Berkshire Revisited

Back in May 2011 I wrote an article on this blog making the case that Berkshire Hathaway was looking cheap (Click here to see the article or go to my May 2011 folder). At the time Berkshire A shares were trading at around $120,000 and the B shares were approximately $80.

I reasoned that Berkshire looked cheap because the price-to-book value was at a historically low level (1.24). I then assumed a more realistic ratio of 1.44 and estimated an 8 percent growth in book value per share to the end of 2013 (the logic for those figures were explained in the original article).

By doing that, I arrived at a forecast year-end 2013 price of $173,000 for the A shares and $115 for the B shares.

So how did I go? Berkshire A shares as of 27 November closed at $174,625 per share and the B shares closed at $116.58.

It just goes to show that it doesn’t always take rocket science to spot a good investment opportunity.

I also added back in May 2011 that I had bought Berkshire shares using Australian dollars. At the time I purchased the Berkshire shares, the Australian dollar was worth $US1.10 (this part was just good luck). So I picked up the A shares at an effective price of around $113,000. The Australian dollar then depreciated to around $US0.92 (again, good luck).

Therefore, in Australian dollars it worked out to a 23% annual compound return over the 2.5 years. An investment in $US would have yielded closer to 15% compound per annum, not as good as my return, but still a very nice return.

I will add that I’ve now sold the shares. I don’t think Berkshire looks anywhere near as cheap today and I have plenty of algorithmic trading opportunities (which is really my bread and butter these days).

Decades ago, one could buy Berkshire at almost any price and have obtained excellent returns. Those days are long gone. Today, those kinds of returns will only have a chance of being achieved if Berkshire is bought when the price-to-book value is at a very low level.

This is a very basic, long-term mean reversion strategy - buy when price-to-book is very low and hope it reverts to the mean. Well, it worked this time. And of course, my thanks go to the US Federal Reserve for allowing it all to happen.*

I’ve commented in other articles on the legions of Buffett acolytes out there, but perhaps the best observation on this is attributable to the hedge fund manager Michael Burry (who foresaw and profited immensely from the sub-prime crisis), quoted in Michael Lewis’s brilliant book The Big Short:

“At one point I recognized that Warren Buffett, though he had every advantage from learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules. I also immediately internalised the idea that no school could teach someone how to be a great investor, if it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

Most people have the opposite reaction, they see what Buffett has done, it looks relatively straight forward, so they attempt to emulate him, but they can’t. And this is why I wouldn’t be giving a cent to Buffett clones, but I may have more to say on this in a future article.

 *The policies of the US Federal Reserve are either brilliant or absolutely crazy, but I can’t work out which it is    right now.

Magellan: Flavour of the month, but will it last?

Magellan Financial Group has certainly been “flavour of the month” in recent times. The company’s shares trade on a high price-earnings ratio of around 26 and they have attracted plenty of media attention. They certainly have achieved good results, but as is so often the case, these results are over relatively short periods of time, and I would argue, due to a unique set of circumstances.
 

A look at the listed Magellan Flagship Fund or the unlisted Magellan Global Fund will immediately reveal the modus operandi of the company – buying large good quality (mostly American) companies at what they deem to be attractive prices (e.g. Google, Microsoft, Apple, Wells Fargo, Visa, McDonalds, Yum Brands and so on). Sound familiar?

Hamish Douglass and Chris Mackay, (the founders of Magellan), like so many Australian fund managers these days, are die hard Buffett acolytes. Buffett of course moved on from pure stock investing decades ago and the technological landscape has changed dramatically since his halcyon days.

The Magellan Flagship Fund annual report does make for some interesting reading, but not for the disclosure of investment holdings or the ubiquitous fees that investors must pay. The relationship between the fund and its prime broker (Merrill Lynch) is much more interesting.

