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John Vincent
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Previously a professional in the software industry and currently focused on absolute returns based on investment research and analysis associated with our personal portfolio.
My blog:
One Family's Blog
My book:
Profiting from Hedge Funds: Winning Strategies for the Little Guy
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  • Half Baked CNN Coverage of Berkshire Hathaway's latest stake adjustments
    CNN Money ran an article on 08/15/11 titled “Buffet Adds $58 Million Stake in Dollar General” with the opening line “If you want to invest like Warren Buffett, start by adding Dollar General to your portfolio and offloading shares of Kraft”. Anyone glancing at the headline and the first lines would gather Warren Buffet to be mighty bullish on Dollar General and bearish on Kraft. The complete truth however went largely missing. There is no denying $58 million is a solid chunk of change – but it pales in comparison to Buffet’s investment portfolio size which towers at over $115 Billion (~$48B Cash, ~$67B Equity). This brings the value of the new stake in Dollar General to be just 0.05% of his total investments. It is also a fact that Buffet bid adieu to six million shares of Kraft during the second quarter. The article conveniently omitted to mention that his remaining stake of 99.5 Million Shares of Kraft is valued at around $3.5 Billion which is around 3% of the value of his total investments. The naked truth is that Berkshire Hathaway’s current stake in Kraft is valued at over sixty times the value of his new Dollar General stake. The article naively implies getting rid of Kraft and buying Dollar General is a sure bet to be an investor like Buffet.

    Rather than quoting large numbers, let us cut to the chase and compare how changes in the share price of Dollar General and Kraft will impact Berkshire Hathaway’s overall portfolio value. The task at hand is to have a 1% impact on Berkshire Hathaway’s investment portfolio, and for that the overall portfolio value has to increase or decrease by around $1.15B. The table below shows how Dollar General’s (DG) and Kraft’s (KFT) stock prices should move to have the 1% impact on Berkshire Hathaway’s portfolio:

    Stock Berkshire Hathaway Holdings Value Current Price per Share Projected Price Per Share for 1% Performance Imapct
    Dollar General (DG) $58M $32.19 $670.44
    Kraft (KFT) $3.5B $34.68 $46.07

    Dollar General’s price per share has to go up to $670.44 from the current share price of $32.19 for Berkshire Hathaway’s Dollar General Holdings to have a 1% positive performance impact on the overall portfolio. By the same token Kraft’s price per share only needs to go up from $34.68 to $46.07 to have the same impact. To summarize, the CNN articles’ premise is completely misleading - the portfolio adjustments in the second quarter 2011 are very minor compared to the overall portfolio size to warrant any such judgment call. Furthermore, Berkshire Hathaway’s 2nd quarter 2011 adjustments may have nothing to do with Warren Buffet’s stock selection. It is highly likely that the Dollar General (DG) pick was by Todd Combs, the hedge fund manager Buffet tapped in late 2010, as the amount involved is comparatively little. While the article by CNN Money did a disservice to the investing community, articles from Bloomberg and Morningstar did convey reputable information. Readers can also find the information by comparing Berkshire Hathaway’s latest 13F SEC filing with their previous filing.

     
    Aug 18 7:15 AM | Link | Comment!
  • Triple Leveraged ETFs - An Introduction
    The Triple Leveraged ETFs which debuted in November 2008 is still considered as a relatively new product from Direxion. Direxion is a 1997 private enterprise focused in specialized investment products. Below is a list of some of the most popular Direxion Triple Leveraged ETFs:



    ProductTicker SymbolPerformance Benchmark
    Direxion Energy Bear 3X SharesERY300% the inverse of the return of an investment in the Russell 1000 Energy Index.
    Direxion Energy Bull 3X SharesERX300% the return of an investment in the Russell 1000 Energy Index.
    Direxion Financial Bear 3X SharesFAZ300% the inverse of the return of an investment in the Russell 1000 Financial Services Index.
    Direxion Financial Bull 3X SharesFAS300% of the return of an investment in the Russell 1000 Financial Services Index.
    Direxion Large Cap Bear 3X SharesBGZ300% the inverse of the return of an investment in the Russell 1000 large-cap index.
    Direxion Large Cap Bull 3X SharesBGU300% of the return of an investment in the Russell 1000 large-cap index.
    Direxion Small Cap Bear 3X SharesTZA300% the inverse of the return of an investment in the Russell 2000 small-cap index.
    Direxion Small Cap Bull 3X SharesTNA300% of the return of an investment in the Russell 2000 small-cap index.

    The 300% leverage is achieved by using futures contracts and swap contracts. Below is a look at how the expenses associated with leverage affects the overall performance (taken from Direxion leveraged fund introduction sheet):



    ProductFormulaExpected Return Sample
    3X Bull FundsDaily Benchmark Return * Daily Beta - Daily Interest Expense – Daily Fund Expense Ratio2.00% * 3.0 - 0.03% - 0.005% = 5.965%
    3X Bear FundsDaily Benchmark Return * Daily Beta + Daily Investment Income – Daily Fund Expense Ratio2.00% * 3.0 + 0.06% + 0.005% = 6.065%

    The expected return sample assumes a benchmark return of 2% for the bull fund and a -2% return for the bear fund. As shown, the impact of expenses is minimal on a daily basis – in fact, for the bear fund, there is investment income associated with creating the leverage as opposed to an expense for the bull fund because, the bear fund uses short-selling which realizes income that can be invested to produce daily income.

    The question to help figure out the risk associated with the leverage is: What happens to an investment in one of these funds (either bull or bear), if the associated index goes up more than 33.34% one day and follows it up with a 33.34% down day? – The answer is that your investment will go to zero – the up-day will wipe out the bear fund while the down-day will wipe out the bull fund. Such an outcome is unlikely but helps demonstrate the fact that in volatile markets that lack direction, these investment options can lose value very quickly. A more realistic example in a market that lacks direction using FAS and FAZ and assuming FAS and FAZ along with the associated index value is all at 100 at the start of the first trading day:




    End of Day
    Index Performance PercentageIndex ValueFAS ValueFAZ Value
    One-3.0097.0091.00109.00
    Two+3.0099.9199.1999.19
    Three-5.0094.9184.30114.07
    Four+10.00104.41109.5979.85

    So, over the course of just 4-days, there is an underperformance - FAS should have been at 113.23 and FAZ should have been at 86.77. Another example that uses FAS and the same assumptions in a market that is in a steady up-trend follows:



    End of DayIndex Performance PercentageIndex ValueFAS ValueFAZ Value
    One+3.00103.00109.0091.00
    Two+2.00105.06115.5485.54
    Three+5.00110.31132.8772.71
    Four+4.00114.72148.8163.98

    In this scenario, there is an outperformance when compared to the target index value at the end of the fourth day – FAS should have been 144.16 and FAZ should have been at 55.84. Similar outperformance exists in a steady down-market as well.

    Summary:

    It is critical to understand the use of leverage and how it impacts the performance of the funds over a period of time. Since these funds track the performance of the associated index at 3 X (or inverse) leverage on a DAILY basis, it is not possible to mimic the performance of the associated index over a period of time. As the latter spreadsheets indicate, if one can guess the market direction correctly, the funds can provide outperformance over the period of time anticipated. Conversely, in a market that lacks direction, these funds are unsuitable.

    The legitimate question that begs is if one can get 3X leverage using these funds, why not funds that have leverage 5X, 10X, 100X, etc. Presumably, one can strike gold overnight by guessing the market direction correctly for a single day by holding a 100X leveraged fund. While the advantage is undeniable, technically it is impossible to increase leverage much further – margin requirements limit the amount of leverage possible. A commonly overlooked factor is that the chances of these funds going to zero over a short period of time increases as the leverage increases. Looking at the performance of FAZ/FAZ since its inception should make this pretty obvious - both these indexes show large negative returns over the few years since inception, indicating a strong possibility of both going to zero eventually.

