I try to raise cash in my equity strategy as valuations rise.? I try to reduce cash as valuations fall.? It doesn’t work perfectly, but I do think it reduces risk, and it might improve returns.
Buffett also views cash as valuable.? He views it as a call option on other assets, as is noted in thesetwo articles.? With cash, your downside is limited — you can just sit and wait for a good opportunity.? In one sense, if you wait too long, the opportunity cost of cash could be significant, but over most 5-year periods there is a drawdown in asset prices that avail good opportunities.
Cash gives you options, perhaps not options in the same sense as “puts and calls,” but options in the sense of choices that are easily achieved.? Particularly for Buffett, who is the choice of many who want to exit their private business, and want their culture/friends to survive, rather than receiving top dollar as a sales price.
Even as the Fed tries to make cash less attractive to hold, it is still valuable to those that prize flexibility.? That is the virtue of cash, and it is impossible to erase.
Like gold, cash is special because it doesn’t do anything.? Even money market funds do nothing, or almost nothing.? It just sits there, waiting.? It waits for the day when the Fed is forced to raise rates because inflation is running faster, even though the economy is still underemployed.? It waits for the day when bond yields rise and stock prices fall, where there are good opportunities to use the cash.
Having cash on hand allowed my church to buy a building cheaply in March 2009, and allowed me to help rescue a friends business, as well as buy some cheap stocks.? The same was true for me in October 2002, when I fully deployed my cash into stocks.
Cash is flexibility.
Cash says, “I don’t know.”
Cash says, “I don’t care.”
Cash says, “I’m ready.”
When opportunities are numerous, I am more than willing to part with my cash.? But when yields are low, and valuations are high if profit margins mean-revert, I would rather have more of a cash buffer.
For my account, and client accounts, I did buy some stock last week.? If the weakness had persisted, I would have bought more.
I still have an above average amount of cash (for me).? I am waiting for opportunities to get better before I deploy it.
Here’s the quick summary of what I will say: People and companies need liquidity. ?Anything where payments need to be made needs liquidity. ?Secondary markets will develop their own liquidity if it is needed.
Recently, I was at an annual meeting of a private company that I own shares in. ?Toward the end of the meeting, one fellow who was kind of new to the firm asked?what liquidity the shares had and how people valued them. ?The board and management of the company wisely said little. ?I gave a brief extemporaneous talk that said that most people who owned these shares know they are illiquid, and as such, they hold onto them, and enjoy the distributions. ?I digressed a little and explained how one *might* put a value on the shares, but trading values really depended on who was more motivated — the buyer or the seller.
Now, there’s no need for that company to have a liquid market in its stock. ?In general, if someone wants to sell, someone will buy — trades are very infrequent, say a handful per year. ?But the holders know that, and most plan not to sell the shares, looking to other sources if they need money to spend — liquidity.
And in one sense, the shares generate their own flow of liquidity. ?The distributions come quite regularly. ?Which would you rather have? ?A bucket of golden eggs, or the goose that lays them one at a time?
Now the company itself doesn’t need liquidity. ?It generates its liquidity internally through profitable operations that don’t require much in the way of reinvestment in order to maintain its productive capacity.
Now, Buffett used to?purchase only companies that were like this, because he wanted to reallocate the excess liquidity that the companies threw off to new investments. ?But as time has gone along, he has purchased capital-intensive businesses like BNSF that require continued capital investment. ?Quoting from a good post at Alpha Architect?referencing Buffett’s recent annual meeting:
Question: ?In your 1987 Letter to Shareholders, you commented on the kind of companies Berkshire would like to buy: those that required only small amounts of capital. You said, quote, ?Because so little capital is required to run these businesses, they can grow while concurrently making all their earnings available for deployment in new opportunities.? Today the company has changed its strategy. It now invests in companies that need tons of capital expenditures, are over-regulated, and earn lower returns on equity capital. Why did this happen?
