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Jasper M
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Retired, 48, been making my own financial decision since I was 17. Every day, for the rest of my life, I will be a recovering Merrill Lynch customer. Proudest Financial Moments: Personal Best return on equity: 20/1, Leap Puts on Citi & GE, closed in late 2008 Personal best adjusted for... More
  • NOTE the assumptions 8 comments
    Oct 3, 2010 10:48 PM | about stocks: PRU, HOG, AAPL, MS, GE, GS, UUP, BRK.B, SHLD, SPY, HYD
        The Administration, and its various loyal mouthpieces, tell us all is well, "welcome to the recovery", etc. And this includes an assumption, usually unspoken, that stock prices will rise.  They clearly hope so, otherwise the huge taxpayer position in things like GM, AIG, and Citi would be underwater forever, and 'we can't have that!
        It goes without saying that, in such an environment, it is also presumed that Warren Buffet will do well. 
         
       But, interestingly to me, much of these assumptions line up very well with the expectations of well over half of the "doom and gloom" crowd. If you flit on over to Zero Hedge, probably The main crossroads of shark-jumping conspiracy theory, the nigh-unchallenged assumption currently is of an inflationary collapse, that propels the absolute price of productive assets (=stock in dividend paying companies) higher and higher. And again, Warren buffet is expected to prosper. 
       Who would have thought we would find Tim Geithner and "Tyler Durden" on the same page?  
       The 'evidence' brought up to support this is a supposed rise in money supply . . . when a significant fraction of this is bank balance sheets, which are marked to mythology, not to market. The problem with that is, to actually serve as money supply, to be offered as payment in a free market, those assets must be exposed to market valuation, if only briefly . . . at which point, much of it vanishes. Let me direct anyone doubting this to the results of various FDIC closures, where bank that re supposedly only marginally insolvent end up costing the taxpayers many millions, as their buyers demand assets be marked to market. 
      
        Gold is also enjoying a singular uniformity of opinion about its immediate future: 90% bulls. And why not? The immediate past has been stellar; and that's pretty much all that goes into the calculus of most participants. Such excesses of opinion are seldom stable, and usually lead to declines. Nothing startling about that – most long bull markers are full of scary pauses. 
        But this time, so many leverage happy, yield–hungry players have loaded up on gold, that any decline is likely to get amplified considerably. All those hedge funds, desperate to generate the alpha that will justify their "2 and 10", are piling into gold like they piled into everything else, and it will have the same result. 

        And the further away from 'the gold standard' you go in commodities, the more severe these certainties seem to get. Silver is 90+% bulls. Some of the softs are even worse. And we are now told definitively that "Oil is now permanently above $80" (Zero Hedge, again) – the ghost of Boone Pickens' lost billions will haunt that call. 
       Likewise, the $US, we are oh-so-confidently assured, is toast. This despite the fact that every other major currency is worse off (I omit the Swissie from this, as its total volume is much less). The Euro is doomed by the blatantly criminal fraud of its shaddier users, and China is an absolute catastrophe waiting to happen. 

        Note the assumptions.
        People are assuming, nearly universally, that not only is QE2 coming, but that it will have some effect. Given the verifiably teensy impact of QE 1, this is very much unfounded. They expect an inflationary pulse, when all the real data show, and in fact all not-prostituted economic theory predicts, a decline in money supply. 
        People assume that the recent 'go-go' economy is the norm, and the troubles of the last 3 years are some sort of anomaly. A quick flip through the history books will tell you otherwise – unless of course, "it's different this time". 
        Deflation is inevitable at this point, a falling safe. Credit is saturated, to the point where marginal addition is decreasing money supply. There is nothing the Fed can do to prevent deflation, but much they will try, which will accelerate it. 
       And thank goodness! The 'growth' was the result of demand artificially pulled forward, by government meddling (=low interest prices), and was therefor unsustainable. Prices must come down . . . and they will, to the betterment of frugal consumers throughout the nation. It will be painful to some, debtors and foolish lenders, but that is the bed they made.
       And this means the $US will go up. Probably up a lot, a lot more than the powers That Be would wish . . . and probably despite their repeated attempts to prevent it. 
        But when these deflationary realities forces themselves on all those monolithic inflation assumptions, there is going to be quite shock in the market places. A lot of money lost. And gained. 

    My money were my mouth is: This is my deflationary expectation portfolio.

    Short PRU (legacy position, but nowhere to go but down)
    Short HOG (luxury, that routinely kills its owner)
    Short AAPL (a little guilt here, but they are not the Apple I remember)
    Short HYD (high yield muni fund – kiss of death)

    jan '11 Puts on MS, GE, GS, & HOG
    jan '11 & march '11 calls on UUP
    leap puts on BRK-B, SHLD (splat!), & SPY
     all of the above well out of the money, save MS, GE, & GS

       These are my actual, current positions. 



    Disclosure: I hold all the positions specifically mentioned.
    Themes: inflation, deflation, QE, Fed, Warren Buffet Stocks: PRU, HOG, AAPL, MS, GE, GS, UUP, BRK.B, SHLD, SPY, HYD
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Comments (8)
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  • Parker Bohn
    , contributor
    Comments (26) | Send Message
     
    Interesting.

     

    I am short BRK-B leaps, way out of the money at 35.
    BRK-B looks fairly valued to me at the current $80-90 range. I think it would be quite cheap under $50. $35 is absurd, and I'm happy to pick up a few dollars providing insurance on this.

     

    You are obviously no dummy, and I rarely get an opportunity to hear from someone on the opposite end of one of my positions. Please let me in on your thought process a bit more.
    Thanks!
    7 Oct 2010, 04:35 PM Reply Like
  • Jasper M
    , contributor
    Comments (1652) | Send Message
     
    Author’s reply » Mr. Bohn,
    My puts' strike is $40, so we are fairly close to counterparties on this one! An interesting conversation, indeed.

     

    More of my thoughts, as requested:

     

    BRK is, at its core, an insurance firm. And that means arbitrage of risk. Le Buffet et al looks for where they estimate fear is overstated from actual risk (high bond yields and/or low equity prices), and jumps in to take the difference.
    1) Like Napoleon before him, Buffet shows signs of operating past his mental prime.
    2) The coming environment is one even he has not operated in before.
    3) Even if I'm wrong about the above, much of current price is built on his name. Even if his successor(s) are as good, his inevitable absence will not be received well.
    4) Deflation certain, = $US up, asset prices down.
    5) Insurance, like all finance, is a leverage game. And leverage will increase the pain on the way down. It is no accident that the collapse of stock prices in 2008 was led by financials.
    6) Feds are out of bailout wiggle room, as voters are getting cranky.
    7) Housing prices, the final underpinning for So Much of the credit pyramid, has continued to Just Get Worse.
    8) For those who follow technical analysis (I do), the Elliott Wave counts are just ghastly.
    9) If you follow fundamentals, adjusted for The Split, BRK was down around 50 in March of '09 . . . and the fundamental picture seems certain to get even worse than then.
    (I address several of these in more depth in various previous Instablog posts)

     

    Summing up, looks to me like there's Thousands of points of vacuum under this market in general, and every reason to expect BRK to get more than its share of that decline.
    So, let me say that I admire your courage.
    7 Oct 2010, 07:09 PM Reply Like
  • Parker Bohn
    , contributor
    Comments (26) | Send Message
     
    Thanks for the discussion. It is useful to me to look at BRK in more detail. I bought BRK shares during the crisis, and I've had to learn more about the company as the share price has risen and my margin of safety has shrunk.

     

    Simple is good, so I'm going to attempt to value BRK with a simple sum of the parts method (all numbers are billions).

     

    Subsidiaries (worth a total of 111 to 135)
    44 = BNI - Burlington Northern's purchase price counting BNI shares already held + debt assumed.
    14 = Geico - looks to be about the same size / market share as PGR, which is publicly traded at a value of 14
    15 = General Re - valued at 10 times (underwriting earnings + an estimated 5% return on insurance float)
    16 = BH Reinsurance - also valued at 10 times (underwriting earnings + an estimated 5% return on insurance float)
    11 = Midamerican Utility - valued at 10 times 2009 net income
    11 to 35 = Other Businesses (Marmon Group, McLance, Dairy Queen, Borsheim, Clayton Homes, etc) - if valued at 10 times depressed 2009 earnings, you get a value of 11. 15 times full earnings (2007-2008) gives 35.

