couple of year ago? 

Assuming a 50% payout ratio on $6.00 or so in EPS, that would be $3.00/share in dividends.  Using a $100/share price, that's a 3% dividend yield.  Assuming JPM grows along with the economy (4% nominal), that's an expected total return of 7%/year against what I would assume a normalized long term rate of 4% (actual is 2.3%).  As a sanity check, EPS grew around 4%/year from 2007 to 2016. 

OK, students will immediately jump on me and argue that earnings growth should be 6.5%/year for a 9.5%/year return (50% retention at 13%). Well, JPM is a big bank so it may not be able to grow that much more than GDP over time, so let's just say earnings grow at nominal GDP.  That would just mean that payouts would be higher as capital can't be invested at a 6.5% growth rate.  

In that case, payouts may be 70%.  On a $6/share EPS, a 70% payout is a $4.20/share dividend for a yield of 4.2% (again, at a $100 stock price).  4.2% dividend yield plus 4% growth is 8.2% expected return. 

This reminds me of Buffett talking about how he bought a stock yielding more than the financial products the company was selling. 

Of course, as we wait for things to normalize, bad debt may normalize too; JPM is sort of over-earning in the sense that credit trends are really good now. This has probably bottomed out and should head higher. I don't think there are any time bombs at JPM, but it will sort of be a race on the economy picking up steam and interest rates normalizing versus credit trends bottoming out. 

But of course, stocks never trade at what they are supposed to trade at. Which leads to my next digression.

Models and Odds: Ed Thorp Book
I was actually going to make this a whole separate post; maybe I still will.  But writing the above got me back to thinking about models, odds and things like that.

This goes back to the argument about stocks being expensive or not, wondering about being short because the market is overpriced and losing money for years on end etc.

I just finished this book by Ed Thorp:  A Man for All Markets

And I have to say it's one of the best books I've read in a long time. It's not a manual like Securities Analysis or the Greenblatt books, but an autobiography.  But it is a fascinating read. Some may be disappointed by the lack of mathematical details, but this is not meant to be that sort of book. In any case, the math involved in what he talks about is widely available now anyway. But the thinking that went behind figuring all this out is fascinating.

Other than his adventures in Las Vegas, I've been involved in just about every area he talks about in the book, from options, warrants, convertible bonds, closed-end funds, even the Palm stub trade, statistical arbitrage etc. (One thing he fails to mention about the Palm trade is that even though it looks like the market is inefficient, in some cases, there is no stock to borrow to implement the trade; rebates go through the roof and reduces or takes away potential profit etc... The stock lending side is often not as visible).

For Buffett fans, there is a whole chapter on Warren Buffett, which is fun to read. They knew each other and Buffett even checked him out over dinner long ago.  Thorp also invested in Berkshire Hathaway but moved his money elsewhere as returns went down as BRK got larger.

One interesting fact that Thorp mentions is that the Buffett partnership returned 29.5%/year, gross, in the 12 years from 1956-1968 versus 19%/year for small caps stocks and 10% for large caps. I knew Buffett made his money buying small/microcaps back then, but it was surprising that a good half of the outperformance came from the small cap bias.  Maybe I should not have been surprised.  But anyway, I did take note of that as I read the book.

OK. Back to models. Early in my career, I spent a lot of time creating models; economic models, stock market valuation models, statistical models, single stock valuation models, technical trading systems, mean-reversion trading models (early stat-arb) etc...

And what struck me while reading the Thorp book was the difference between the typical economist who creates models and the traders that write models.

Economists plug in all these numbers and tell you that the economy should do this or that, and that the market should be valued here or there. And sometimes, they get all caught up in their models and think they are absolutely right and get their head handed to them.  I've seen this happen time and again. One benefit of working at a large firm was that I sat through many presentations (people pitching big banks to fund their proprietary trading models/ideas).  And a lot of the ideas lacked real world common sense.

And then you read what Thorp did. For example, he created the option model before or at the same time as Black-Scholes etc. This model told you what an option or warrant was theoretically worth. But the model would have been useless if there wasn't a way to capture the price difference. You can hedge the option by trading the stock and capture any mispricing.

