In Search of the Perfect Investment

Seth Klarman is a self-made billionaire investor money manager. The man is brilliant. Early in his career he wrote a wonderful value investing book called Margin of Safety. It’s out of print but sells on eBay for $2,400 used.

He recently spoke at the CFA Institute annual conference. Here are excerpts of his comments courtesy Advisor Perspectives.

Government involvement is why Klarman is more fearful now than at any previous point in his career. He said he always thought, until recently, that he could do well by having a good process and a clever approach, and his wits would enable him to find good bargains. Now, however, he said a new question affects his outlook: will the dollar be worth anything?

His clients are US-based investors, his results are measured in dollars, and he hedges his positions back to dollars. While he conceded that this crisis might not be different from other crises – and we might successfully recover from it – he is worried that the solution to every problem is to push the problem further down the road. Politicians find it easier to “create inflation” than to tackle the serious problems, he said.

“We didn’t get the value we should have from this crisis,” he said, contrasting the recent woes with the Great Depression, which spurred one or two whole generations to change their values – Americans in the decades after the Depression believed in saving and not borrowing to the point of overextending themselves. Though the Depression itself was terrible, Klarman said, “it was a great thing to have a Depression mentality.”

Klarman warned that sovereign debt crises, such as the US may potentially face, are characterized by what Malcolm Gladwell describes as “tipping points,” and that history is not a perfect guide. Everything may seem fine with countries with overextended debt, until one day it’s no longer fine and a crisis unfolds.

Journalist Jim Grant has described debt has “money of the mind,” and Klarman said that description applies to sovereign debt too. “If we think the US will pay us back and not suffer from inflation, investors will line up to buy its debt,” he said. Otherwise, we will have failed auctions and higher interest rates.

Through his public remarks, Treasury secretary Tim Geithner seems to have been lulled into thinking that there is nothing we can do that will cause us to not be AAA, Klarman said. “That kind of thinking virtually guarantees we will not be AAA.”

He protects his portfolio against “tail risk” – unlikely but possibly catastrophic events, such as much higher inflation. He does not use TIPS for this purpose; he believes the government understates inflation because it has an incentive to do so.

Klarman said it is more likely that bond market vigilantes will react to inflation risk before it shows up in government-reported data. He has bought out-of-the-money put options on bonds. If rates go up by as much as 5% or even 7%, he will not profit. But if rates rise by 20% or 30%, then he could make 50- to 100-times his investment. He said the odds of such a scenario were unlikely in the short term and more likely five years out – but not a 50/50 probability.

He compared such protection, which is available at a reasonably low cost, to buying homeowners insurance.

Tail risk protection is “very much art and not science,” he said, and advised investors to contemplate many scenarios with and without the dollar as the reserve currency. Gold is not necessarily the answer, he said, because it could go “berserk” on the upside or could go down from its current record high. Nonetheless, he said gold has a role in a portfolio because “it has the age-old aspect of being seen as a store of value.”

The purpose of owning gold is not to make money, he said. “If the world gets really bad, we want to protect as much of clients’ purchasing power as possible, or offset a decline in market value of their assets.” He said his goal is to avoid “being down 30% and being paralyzed.”

Clearly, his downside protection strategy involves many more elements than those he discussed, and he said he did not want to reveal those details for fear that those in attendance would “frankly, overpay for derivatives.” He stressed that he does not have a fundamental view that he knows what will happen with regard to tail risks, and he recommended seeking inexpensive hedges.

You can read the entire Advisor Perspectives newsletter. Click SethKlarmanIsWorried.

The fear everyone has. I think this was the last bill they printed. It didn’t buy much.  I believe they now use American dollars.

Went to a luncheon talk yesterday by Simon Johnson, MIT professor and author of

Points he made:

+ There is no social value to having a bank larger than $100 billlion. Yet our six larger banks are now 62% of the U.S. economy, versus 56% when this mess started a couple of years ago.

+ The big six will fund another boom with cheap borrowing.we don’t know what it will be. It won’t be housing. But it will go bust with huge consequences, just like the last one funded by the banks.

+ There is no chance of breaking up the big banks under the present proposed financial reform legislation. They successfully lobbied against that.

+ The Chinese called Hank Paulson (our treasurer at the time) up and said if you force us to take a loss on Fannie and Freddie, we’ll take our money out of the u.s.Our government then bailed out Fannie and Freddie and the Chinese got all their money back. Fannie and Freddie should now be euthanized.

+ It’s worse in Europe. There’s less openness. The banks have much worse performing loans than even ours.

+ What going to happen now? Throwing money at a problem will stablize the problem for the short-term, but won’t affect the long-term problem.

Interest rates continue to fall. Normally they rise when a a recovery gets under way. But with everyone fleeing to the “safety” of US treasuries, prices are high; rates are low.

