The market rally off its recent lows is paying off for some contrarian investors (see WSJ article). While contrarian investing can mean many things, it often involves buying out-of-favor and beaten-down stocks, or selling those that are over-extended after a nice, and often too-far, too-fast, rally. Essentially, contrarian investors often go against the grain of market sentiment. Of course, given the massive sell-off, some could argue that the markets had no were else to go but up, but timing is important, and hindsight is 20-20. Whom among us was 100 percent certain late last year that the markets were not going lower, or for that matter, were going to recover at all anytime soon, even for a quick bear rally? Even successful contrarian investors such as Warren Buffett, Bill Miller, and David Dreman had a difficult 2008, with Buffett himself adding to down investments prematurely. While those with less than perfect timing may eventually be proven to once again beat the market if held long enough (often a requirement for contrarian investors who have low levels of turnover and high levels of patience), those that are most successful understand both timing and value. It is important to remember that beaten down companies can go lower, or even fail, while those running up too fast can keep soring as the markets remain irrational longer than your ability to remain solvent. But now, in the mists of a nice bear (or new bull) rally, it is easy to once again have stars in our investing eyes. Yet while we dream, contrarian investors may already be looking for those stars that are ready to fall back to earth after a nice, and possibly unjustified, run. After all, summer is often a good time for spotting shooting stars, which are really not stars at all, but bits of dust and rock burning up as they fall from the sky. Maybe now is the time to start enjoying the show.
An recent article in the WSJ discusses the AIG risk models developed by Gary Gordton (note, Gorton, not Gordon as originally posted), a professor at the Yale School of Management. The headline of the article boldly states "Behind AIG's Fall, Risk Models Failed to Pass Real-World Test." Yet, did the models really fail? Gordton's models were developed to gauge the risk of AIG's credit default swaps, but according to the article, "... AIG didn't anticipate how market forces and contract terms not weighted by the models would turn the swaps, over the short term, into huge financial liabilities." The quote is interesting in that it highlights what may be at the heart of AIG's problems. As a result of its ignorance on whether the short-term collateral risk needed to be considered, or its belief that such risk was not something to be worried about, AIG made a decision to not have Gordton assess these threats - even stating later that it knew his models did not consider such risk. So this begs the question once again. Did the models really fail (as approached by Gordton and approved by AIG), or was it more of a lack of understanding of the very products they were modeling? I know some will ask what's the difference - in the end the models were incomplete - but the distinction is significant.
In hindsight, it is easy to point fingers and wonder exactly what risk AIG was even trying to manage. But the real problem here seems to be less about one particular modeler getting it wrong, or developing incomplete models, and more about management ignoring to consider some risk while putting faith in the very same models that were not designed to give the level of confidence or enterprise-wide coverage that is being used to engender confidence. Even the WSJ article (in the body of the story) mentions how "Mr. Gordton's models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn't attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG's finances." Of course, this did not keep AIG from trading as though it did, and therein lies the problem. The failure here is less about modeling, or even risk management, and more about corporate management and decision making. Yet, the perception that the problem is with modeling is widespread. Even Warren Buffett is quoted as saying "All I can say is, beware of geeks .... bearing formulas." But what is the alternative? Shall we abandon all risk modeling and simply use our gut instincts? Should we just take risk off the table completely? I don't believe so. While better risk management models should continue to be developed, maybe a little humility is a good place to start. Understanding a company's limitations is key to uncovering its strengths and protecting against its weaknesses.
The Inside Scoop feature at Barron's (see article) is reporting on how Warren Buffett has increased his position in Burlington Northern Santa Fe (BNI). Earlier this week, Buffett bought another 825,000 shares, bring his total position to about 19% of the company. Not only does this recent transaction put approximately one-fifth of the company in strong hands, but Buffett has also recently sold 5.5 million puts in October, with strike prices ranging from $75-$80. The put position effectively places a floor on the stock, since if the past is any indication, the position implies that Buffett is comfortable being a buyer at these strike price levels.
As with the rest of the market, Burlington has fallen over the last month, but not as much as some of its biggest competitors. Since Burlington hauls a higher percentage of coal and fertilizer, as well as other domestic goods, analysts believe they will most likely not be hit as hard by a global recession. Furthermore, any return to higher fuel costs, which will impact global growth, could also help Burlington weather any further downturn as companies continue to shift from trucking to the rails for transporting their goods. As the chart below shows (from BigCharts.com), BNI, the DJIA, and the Dow Transports (DJTA) have diverged somewhat since the beginning of the year.