All of the strategies that Thorp was involved in had very specific odds attached to them, including the possibility of adverse outcomes. What are the odds of this or that? What happens when you are on an expected, normal losing streak? You have to have enough capital to be able to stay in the game. Traders' models usually have a "what if this happens, or what if that happens? what are the odds of this or that happening?".  Economist models are like, "This is what will happen and all the back-testing proves it will happen... we have calculated to the seventh decimal places using 30 models and they all confirm we are right". If you ask them, but what if reality deviates from the model? They say, "it won't because we are right".

Even some investors I respect had a huge hedge on their equity book that lost them tons of money. It made sense on the surface; stocks are expensive so we must hedge our equity exposure. The problem is that, as I have shown in previous posts, overvaluation is a very poor reason to go short the market or put on hedges (well, it might make sense to do some hedging).

I've seen the bubble in Japan in 1989 and the U.S. bubble in 1999 and I would guess that most people who correctly identified those as bubbles didn't make money when the markets collapsed. It was stunning how many funds were hurt during the late stages of the bubble and weren't around to capitalize when they were proven correct.

The problem with overvalued markets is that the odds of a blow-off are pretty high, and when things blow off, the more expensive things are, the higher they go. So, if you own a bunch of value stocks and hedge using the S&P 500 index or some other market cap-weighted index, you will probably be destroyed as the expensive large caps will go up the most.  (This reminds me of something I did long ago; I owned some value stocks that went up 20-30% so was proud of myself, but was short Starbucks against it and that doubled... Oops.  So much for hedging a value portfolio with a growth/mo-mo stock).

There was an interesting article recently that said that a bubble isn't a bubble unless the market has gone up 100% over a period of two or three years or something like that.

This is why people like Thorp would not make directional bets on the market. One can easily observe that markets are expensive, but what is the edge that that specific observation brings to you?  I remember Buffett telling someone, when shown a chart of how overvalued the stock market is, that it's just a squiggly line and it can go this way or that way, who knows which way it would go? That seemingly 'clueless' response is much wiser than it seems on the surface.

If you hedge using market-cap weighted indices or go net short, can you survive a real bubble-like blow-off? What are the odds of such an event occuring?  Is it really zero? I bet that this is not even incorporated in most models or the thinking of most investors. Of course, most of the quant funds would have this worked out (or hedged out); quants don't like to take risks that they can't hedge.

On the other hand, if you are a long manager, do you need to care about the odds of a correction? No, because if you own solid stocks that won't go bust (like owning JPM from 2007-2016), then corrections don't really matter. You just ride it out. The only way the market can break you is if the companies you own actually go out of business.  Otherwise, you may just have to wait longer to realize value. But otherwise, there is not that much risk.  This is not true when you are short, of course; it is much easier and probability of survival higher for a long to live through a bear market than the other way around.

Cheap Labor
Back to JPM. The great thing about JPM is that we get all of this for so cheap. OK, 'cheap' may be offensive to average folks out there earning normal salaries. So I shouldn't say that too much. But still, cheap is cheap. We paid Dimon 0.1% of profits. Compare that to other financials! (from the proxy).  Let's not get into hedge fund fees here.



...also from the proxy:



And for the Berk-heads here, a familiar new face on the board:



OK, this is getting way too long.  There is a lot more in Dimon's Letter to Shareholders so go read it. I may post more about it later (but maybe not), but let me just get this post out before more time goes by without a post!


Buffett on Valuation

Buffett was on CNBC the other day and it was very interesting as usual. Well, most of what he says is not new.

Not in Bubble Territory
Anyway, he was asked about the stock market and since so many people keep saying that the stock market is overvalued or that it's in a bubble, I found it interesting that he says that, "we are not in a bubble territory or anything of the sort now."

He said that:
  • it's a "terrible mistake if you stay out of a game because you think you can pick a better time to enter it...", or something like that. He's been saying the same thing for years. 
  • if interest rates were 7 or 8%, prices will look "exceptionally high", but that measured against interest rates, stocks actually are on the cheap side.
  • if interest rates stayed at 2.30% over the next ten years, "you would regret not owning stocks".
  • we have to measure against interest rates.  Interest rates acts as gravity for valuations.
  • compared the long bond to an entity trading at 40x earnings with no growth and said stocks are attractive compared to that. 

This agrees with the charts/analysis I've been posting here relating P/E ratios with interest rates.

I know  there are quants who say this is wrong, that P/E ratios can't be compared to interest rates (we discussed this in the comments section of one of my posts about P/E's). I understand that argument, but history shows that the market does in fact use interest rates to value the stock market however theoretically wrong it may be, and the greatest investor of all time does so too.

