Just Own Berkshire?

A friend asks:

Is the portfolio you own with shares of Berkshire Hathaway diversified enough to be your entire equity portfolio?

Here’s my response, with a bit of added color versus my original reply. It’s helpful to have Berkshire’s top 13F holdings (included below) for reference:

180930_BRK_13F
Source: Berkshire 13F via WhaleWisdom.com

Do I think you could buy today’s Berkshire 13F portfolio and hold it forever as a well-diversified portfolio? No. There’s no such thing as a permanent stock portfolio. Capital markets are far too dynamic for that.

What you’re really buying (and thus have to underwrite) with a share of Berkshire are Warren and Charlie’s capital allocation skills. This is an extremely concentrated portfolio. Not necessarily a bad thing for skilled investment managers like Warren and Charlie. But just a handful of stocks and their idiosyncratic characteristics are going to drive portfolio performance.

Do I believe you could plausibly own Berkshire and only Berkshire as a kind of closed-end fund/ETF managed by Warren and Charlie? Yes, I do. The obvious issue you run into here is that sooner or later Warren and Charlie are going to shuffle off this mortal coil. I suspect it’ll be much tougher for investors to maintain the same level of conviction in their successors.

Would I do it myself? No. It’s an awful lot of single manager risk to take, to just own Berkshire. Even if Warren and Charlie were immortal, it would be a lot of single manager risk to take. However, I could definitely see using Berkshire alongside just a couple other highly concentrated managers, if you’re the kind of investor who doesn’t mind high tracking error and is concerned more with the risk of permanent capital impairment than volatility.

Could you potentially just use Berkshire in place of an allocation to large cap US stocks? Yes, I definitely think you could.

The answer to this question really hinges on your definition of risk, and issues of path dependency in investment performance. In my view, the starting point for any asset allocation should be the global market capitalization weighted portfolio. Deviations from the global market capitalization weighted portfolio should be made thoughtfully, after careful deliberation. Whenever you deviate from the global market capitalization weighted portfolio, you are implicitly saying you’re smarter than the aggregated insights of every other market participant.

Sorry to say, but you’re probably not that smart. I’m probably not that smart, either.

To concentrate an investment portfolio in a single share of Berkshire implies you have a massively differentiated view of where value will accrue in the global equity markets, and that you’re extremely confident in that view. In hindsight, it seems obvious Berkshire would be a great bet. But in financial markets, literally everything seems obvious in hindsight.

Does this mean a concentrated bet on Berkshire wouldn’t work out?

Absolutely not. It just means we need to carefully consider whether a highly concentrated bet on Berkshire makes sense in light of its potential performance across a broad range of possible futures.

Personally, I’m not confident enough in my ex ante stock and manager selection abilities to bet the farm on a single pick like that.

And I think that’s true for most of us.

Ode To Liquidity

When it comes to risk management there is one consideration that towers over all the others. That is liquidity.

The word “liquidity” can mean different things in different contexts. Sometimes it literally means “cash.” Other times it refers to your ability to quickly convert the full value of another asset (like a stock or a mutual fund share) into cash. This post will reference liquidity in both contexts.

Liquidity (“cash”) is the lifeblood of our financial lives. It is the medium through which we move consumption forwards and backwards in time. It is the bridge that links spending, saving and investment.

You don’t fully appreciate the importance of liquidity until you need it and don’t have it.

Poor people understand this intuitively. For a poor person life is a never-ending liquidity crisis. It is the global financial crisis on repeat. There’s a reason the foundation for all financial planning is the net cash emergency fund. The net cash emergency fund is your liquidity buffer. It’s loss-absorbing capital. It’s what keeps you from getting caught in the vicious cycle of dependency on short-term, unsecured, high cost debt like credit cards and payday loans.

Funnily enough, there are plenty of rich people who live life on the edge of a liquidity crisis. Some of these people have a large amount of their net worth tied up in real estate or private business ventures. You can have a lot of paper wealth but still very little liquidity.

When the shit hits the fan, your paper net worth is irrelevant. If you don’t have enough cash on hand to meet your financial obligations, you are toast. This is the story of every banking crisis in the history of finance.

Sure, you can sell the illiquid things you own to raise cash. But that takes time. And the less time you have to sell the worse your negotiating position gets.