Warren Buffett?It?s one of the problems of prosperity. The ideal business is one that takes no capital, but yet grows, and there are a few businesses like that. And we own some?We?d love to find one that we can buy for $10 or $20 or $30 billion that was not capital intensive, and we may, but it?s harder. And that does hurt us, in terms of compounding earnings growth. Because obviously if you have a business that grows, and gives you a lot of money every year?[that] isn?t required in its growth, you get a double-barreled effect from the earnings growth that occurs internally without the use of capital and then you get the capital it produces to go and buy other businesses?[our] increasing capital [base] acts as an anchor on returns in many ways. And one of the ways is that it drives us into, just in terms of availability?into businesses that are much more capital intensive.
Emphasis that of Alpha Architect
Liquidity is meant to support the spending of corporations and people who need services and products to further their existence. ?As such, intelligent entities plan for liquidity needs in advance. ?A pension plan in decline allocates more to bonds so that the cash flow from the bonds will fund expected net payouts. ?Well-run insurance companies and banks match expected cash flows at least for a few years.
Buffer funds are typically low-yielding assets of high quality and short duration — short maturity bonds, CDs, savings and bank deposits, etc. ?Ordinary people and corporations need them to manage the economic bumps of life. ?Expenses are up, and current income doesn’t exceed them. ?Got cash? ?It certainly helps to be able to draw on excess assets in a pinch. ?Those who run a balance on their credit cards pay handsomely for the convenience.
In a crisis, who needs liquidity most? ?Usually, it’s whoever is at the center of the crisis, but usually, those entities are too far gone to be helped. ?More often, the helpable needy are the lenders to those at the center of the crisis, and woe betide us if no one will privately lend to them. ?In that case, the financial system itself is in crisis, and then people end up lending to whoever is the lender of last resort. ?In the last crisis, Treasury bonds rallied as a safe haven.
In that sense, liquidity is a ‘fraidy cat. ?Marginal borrowers can’t get it when they need it most. ?Liquidity typically flows to quality in a crisis. ?Buffett bailed out only the highest quality companies in the last crisis. Not knowing how bad it would be, he was happy to hit singles, rather than risk it on home runs.
Who needs liquidity most now? ?Hard to say. ?At present in the US, liquidity is plentiful, and almost any?person or firm can get a loan or equity finance if they want it. ?Companies happily extend their balance sheets, buying back stock, paying dividends, and occasionally investing. ?Often when liquidity is flush, the marginal bidder is a speculative entity. ?As an example, perhaps some emerging market countries, companies and people would like additional offers of liquidity.
That’s a major difference between bull and bear markets — the quality of those that can easily get unsecured loans. ?To me that is the leading reason why we are in the seventh or eighth inning of a bull market now, because almost any entity can get the loans they want at attractive levels. ?Why isn’t it the ninth inning? ?We’re not at “nuts” levels yet. ?We may never get there though, which is why baseball analogies are sometimes lame. ?Some event can disrupt the market when it is so high, and suddenly people and firms are no longer so willing to extend credit.
Ending the article here — be aware. ?The time to take inventory of your assets and their financing needs is before the markets have an event. ?I’ve just completed my review of my portfolio. ?I sold two of the 35 companies that I hold and replaced them with more solid entities that still have good prospects. ?I will sell two more in the new year for tax reasons. ?My bond portfolio is high quality. ?My clients and I are ready if liquidity gets worse.
This morning, I looked at the fall in the Chinese stock market, and I said to myself, “It’s been a long journey since the last crash.” After that, I wrote a brief piece at RealMoney, and another at what was then the new Aleph Blog, which was republished and promoted at Seeking Alpha, and got featured at a few news outlets. ?It gave my blog an early jolt of prominence. I was surprised at all of the early attention. That said, it encouraged me to keep going, and eventually led me away from RealMoney, and into my present work of managing money for upper middle class individuals and small institutions.
I try to write material that will last, even though this is only blogging. ?Looking at the piece on the last China crash made me think… what pieces of the past (pre-2015) still get readers? ?So, I stumbled across a way to answer that at wordpress.com, and thought that the array of articles still getting readers was interesting. ?The tail is very long on my blog, with 2725 articles so far, with an average word length of around 800. ?Anyway, have a look at the top 20 articles written before 2015 that are still getting read now:
Though I write about personal finance, it’s not my strongest suit. ?Nonetheless, when I?wanted to write some articles about personal finance for average people, I realized I needed to limit myself mostly to cash management. ?A few of the articles in the new series “The School of Money,” should be good in that regard.