Source: BigCharts.comOften the DJIA will follow the transports, but in this case the market sell-off in October has caused the transports to catch-up on the downside with the general market. BNI fared a little better during this time. Each has gained over the last week. Of interest is how the transports are bumping up against resistance levels in place since January, whereas BNI has actually found some support at these levels. If the market can break these levels and continue to build a bottom in November (or even begin to rally), and the six months from November to April do turn out to be bullish after the heuristic-based "sell in May and go away - until November" trades are unwound, than BNI may not only be a potential recession play, but it may also help to lead the market over the next year. Nothing is fool proof, but with the winds of Buffett, energy (coal), and ethanol (fertilizer) at your back, the profit trains could start rolling again for BNI stock holders.
What is the hot new hedge fund strategy? Convertible Arbitrage? Distressed Debt? Emerging Markets? Event Driven? Macro? Long / Short, Risk Arbitrage? Quant? No, if a new hedge fund by a former Columbia professor is any clue, it is value (see Bloomberg article). The new company, called the Van Biema Value Partners, plans to invest in no more than 20 small Asian managers that follow value investing principles. When people start losing significant amounts of money, it is interesting how Buffett and Templeton start to appearing wise again.
Here is the link to the recent New York Times Warren Buffett Op-Ed (free subscription required). Worth a read if you have not already come across it.
As the financial musical chairs continue to get shifted, we are now learning that Warren Buffett, who has been relatively silent (investment wise) until last week, is now beginning to see value in the markets (see WSJ article). Is Buffett investing only in small regional banks, as some others are doing. No. Berkshire Hathaway is taking a position in Goldman Sachs, investing $5 billion in return for receiving perpetual preferred shares in Goldman. At the same time, Goldman will also be looking to do a stock offering to raise over $2 billion in additional capital.
This turn of event is significant, in my opinion, in that it signals a couple of important points. For one, by taking a sizable position in Goldman, the richest man in the world is indicating that the financials are in value territory, and that it is time to step up and take a position. This will certainly give a boost of confidence to other investors. The move by Goldman also shows that companies themselves are willing to recapitalize, believing that the market is now stable enough to do so, or at least that there are government and Buffett-type backstops available if times get difficult. Given the recent restrictions on short sales, this also appears to be a good time to do a secondary given that the diluting affects of the offering are less likely to be punished by short sellers and the market. Is volatility behind us, and is this a bottom? No, and probably not. Nonetheless, we may be finally reaching a point where leading companies in leading industries (and even non-leading industries) will finally begin to see their value reflected in the market place. This may not be a bottom, and financials will certainly still see volatile times ahead, but looking through the cloud of bankruptcy does allows potential opportunities to start appearing.
As reported in a recent Bloomberg article, Warren Buffett's telephone has been ringing off the hook. As the credit markets seize-up, more distressed sellers are looking to Omaha as the last source for funding. As mentioned in the article, "Buffett right now is probably about the only money in the world, in the billions of dollars range, that the check will clear overnight." This has some analysts bullish on Berkshire Hathaway stock. Buffett is known as a value investor, and the market is certainly on sale right now. The combination of his deep pockets allowing him to buy just about whatever he wants, and his liquidity and reputation allowing him to set the terms, makes it likely that he will be able to add value to Berkshire. Of interest in the article is how the price of Berkshire stock has been rising as the TED spread (bank borrowing cost) has been increasing. As usual, market corrections have a way of separating the wheat from the chaff.
Nothing too earth shattering here, and the Buffett interview is rushed as he on the baseball field at Boston to throw out the first pitch, but it nonetheless highlights how we all are in the same situation. When asked about the uncertainty of the markets, whether housing will recover, or whether Fannie and Freddie will be expensive to taxpayers, he basically says, "I don't know." Probably the most honest statement yet, and an illustration of how were are all just feeling around in the dark with regarding to the housing and credit crisis. There will be winners and losers in the end, as there already have been with Fannie and Freddie, but hope is still entering into the equation. Just ask Lehman.
Source: Wall Street Journal Online Video
Deutsche Bank is now offering ETNs that tracks the Benjamin Graham Intelligent Value indexes (see IndexUniverse article). The indexes are based on the value-based investment philosophy of the well-known and revered economist and investor for which the ETNs are named. Three value-oriented funds are being offered, broken down into total market, large-cap, and small-cap segments as follows:
- Benjamin Graham Large Cap Value ELEMENTS (NYSEArca: BVL)
- Benjamin Graham Small Cap Value ELEMENTS (NYSEArca: BSC)
- Benjamin Graham Total Market Value ELEMENTS (NYSEArca: BVT)
In its recent first quarter statement, Berkshire Hathaway released that it has bought derivatives on various stock indexes that were set to expire between 2019 and 2028. The indexes of interest for Berkshire include the FTSE, Euro Stoxx 50, Nikkei, and S&P 500. The derivative plays included multi-billion dollar positions that involved selling puts on the indexes. The report has Berkshire with $4.5 billion in premiums and $4.6 billion in liabilities at the end of 2007.
Apparently, Berkshire is not done and is continuing to increase its position in Q1, where premiums increased by $383 million by selling additional puts. This increases its derivative liabilities to $6.2 billion. In Q1 the positions went against Berkshire, causing it to record a loss of $1.2 billion. Given the long expiration dates, the losses appear to be mainly mark-to-market accounting losses, and not positions that have been closed. Each of the indexes that puts have been written against have been down collectively for the year.
Of interests is that since $4.5 billion was generated in premiums in 2007, the notional value of the assets (indexes) themselves could be estimated to be in the range of $70-$100 billion. While Berkshire's insurance businesses has surly used derivatives to hedge risk, this direct move into derivatives is both surprising and understandable at the same time.
On the one hand, Buffett has repeatedly talked about derivatives being "financial weapons of mass destruction," and something that has contributed to the current problems we are experiencing in the markets. Granted, there is a big difference between writing naked puts and exposure to a CDO-squared, where counter-party risk is not only huge, but often at times unknown. Nonetheless, it is an interesting move and turn of events.
On the other hand, Berkshire's large insurance businesses have been providing a large float for Buffett to redeploy. The writing of naked puts will now provide extra income that can be put to work, albeit at a different level and degree of risk. Furthermore, the move signals that Buffett feels that any market correction is over, and that the indexes are going up. If you believe this, as Buffett apparently does, then selling puts would seem less risky, and would also give you the cash you need to begin buying relatively cheap assets that you expect will be moving up from recent lows. Buffett has said as much, stating recently that he believes the worst of the credit crisis is over for Wall Street and the markets, even though individuals will still feel pressure. With the recent moves, Buffett is certainly putting his money where is mouth is. Finally, in addition to market direction bias, this move may also be giving us clues about the insurance business, and the level of float that Berkshire needs and expects to receive in the future. Time will only tell how all this plays out for Berkshire and its shareholders. I am sure some are surprised, excited, and a little anxious.
Tickers: BRK.A, BRK.B
Jason Zweig of Money (as reported at IndexUniverse.com) was asked a question about what a young individual in their 30s should invest in. What is the single best investment idea? Buffett quickly suggested investing all they had to invest in a very low cost index fund from a reputable firm, a suggestion he has made on numerous other occasions. Buffett mentioned Vanguard in particular, the John Bogel founded company with a number of index funds to choose from. Of course, Buffett could have suggested another - Berkshire Hathaway. While technically not an index fund, or even close for that matter, it does have some of the diversification effects that an index fund would delivery, albeit Berkshire is exposed more than average to the insurance industry. Barron's also recently declared it fairly priced, after not long ago mentioning that it was a little expensive (before it pulled back). But touting his own stock would not be Buffett's style. Furthermore, Buffett is correct that an index fund would certainly track the indexes better, something that rarely seem to occur with Berkshire anymore, although I would have to run the numbers to be sure. Rather than touting his stock, Buffett is more comfortable touting the individual companies within Berkshire, along with their products - and sampling them with the freedom and joy of a school boy. Then again, I imagine $60+ billion would make you feel a little giddy at times, but how would I, or just about anybody really know.
Tickers: BRK.A, BRK.B
Warren Buffett was smiling this morning on CNBC while announcing his role (and that of Berkshire Hathaway) in helping Mars Inc. buy Wrigley. Berkshire will be contributing about $6.5 billion to help with the acquisition. What does Buffett get in return? The $6.5 billion consist of $4.4 billion of subordinated debt to help Mars pay for the acquisition, along with a $2.1 billion equity stake in Mars after the deal closes, with the shares being bought at a discount. Just another version of the "golden rule" - those with the gold make the rules. On the other hand, a nice premium is being paid for Wrigley, something that Buffett usually tries to avoid, although he has paid-up a few times to get a strong name. At least here he is getting a discount on the premium (if that makes sense).
Of course, everything may not be as sugar coated as the company's products. A combined Mars - Wrigley will control a large segment of the confectionery market, creating a "global powerhouse" to use the WSJs words. It will be interesting to see if this becomes an anti-trust concern. After all, regulators do not have anything else to work on right now, so making sure the chocolate and sugar markets are not being cornered should be a priority.
Finally, the real story may have been the fact that Goldman Sachs was willing to step up to the plate and fund the merger to the tune of $5.7 billion. Not a big risk or huge numbers for Goldman (interesting how $5.7 billion is not considered huge anymore), but certainly big enough to show up on the financial statements. Personally, I kind of miss Merger Mondays. It always starts the week off with a little momentum. Not sure this is the blockbuster that will break the trend, given that Berkshire was needed to co-sign the loan, but it is a start.
Tickers: WWY, BRK.A (for those driving Mercedes), BRK.B (for the rest of us)