There is nothing a shrewd buyer delights in more than finding a forced seller who’s running out of time. This is the essence of distress investing. Distressed investors are often able to buy good assets for fractions of their value because the sellers are desperate for liquidity.

Does this mean you should never own illiquid things?

No!

It means you should never assume you will be able to sell an illiquid thing at a favorable price at a place and time of your choosing.

As an individual, how do you know if it’s okay to own an illiquid thing?

If you can write it down to zero the moment you buy it, and it will not impact your ability to make good on your day-to-day obligations, it is okay to own the illiquid thing from a liquidity standpoint. The thing may still turn out to be a terrible investment, but that’s a separate issue.

These days there are lots of things being marketed to regular folks that are illiquid things disguised as liquid things. These are things like interval funds–the mutual fund world’s answer to private equity. These are also things like non-traded REITs with redemption programs that allow you to withdraw, say, a couple percent of your investment every quarter.

Perhaps your financial advisor has pitched one of these things to you.

Read the fine print!

The underlying assets in these funds are illiquid, and the fine print always allows the investment manager to suspend your redemption rights. Third Avenue Focused Credit investors thought they had daily liquidity, like in any other mutual fund.

Ask them how that worked out.

It’s Just Business

“Your father did business with Hyman Roth, your father respected Hyman Roth, but your father never trusted Hyman Roth.” – Frank Pentangeli, The Godfather, Part II

Frank Pentangeli is one of my favorite characters from The Godfather movies. He’s a lovable, old-fashioned gangster struggling to eke out a living in a brutal and cynical world. Frank’s fatal flaw is that he’s not smart enough to see all the angles. He never fully grasps how completely he’s at the mercy of forces much larger and more powerful than himself. He clings to a code of honor that seems increasingly outmoded as the plot evolves.

And so, it’s fitting that when Pentangeli finally goes out near the end of Part II, it’s not because someone whacks him. It’s because Tom Hagan convinces him the only way to salvage his honor and dignity is to off himself. The scene is one of the best in all three movies.

In Epsilon Theory speak, Frankie Five Angels is a lousy player of the metagame. (h/t to Epsilon Theory for inspiring this post, btw)

godfatherii_tom_frank

Despite Frank’s obvious flaws, his acute sense of personal honor was useful when it came to judging the character of his business partners and counterparties. His most famous line (quoted above) is a testament to the fact you can always choose to do business with someone at arm’s length. Trust is not a prerequisite for a mutually beneficial business relationship.

So it is with the sell-side.

We do business with the sell-side. We respect the sell-side. But we should never, ever, under any circumstance trust the sell-side.

I was moved to reflect on this after another one of those “market outlook” meetings where a “portfolio specialist” (a salesman with his CFA designation) from a big asset manager comes and talks to you about how the next recession is at least a couple years away* and sure there some risks but nonetheless the fundamentals are sound. Oh and by the way have you looked at leveraged loan funds lately?

Sure, leveraged loan covenants suck, and the space is red hot, and investors will get burned eventually. But there’s still a couple years left in the trade.

Sure, high yield looks like a crap deal on a relative basis, but on an absolute basis there’s still a supportive bid for yield from foreign buyers.

Sure, this stock trades rich, but our analysts can see a path higher from here.

How many times have you heard this stuff? Or stuff that rhymes with this?

Our relationship with the sell-side should always and everywhere be a transactional relationship. But the goal of every great salesman is to turn a transactional relationship into a personal relationship. Personal relationships bring with them all kinds of social conventions and obligations. Unless you’re a complete sociopath, it’s nigh on impossible to behave in a transactional manner once a business relationship turns personal.

That doesn’t mean you can’t go to lunch with the sell-side.

It doesn’t mean you can’t use research from the sell-side.

It means you should never, ever under any circumstance allow yourself to believe the helpful guy or gal from the sell-side you have lunch with once a quarter is truly on your side of the table, always and everywhere with your best interests in mind.

If you do this, and you choose to trust these people instead of merely transacting business with them, you will eventually discover that they do not, in fact, sit on the same side of the table as you. They do not, in fact, suffer like you when the bill of goods they’ve sold you blows up.

And it’ll cost you.

*The next recession is always at least a couple years away.