What if?
OK, many commentators and pundits are baffled at this huge rally in the stock market thinking it's insane and taking the market to extreme valuations.  I have been posting here for a while that the valuations aren't all that extreme given the interest rate environment, even if you assume interest rates go up a lot from here.

Well, Buffett says if rates get up to 7-8%, then stocks are really expensive. But will rates get up that high? Even though I'm not an economist and have no idea what interest rates will do (actually there is no relationship between the two), I tend to believe that interests rates will get to 4-5% at most, on average.

So, let's play a simple what if game. This is not a prediction or anything, just a scenario that sounds plausible and is not at all a stretch.

What if GDP growth is stuck, more or less, at the 2% level?  Maybe Trump gets it up to 3%, but a lot of people don't think that is possible (except Jamie Dimon who thinks we can go much higher in terms of growth). And let's say that inflation does tend towards the 2% level.  That gets us to a nominal GDP growth of 4% or so over time.

Let's also assume that long term rates do revert to the level of nominal GDP growth.  Then long term rates would get to 4%. Of course, there will be overshoots in both inflation, GDP growth and interest rates. But over time, it's not hard to imagine interest rates averaging 4%. Total debt levels, demographics etc. make it hard to imagine higher nominal GDP growth.

So using the earnings yield-bond yield model, let's assume that the earnings yield tracks closely to the long term interest rate of 4%.  That means, over time, that the P/E ratio can average 25x in this environment.

Right now, 25x P/E ratio just seems super-expensive to many people because they look at the past 100 years and the stock market hasn't stayed at the 25x level for very long and has more often signaled a major market top than anything else.

But given the above scenario, it's not really inconceivable that the market P/E gets up to this level for an extended period of time. Some will argue that Japan has had lower interest rates and has been unable to sustain a high P/E ratio, but Japan has a lot of problems at the micro level too (companies not allowed to cut costs in their system of "corporate socialism" where large corporations are expected by the government to carry the burden of unproductive, unnecessary workers).


S&P 500 at 3250, DJIA at 29,000
The consensus EPS estimate for the S&P 500 index is $130. OK, I know that this will come down throughout the year, but that's what we have now so let's just use it. I'm not making a prediction or anything, just conducting a simple thought experiment.

Using the above, future average P/E of 25x, that would put the S&P 500 index at 3250!.  Using the same percentage increase, that would take the DJIA to 29,000!

Believe me, that sounds just as stupid to me as it does to you. I'm just making simple assumptions and plugging in numbers. My own personal experience (anchoring?), however, makes these figures hard to swallow.

But you see, it doesn't take much for the market to get up so high, and I am using a 4% interest rate, not 2.3%! So a large increase in interest rates is already built in.

Sure, inflation can get out of control and rates can go higher. I am just trying to figure out a long term, stable-state, through-the-cycle sort of scenario, and 4% rates and 25x P/E ratio just seems normal in that sense.  OK, so we can expand that to 5% rates and 20x PE; so let's just say rates can get to 4-5% and P/E ratios to 20-25x without it being stretched in any way.

Again, this sounds crazy and sort of feels like 'new era' thinking and Irving Fisher's "permanently high plateau". I know. Every time I make a post like this, I feel like I am putting in the top. But this doesn't feel like justifying anything new. In fact, I am insisting that things will go back to the way they always were; P/E ratios will be driven by interest rates, interest rates will be determined by nominal GDP growth rate etc.

I'm not making any outrageous assumptions like real GDP growing 4%/year or earnings growing 15%/year into perpetuity or anything like that.

And keep in mind that in this scenario, this is just the future 'average'. The markets can get much higher than 25x P/E in a manic phase and much lower in times of panic.

In fact, this has already been happening. The stock market has been overvalued in the eyes of many since the 1990's and hasn't reverted back to 'normal' levels in a long time. I think the error is that many look at raw P/E's and don't account for interest rates.

Not to be Bullish
And by the way, I have been saying this sort of thing over the past few years not because I am bullish; I am actually an agnostic (but bullish over the long term). I say this stuff to counter a lot of the "market is overvalued so it must go down!" argument and to caution people (and myself) to stay the course and act rationally.

Some funds claim to use a lot of sophisticated models and they write great reports, but at the end of the day, they are just net short the market (and have been for years!). That's just gambling; betting all their client's money on a single trade. Crazy.