NEW YORK (MarketWatch) — The Treasury Department sold $42 billion 2-year notes on Tuesday at a yield of 0.769%, the lowest cost for the government ever but a little higher than traders expected. The amount is the least since August. Bidders offered to buy 2.93 times the amount sold, versus an average of 3.12 times at the last four auctions. Indirect bidders, a group that includes foreign central banks, bought 36.2%, compared to an average of 40.6% of recent sales. Direct bidders, a group that includes domestic money managers, purchased another 15.2%, versus 13.6% on average. The broader bond market remained higher after the auction. Yields on 10-year notes (UST10Y 3.23, +0.07, +2.12%) , which move inversely to prices, fell 6 basis points to 3.14%.

Congratulations. You’ve only lost $1 million dollars. John Clarke and Bryan Dawe calculate the cost of the European debt crisis (very funny).

To watch this sad (but hilarious) video. Click here.

Experts Have new solution to plug Gulf oil leak.

WASHINGTON – At a conference of oil leak experts in Washington today, attendees proposed plugging the massive oil leak in the Gulf of Mexico with executives of BP, the company responsible for the catastrophic spill.

“We’ve tried containment domes, rubber tires, and even golf balls,” said William Cathermeyer of the National Oil Leakage Institute, a leading consultancy in the field of oil leaks. “Now it’s time to shove some BP executives down there and hope for the best.”

Submerging the oil company executives thousands of feet below the ocean’s surface could be a “win-win” situation, Mr. Cathermeyer said.

“Best-case scenario, they plug the leak,” he said. “And at the very least, they’ll shut the fuck up.”

But even as the oil leak experts proposed their unorthodox solution, environmental expert Marilyn Sufranski warned of the possible negative consequences of plugging the oil leak with BP executives.

“The Gulf of Mexico is slimy enough already,” she said.

This FDA warning applies to me. My doctor has had me permanently on Prilosec since he discovered some nasty ulceration at the bottom of my esophagus. The ulceration was caused by too much stomach acid, hence the Prilosec (or its more generic form omeprazole). Yesterday the FDSA warned against long-term use:

FDA: Possible Fracture Risk with High Dose, Long-term Use of Proton Pump Inhibitors
The U.S. Food and Drug Administration today warned consumers and health care professionals about a possible increased risk of fractures of the hip, wrist, and spine with high doses or long-term use of a class of medications called proton pump inhibitors. The product labeling will be changed to describe this possible increased risk.

Proton pump inhibitors, available by prescription and over-the-counter (OTC), work by reducing the amount of acid in the stomach. Prescription proton pump inhibitors include esomeprazole (Nexium), dexlansoprazole (Dexilant), omeprazole (Prilosec, Zegerid), lansoprazole (Prevacid), pantoprazole (Protonix), and rabeprazole (Aciphex). Prescription proton pump inhibitors are used to treat conditions such as gastroesophageal reflux disease (GERD), stomach and small intestine ulcers, and inflammation of the esophagus.

OTC versions, used for the treatment of frequent heartburn, include omeprazole (Prilosec OTC, Zegerid OTC) and lansoprazole (Prevacid 24HR).

“Epidemiology studies suggest a possible increased risk of bone fractures with the use of proton pump inhibitors for one year or longer, or at high doses,” said Joyce Korvick, M.D., deputy director for safety in FDA’s Division of Gastroenterology Products. “Because these products are used by a great number of people, it’s important for the public to be aware of this possible increased risk and, when prescribing proton pump inhibitors, health care professionals should consider whether a lower dose or shorter duration of therapy would adequately treat the patient’s condition.”

FDA’s warning and decision to revise the labeling of proton pump inhibitors are based on the Agency’s review of several epidemiological studies that reported an increased risk of fractures of the hip, wrist and spine in patients using proton pump inhibitors. Both the Warnings and Precautions section of the prescription labeling and the Drug Facts label on OTC proton pump inhibitors will address these findings.

This IS tasteless.  Representative Barney Frank introduces the new “Don’t ask. Don’t tell” uniform.

I know it’s tasteless. But it’s still funny.

Another solution for the Gulf. President Obama said this morning that if BP failed to plug the hole, the government would have no choice but to take it over. Maybe they’ll plug the leak with newly-printed dollar bills? They’re quite experienced with that “strategy.”

Elizabeth Warren teaches bankruptcy law at Harvard. When companies go broke, the shareholders lose everything and the creditors take a hit. when AIG went “broke,” the government bailed the creditors out 100% and the shareholders are still alive. Latest price for AIG is $34.39. She wonders why taxpayer money was necessary to bail out AIG? I do too.

In November CIT went broke. CIT listed $71 billion in assets and $64.9 billion in debt in a Chapter 11 filing in U.S. Bankruptcy Court in Manhattan. The U.S. Treasury Department said the government probably won’t recover much, if any, of the $2.3 billion in taxpayer money that went to CIT.

Harry Newton, who’s mulling some simple solutions:  A new long-term energy policy to encourage alternative energy investments; legalization and taxing of all illegal drugs; substantially higher interest rates to discourage more inane borrowing. Why do I get the impression that the White House is fiddling while the economy burns? There is, however, always hope: