Introduction
Trying to escape reliance solely on experience,
I rely on my student skills for this post. I have indicated numerous times that
the Neuro-economics professors/scientists at Caltech have shown most people use
their cumulative experience as the main or sole basis for making judgments. I
try to study current and past history as an important source of additional
experiences.
This week I have turned to two of
what many have called in their time the smartest men around, Sir Isaac Newton
and Warren Buffett. The latter's annual letter came out Saturday morning and I
read it before we drove to Mount Vernon to celebrate General George
Washington's 285th birthday. While the letter was signed by Warren, it clearly
contained some of Charlie Munger's insightful views and was probably edited by
the incomparable Carol Loomis.
Sir Isaac Newton
Sir Isaac is acclaimed as the
identifier of the laws of gravity. For many of us market followers this is
often translated to what goes up, comes down. We always hope that our
particular investment will either continuously rise or we get off the back of
the market tiger successfully before he runs in the other direction.
At this particular point I have been
focusing on Sir Isaac's investment activities to guide my clients' and family's
investment accounts. For almost any gathering of people who are involved with
the market the question comes up, “Should we sell after this remarkable rise we
have had in many stock markets around the world?” I should not claim
forecasting skills, but I can serve up lessons from history.
The South Sea Company was what we
would call today an unusually clever public-private partnership that was
founded in 1711. The company was awarded a commercial trading monopoly with the
lands in the South Seas (South America) and for this the company would assume
the war debt coming out of the War of Spanish Succession which ended with the
Peace Treaty of Utrecht in 1713. Originally the promise of the company was a 6%
yield, but as the government offloaded more of its debt on the company, the
promised yield was dropped first to 5% and then 4%. In the Peace Treaty the
monopoly was translated to mean one ship a year and there were some
restrictions as to the commodities to be traded, but with the fabled gold and
silver production in South America the ownership of this team of wealth was
deemed to be very valuable. In January of 1720, not quite 400 years ago, the
stock was trading at £128, in February £175, March £330 and £550 in May. Somewhere
in this parabolic price rise, Sir Isaac (being well trained in mathematics)
sold out. Well and good for our hero.
The only problem was that on the way
to its ultimate peak of 1000, Sir Isaac got sucked back in, and when it
collapsed to 100, he had lost £20,000. According to one account that the loss
would be worth £268 million today.
(For those who are interested I would be happy to
discuss this bit of history and the roles of the government, the main bank, and
other bubbles.)
One of the risks of using the past
as a measuring device is that occasionally one can be premature and in some
cases quite premature. It is not too bad missing the last opportunity at or
near the top. The real penalty is borne by those who get sacked back in by envy
and the belief that they can identify the top and go back in and stay in during
an unconscionable decline. I guess the best defense system is the
willingness to accept both the loss of presumably large opportunity and actual
realized losses during one's hasty parachute exits.
With the lesson from Sir Isaac
Newton's experience in my mind I am paying increasing attention to
expressed sentiments triggering actions. For example, according to one report,
Renminbi transactions accounted for over 95% of total Bitcoin exchanges. I am
seeing what I believe to be similar activities in some commodities as many
Chinese are desperate to get some of their wealth out of their own currency.
Further, I see some signs of potential large disruptions in currencies
and treasuries. My concerns are based on the fact that these markets are bigger
than the stock markets and through margin and derivatives heavily committed traders could quickly come
into insolvency. This would be too bad for them and their investors. However,
it could be very unfortunate to their counter-parties. Often these very same
organizations supply credit and facilities to other market participants which
could cause a disruption in the stock markets no matter what their level, but
particularly if stock prices reflect an increase in speculation.
The Buffett Letter
I suspect that the lead item in
Monday's financial press will be about his shareholder's letter released early
Saturday morning. Most of the focus will be about the value of
Berkshire Hathaway shares. As usual I will not compete, but focus as to broader
implications on the report as if both Warren and I were back at Columbia.
The 52 year record of performance of
Berkshire-Hathaway is truly remarkable. What struck me was over this period
there were eleven years when the market value of Berkshire's shares went down
and eleven years when the S&P 500 went down. What was interesting is that
in eight out of eleven they were different years. This suggests to me while
both time series produced good results (20.8% for Berkshire and 9.7% for the
S&P 500), they are not good tracking devices for each other. Thus they are
not well correlated to each other. One of the reasons I suspect that many
accounts that are broad market index centered will be underperforming is that
the correlations in today's market is widening. This theme was repeated in a
couple of examples from the letter.
Every year since 2002 the operating
income, including interest and dividends has produced more for the shareholders
than capital gains. These results are the product of a relatively low turnover
of its securities investments and the increasing shift to buying companies
rather than securities.
The preference of Buffett and Munger
to buy whole companies is producing better long-term results than buying
publicly traded securities. This is due to trading, when appropriate, the
absence of dividend requirement and the ability to leverage. Other corporate
investors have seen this as well which in turn has led to an absolute shrinkage
in the number of US publicly traded companies. Further, there are fewer mega
cap companies that can profitably use the ministrations applied by Berkshire
and ValueAct. Thus, I suspect that there will be more acquisitions made
and there will be some medium cap deals that show larger potentials will be
acquired.
Berkshire reports the earnings of
Clayton Homes under Financial and Financial Products rather in their
manufacturing complex. While the bulk of the revenues for Clayton comes from
manufacturing homes the bulk of the earnings comes from its mortgage
operations. There are many public companies and their subsidiaries are
similarly misclassified compared to the better security analysis
exercised by Berkshire. In a similar vein, many sector and industry index
funds have been characterized improperly. Again this may come back
to haunt certain sector and industry index ETFs.
All investors and their managers
should be indebted to Warren Buffett's page 22 where he shows the almost ten
year record of Protege Partners choice of five fund of funds, which include some 100 individual hedge funds'
annual performance from 2008 compared with an S&P 500 index fund. For the
nine completed years, the S&P fund was the best in five years. The best of the
fund of funds beat the Index fund four times and the others one to two times.
What I take out of this are the following:
1.
It is difficult to the beat the market .
2.
The market indicator does not win in each year.
3.
In its best year the index was up +32.3% and worst was off -37.0%, both of more
are reasonable expectations for some future years.
4.
It is quite possible that the funds suffered from over-diversification
and this is true particularly true versus Berkshire itself.
In Conclusion
One wag has suggested that the only
thing the markets are guaranteed to create is humility. Thus, as a never-too-old
student I hope to learn from others, so I make fewer investment mistakes and
hope you do as well.
__________
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