The Flagship Fund’s balance sheet (30 June 2013) nets $120 million of borrowings from Merrill against cash held on behalf of the Fund with Merrill ($123 million). Instead of seeing borrowings stated as $120 million on the balance sheet and cash as $123 million higher than stated, you see no borrowings and cash stated as $3m more as a result of netting the $120 million in borrowings against the cash of $123 million. That’s misleading, but perfectly acceptable under our (sometimes bewildering) accounting standards.

However, when we start reading the notes to the statements we discover that Merrill has security over up to $200 million of the Flagship Fund’s holdings. Further, we are told that Merrill doesn’t segregate its own cash from the cash belonging to the Magellan Flagship Fund and that Merrill can use the Flagship Fund’s cash in the course of its own business!

So now we have counter-party risk on a fairly large scale. If Merrill were to become insolvent, the Fund becomes an unsecured creditor and could potentially lose up to $200 million of its investments!

Now these arrangements may be normal with the flashier modern listed investment companies, but any investor casually perusing the Flagship Fund’s balance sheet alone is probably not aware of the debt the Fund carries or the fact that there is significant counter-party risk.

An investment in the Flagship Fund is not the same as an investment in Argo, Milton Corp. or AFIC – these companies have much lower levels of risk (and are generally the preserve of older investors who live in the wealthier suburbs of Sydney, Melbourne and Adelaide).

Institutional investors have poured money into the Magellan Group – billions. But I do wonder why. Are they incapable of making direct investments themselves into the type of companies that Magellan invests in? Nothing Magellan is doing is rocket science, it’s hardly another Renaissance Technologies.

 

Yes, Magellan has achieved good results, but the set of circumstances that allowed them to achieve those results is not readily repeatable. The major factors that assisted Magellan’s results are:

1.    Quantitative easing in the US;

2.    The purchase of companies at knock down prices during the GFC;

3.    The purchase of US and other foreign securities when the $A was very high and the subsequent benefit of the recent depreciation of the $A against the $US and other currencies.

The influence of quantitative easing in Magellan’s results is absolutely obvious to me, there is simply no way their results would have been achieved without it. The Federal Reserve has engineered an American bull market through quantitative easing, but the party must end at some point.

Now I ask you, how many times in a lifetime do you think this scenario will repeat?

The enthusiasm for Magellan also makes me think of Platinum Asset Management circa 2007. The stratospheric prices that Platinum shares got to on its first day as a listed company in May 2007 were silly (and they have never reached anywhere near that level since – more than 6 years later). And no one seriously thinks that Kerr Neilson is an Australian (or dare I say, South African) version of Warren Buffett as some did back in 2007 and earlier.

Now Douglass and Mackay are not versions of Buffett either. They obviously have some skills, but are not in the Buffett league. They may get some more nice “free kicks” from the devaluation of the $A against the $US. Further, Australian domestic funds management businesses should prosper in an environment of extremely low interest rates and an Australian market that doesn’t seem over-valued to me (within the context of current interest rates). But please let’s not think of the folks at Magellan as some sort of new messiahs and value the shares at ridiculous prices. And please be very conscious of what quantitative easing has done for Magellan and what it will mean when it ends.

(The picture accompanying this article is of the famous Portuguese explorer Ferdinand Magellan).

The cost of an Oxford education

Imagine two students living in Australia who are about to enter university, Paul and Peter. Both achieved excellent results in their final year of school. Coincidentally, both also recently inherited $160,000 from a relative.

 

Paul and Peter both live about 15 minutes away from their local university. According to a recent report published by one of those university guides, this local university was ranked 55^th in the world for overall quality of education. When one considers how many universities there are in the world, this is certainly a high ranking.

Paul has decided to attend this university, it is close to where he lives, has good facilities and staff and offers the degree he wants to study for. Paul has chosen to study Economics and History. Paul will use approximately $30,000 of his inheritance to pay for his degree. The remaining $130,000 will be invested in one of the old blue chip ASX listed investment companies and Paul hopes to leave it there as a “nest egg”.

