In Search of the Perfect Investment

Who said shorting doesn’t work?

HPQ is going lower, especially after Meg Whitman’s depressing remarks.

How does Buffett do it? I will admit to losing money with a short-lived investment in Berkshire Hathaway. But many investors who’ve been in for years have done well.

Meantime, Buffett’s reputation stands tall. The Economist’s Buttonwood columnist tried recently to explain all:

The secrets of Buffett’s success: Beating the market with beta

IF INVESTORS had access to a time machine and could take themselves back to 1976, which stock should they buy? For Americans, the answer is clear: the best risk-adjusted return came not from a technology stock, but from Berkshire Hathaway, the conglomerate run by Warren Buffett. Berkshire also has a better record than all the mutual funds that have survived over that long period.

Some academics have discounted Mr Buffett as a statistical outlier. Others have simply stood in awe of his stock-picking skills, which they view as unrepeatable. But a new paper* from researchers at New York University and AQR Capital Management, an investment manager, seems to have identified the main factors that have driven the extraordinary record of the sage of Omaha.

Understanding the success of Mr Buffett requires a brief detour into investment theory. Academics view stocks in terms of their sensitivity to market movements, or “beta”. Stocks that move more violently than the market (rising 10%, for instance, when the index increases by 5%) are described as having “high beta”, whereas stocks that move less violently are considered “low beta”. The model suggests that investors demand a higher return for owning more volatile-and thus higher-risk-stocks.

The problem with the model is that, over the long run, reality has turned out to be different. Low-beta stocks have performed better, on a risk-adjusted basis, than their high-beta counterparts. As a related paper+ illustrates, it should in theory be possible to exploit this anomaly by buying low-beta stocks and enhancing their return by borrowing money (leveraging the portfolio, in the jargon).

But this anomaly may exist only because most investors cannot, or will not, use such a strategy. Pension schemes and mutual funds are constrained from borrowing money. So they take the alternative approach to juicing up their portfolios: buying high-beta stocks. As a result, the average mutual-fund portfolio is more volatile than the market. And the effect of ignoring low-beta stocks is that they become underpriced.

Mr Buffett has been able to exploit this anomaly. He is well-known for buying shares in high-quality companies when they are temporarily down on their luck (Coca-Cola in the 1980s after the New Coke debacle and General Electric during the financial crisis in 2008). “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” he once said. He has also steered largely clear of more volatile sectors, such as technology, where he cannot be sure that a company has a sustainable advantage.

Without leverage, however, Mr Buffett’s returns would have been unspectacular. The researchers estimate that Berkshire, on average, leveraged its capital by 60%, significantly boosting the company’s return. Better still, the firm has been able to borrow at a low cost; its debt was AAA-rated from 1989 to 2009.

Yet the underappreciated element of Berkshire’s leverage are its insurance and reinsurance operations, which provide more than a third of its funding. An insurance company takes in premiums upfront and pays out claims later on; it is, in effect, borrowing from its policyholders. This would be an expensive strategy if the company undercharged for the risks it was taking. But thanks to the profitability of its insurance operations, Berkshire’s borrowing costs from this source have averaged 2.2%, more than three percentage points below the average short-term financing cost of the American government over the same period.

A further advantage has been the stability of Berkshire’s funding. As many property developers have discovered in the past, relying on borrowed money to enhance returns can be fatal when lenders lose confidence. But the long-term nature of the insurance funding has protected Mr Buffett during periods (such as the late 1990s) when Berkshire shares have underperformed the market.

These two factors-the low-beta nature of the portfolio and leverage-pretty much explain all of Mr Buffett’s superior returns, the authors find. Of course, that is quite a different thing from saying that such a long-term performance could be easily replicated. As the authors admit, Mr Buffett recognised these principles, and started applying them, half a century before they wrote their paper.

* “Buffett’s Alpha”, by Andrea Frazzini, David Kabiller and Lasse Pedersen, August 2012
+ “Betting Against Beta”, by Andrea Frazzini and Lasse Pedersen, October 2011

The debate reported.

Millions of Americans Lose Consciousness

DENVER (The Borowitz Report)-Millions of Americans lost consciousness on Wednesday night between the hours of 9 and 10:30 P.M. E.T., according to widespread anecdotal reports from coast to coast.

The sudden epidemic of sleepiness prevented voters from watching more than a minute or two of the first Presidential debate between former Massachusetts Governor Mitt Romney and President Barack Obama, which the few observers who remained awake have called the most tedious in American history.

Moderator Jim Lehrer’s opening instruction to the audience that they remain silent proved unnecessary, since within minutes most of them sat with their heads tipped forward, drool visibly dangling from their mouths.

Mr. Obama began the debate with a high-risk tactic that seemed designed to alienate huge swaths of the country-the use of math and facts-but ultimately his words seemed unlikely to turn off many viewers, who were soon off on their journey to dreamland.

Mr. Romney’s much-trumpeted “zingers” were nowhere in evidence, except for a mystifying non-sequitur attack on PBS’s Big Bird.