This is a controversial piece on the most secretive aspects of what Buffett does in investing. ?I have tried to get people from the media to pick up this story, but no one wants to touch it. ?I think I am one of the few admirers of Buffett willing to be critical… but so what? ?Hasn’t worked on this story.
This short series goes through my worst investing mistakes. ?It’s almost finished. ?I have one or two more articles to write on the topic. ?This one covers my early days, where I made a lot of rookie errors.
Here I do a post aiding all of my competitors, giving the relevant references to the de minimus laws for registered investment advisers in all 50 states, plus DC and Puerto Rico. ?Note that I got my home state of Maryland wrong, and I corrected it later.
Cramer generates controversy, and thus pageviews as well. ?As an aside, TheStreet.com is down another 20% since I wrote that. ?Still, the piece had my insights from brief discussions that I had with Cramer, way back when.
I have always enjoyed the times where I have had the opportunity to interact with the authors of the books that I have gotten to review. ?Guy Spier was a particularly interesting and nice guy to interact with.
This is the predecessor piece to the one rated #14 on this list. ?Brief, but gets the points across on what the best exchange traded products are like. ?It was written in 2009.
I’ve been banging this drum for some time, and the last one in this series was quite popular also. ?This article highlighted how much average investors lose relative to buy-and-hold investors in the?S&P 500 Spider [SPY]. ?Really kinda sad, underperforming by ~7%/year.
I had forgotten that I had written this one in 2011. ?Why does it still get hits? ?In it I argue that the US will get out of its difficulties more easily than Japan. ?(Maybe this gets read in Japan?)
My contention is that Actuaries are underrated relative to Quantitative Analysts, and have a lot to offer the financial markets, should the Actuaries ever get their act together.
I was shocked at this one, written in 2008. ?This post explains a math concept in simple visual terms for teachers to explain?greatest common factors and least common multiples.
Should it be any surprise that the last three, the most popular, are on Buffett, Berkshire Hathaway and Insurance? ?People go nuts over Buffett!
The one novel thing I bring to table here is my understanding of the insurance aspects of BRK. ?Each of the three deal with that topic in a detailed way. ?Aleph Blog is pretty unique on that topic; who else has written in detail about the insurance company-driven holding company structure? ?Aside from that,?many don’t get how critical BRK is to covering asbestos claims, and don’t get the economics of insurance float. ?Many think float is magic, when it can lead to an amplification of losses, as well as an intensification of gains.
These last three pieces got really popular in March, around the time that BRK released its 2015 earnings, even though they were one year old.
Anyway, I hope you found this interesting… I was surprised at what gets read after time goes by. ?One final note: for every time the most popular pre-2015 article was read, articles that would have been rated #22 and beyond got read 10 times… and thus the long tail. ?It’s nice to write for the long term. 🙂
Full disclosure: long BRK/B for myself and clients
I was riding home with child number seven after a basketball practice about four months ago — this is the child that if any of mine has the capability of taking over for me someday, this is the one. She said to me, “Dad, I always knew we were better off than most, but it finally sank home to me how much better off we are than most of the people we know.”
Me: “What do you mean?”
7: “I’ve been talking with my friends after basketball practice, after church, and other times, and I hear about what happens when their parents?have a?$500 surprise bill for a repair, and things like that. ?They have to scrape for months to deal with the added expense, and they can’t do a lot of things that they do normally while they rebuild their finances.”
Me: “Okay, so what makes us different?”
7: “We just had three disasters hit us at the same time, and you just dealt with them for the long term without making?a lot of noise about it. ?Had that happened to any of my friends’ families, they would not know what to do, it would be impossible for them to do it without help.”