Peter is much more status conscious than Paul. Peter has always wanted to attend Oxford or Cambridge. He is very impressed by the old buildings, the eccentric traditions and some of the well-known past graduates of those two institutions.

Peter makes an application to Oxford as a foreign student. He has decided to study for a BA in History and Economics. After the application process concludes, Peter receives the pleasant news that his application has been successful. As it happens, the cost of Peter’s three year degree (plus living expenses and the odd airfare back home) will equal the amount of his inheritance.

Peter’s successful application to Oxford is a great talking point amongst his relatives and friends. A very bright future is envisioned for Peter. Peter won’t admit it, but he is enjoying all this attention from his friends and relatives.

While Paul’s relatives and friends are happy about his successful application to the local university, it hasn’t been met with the same adulation that has been accorded Peter.

Peter’s time at Oxford is generally pleasant, but he does get a little homesick on occasions. He misses family and friends.

Paul on the other hand has made minimal changes to his lifestyle. He still lives at home and has friends from school attending his university.

Both Paul and Peter complete their degrees at the age of 21.

Now we fast forward 39 years. Paul and Peter are both 60 and about to retire from successful careers.  Paul never did touch that inheritance. He simply collected dividends and enjoyed the capital growth. That inheritance is now worth $2m and pays approximately $80,000 in dividends each year.

Paul and Peter both earned approximately the same amount of money during their careers. Peter (despite attending Oxford) was unable to out-earn Paul. As we mentioned earlier, Paul is just as bright as Peter and also has a similar temperament and personality.

 

So now we can say that the cost of Peter’s Oxford education was in the vicinity of $2m, being the money that his peer Paul now has that he doesn’t. It’s a high price to pay for a “brand name” education.

Obviously, universities such as Oxford rely very heavily on their brand. Oxford’s more recent move into awarding MBAs is a very good example of this. Oxford has no history as a business school. It simply wished to capture a portion of the market for MBAs that it was previously missing out on.

The MBA degree at Oxford appeals to a certain clientele. The applicants tend to be people who have reasonably good jobs in the business world (but not always) and who (in all likelihood) would not have been successful undergraduate applicants but now are afforded the opportunity to obtain an Oxford qualification at a cost which is less than an undergraduate degree. It is very good marketing and I certainly applaud Oxford for it.

Harvard also uses its “brand name” to increase its earnings. The short management courses are a very good example of this. These courses are marketed to executive level people (from all disciplines). They undertake a very short course at Harvard for which they will be awarded some sort of certificate.

It amuses me no end when I see these certificates decorating the office walls of people who have attended these courses.

Once again, the vast majority of these people would not have been successful applicants to Harvard for under graduate degrees. Harvard is simply using its brand name (like Oxford) to charge very high fees for a short course (with relaxed entry criteria) that allows the applicant to say that they attended the university*.

 

* I too have been to Harvard, I visited some years back while on a trip to Boston.

 

Alan Kohler, Tim Toohey & the RBA get it wrong

On 9^th May 2011, Alan Kohler wrote the following on the Business Spectator web site:

Don’t be misled by last week’s commodities crunch, the Australian dollar is heading higher – much higher. That’s partly because of the return of the carry trade.

Kohler’s article was sent to me by a friend and it made me chuckle because it was absurd.

In that same month, I wrote an article on this blog (see The Volatile Australian Dollar), stating why I thought that both Alan Kohler and Tim Toohey (a Goldman Sachs economist, whose research Kohler’s article was based on) were completely wrong.

Now when Kohler made his characteristically bold pronouncement, the Australian dollar was trading at around $1.07 to the US dollar. But Kohler and Toohey told us it was going much higher!

In July of 2011 it reached $1.10 (as it had a few months prior), but from there it was all down hill.

With the Australian dollar now around $0.92 to the US dollar and never having traded above $1.10, we can say that Kohler and Toohey got that call completely wrong. In fact, it would not have been possible to have gotten it more wrong.