Trust me, I get the same queasy feeling you do when I type 25x P/E. I honestly don't know what I would do with the S&P 500 index at 3000.  I know I would be very uncomfortable (if it happened within the next year or two).

So I'm not really being a Pollyanna.

When considering this stuff, it becomes less of a mystery why Buffett would spend $20 billion buying stocks since the election (or including some buys just before). And it becomes a big mystery why anyone would want to be net short this market (unless you are a short term trader who will be in and out as markets rally, like some hedge funds do etc...).

Sanity Check
And by the way, when all this talk of high P/E's make you nervous, just go check out my valuation sanity check page at the Brooklyn Investor website. This is updated after the close every day.

    Sanity Check

I often look here to make sure I am not seeing the trees looking like the Nifty Fifty.  When I see 20x or 30x P/E ratios on the S&P 500 index, I look at individual stocks to see if I see the same thing. If I do, maybe I worry. If I don't, I don't worry at all and assume the high market P/E is due to large cap, speculative names trading at high P/E's and/or hard-hit industries dragging down the 'E', or some of both.

Speaking of the Nifty Fifty, in the Bogle book I mentioned here the other day (Bogle book), he mentions a Jeremy Siegel study that showed that 50 nifty stocks bought at the start of 1971, near the peak, marginally outperformed the market over the subsequent 25 years.  Nifty Fifty returned 12.4%/year versus 11.7%/year for the stock market.

That's kind of crazy.  Even if you bought the Nifty Fifty at near the top, you would've beaten the market over the next 25 years, returning an above average 12.4%/year. By average, I mean the market returned 10%/year in the past 100 years or so.

Pzena Q4 Commentary
Pzena Investments posted their Q4 commentary and it follows up on their theme of the value cycle, and it is very interesting.

Check it out here.

Anyway, it shows that value has started to outperform again but that we are still early in the value cycle. Check out the tables and charts below.






I thought that was really interesting and I tend to agree with it. As much as I agree with Bogle and Buffett about indexing, there does seem to be a big, extended move in that direction which would have impact on valuations of individual securities, so it seems to make sense that maybe individual stock pickers can start beating indexes again (but don't bet on many being able to do so).

I still have a lot to say (or at least think about) in terms of fund managers, but that will have to be in a future post.




Six Sigma Buffett, Taxes, Fund Returns etc.

Whenever I read about Buffett and other great managers, what I tend to see all the time are things like, "xx has beaten the market y out of z years; the odds of that happening are 1 in 5,000!" or some such thing. Not too long ago, there was an article about managers with outstanding performance and the screen was based on who beat the market five years in a row, ten years in a row or something like that.

But for me, I tend not to care about that at all. In fact, I would rather invest with someone who only beat the market seven out of the last ten years but with a wider and more consistent margin than someone that beat the market ten years in a row, and only with a small margin.

So that got me thinking about what I should look at. Well, when I say that, I don't mean that I would use this stuff to choose investment managers since I don't really invest in funds at all. What I mean, I guess, is that if I don't like the above 'beat the market x out of y years', what is a better indicator?

Tax Digression
But before that, I just happened to be reading the 1986 Berkshire Hathaway letter to shareholders and came across this comment about taxes.  Trump is expected to do something about taxes and I heard Buffett or Dimon mention somewhere recently that any tax cut will be competed away by the market implying that it won't make a difference to investors.  Anyway, this is what he wrote about it back in 1986 after the last big tax change:

Taxation

The Tax Reform Act of 1986 affects our various businesses in
important and divergent ways. Although we find much to praise in
the Act, the net financial effect for Berkshire is negative: our
rate of increase in business value is likely to be at least
moderately slower under the new law than under the old. The net
effect for our shareholders is even more negative: every dollar
of increase in per-share business value, assuming the increase is
accompanied by an equivalent dollar gain in the market value of
Berkshire stock, will produce 72 cents of after-tax gain for our
shareholders rather than the 80 cents produced under the old law.
This result, of course, reflects the rise in the maximum tax rate
on personal capital gains from 20% to 28%.

Here are the main tax changes that affect Berkshire:

o The tax rate on corporate ordinary income is scheduled to
decrease from 46% in 1986 to 34% in 1988. This change obviously
affects us positively - and it also has a significant positive
effect on two of our three major investees, Capital Cities/ABC
and The Washington Post Company.

