Happy Thanksgiving

November 24, 2005 | Filed under Business School (Wharton), Finance & Investing by Kurt

Given the number of international students at Wharton, each cohort (65 student unit) has an elected officer that explains holidays and cultural issues (Diwali, Ramadan, and so on). Included in the Thanksgiving email was this gem:

Here is an interesting fact that we should all take to heart as we look for apartments in the New York city area for the summer of 2006 or any time thereafter: The entire island of Manhattan was purchased in 1626 for $24 of beads from the Canaries tribe (which by the way did not own the land)…..Gotta Love America!

Now for those in Finance, using an Opp Cost of Capital of 5% (compounded annually) and a time of 379 years we find that the FV in 2005 of that investment would be $2,576,057,716.90. The actual cost of land in New York is currently $1,050 per buildable sq foot (per Real Deal.com). There are 15,170 acres of land or 660,805,200 sq ft of buildable land in Manhattan (bureau of NY statistics) for a total value of $693,845,460,000.00. This leads to a PV in 1626 of $6,464.25 and more importantly a positive NPV of $6,440.25. Disappointingly, the IRR for this project would only have been a measly 1.56% above the opportunity cost of capital.

Everyone seems to think they can get 10% returns forever, but clearly most wealth doesn’t grow this way over the long term - no assets/investments/families that were worth $1,000 in 1800 are worth $305B today (1,000*1.10^205). Where’s the disconnect?

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Underreporting alternative investment risk

September 5, 2005 | Filed under Finance & Investing by Kurt

From the NY Times:

By Mr. Lo’s measures, hedge fund investments are less liquid now than they have been in 20 years. His work shows that the same pattern of investing preceded the 1998 global hedge fund meltdown and the 1987 stock market crash.

But that’s not the only reason for worry. He says that crises like that of 1998 may be more predictable than was previously thought - and that another crisis is likely.

The 1998 panic is generally thought to have been set off by the Russian government’s default on its debt. But Mr. Lo points out that only a minuscule proportion of the world’s hedge fund investments were in Russian government bonds.

In his paper, he shows that the catastrophic losses of 1998 were preceded by a noticeable series of months of mediocre performance. Mr. Lo argues that while a hedge fund crisis appears to be sudden and to be caused by unforeseen events, the breakdown is only the late stage of the problem. As more hedge funds compete for the same slice of the pie, he says, their managers feel that they have no choice but to “leverage up,” juicing their returns by borrowing more money to make bigger investments.

I need to read the paper to find out how he substantiates the claim that hedge funds are less liquid today than for the past two decades; having said that it makes a lot of sense that as alpha is competed away managers will leverage up to maintain returns. Also note the inherent risk asymmetry for hedge fund managers; hitting home runs makes them tons of money while blowing up the fund only results in the loss of a job (their payout looks like a long call option). Hedge fund buyers, on the other hand, get a payout that looks like repeated selling of puts; long periods of steady profitability punctuated by occasional disasters (see this ppt). The concepts aren’t rocket science but trying to quantify the problem is quite difficult. From the article:

Mr. Lo refers to some of his research as “measuring how strong the camel’s back is and how much straw is already on it,”

At the risk of getting out of my depth, I loosely monitor the VIX and credit spread to see how much money may be chasing short term returns at the expense of a blowup. This graph is from PIMCO:

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Intermediate personal finance

June 19, 2005 | Filed under Finance & Investing by Kurt

Or, what’s an individual’s optimal investment leverage?

I’ve been thinking about this for a while and finally got around to doing it. The results are posted here because they’re too verbose for the blog. Formatting sucks because the only HTML editor I have on my travel computer is Notepad or MS Word and neither is very fun to work with….I’ll re-post a cleaner version when I get back home.

The bottom line is that I validated conventional wisdom; wealthier individuals should take less risk and asset-poor individuals should take more risk. My contribution is adding a quantitative toolset that lets any moderately sophisticated Excel user model how their savings might play out in retirement at a given risk level.

As always I welcome positive or negative feedback.

Update: I forgot to mention the original reason I built this, which was basically to see how likely I was to acheive my investment goals (10% likely, 50% likely, etc.). In the writeup I’m mostly discussing relative outcomes but for a lot of folks the most interesting part of the model will be to plug in where they are today, where they want to be, and what they expect the market parameters to be in order to see how likely they are to meet their goals.