I also quoted John Taylor (CEO and founder of FX Concepts) in my May 2011 article. Taylor had the opposite opinion to Kohler and Toohey. Taylor of course was correct (as I strongly suspected he would be).

Now anyone can get a call wrong and that’s ok as long as your original rationale was sound. In this case the argument made by Kohler and Toohey was not sound. And both of them should have known better (especially Toohey). It was also unfortunate for Kohler that he put misplaced faith in Toohey’s research and went on record with it.

Of course, as a business journalist, you can make all sorts of incorrect predictions safe in the knowledge that no one will hold you to account for them. But why shouldn’t we hold people who make their living writing such things to account for what they go on record as saying? In Kohler’s case, he also sells an investing newsletter and therefore should be held to much higher account than other business journalists.

Kohler and Toohey are obviously not important figures, but unfortunately for everyone who lives in this country, the Reserve Bank of Australia (RBA) is an important entity.

The market ignored a few of the unnecessary interest rate cuts made by the RBA prior to May 2013, but the cut on 2 May 2013 was not ignored. It resulted in a devaluation of the Australian dollar by approximately 10 percent against several currencies in a matter of weeks.

This is quite scary stuff and the worst part is it’s not of any benefit to the country. The only end result of further devaluation of the Australian dollar can be inflation coupled with the reduction in income to self-funded retirees (and others who derive most of their income from fixed interest investments).

Having seen the fierce and disorderly devaluation of the Australian dollar in no time at all and the spooking of the share market by the cut, one would think that the RBA will hold off on any future cuts, but I honestly believe they are stupid enough to make further interest rate cuts. They have done stupid things in the past, remember how they ramped up interest rates at the beginning of the GFC? I have no faith in their ability to properly manage economic conditions or in their forecasting ability.

Why algorithmic trading will eventually replace fund managers

The traditional fund manager who uses his or her “expertise” to select stocks for their clients will gradually become an endangered species (and they know it). This is why you have been hearing a lot of negativity from these people about high frequency/algorithmic trading in recent times. These people know that their own returns are materially inferior to that of many high frequency/algorithmic traders.

As I’ve said previously here, most fund managers (and very especially Australian fund managers) have no discernable stock picking skills. Sure, you will have those who can point to index beating records over relatively short periods of time, but show me any fund manager in Australia who has returned a compound 15-20%+ over 20 or more years – they simply don’t exist. Most of them can’t even match a low cost index fund over time.

Many of these people have reached a station in life which is out of all proportion to their actual abilities. They have been able to so this by taking passive fees on assets under management which amount to billions of dollars across the industry.

How do they attract funds? Here’s how:

1. Firstly make sure you have a few years of good performance under your belt. This will have been obtained by simply getting lucky, playing popular (but temporary) trends, or with the assistance of a raging bull market (or all three);
2. If you can, appear in the media as an “expert” – the media classes anyone who is employed in the investment industry and who is breathing as an “expert”;
3. It always helps to have some charisma and to come across confidently;
4. Market your returns to investors who are too naïve to see through you and too lazy to care about the management of their own money;

 There you have it. Now you can sit back and charge 1-2% on assets for lousy performance. This can amount to millions of dollars and if you fail later on, don’t worry, you will get to keep all of your ill-gotten gains which were made when times were good.

Remember the full service stock brokers and also the old market makers? These guys use to rip us off – they literally stole our money for doing very little. Most of those guys are now out of business due to the internet and alternative market places and every day I’m thankful for that.

(Incidentally, I know many high frequency traders are involved in market making too, but their spreads are much lower than the old time market makers. The modern high frequency market makers simply cannot capture similar spreads to what the old market makers use to.)

The fund manager belongs in the same category as the old time stock brokers and market makers. Nearly all of them over-charge their clients. If you do not take responsibility for your own investments (including superannuation), you can be sure that someone is enjoying a very pleasant life style at your expense.