I say this knowing that over the years there has been a lot
of fuzzy and often partisan commentary about who really pays
corporate taxes - businesses or their customers. The argument,
of course, has usually turned around tax increases, not
decreases. Those people resisting increases in corporate rates
frequently argue that corporations in reality pay none of the
taxes levied on them but, instead, act as a sort of economic
pipeline, passing all taxes through to consumers. According to
these advocates, any corporate-tax increase will simply lead to
higher prices that, for the corporation, offset the increase.
Having taken this position, proponents of the "pipeline" theory
must also conclude that a tax decrease for corporations will not
help profits but will instead flow through, leading to
correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the
taxes levied upon them, but absorb them also. Consumers, this
school says, will be unaffected by changes in corporate rates.

What really happens? When the corporate rate is cut, do
Berkshire, The Washington Post, Cap Cities, etc., themselves soak
up the benefits, or do these companies pass the benefits along to
their customers in the form of lower prices? This is an
important question for investors and managers, as well as for
policymakers.

Our conclusion is that in some cases the benefits of lower
corporate taxes fall exclusively, or almost exclusively, upon the
corporation and its shareholders, and that in other cases the
benefits are entirely, or almost entirely, passed through to the
customer. What determines the outcome is the strength of the
corporation’s business franchise and whether the profitability of
that franchise is regulated.

For example, when the franchise is strong and after-tax
profits are regulated in a relatively precise manner, as is the
case with electric utilities, changes in corporate tax rates are
largely reflected in prices, not in profits. When taxes are cut,
prices will usually be reduced in short order. When taxes are
increased, prices will rise, though often not as promptly.

A similar result occurs in a second arena - in the price-
competitive industry, whose companies typically operate with very
weak business franchises. In such industries, the free market
"regulates" after-tax profits in a delayed and irregular, but
generally effective, manner. The marketplace, in effect,
performs much the same function in dealing with the price-
competitive industry as the Public Utilities Commission does in
dealing with electric utilities. In these industries, therefore,
tax changes eventually affect prices more than profits.

In the case of unregulated businesses blessed with strong
franchises, however, it’s a different story: the corporation
and its shareholders are then the major beneficiaries of tax
cuts. These companies benefit from a tax cut much as the
electric company would if it lacked a regulator to force down
prices.

Many of our businesses, both those we own in whole and in
part, possess such franchises. Consequently, reductions in their
taxes largely end up in our pockets rather than the pockets of
our customers. While this may be impolitic to state, it is
impossible to deny. If you are tempted to believe otherwise,
think for a moment of the most able brain surgeon or lawyer in
your area. Do you really expect the fees of this expert (the
local "franchise-holder" in his or her specialty) to be reduced
now that the top personal tax rate is being cut from 50% to 28%?

Your joy at our conclusion that lower rates benefit a number
of our operating businesses and investees should be severely
tempered, however, by another of our convictions: scheduled 1988
tax rates, both individual and corporate, seem totally
unrealistic to us. These rates will very likely bestow a fiscal
problem on Washington that will prove incompatible with price
stability. We believe, therefore, that ultimately - within, say,
five years - either higher tax rates or higher inflation rates
are almost certain to materialize. And it would not surprise us
to see both.

OK, the last paragraph is kind of interesting too. Buffett said he bought $12 billion in stocks after the election so I guess he is not so worried about the fiscal position of the U.S.

Back to fund performance stuff...

Comparing Two Distributions
I said that I don't care for the 'beat the market x out of  y years' idea. So that got me thinking about the simple high school statistics problem of comparing two normal distributions. I am aware of the argument against using normal distributions in finance, but I don't really care about that here. I am just looking for some simple descriptive statistics. I'm not creating a derivatives pricing model to price an exotic option for a multi-billion dollar book where modeling errors can cause huge losses. So in that sense, who cares. Normal distribution is fine for this purpose.

Plus, I am not so interested in factor models that try to assess fund manager skill. Some people use factor models and whatever is left over is what they define as 'skill'.  Well, say the model cancels out 'quality' as a factor and doesn't give the manager credit for it; what if the manager intentionally focused on quality investments? Should he not get credit for it? Having said that, I don't know much about these models so whatever...  I don't get into that here. Whatever factor exposures these managers have, I assume the manager intentionally assumed those risk factors to gain those returns.

Basically I just want to compare two distributions and see how far apart they are. It's basically the question, is distribution A, with 99% confidence, the same as distribution B? In other words, are the two distributions different with any degree of statistical significance? Or are we just looking at a bunch of noise resulting from totally random chance?