We Need To Talk About Multiple Contraction

In light of recent market moves I wanted to revisit this post about discount rates and how they might impact valuation multiples (spoiler: it’s an inverse relationship). I think the post holds up pretty well. The key feature was this chart:

118_Implied_Cost_Equity_SP
Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

Recall that there’s an inverse relationship between the discount rate and the multiple you should pay for an earnings stream. The discount rate has two components:

1) a riskfree interest rate representing the time value of money (usually proxied by a long-term government bond yield), and

2) a “risk premium” meant to account for things like economic sensitivity, corporate leverage and the inherent uncertainty surrounding the future.

Back in January I wrote:

By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

I am reminded of this as I read this post from Josh Brown, featuring the below chart:

daily-shot-sp-attribution
Source: Bloomberg via WSJ Daily Shot & Reformed Broker

Taken together, this is a fairly vivid illustration of why the current level of corporate earnings matters far less than long-run expectations for margins, growth, and (perhaps most importantly) the discount rate.

(You do remember what’s happening with interest rates, don’t you?)

Assuming no growth, a perpetual earnings stream of $1 is worth $20 discounted at 5%.

Raise that discount rate to 10% and the same earnings stream is worth $10.

Raise it to 15% and the value falls below $7.

And so on.

Now, there’s no way to reliably predict what the discount rate will look like over time. The real world is not as simple as my stylized example. On top of that the discount rate is not something we can observe directly. The best we can do is try to back into some estimate based on current market prices and consensus expectations for corporate earnings.

So, what’s the point of the exercise?

First, I don’t think it’s unreasonable to expect some mean reversion when the estimated discount rate seems to lie at an extreme value. And yes, I counted short-term rates at zero percent as “extreme.” As the above attribution chart clearly demonstrates, multiple contraction can be quite painful.

Second, this should explicitly inform your forward-looking return expectations. Generally speaking, the higher the implied discount rate, the higher your implied future returns. There is good economic sense behind this. “Discount rate” in this context is synonymous with “implied IRR.” To look at a 5% implied IRR and expect a 20% compound return as your base case makes no economic sense. Assuming the implied IRR is reasonably accurate, the only way that happens is if you sell the earnings stream to a greater fool at a stupidly inflated price.

Do fools buy things at irrationally high prices?

Yes. Indisputably. All the time.

Does that make price speculation a sound investment strategy?

No, it does not.

“Multiple expansion” is just a fancy way of saying “speculative price increase.”

Likewise, “multiple contraction” is a fancy was of saying “speculative price decline.”

Private Credit Stats

Sometimes I hear people say we “deleveraged” following the 2008 financial crisis. Sure, the consumer may have deleveraged, but I can assure you there’s plenty of debt left sloshing around in the system. A bunch of it has moved from bank balance sheets to what can loosely be thought of as the hedge fund space.

We call this private credit or direct lending. It’s huge right now in the institutional investing world. Sometimes it feels like every scrappy hedge fund guy in the world is launching a private credit vehicle.

Today, I came across a great paper by Shawn Munday, Wendy Hu, Tobias True and Jian Zhang providing an overview of the space. If, like me, you’ve been inundated with pitch decks from private credit funds over the past couple years, you won’t find much in the way of new information. But the stats are worth perusing.

private_credit_aum
Source: Munday, et al
private_credit_Commits
Source: Munday, et al
pooled_MOICs_IRRs
Source: Munday, et al
IRR_by_vintage_year
Source: Munday, et al

If you are an allocator this is nice base rate data for the space. According to the pitch decks everyone is targeting a net IRR in the mid-teens. It doesn’t surprise me that the median IRR for the post-crisis era is closer to 10% than mid-teens.

Personally, I’m inclined think median returns over the next decade will look more like the 2006 and 2007 vintages. Anecdotally, I can tell you there are middle market deals getting done out there with six turns of leverage and 7% yields. Unless you’ve got warrant coverage, you’re not getting anywhere near 15% IRR on a deal like that.

That kind of behavior reeks of yield chasing.

And we all know what happens to yield hogs.

Eventually, they get turned into bacon.

3Q18 US Factor Returns

Below are my factor return charts, updated for 3Q18. As always, this data lags by one month, so it is technically through August 31. Note also that the more recent bout of market volatility lies outside this date range. It will fall inside the next update.

This one features more of the same. Returns to Market and Momentum continue to grind higher, leaving the more value-oriented factors in the dust.