But why is algorithmic trading superior?

1. Algorithmic strategies can be accurately tested on vast amounts of data (often in seconds or minutes);
2. Algorithmic strategies can be executed by computers, removing human emotion from trading decisions;
3. Algorithmic strategies are consistent in what they do (unlike many humans);
4. Algorithms can detect patterns that are imperceptible to humans;
5. Algorithms can scan vast amounts of data, much more than a human ever could;
6. Algorithms can adapt to different environments, something many humans cannot do;
7. Properly conceived and successfully tested algorithms have predictive ability, something the vast majority of humans do not;
8. Advances in computing power are making algorithmic strategies cheaper and cheaper to implement as time goes by;
9. Because most algorithmic strategies are short-term, they are not as exposed to general market risk as buy and hold strategies, (e.g. regulatory risk is an all too common factor in Australia these days);
10. For all of the above reasons, algorithms have now advanced to the stage where they can trade stocks better than many humans.

This is why, over time, the traditional fund manager will go the way of the Dodo. As will the analysts at the investment banks and the economists (if you want to be rich, don’t listen to these people – they have mortgages). Algorithms can do all of their jobs much better than they can and in years to come they will.

The lazy, over-compensated fund managers will make a lot of noise and attempt to frighten people to maintain the status quo, but it will ultimately be futile.

Mohnish Pabrai’s comparative returns are misleading

The other day I was reading through the Pabrai Investment Funds Annual report for last year when it suddenly occurred to me that the comparative returns that Pabrai publishes there (i.e. his funds’ returns versus the various indexes) is misleading. Why you ask? Well, it all has to do with taxation.

Let’s have a look at the Pabrai investment funds:

Pabrai Investment Fund 2 (an Illinois Limited Partnership) – Commenced operation on 1^st October 2000 when units were issued at $10 each. As at 30 June 2012, the net asset value (NAV) of a unit was $43.36, an average annual compound return per annum of 13.3%.

Pabrai Investment Fund 3 Ltd (a British Virgin Islands corporation) – Commenced operation on 2^nd February 2002 when shares were issued at $10 each. As at 31^st December 2012, the NAV of these shares was $33.21, an average annual compound return per annum of 9.7%.

Pabrai Investment Fund 4 (a Delaware Limited Partnership) – Commenced operation on 1^st October 2003 when units were issues at $10 each (Pabrai must have a fondness for the figure of $10). As at 31^st December 2012, the NAV of these shares was $18.85, an average annual compound return per annum of 7.1%.

Now, the British Virgin Islands Corporation (Pabrai Investment Fund 3 Ltd) pays no income tax or capital gains tax in the British Virgin Islands and also pays no income tax in the United States. This is the reason that Pabrai domiciled this company in that jurisdiction. It’s also a fund for non-US investors. There is nothing wrong with this, it’s good tax planning. 

But when Pabrai compares the returns of Pabrai Investment Fund 3 to the returns of the Dow Jones Industrial Average (DJIA), the NASDAQ or the S&P500, he is comparing the returns of a fund which pays no tax with an index whose constituents must pay tax. 

For a moment, imagine that the US Federal and State Governments legislated to exempt all constituents of the DJIA from paying tax. What affect would that have? It would immediately increase the value of all the constituents of that index. Rationally, the percentage increase would be by approximately the tax rate divided by one less the tax rate multiplied by 100 or (TR% / (1-TR%) )*100. Of course, it’s not quite that simple, but you get the gist of it.

When Warren Buffett (or any other person running a US domiciled tax-paying investment corporation) compares their corporation’s returns to an index, it’s a fair comparison because like is being compared with like.

When an individual running a non-tax paying corporation compares their returns to an index which consists of tax-paying corporations, the comparison is not fair. A fair comparison would be to take the returns generated by the non-tax paying entity and then apply a notional tax rate based on the average tax rate paid by the constituents of the index being compared to and then compare the returns.