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Intro to personal finance

June 2, 2005 | Filed under Finance & Investing by Kurt

During my test prep procrastination today I talked about investing with a friend who’s still in college and not finance saavy. I started thinking about what individuals should focus on when doing their own investing. For example, my view is that individuals should not try to pick stocks unless they really enjoy the process of stock selection per se (or see the choosing as entertainment, like a horse race). There is a mountain of empirical evidence that stock picking is hard to do well; individuals are statistically unlikely to beat a passive index investment. Thus a new investor should focus their learning on things that have guaranteed values (such as tax and liquidity planning) rather than stock picking. Note that this is probably not as fun to execute, resulting in several cable channels devoted to stock picking and none that I know of devoted to tax planning or asset allocation. Nevertheless I think the dollar return on time invested will be infinitely higher for structural investment planning than stock picking.

Now that 99% of my readers have stopped reading this post*, here’s my point: the biggest decision a novice investor needs to make is how much to save. This is much more important than stock picking and significantly more important than asset allocation or tax planning. It’s obviously possible to save too little; it’s also possible to save too much - deferring too much gratification. For example, delaying graification in college might mean postponing a trip around the world; unfortunately ten years later this trip may not be an option because of more commitments, disability, or other unforseen constraints - the deferral backfired and the savings can not be used.

There’s a basic level of savings that everyone should have; as in Maslow’s hierarchy there is a foundation level of savings necessary for people to feel secure; the cushion to handle car repairs, minor medical expense, or property disaster without resorting to outside assistance. Once this is established, why should you save? Owning Microsoft vs. GE is not as important as understanding whether one is saving for early retirement, preserving a windfall, funding a child’s education, or enabling philanthropy. It’s tough to make the right decision about how much gratification to defer until you understand what you’re saving for.

Obviously this is oversimplified. If an investor is saavy and dedicated enough the problem becomes more nuanced. The degree of gratification to defer becomes a question of probabilities; what is the probability I will get to spend these reserves while I can still enjoy them (i.e., before unexpected death or disability). How long and expensive a life do I need to plan for? Although I probably shouldn’t admit it I’ve actually nerded out to the point of writing a Monte Carlo simulation to vary life expectancy and annual rates of return on a portfolio (annual timesteps for 100 years) to build a distribution of required capital at a certain age. For example, based on a consumption forecast of $X/year (2005 real dollars) starting at age Y, what is level of savings required at age 30 to be 95% confident that I will not run out of money before dying? Assign probability distributions to the portfolio return and chance of death in each timestep and let 10,000 trials run to get the answer…..Note though that I did this as a fun/intellectual exercise; I’m not actually that obsessive about financial planning.

*Rhetorically speaking. 99% isn’t a possible outcome since it’s not a divisor of 2 readers.

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Notes from Buffet

April 12, 2005 | Filed under Business, Finance & Investing by Kurt

Found at Anumati. I really like >95% of what I’ve heard Buffet say - in notes from student meetings, annual reports, etc. It’s pretty neat that someone as wealthy as he is can still keep a sense of common values.

Also interesting is this look at Charlie Munger.

Here are someone’s outstanding notes from a meeting with Warren Buffett
that occurred on January 28th, 2005.

How Warren spends his day:

· Wakes up at 6:45, reads paper at home, often
doesn’t make it into the office until after the market opens

· No set schedule, WB hates having a full calendar

· Always takes reading material home

· Spends 80% of the day reading, 20% talking on
the phone (he then said it might be more like 90/10)

· Phone conversations are generally short

Investment process:

· In the past some things were cheap enough WB
could decide in a day (this was somewhat a function of a time period where
companies would sell at 2-3x earnings)

· Decisions should be obvious to onlookers. You
should be able to explain why you bought something in a paragraph.

· “I don’t do DCF” (WB says he does a rough
approximation in his mind)

· Finding ideas is a function of cumulative
knowledge over time. Something just comes along – usually an event takes place,
like a good management team screwing up – that creates the opportunity (WB
seems to imply here that his reading isn’t specifically targeted at finding
ideas, but rather that ideas jump out at him as a natural consequence of
vociferous reading)

· You must be patient…good ideas tend to be
clustered together, and may not come at even time intervals…when you don’t find
anything for a while it can be irritating

· WB isn’t bothered by missing something outside
his circle of competence

· Missing things inside the circle is nerve
racking…examples include WMT, FNM

Advice for new investors:

· Don’t worry too much about your mistakes

· Don’t learn too much from your mistakes

· Don’t become Mark Twain’s frog that never sat
again on a stove after being burned

· BUT…never be willing to play a “fatal” game

· Don’t confuse social progress with the chance to
make money – look at airlines and autos for examples

· Law degree is not essential, but good if you
think it will help in your specific career

· Learning to think like a lawyer is a valuable
trait

· Allocate even more of your day to reading than
he does

· Read lots of K’s and Q’s – there are no good
substitutes for these

· Read every page

· Ask business managers the following question:
“If you could buy the stock of one of your competitors, which one would you
buy? If you could short, which one would you short?”

