Tom Brown recently posted a rebuttal to Jason Zweig’s Wall Street Journal column. Geoff Gannon also wrote a great follow-up article with more on Benjamin Graham. I suggest reading all three articles.

In this post, I wanted to comment on a few aspects of Tom Brown’s argument, some of which I have been thinking about lately. The following is a quote from Tom’s post:

True value investors, by contrast, tend not to worry what might happen in the interim. Instead, they come up with their best estimate of a financial company’s intrinsic value by estimating the magnitude of likely losses along with its “normalized” earnings level two or three years out. They then compare that estimate of intrinsic value with the stock’s price today. Zweig says such estimates are impossible. I disagree.

I have always enjoyed Tom’s posts, but I can see a few problems with the above statement. (As a disclaimer, I know relatively little about financial companies, as they are out of my circle of competence. I hold no interest in any financial beside Berkshire Hathaway.)

First observation:
With highly leveraged financial companies, what happens in the “interim” can not only hurt you, it can kill you. Compare a bank to a retailer. Let’s say that you find a cheap retailer, where you estimate normalized earnings a few years out to derive its value. Assuming your estimate is correct, you should be able to ride out any short-term volatility to obtain the long-term value of the company. Like Tom says, that is the foundation of value investing.

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The cover story of the May edition of the Bloomberg Markets magazine discusses Nassim Nicholas Taleb’s affect on Wall Street:

On a freezing day in March 2007, Nassim Taleb walked into a conference room at Morgan Stanley’s Manhattan offices on 47th Street and Broadway to address a group of the firm’s risk managers. His message: Your models don’t work.

Using a whiteboard to scribble out his calculations, Taleb, now 48, began one of his rants, this time against stress tests–Wall Street lingo for examining how a market rout will play out. Stress tests are inherently risky because they ignore rare but potentially devastating events, Taleb said.

See the Full Article here

It’s always interesting to see what other investors or thinkers have on their bookshelf. In the introduction to the article, there’s a picture of Nassim Taleb in his library. Using the hard copy, I picked out a few books that Taleb has read (or hasn’t read, by Umberto Eco standards). These should be useful for expanding one’s network of mental models:

• Darwin’s Dangerous Idea, by Daniel Dennett
• Collapse, by Jared Diamond
• Guns, Germs and Steel, by Jared Diamond
• The Selfish Gene, by Richard Dawkins
• Rational Herds, by Christophe Chamley
• The Perception of Risk, by Paul Slovic
• Knowledge and Decisions, by Thomas Sowell
• Serendipity, by Royston Roberts
• The Construction of Preference, by Sarah Lichtenstein and Paul Slovic
• Evolutionary Dynamics, by Martin Nowak
• The Quark and the Jaguar, by Murray Gell-Mann
• Why Beauty is Truth, by Ian Stewart
• The Eastern Origins of Western Civilization, by John Hobson
• For and Against Method, by Imre Lakatos and Paul Feyerabend
• Probability via Expectation, by Peter Whittle
• Probability Theory, by E. T. Jaynes
• Plight of the Fortune Tellers, by Riccardo Rebonato
• Imperfect Knowledge Economics, by Roman Frydman and Michael Goldberg
• The Business of Options, by Martin O’Connell
• The Logic of Scientific Discovery, by Karl Popper
• Unmaking the West, by Philip Tetlock

On another note, I have joined the team of authors at Reflections on Value Investing. If you haven’t already, head over and subscribe to the RSS feed. It’s a must for any value investor. Although this was posted at both sites, for the most part, my occasional posts at Reflections will have different content than FutureBlind.

In today’s Wall Street Journal, there’s a great interview with Edward Thorp and Bill Gross.

Both investors are asked about current market conditions and their thoughts on investing in general.

Ed Thorp is a hedge fund manager who ran Princton-Newport Partners and has returns of 20% over a 28-year period (ending 1998). In addition to his investing skills, Thorp is best known for his work at the Blackjack tables. In 1962, he authored the book Beat the Dealer, which explained the methods he used to win at Blackjack.