For example, if we applied a notional 25% “tax” to Pabrai Investment Fund 3, that 9.7% average return (mentioned above) might become about 7.3% - hardly returns to write home about. Incidentally, Pabrai Investment Fund 3 is the only vehicle currently open to new investors.

But what about Pabrai’s limited partnerships? They too pay no tax. All tax is paid by the individual unit holders.

So I would put it to you that any performance comparisons between any of the Pabrai funds and the various US indexes are misleading because any reported out-performance will always be skewed unfairly in Pabrai’s favour.

Pabrai has talked at some length in the annual letter about how he has compounded his own net worth at close to 26% per annum (since about 1995). That’s great for Pabrai, but the funds mentioned above haven’t achieved anywhere near this figure and as I’ve explained here, even those returns are misleading when compared to any index. So why mention your own much better individual performance?

My own net worth has increased at an average annual rate of 16.1% (post tax) from 1995 to 2012. On a pre-tax basis (if I had never had to pay income or capital gains taxes) it would have been roughly 23% per annum. That statistic alone demonstrates the difference between pre-tax and post-tax returns. 

So, finally, to have some fun, if I had issued shares at $10 each (Pabrai’s favourite number) on 31 December 1995 in “The Stock Scribe” (me), as at 31 December 2012, those $10 shares were worth $127.

Nathan Tinkler’s troubles are mounting

On 21 May, Blackwood Corporation (BWD.AX) announced that liquidators acting on behalf of the creditors of Mulsanne Resources had made an application in the Supreme Court of New South Wales to freeze the assets of Nathan Tinkler.

Nathan Tinkler’s story is an incredible one. I don’t really know of anyone who had made so much money as quickly as Tinkler did from scratch. But as they say: “Easy come, easy go.”

Tinkler was originally a coal mine electrician working in the Hunter Valley of New South Wales. He formed a company called Custom Mining which eventually purchased the Middlemount coal deposit in Queensland. Custom Mining paid $A30m for that deposit (although I believe Tinkler only used about $A1m of his own money and did a deal with a well known law firm to do all the legal work for an equity interest, most people would have been shown the door).

Now here is the unbelievable part, within one year of purchasing Middlemount, Macarthur Coal bought it for $A275m from Custom Mining delivering Tinkler an enormous profit.

Now, I’m a conservative character and if it was me, I would have realized how lucky I was and not put any of this new found wealth in jeopardy. But Tinkler didn’t make all that money by being conservative or risk averse and he was after even more. Deal-making on a grand scale has seen the demise of many an entrepreneur in this country.

Tinkler got more, a lot more. Tinkler made hundreds of millions more from seemingly miraculous  deals in the coal sector with the end result being that he was apparently worth $A1 billion by the time he was 35 years old (in 2011). But it wasn’t to last.

Tinkler indulged himself with his new found wealth, he bought race horses, interests in a rugby league team and a soccer team as well as plenty of flashy cars. The well trodden path of many a nouveau riche.

It all came unstuck when Tinkler made a deal with Blackwood Corporation (a coal mining minnow), to purchase approximately $A28m in equity at around 30 cents per share (via Mulsanne Resources). A very ill-timed agreement as Blackwood shares were set to start a steep descent shortly after the agreement was entered into, proving that not everything Tinkler touched turned to gold.

Now, $A28m for someone supposedly worth around $A1 billion shouldn’t have caused any concerns whatsoever. But after Mulsanne Resources missed a few payment deadlines, it started to become apparent that Mulsanne wasn’t going to pay up and the liquidators of Mulsanne allege that it was insolvent when it entered into the agreement.

Now, I’m not about to speculate on the reasons that this whole deal went sour, that will be discussed in court. But suffice to say, this episode has done enormous damage to Tinkler’s reputation – you simply shouldn’t enter into agreements that you can’t consummate.