The simple comparison of two distributions is:

standard deviation of the difference between two means (Std_spd) =

   Sqrt[(Vol_A^2/n) + (Vol_B^2/n)]

   where: Vol_A = standard deviation of distribution A and
               n = number of samples

So the z-score would be:
  (mean_A - mean_B) / Std_spd

And then you can just calculate or look up the probability from this z-score.

Looks good.  This would tell me how significantly different a manager's return is versus the market.

But the problem is that these two distributions are not independent. In your old high school statistics text book, the example is probably something like number of defective parts in factory A versus factory B.  Obviously, those distributions would be independent.

This is not so in the stock market. A fund manager's returns and the stock market's return are not independent. Hmm... Must account for that.

The answer to that goes back to my derivative days; calculating tracking error. Sometimes fund managers or futures traders wanted to use one index to hedge against another. An example might be (in the old days!) an S&P 100 index option trader wanting to hedge their delta using the S&P 500 index futures.  Does this make sense? What is the tracking error between the two indices? Does it matter? Is the tracking error too big for it to be an effective delta hedge? How about using the S&P 500 futures to hedge a Dow 30 total return swap? TOPIX index swap with the Nikkei 225 futures?

Anyway, the calculation for tracking error simply makes an adjustment by making a deduction for correlation (getting square root of the covariance).

So, the above formula becomes:

    Sqrt[(Vol_A^2/n) + (Vol_B^2/n) - ((2 * Vol_A * Vol_B * correlation(A,B)) / n)]

Using this formula, I calculated all this stuff for the superinvestors, just for fun.

I just wanted to know simple things like, is it harder to outperform an index by 10% per year over 10 years, or by 3% per year over 20?  Or something like that.  The Buffett partnership was only 13 years, and Greenblatt's Gotham returns in the Genius book is only 10 years. But the spread is so wide that it is yugely anomalous to achieve, or is it? This is sort of what I wanted to know. It normalizes the outperformance spread versus the length of time the outperformance lasted.

Few Standouts
A few of the standouts looking at it this way, not surprisingly:

  • Buffett Partnership 1957-1969:  a 6.0 sigma event, 1 in 1 billion chance of occurring (yes, that b is not a typo!) 
  • Walter J. Schloss 1956-1984:  5.2 std, 1 in 9.4 million 
  • BRK 1965-2015:  4.8 std, 1 in 1.3 million
  • Greenblatt (Gotham 1984-1994): 3.8 std, 1 in 14,000
  • Tweedy Brown 1968-1983: 3.7 std, 1 in 9,300

For the Graham and Doddsville superinvestors, I looked first at the "beat the market x out of y years" to see the probability of that happening assuming a 50% chance of beating the market in any given year. And then I'll compare the two distributions as described above. At the end, I also added Lou Simpson's returns from the 2004 Berkshire letter.

Keep in mind that just because a manager is not in the 4-5 sigma range, that doesn't make them bad managers. Some of these numbers are just insanely off-the-charts and can't be expected to happen often.

Anyway, take a look!

Buffett Partnership (1957-1969)
Beat the market 13 out of 13 times: Chance of occuring: 0.012% or 1 in 8,192.

Given that Buffett partnership gained 29.5%/year with a 15.7% standard deviation while the DJIA returned 7.4%/year with a 16.7% standard deviation and the Partnership had a 0.67 correlation, the partnership returns is 6.0 standard deviations away from the DJIA.  6 standard deviations make the partnership returns a 1 in 1 billion event.

What's astounding is that the standard deviation of Buffett's returns is actually lower than the DJIA.


BRK 1965-2015
Beat market 40 out of 51 years:  0.003% chance or 1 in 35,000

                     BRK        S&P500
Return          19.3%        9.7%
std                14.3%      17.2%
correl             0.61

4.8 std, 1 in 1.3 million

This uses book value, which may not be fair as not everything in BPS is marked to market (over 51 years). Using BRK stock price, it would be a 3.2 std event, or 1 in 1,455. But this too may not be fair as the volatility of the price of BRK is more a function of Mr. Market than Mr. Buffett.  This may be true of all superinvestor portfolios, but in the case of BRK, there is a penalty in that we are looking at the volatility of a single stock (BRK), and not the underlying portfolio.  Single stock volatility is usually going to be much higher than that of a portfolio.