    We have nibbled a few times on FAS/FAZ on a short-term basis realizing small profits. Our opinion is that these products are suitable for the following scenarios:
    1. The benchmark index is at extremely overbought levels. Entering the bear-funds at such levels should prove beneficial over the short-term (a few days).
    2. The benchmark index is at extremely oversold levels. Entering the bull-funds at such levels should prove beneficial over the short-term (a few days).
    3. You anticipate a steady bull/bear market for the benchmark index. Entering the bull/bear funds during such market conditions should prove beneficial over the anticipated period (longer term).
    4. Day trading – when the benchmark index is extremely volatile, there is an opportunity to do roundtrips to realize small profits (intra-day).

    Because of the leverage and associated risks, the above strategies should only be used with small portions of your overall portfolio. But, the risk-reward ratio is good assuming your strategies are sound and comfortable to work with.


    Aug 12 1:43 AM | Link | 1 Comment
  • Exec-proofing – Avoiding Companies That Suffer From Excessive Executive Pay
    The raison d'être behind this approach is to ensure that we steer clear of companies that experience diminished shareholder returns when company executives and the board of directors work together to augment themselves as opposed to the company’s shareholders. Executive compensation and the excessive nature of it is a very complex topic and numerous factors guide executive compensation up at a much faster pace than that of rank-and-file workers on an average basis. Further, the base numbers are hundred-fold higher for executives as compared to average workers in corporations.

    Below is a look at several popular alternatives for gauging executive pay and how they come up short when it comes to effectiveness. This is also an attempt to debunk several myths about executive compensation:
    1. Let market forces determine the level of compensation: This alternative essentially makes the argument that there is no problem as market forces guide compensation. Should that be true, the counter point would be that the bigger and more profitable companies would always have at their helm the highest skilled CEO’s, a point that can easily be refuted.
    2. CEO pay should parallel company performance: Getting paid a significant percentage from the earnings generated is presumably valid. However, there is a huge misunderstanding in such a thought process – the individual concerned usually owns a significant portion of the company’s outstanding shares making it possible for them to participate at that level on the company’s earnings anyway. Issuing salary commensurate with earnings or its growth there of is essentially double dipping on a very large scale. This is especially true when the CEO happens to be a founder.
    3. Use the CEO’s track record as a measure of pay: While it is common for Wall Street to label CEO’s as “turnaround stars” and “growth stars” the problem is usually that such “stars” usually demand (and get) a premium that far exceeds the additional value that their track record brings to the company.
    4. Compare the ratio of the average executive pay to the CEO compensation in the company: This is counter-intuitive as the executive team generally holds an unfair edge compared to rank and file workers. Therefore, in the companies that have a problem with excess compensation, it is highly likely to find a correlation where the other executives are also enjoying excessive compensation making it a bigger problem as far as shareholder value goes.
    A gauge of executive compensation that makes a lot of sense to us is comparing CEO compensation with the average pay across the company - the higher that number, the more the company has a problem with excessive compensation. This gauge ignores such factors as the size of the company, profitability, and earnings growth but instead focuses on the disparity of pay. The main idea with this gauge is recognizing that, in an ideal world, all employees get to participate in the success of the company they work for, albeit on a scale that is commensurate with skill-level.

    The gauge favors companies that encourage a career path that ends at the CEO level as opposed to hiring from outside - the SEC filings for the last five years can be used to come up with a figure for average annual CEO compensation and divide it with the average compensation of the rest of the employees in the company. Needless to say, such an exercise is time consuming to compile. A similar measure that has most of the characteristics of this but less difficult to compile is to compare CEO compensation with the average worker wage of roughly $20/hour.


    Aug 12 1:19 AM | Link | Comment!
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