· Always read source (primary) data rather than
secondary data

· If you are interested in one company, get
reports for competitors. “You must act like you are actually going into that
business, and if you were, you’d want to know what your competitors were
doing.”

Why more people don’t follow his advice:

· The advice doesn’t promise enough…it’s not a
“get rich quick” scheme, which is what a lot of other philosophies promise

· WB mentioned that when he was really young he
started investing using technical analysis, but found that he never could make
any money with it

· “I realized that technical analysis didn’t work when
I turned the chart upside down and didn’t get a different answer.”

· After seeing that charting didn’t work, he
switched to Graham…it made sense and it worked

What Warren reads:

· Most of reading includes K’s, Q’s and 5
newspapers daily

· Hasn’t found much worthwhile book reading
outside of Graham and Fisher

Advice to nonprofessional investors:

· If you like spending 6-8 hours per week working
on investments, do it

· If you don’t, then dollar cost average into
index funds. This accomplishes diversification across assets and time, two very
important things.

· “There is nothing wrong with a ‘know nothing’
investor who realizes it. The problem is when you are a ‘know nothing’ investor
but you think you know something.”

Avoiding human misjudgment:

· WB said repeatedly that it doesn’t take above a
125 IQ to do this…in fact, IQ over this amount is pretty much wasted. It’s not
really about IQ.

· Staying within circle of competence is paramount

· When you are within the circle, keep these
things in mind:

· Don’t get in a hurry

· You are better off not talking to others

· Just keep looking until you find something
(don’t give up)

· Good ideas come in clumps – by time, by sector,
by asset class

Discount rates used for valuation:

· Use a long term normalized interest rate for
Treasuries…e.g. 6%

· Don’t use different discount rates for different
businesses…it doesn’t really matter what rate you use as long as you are being
intellectually honest and conservative about future cash flows.

· Only want one variable to compare in order to
assess the viability of an investment – price versus value. If we allowed
discount rates to change it would lead to more than one variable.

· WB’s assessment of the risk of a company is
baked into the probabilities for future cash flow scenarios of the company

· “I don’t know what the true cost of capital is
for a business unless we own it”

Starting a fund from scratch today:

· Probably would do the same thing he did before

On Berkshire…

Managing Berkshire:

· Focused hard on creating a company over time
that he would like today…built the company around the way he likes to work

· Hates meetings, managing people, and company
rituals

· BRK has no general counsel or IR

· Directors meet in person only once per year

· 17 people employed at HQ

· “I don’t call managers of my businesses, they
call me”

Buying businesses:

· The first question I ask is: “Does the owner
love the business or does he/she love the money?” It’s very easy to tell the
difference.

· I am proud to be able to provide a good home for
many businesses. It is like finding a home for a painting. Business owners who
are looking to sell can either sell their businesses to Berkshire (like putting
a painting in the Metropolitan Museum of Art) or sell to an LBO and let them
tear it up, dress up the accounting, and resell it (like selling a painting to
a porn shop).

Why he has a large cash position:

· Can’t find things to buy

· In the past there were times it was like
shooting fish in a barrel…sometimes even like shooting idle fish in a
barrel…it’s not like that now, but there will be times in the future when it
will be like that again.

· Berkshire is currently putting a few billion to
work buying a stock, but it wouldn’t trouble him deeply if they were not able
to take the position

On specific industries or companies…

Subprime mortgage industry:

· There are similarities between subprime and
manufactured housing financing

· The most important factor for the subprime
industry is the health of the economy, which has been good of late

· Securitization moves the ultimate lender farther
away from borrower, which is what causes problems

· A shock will probably not occur unless we see
materially higher long interest rates…200- 300bps

· As long as participants in that industry are
charging a high enough interest rate to account for the inherent credit risk,
it should be okay.

· As far as housing prices go, there won’t be a
problem until the collateral value falls below the value of the loan

· “We haven’t played in that [the subprime industry]
yet, but we do own H&R Block, which does some of those loans, although they
don’t keep the paper.”