The only fireworks came at the very beginning of the debate, when Mr. Obama congratulated his wife, Michelle, on their twentieth wedding anniversary, drawing this response from Mr. Romney: “I disagree with your decision to marry Michelle. On Day One, I’ll reverse it.”

 That was comedy.

Four years ago Susan and I went to Pennsylvania and knocked on doors for Barack Obama. This year they didn’t ask us. I guess they lost the database! Susan went to bed last night thoroughly depressed at Mr. Obama’s miserable performance. I went to bed thinking that Obama had got old, was beaten down, had lost the plot, had become ineffectual and Mr. Romney might make sense.

One night. One debate. Amazing. Even the pundits on MSNBC were horrified.

Reminded me of a old, bad joke:

It’s the Metropolitan Opera. The audience is excited.

The curtains part. The stage manager appears. “I’m sorry, but Mr Caruso won’t sing tonight. He has died.”

From the back of the theater comes the cry, “Gib him an enema.”

“Perhaps you don’t understand. Mr. Caruso has died. An enema is not going to do him any good.”

From the back of the theater comes the the cry. “It ain’t gonna ‘urt him!”

Did Obama need an enema?

Phenomenon: This Korean music video has had 48 million views. That’s a lot of people watching a mindless music video which repeats the same words again and again — in Korean, no less. Click here. How it go there is in this Business Insider article. Click here.

There’s a lot of people with a lot of time on their hands watching YouTube videos, checking Facebook and sending each other Twits. I’d rather play tennis.

Doors and windows. Our biggest pain (bad pun) are our windows and doors. The windows won’t close or open. The doors don’t latch. The holes won’t take the latches. Some doors close with no help. Some doors won’t close. It’s totally annoying. There’s a boring moral here: Don’t trust your architect or contractor to check your carpenter. CHECK, CHECK, CHECK yourself.

Why do I hate AT&T? Let me count the ways. Let’s start with trying to view my cell phone account on line. Who’s the moron here?  Me or the person who designed AT&T’s online billing system?

Two excessively stupid jokes. Needed after last night.

Weather Forecasting
It’s late fall and the Indians on a remote reservation in South Dakota asked their new chief if the coming winter was going to be cold or mild.

Since he was a chief in a modern society, he had never been taught the old secrets. When he looked at the sky, he couldn’t tell what the winter was going to be like.

Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect firewood to be prepared.

But, being a practical leader, after several days, he got an idea. He went to the phone booth, called the National Weather Service and asked, ‘Is the coming winter going to be cold?’

‘It looks like this winter is going to be quite cold,’ the meteorologist at the weather service responded.

So the chief went back to his people and told them to collect even more firewood in order to be prepared.

A week later, he called the National Weather Service again. ‘Does it still look like it is going to be a very cold winter?’

‘Yes,’ the man at National Weather Service again replied, ‘it’s going to be a very cold winter.’

The chief again went back to his people and ordered them to collect every scrap of firewood they could find.

Two weeks later, the chief called the National Weather Service again. ‘Are you absolutely sure that the winter is going to be very cold?’

‘Absolutely,’ the man replied. ‘It’s looking more and more like it is going to be one of the coldest winters we’ve ever seen.’

‘How can you be so sure?’ the chief asked.

The weatherman replied, ‘The Indians are collecting boatloads of firewood !’

The Siamese twins
Siamese twins walk into a bar in Canada and park themselves on bar stools.

One of them says to the bartender, “Don’t mind us; we’re joined at the hip. I’m John, he’s Jim. Two Molson Canadian beers, draft please.”

The bartender, feeling slightly awkward, tries to make polite conversation while pouring the beers. “Been on holiday yet, lads?”

“Off to England next month,” says John. “We go to England every year, rent a car and drive for miles. Don’t we, Jim?” Jim agrees.

“Ah, England!” says the bartender. “Wonderful country… the history, the beer, the culture…”

“Nah, we don’t like that British crap,” says John. “Hamburgers and Molson’s beer, that’s us, eh Jim? And we can’t stand the English – they’re so arrogant and rude.”

“So why keep going to England?” asks the bartender.

“It’s the only chance Jim gets to drive.”

Harry Newton who rues newness. If it works, why screw with it. that’s my mantra. Case in point: After this site started messing up with “too many processes,” the web hoster’s tech support insisted I upgrade to the latest version of WordPress, which I use to post this blog. Sadly, the latest, greatest version of WordPress is not the greatest. It basically sucks. Every morning I fight it, often using my meager HTML software skills to hack at the base code. So far, I’m muddling through. Meantime, though I now use Windows 7, I still use Office 2003, with its Outlook 2003 — the last Outlook I could actually find things easily.  To search, I use an outside program called Lookout. Sadly, Microsoft bought Lookout and promptly killed it — forcing later Outlook versions to use Microsoft’s own inadequate searching tool. In short, before you “upgrade,” think 15 times.

As I predicted, JMI started trading below its offering price of $20. It closed last night at $19.60. It may fall a little further. Buy some on weakness. It wil bounce back in coming weeks, as its portfolio gets bought. And it will soon yield 14%.