For more information on Ed Thorp, check out the book Fortune\’s Formula. It’s a great read that details the evolution of information theory, the Kelly Criterion, gambling strategies, hedge funds, and the mob’s involvement in all of the above. Math, gambling, the mafia, and investing. Who could ask for anything more? Also, if you’re interested in Thorp’s Blackjack strategies (card counting), the book Bringing Down the House is another great read. But I’ll stick to the subject of investing for this post.

Over-betting

Below is a section from the WSJ article where Gross and Thorp discuss hedge funds:

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Buffett has pulled it off again. He’s made a creative, favorable bet that may pay off handsomely for long-term Berkshire shareholders.

Over the past year, Berkshire Hathaway sold put options on the S&P 500 and three foreign indices. Expiration of these puts range from 12 to 20 years out, and Berkshire collected $4.5 billion in premiums. Unlike regular puts, these are exercisable only at their expiration dates. On those dates, Berkshire makes a payment only if the index has lost money over the period of the option.

Selling these puts is essentially saying: In 15 years, I promise to buy the S&P 500 from you at a price of $1,468 (closing 2007), if it trades below that price. In exchange, you give me $4.5 billion right away.

Buffett doesn’t disclose the size of the actual options. The $4.5 billion in premiums tells you they are big, but apparently not big enough relative to Berkshire to cause any problems.

The counterparties (the people who made the agreement and paid the premium) are most likely large financial institutions who are hedging their long-term bets in favor of the market. So it may turn out to be a dumb bet for them, but they’re essentially purchasing insurance on what they have or will have in the market.

For Berkshire to lose money, a few things have to happen. To keep it simple, let’s just talk about the S&P 500, because we don’t know which foreign indices were used.

1. First, over the next 12 to 20 years, the market would have to have a negative cumulative return.
2. Second, that negative return would have to be large enough to overcome the premiums received.

How large? Once again, we don’t know the size of the options. But the premiums, which were $4.5 billion at the time they were written, will have compounded for more than 15 years by the time of expiration. If Buffett (or future Berkshire managers) can achieve 15% annual returns, the premium cash will have grown to over $36 billion. So the aggregate losses on the put options—the size of the options times the amount of negative returns—would have to exceed $36 billion for any profits to be erased.

Because of their long-term length, it mitigates the risk of a short-term Black Swan-type event affecting the options. A “Black Monday” one day anomaly would have little effect, other than a temporary quarterly adjustment. Something could still happen (i.e. a long depression, or a nuclear war, God forbid) that would cause losses. But this bet seems pretty favorable as long as the world economy does alright in the long run. Chalk one up for the Oracle of Omaha.

Photo by saibotregeel

Tariq Ali writes a great post about the follies of our fellow investing clan. I disagree with a few of the specific points he brings up but think the overall message is right on.

It’s wrong to judge the quant and technical analysis firms without knowing exactly how they work. If an investor who was just starting out asked me what style I suggested, value investing would be my answer, hands down. It’s much easier to grasp, and anyone can do it—you don’t need a PhD or any extraordinary skills. But that doesn’t mean that the other forms of investing aren’t valid.

Some traders are just lucky. Some value investors are just lucky. Both styles have practitioners who are phenomenal at what they do, and who have proved it over time. Until you’ve practiced all of these forms of investing, it’s hard to judge which is more valid.

The Headcount

Using the number of employees at a firm to judge success is misleading. Again, I don’t know much about them, but many don’t just run a single fund. Citadel for example has a wide range of investment-related activities (much like investment banks like Goldman Sachs). Also, it’s hard to get an idea of exactly how many of those employees are the actual decision makers for the portfolio (what really matters).

Warren Buffett has 1.5 employees (himself plus half of a Munger) on the investing side, and manages over $100 billion. I’d say he has done just fine over the years. There are three clear advantages to having a limited headcount. One, it avoids group-think when making decisions. Two, there’s no need to worry about “one-employee disasters”, ala Amaranth and Brain Hunter. And three, more obviously, it lowers overhead for small firms.

Eddie Lampert has a few dozen employees. Mohnish Pabrai has 1.7 employees. Neither is the “correct” amount as it all depends on your investing style. From what I’ve heard, Pabrai does little to no scuttlebutt. Lampert sends his analysts out on research and fact gathering missions and is constantly analyzing mountains of data regarding his positions. Both investors have proven they are highly capable and successful.

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