· REIT structures in the subprime industry aren’t
necessarily a bad thing

· The economy is going to be far more important
than the structure used

Competitive advantage and business model in banking:

· Banking is a good business - many banks earn
high returns on tangible equity

· “Charlie and I have been surprised at how much
profitability banks have, given that it seems like a commodity business.”

· Underestimated how sticky customers are and how
unaware they are of fees banks charge them

· WFC - $4.00 per share after full taxes on $15 of
tangible equity

· If you have a well run bank, you don’t need to
be the #1 bank in an area

· Bank ROA is not highly correlated to size

· You may have to pay 3x tangible equity to buy a
bank

· Only problem with banks is that sometimes they
get crazy and do dumb things…’91 was a good example

· If a bank doesn’t do dumb things on the asset
side, it will make good money

Auto industry outlook (especially GM):

· GM bonds are currently selling at B spreads

· Auto industry is a very tough business

· In the ’60’s GM had over 50% of the US car
market…people thought they were impenetrable

· GM did dumb labor deals when the accounting
didn’t require accruals for costs

· GM is now a terrible life/health benefits
company with an auto business attached

· Auto business is well managed, but labor issues
are just killer

· 2000 auto companies were started after Henry
Ford – there are now 3 left in the US – no money has been really made over time

Musings on Coke:

· The chance that Coke is not the leader in the
carbonated beverage business in the future is very small

· Candy bars become very entrenched in their
markets and are hard to unseat…they don’t travel well into new markets

· Coke travels well into new markets

· One of the most important thing about Coke as a
consumer product is that Coke does not have a “taste memory.” In other words,
the taste of Coke doesn’t accumulate in your mouth. This is what makes it easy
for some people to have 3,4,5+ Cokes each day. They never tire of it because
there is no taste residue. Orange or grape soda accumulates and you get sick of
them. Same thing with chocolate. There is no diminishing marginal utility of
taste for Coke. WB doesn’t believe there has ever been a word written about
this phenomenon.

On currencies…

Bet against the dollar / currency hedging:

· Currently owns over $20B in foreign currency

· No strong feeling on which currencies will do
best against the dollar

· Increasing interest rates will also add to debt
service burden to foreigners

· Every day US consumes 5% more than we produce…US
is like an enormously wealthy family with a very large farm, and we keep
mortgaging larger and larger pieces of it to foreigners

· Foreigners own net $3T of US securities…goes up
$2B per day

· This is not a “doom and gloom” bet on the US –
still a great country with great infrastructure

· Formulated thesis after reading Bureau of
Economic Analysis data

· In November trade imbalance with China was $16B
($190B annualized)

· This is not a short term bet…don’t know where
the dollar is going over the next year…this is a five year bet

· Typical investor should not make the same bet
unless one found a foreign stock that was attractive…could buy the stock and
leave the currency risk unhedged

· WB never hedges currency risk when he buys a
foreign security because he likes the extra diversification it provides

Impacts of the potential revaluation of the Yuan:

· If it revalues 10-20% it probably won’t have a
material impact because the discrepancy between labor costs in China and US is
so large

· It is unlikely that China will remove the peg

· Wal-Mart is opening up big in China

The future of the Euro:

· There will be strains, but it should be fine
over the long term

· WB believes it has been a good thing for Europe
and the world

On inflation…

Inflation and the CPI:

· CPI is flawed as a measure of inflation

· Average person’s CPI has a very different
composition than the weighted CPI used to calculate inflation

· CPI understates human consumption

Businesses often have contracts that range from
90 to 360 days, therefore inflation lags substantially

· Eventually higher raw material costs will get
passed through to the consumer

· Health care is 6% of CPI, but 14% of GDP

· Home ownership was taken out of the CPI 20 years
ago and replaced by an imputed rent amount Rental rates have not risen since
then but home prices have…the increased burden of higher home prices has been
fortunately offset for a while by lower interest rates

On commodities…


Oil and natural gas:

· Everyone thinks oil has moved a lot…you have to
consider the weakening of the dollar…if you look at oil priced in Euros it has
not moved a lot…same situation with gold

· We have seen a real increase in many raw
materials…coal is a good example; very scarce right now

· WB doesn’t play the game of betting on the price
of oil or commodities often

· Natty – MidAmerican is looking at an Alaskan
pipeline

· Alaska has 80T-90T cubic feet of natural gas (a
lot)

· Trouble with Alaska opportunity:

· $2/mcf transport costs

· Takes 6-7 years to build pipeline – hard to make
6-7 year commitment with uncertain future price outlook

· Same issue with LNG terminal build-out

· Most commodity companies don’t trust current
prices because they’ve been burned too many times on price

· Oil exploration in the US is tough

· Today our onshore production is 6MM barrels/day

· We used to be self-sufficient in oil production,
to the point where we had to periodically shut down because we were producing
too much

· US is the most explored oil province in the
world – haven’t found a real elephant in the lower 48 states in 30-40 years

· BRK is not tempted to bet in the oil exploration
business in any material way

Aluminum:

· No real opinion on it

· The problem with raw materials businesses is
that there’s no brand identity…no one ever says, “I want a Coke only if it
comes in an Alcoa aluminum can”

· Aluminum, to a large degree, is just stored up
electricity, because power is such a huge component of its production cost

On public policy…

Privatizing social security:

· We must remember that social security is not for
you or me

· 10-20 million people will not be able to support
themselves when they are old

· A rich society like the US should provide that
support for its citizens (before one is productive a society should provide
good schools, and after one is productive, a society should provide financial
support).

· Don’t think it’s good to let less competent
investors do it on their own…they need help, they are not “wired” to be good
investors, and it’s our responsibility to help provide them with the highest SS
base possible

· Privatization plan would lower the base and
require you to invest to make up the difference

Miscellaneous…

Impact of emerging economies on US:

· Don’t think it will be anything dramatic

Social activities:

· Spends 1-2 hours 4-5 times per week playing
bridge

Charity:

· Doing charity work is the opposite of investing
– with charity, we look for the most difficult problem to solve and the ones
that have the lowest probability of success

· WB is giving guidelines to trustees (see above),
but he’s not dictating exactly where he wants to give. WB realizes that he will
have no idea what the big problems will be in the distant future after he’s
gone

Warren’s success:

· “I was born wired to allocate capital well.” If
I was born in Bangladesh and I walked down the street explaining that “I
allocate capital well”, the townspeople would say “get a job”.

· Bill Gates says that if I was born 1000 years
ago, I wouldn’t survive because I am not fast or strong. I would find myself
running from a lion screaming “I allocate capital well!!”

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Investing for the long term

December 21, 2004 | Filed under Economics, Finance & Investing by Kurt

I’ve thought a lot about how US government deficits are going to affect financial markets in the future, specifically the money my wife and I put aside to retire on. Here’s my basic fear/expectation: the US government will be unable to control entitlement spending and the commercial sector unable to control balance of trade, leading to more USD denominated bonds and currency being held by foreign investors. Simultaneously we’ll see a growing disparity between Americans who save and those who don’t - savers will have lots of money and non-savers won’t have much at all or have negative worth. What we’re left with is a narrow class of asset holders (foreign investors and a minority of Americans) and a large group of non-asset or net liability holders (the US government and the general public).

Since the US government controls how much currency is printed it’s pretty easy to think that they’d be willing to print more to control deficits. If the majority of voters are not asset holders, the treasury can get away with this since they’re basically ripping off foreigners and the minority of “wealthy” Americans to dig the government out of it’s spending hole (in other words, playing by the rules of a democracy).

What should you/I do to profit if this scenario makes sense? I’m kind of exploring a practical way to short-sell long dated treasury bonds (basically putting me in the same economic position as the US Government). If nothing else I’m trying to stay invested in diversified equities, which will hopefully hedge against inflation much better than holding cash or bonds.

What’s keeping this from coming to fruition? Maybe political pressure in the US to keep nominal interest rates down, which you can’t do if you’re inflating the currency printing more money. Most consumers aren’t going to be happy when mortgage and credit card rates jump, even if they profit on balance from the reduced value of their fixed rate liabilities. Another hindrance could be US political will to keep the dollar as a global benchmark currency, something it couldn’t do if it were to willfully inflate to avoid debt repayment. Finally, although probably least likely, we could see a new age of government fiscal responsibility and/or sharp organic growth in tax receipts from a strong domestic economy.

PS - if anyone has seen/done an analysis on how much of this year’s runup in stock prices is a factor of dollar devaluation I’d be interested in seeing it. I don’t know how much the S&P 500 companies hedge their forward foreign currency earnings, but assuming they’re generally unhedged (and assuming that they get 30% of their gross margin in foreign currency) it seems like 50% of the increase in large cap indexes could be from currency translation of future earnings per se rather than business fundamentals or the demand growth for dollar denominated exports.

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