     

    Equities (as disclosed in BRK's latest quarter, valued at market, 10-8-10. Total = 46)
    10 = KO
    8.2 = WFC
    6 = AXP
    2.9 = KFT
    4.7 = PG
    2.4 = JNJ
    1.9 = WMT
    1.8 = WSC
    8.2 = other equities

     

    Non-traded shares (total = 18)
    5 = GS preferred shares - these pay $0.5 billion per year, so I think they're worth more than 5, which was BRK's cost.
    3 = GE preferred shares - these pay $0.3 billion per year, so I think they're worth more than 3, which was BRK's cost.
    3 = Dow preferred shares - these pay $0.255 billion per year, or an 8.5% annual return if valued at 3.
    3 = Swiss Re preferred shares - these pay $0.36 billion per year, or a 12% annual return if valued at 3.
    4 = 4.4 billion in funding for Mars to buy Wrigley, can't find info on the terms so let's take it close to face value.

     

    Total value of the parts = $175 to $198 billion

     

    I believe that this figure actually understates the value of the BRK for several reasons.
    1) BRK greatly benefits from its conglomerate structure, which gives it a strong credit rating and the ability to allocate capital.
    2) I've taken conservative valuations of everything except for equities & Burlington Northern which were valued at market/cost.
    3) Warren Buffett is old, but he adds more value than a typical CEO, due both to his expertise and his status, which allows him access to deals other CEO's would not have.

     

    BRK's market cap is currently $206 billion. It would not be difficult to argue that BRK is really only worth $150 billion. However at a strike price of 40, you are saying that BRK must trade below $99 billion for you to profit. At my strike of 35, I don't lose money unless BRK trades below $87 billion. Markets often do irrational things, but in this case, I'm happy to bet against it.
    8 Oct 2010, 08:41 PM Reply Like
  • Parker Bohn
    , contributor
    Comments (26) | Send Message
     
    Also, a note on leverage.
    BRK is a leveraged company, however, they are much less leveraged than a pure financial. For instance looking at banks I see that C & BAC have assets equal to 12.5 and 10.1 times equity, respectively. Looking at insurance companies, ALL & PGR have assets equal to 7.3 and 3.4 times equity.
    To contrast, BRK has assets equal to 2.4 times equity.
    Also, comparing BRK to other companies in the property & casualty insurance industry, BRK has a debt to equity ratio lower than 79% of its peers.
    ycharts.com/calculatio...

     

    As evidence of its solidity, BRK didn't take a dime from the government during the crisis, but was actually a creditor to firms in trouble to the tune of about $20 billion, a great opportunity for Buffett.

     

    Thanks again. I'm always looking for disconfirming thoughts, and I find it to be much more valuable talking to someone who disagrees than someone who agrees.
    8 Oct 2010, 08:43 PM Reply Like
  • Jasper M
    , contributor
    Comments (1652) | Send Message
     
    Author’s reply » Oh . . . SO much to answer . . . Please be understanding if I don't touch on each and every line.

     

    In no particular order . . .
    i would argue that, in the current environment, leverage is very hard to accurately quantify, esPecially of financials – So much of their holdings are marked to Unicorn that their actual equity may be zilch. I am quite sure that C and BAC have no real equity, at this point.
    GE, for example. Not a zilch, but Waayyy overvalued.
    And GS. Hatred leads to scrutiny, and it's the nature of depressions that people get cranky, and lax interpretations of laws an rules that were SOP in better times get more stringently applied.
    And, again, once the Fed spigot is shot off, their business model can't last.
    As for "better than 79%", cold comfort if 80% fail.

     

    As for other parts:
    The insurance arm will be on the hook for all sort sorts of thing the agreed to insure because they thought them unthinkable.
    Clayton Homes I once worked for, their HQ in my neck of the woods. I saw enough to convince me that they are following a blatantly predatory business model (well over 50% repossessions, back in '04 or so, and they were Fine with it) and will likely draw all sorts of extra regulatory, and perhaps legal, attention. it's going to be a BAD time to be in real estate, and for some time.
    Most of the large cap equities you mention are on my 'avoid' list, as they seem to be benefiting from the notion that "consumer staples' are relatively immune from bear markets. I believe this is an error. And some of them are getting pretty sloppy, resting on their laurels. For example, I have personally found KFT to be letting the quality of its core product go. WMT is getting undersold where I live.

     

    Conglomerate structure only helps w/ capacity to reallocate capital IF the troubled areas are the minority. In a time of severe stress, Most of those holdings will be crying out for cash, not delivering. And as for credit rating, the world is littered with the bones of conglomerates that failed to get capital.

     

    And I agree that Warren Buffet does inDeed add more than a typical CEO – which is Not a good thing, at his age. Think of it as another uninsurable risk: He is a valuable machine tool, which cannot reliably be replaced, nor even valued, so how would one insure it?

     

    Your posit that you have valued all things conservatively seems to be based on valuing them at "distressed '09 levels". One of the main points I tried to make in my original post (and several others before), is that '08-'09 was not some anomaly, temporarily interrupting a sustainable status quo. Rather, it was a beginning of the unwinding of an epic credit saturation, paused for a bit by yet more unsustainable policy.
    Things can get Way worse than '09; in fact, seem sure to.
    It's not like this hasn't happened before. From the peak in 1929 to the bottom in '32, the Dow lost 89%. The fundamentals are worse now, and the Fed is arguably more constrained.

     

    Finally, you are mistaken on one point – that the company needs to have market cap below $99 billion for me to win: I just need people to be concerned that it Might trade that low Some Time before expiration. Time premiums are cheap now, because people are complacent. That will change
    I have No intention of riding this one all the way down, as I have concerns about the stability of the various exchange. THInk about the effect of the current mortgage fraud crises on real estate . . . now imagine a similar event in, say, equity trade. I don't want my winning to be stuck on the books of a defunked broker. I will close when I think downside volume is peaking, not try to pick a price bottom
    8 Oct 2010, 11:54 PM Reply Like
  • Jasper M
    , contributor
    Comments (1652) | Send Message
     
    Author’s reply » Here's another way to put it:
    BRK's portfolio is a a largely one sided bet on the sustainability of the Status Quo – debts will mostly continue to be serviced gracefully (e.g., GE), "unthinkable" misfortunes will only arise in small, hedge-able amounts (Insurance), decline in money supply and money velocity will never gets so deep as to threaten the cash flow of consumer staple stocks (KFT, PG, JNJ).
    That was a great bet, once upon a time. But not now. The Status Quo won't survive, can't, much less prosper, and hitching one's wagon to it now is an invitation to torment.
    10 Oct 2010, 10:43 PM Reply Like
  • Parker Bohn
    , contributor
    Comments (26) | Send Message
     
    "Marked to unicorn". That's pretty good.

     

    We could argue about BRK forever. I suspect the difference between us goes down to our core investing philosophies. You are a speculator and I am a value investor.

     

    The interesting thing about these puts is that we will probably never know who was right. There are high odds that they will expire worthless, but that doesn't necessarily mean I've made a smart bet. If there is a 25% chance of those puts going into the money, then I've made a mistake at the premium I received. In actuality, I think the market has mispriced these puts, and the real odds of BRK going below 35 are well below 10%.

     

    I do hope the market declines 40-50%. I like it when stocks are cheap. Stocks are not cheap now, but if I had to lock my money up in cash, stocks, or bonds for 10 years, I would choose stocks.
    15 Oct 2010, 07:17 AM Reply Like
  • Jasper M
    , contributor
    Comments (1652) | Send Message
     
    Author’s reply » funny, I don't Think of myself as a speculator. I saw those puts (as I imagine you did) as a value, cheap at the price, compared to likely return. So I took a position, and will hold on to them until I am convinced otherwise (again, I imagine, much like yourself).
    One could argue that the presence of an expiration changes things, . . . but it changes them for both of us, so can't be a criterion for investor/speculator differentiation.

     

    i propose to you that our difference lies, not so much in approach, but in simple expectation. You expect that productive assets, with above average management, will be priced higher later than now. I expect that (generally reliable) historical tendency to be completely overwhelmed by deflationary forces for most of the rest of my life. For me, this is not a case where I think "there's only a 20% chance, but if it hits, I'll make a bundle!" plan. I think this is a near certainty.

     

    Put another way, I see myself as a values investor – but I believe the undervalued asset here is cash. So I take the bearish bets.
    15 Oct 2010, 03:52 PM Reply Like
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