At bottom I’ve added a snap of Research Affiliates’ latest factor valuations. They’re about what you’d expect given the return data, with Illiqudity (think VC and private equity) and Momentum at the high end of their historical ranges. Value remains at the low end.

It’s worth asking: what’s the point of this exercise?

To better understand and contextualize the following (thanks Rusty Guinn):

[T]here is no good or bad environment for active management. There are good or bad environments for the relatively static biases that are almost universal among the pools of capital that benchmark themselves to various indices.

For a diversified portfolio, the variation in returns is explained almost entirely by the aggregate factor exposures. You’d be surprised how many professionals are ignorant of this.

Now, some of that ignorance is deliberate. There’s a reason investment managers don’t often show clients factor-based attribution analyses. The data typically supports the idea that a significant portion of their returns come from the relatively static biases (“tilts”) mentioned above.

As an allocator of capital, it behooves you to be intentional about how your portfolios tilt, and how those tilts manifest themselves in your realized performance. This self awareness lies at the heart of a disciplined and intentional portfolio management process.

3Q18_rolling_avg_factor_returns
Source: Ken French’s Data Library & Demonetized Calculations
3Q18mkt
Source: Ken French’s Data Library & Demonetized Calculations
3q18size
Source: Ken French’s Data Library & Demonetized Calculations
3q18val
Source: Ken French’s Data Library & Demonetized Calculations
3q18mo
Source: Ken French’s Data Library & Demonetized Calculations
3q18_op_profit
Source: Ken French’s Data Library & Demonetized Calculations
3q18inv
Source: Ken French’s Data Library & Demonetized Calculations
201810_RAFI_Factor_Valuations
Source: Research Affiliates

Vulture Capitalism

640px-White-backed_vultures_eating_a_dead_wildebeest
Source: Wikipedia

Predictably, the Sears bankruptcy has attracted much wailing and gnashing of teeth around so-called “vulture capitalism” as practiced by hedge funds and private equity firms (here in the biz we use terms like “activism” or “distressed” investing). “Vulture” is of course used as a pejorative in these articles. Personally, though, I think practitioners should embrace the label.

In nature, vultures play an important role in ecosystems:

When vultures are unable to clean up the carrion in an area, other scavenger animals increase in population. The scavengers that tend to move in where vulture populations are low include: feral dogs, rats, and blowfly larvae. While these animals do help to remove carcasses from the landscape, they are also more likely to spread disease to human populations and other animals as well. In India, for example, the feral dog population increased significantly after vultures consumed cow carcasses poisoned with diclofenac, a painkiller. These feral dogs carried rabies and went on to infect other dogs and local people. Between 1993 and 2006, the government of India spent an additional $34 billion to fight the spread of rabies. India continues to have the highest rate of rabies in the world […]

[…] It is important to remember that even though the vulture species lacks the cute cuddly appearance of some endangered species, it is still a critical piece to a much larger, complex ecosystem. The world needs vultures to help control the spread of disease.

Likewise, vulture capitalists pick apart the corpses of dead and dying firms. Eventually that capital is recycled elsewhere in the market ecosystem.

Now, clearly this is not a pretty process. It is gruesome. It involves ruthlessly cutting costs; it involves firing good, hardworking people; it involves selling off assets and extracting cash instead of going through the “feel good” motions of reinvesting that cash into a dying enterprise. The firms that specialize in these activities are at the pointy end of Schumpeter’s “creative destruction.” It’s not exactly shocking that they’re unpopular with the general public.

But here’s the thing about “vulture capitalists.” They don’t feed on healthy companies. And there’s a good reason for this. Healthy companies are too expensive for distressed funds and buyout firms to get their claws into.

The popular notion that Sears, as a business, is dead money has been around since at least 1988. 1988! That’s thirty years. Three decades. Take a moment and think about that.

For thirty years now it’s been pretty clear the investment case for Sears rests largely on a sum-of-the-parts valuation of the real estate assets. There were very few possible worlds in which Sears would reinvent itself as a thriving retail business—particularly given brutal competition from Wal-Mart, Target, CostCo and others.

So when we talk about Sears we’re talking about the business equivalent of a sickly, dying wildebeest. Vulture capitalists consuming the carcass is simply the natural order of things. Even though hedge funds and private equity firms lack the cute, cuddly appearance of certain other market participants, they remain important pieces of a much larger, complex ecosystem.