Munger 1962-1975
Beat the market 9 out of 14 years: 21% chance or 1 in 5

                    Munger     DJIA
return           19.8%       5.0%
std                33.0%      18.5%
correl:            0.73
#years: 14

2.4 std, 1 in 122.

Sequoia 1970-1983
Beat the market 8 out of 14 years: 40% chance or 1 in 2.5

                Sequoia        S&P 500
return       17.2%        10.0%
std            25.0%        18.1%
correl         0.65

1.4 std or 1 in 12.

This is the in-sample period; the period included in the Superinvestors essay.

Sequoia 1970-2016
Beat the market 26 out of 47 years, 28% chance or 1 in 3.6


                  Sequoia       S&P500
return        +13.7%        +10.9%
std               19.3%          17.1%
corr 0.67

1.3 std or 1 in 10

Sequoia 1984-2016
This is the out of sample period; the period after the essay.

Beat the market 18 out of 33 years, 36% chance or 1 in 3

                  Sequoia      S&P500
return          11.9%         10.9%
std               16.0%         16.6%
corr               0.73

0.5 std or 1 in 3

Sequoia 2000-2016
And just for fun, a recent through-cycle period starting in 2000. They have been underperforming the market since 2007, though.

Beat 9 out of 17 years, 50% chance or 1 in 2.

                   Sequoia     S&P500
return           7.3%          4.5%
std              13.7%        18.1%
correl           0.69

0.9 std or 1 in 5

Walter J. Schloss 1956-1983
Beat the market 22 out of 28 years, 0.2% chance, or 1 in 540

                   WJS      S&P500
return         21.3%     8.4%
std              19.6%   17.2%
corr:             0.75

5.2 std or 1 in 9.4 million


Tweedy, Browne Inc. 1968-1983
Beat the market 13 of 16, 1.1% chance or 1 in 94

                   Tweedy   S&P500
return           20.0%       7.0%
std                12.6%     19.8%
corr:               0.71

3.7 std or 1 in 9,300


Pacific Partners Ltd. 1965-1983
Beat the market 13 of 19 years, 8% chance or 1 in 12

              Pacific       S&P500
returns    32.9%         7.8%
std          60.2%       17.2%
corr:         0.37

1.9 std or 1 in 35


Gotham 1985-1994
Beat the market 9 out of 10 times: 1.1% or 1 in 93 chance

3.8 std, 1 in 14,000

Lou Simpson (GEICO: 1980-2004)
18 out of 25 years. 2.2% chance or 1 in 46.

               GEICO   S&P
return      20.3%    13.5%
std           18.2%   16.3%
corr:         0.74

2.7 std, 0.4%, 1 in 288


Conclusion
So that was kind of interesting. It just reaffirms how much of an outlier Buffett really is. There is a lot to nitpick here too, so don't take these numbers too seriously. I used standard deviation of annual returns, for example. I suspect some of these correlations may be higher if monthly or quarterly returns were used.

This sort of thing may be useful in picking/tracking fund managers. At least it can be one input.  For example, it gives you more information than the Sharpe ratio; whereas the Sharpe ratio doesn't care how long the fund has been performing, the above analysis takes into account how long someone has been performing as well as by how much. But yeah, Sharpe ratio is trying to measure something else (return per unit of risk taken).

Anyway, as meaningless as it may be, it's one way of seeing if it's harder to create a long term record like Buffett (1965-2015) or a shorter super-outperformance like Greenblatt (1984-1994). This analysis says that Buffett's 1965-2015 performance is a lot more unlikely to be repeated (well, at least on a BPS basis; using BRK stock price, Greenblatt's performance is more unlikely!).

I sliced up Sequoia Fund's return into various periods for fun as it is the only continuous data (other than BRK) out of the Graham and Doddsville Superinvestors. I was going to look into their performance since 1984 a little more deeply, but this took a little more time than planned (despite the automation of a lot of it; well, debugging and fixing takes time, lol...).

So maybe I will revisit the Sequoia Fund issue in a later post. My hunch is that the Superinvestor returns were achieved on a much lower capital base so the universe of potential investments were much larger than what Sequoia (and others) are looking at now despite their efforts to keep AUM manageable.

Also, you will notice that comparing the two distributions gives a more nuanced or accurate picture of the performance than just looking at how many years someone has outperformed; it incorporates the spread, correlation, volatility etc...

Anyway, I guess that's enough for now...