Me: “Actually there are a few of your friends whose families would likely survive what hit us easily, but yes, you’ve hit on something that I think is the most significant initial lesson on finance for the 75% of the population on the low end of incomes. ?People need to start saving early, and build a buffer against disasters, etc.? If I were going to give a talk at most churches on personal finance, I would talk only about that, and almost nothing more. ?Earn, budget, save, and be generous. ?After that, we can talk about investing, but it is only relevant to a minority of the population with enough discipline to save early and often, initially aiming for 3-6 months of expenses.”
7: “When did you and Mom finally have that much saved?”
Me: “Going into our marriage back in 1986. ?I had been a graduate student, and your mom a high school teacher in one of the poorest school districts in California, but we still both lived low on the hog, and saved money. ?That gave us enough money that we were able to buy a small house at an opportunistic time six months after we married. ?Within a year, we had rebuilt the buffer, and we haven’t been without it since.”
In personal finance, you have to develop good habits early, and learn that life isn’t about how much you spend. ?I try to teach my kids that — Seven understands it, as does three or four of her siblings. ?The other three or four don’t understand, despite my best efforts — some of it seems to be personality-driven, but I have seen one or two of them change and get better at money management. ?We’ll see… they are still developing.
In finance, you have to focus on what you can control. ?You have reasonable control over ordinary spending. ?You have less control over what you earn, and almost no control over accidents and investment returns. ?Thus the first bit of advice is to live below your means and save. ?The second bit is to plan against catastrophes on a reasonable level. ?Insurance can be useful to protect against some of the worst outcomes. ?Just remember, insurance?is an expense and not an investment.
Along with the above article cited, note these four basic articles and one book review on personal finance:
The last one is useful for learning to live less expensively, while still having most reasonable comforts that others have.
Now, what I have written about above has been noted in the financial media lately regarding a study done by JP Morgan on how many people don’t keep a buffer around, no matter how much they earn. ?Here are two articles that talk about that study (one, two?– good articles both, read them if you can). ?Personally, I’m not surprised having worked with people who earned a lot and spent to the limit. ?They lived far more opulent lives than I do, but decided they would save later.
If you want to save, start now. ?Most good habits have to be started now, or they won’t get started. ?Most good intentions don’t die from a frontal assault, but from the idea that you have plenty of time to change. ?As a result — you don’t change. ?And that is not just you, it is me in my life also. ?Change must start now, or it does not start.
These largely follow my point of view on personal finances. ?Save, protect against bad risks, and take moderate risks to earn money both in work and in investing. ?You can do it too, but remember, it is not a question of knowledge, it is a question of whether you have the will to do it or not. ?I wish you the best in your efforts.
Now if you haven’t done it yet, go build the buffer.
Before I start this evening, I would like to explain some of the reasons for these “Best of the Aleph Blog” articles. ?I write these no closer than one year after an article was written, so that I can have a more dispassionate assessment of how good they were. ?I write these for the following reasons:
Some people want a quick introduction to the way I think.
Some publishers on the web want additional copy, and I let them republish some of my best pieces.
One day I may bundle a bunch of them together, rewrite them to improve clarity, and integrate them to create a set of books on different topics.
One of my editors at RealMoney once shared with me that I was one of the few authors there whose articles got re-read, or read after a significant time had passed. ?This is meant to be mostly “timeless” stuff.
New readers might be interested in older stuff.
I enjoy re-reading my older pieces, and sometimes it stimulates updates, and new ideas.
Anyway, onto this issue of the “Best of the Aleph Blog.” ?These articles appeared between August 2012 and October 2012:
Goes through the details of how a school district outside San Diego mortgaged the future of the next generation who will live there, if any will live there.
A series of articles inspired by what I wrote at RealMoney, encouraging people to be careful about listening to advice in the media on stocks, including those recommended by Cramer.
Governments imagine that they can shape outcomes, and in the short-run, they can.? In the long-run, the real productivity of the economy matters, and only those that can make it without government help will make it.? Whatever government policy may try to achieve, eventually the economy reverts to what would happen naturally without incentives.? There is a natural carrying capacity for most activities, and efforts to change that usually fail.
Applying math to economics has been a loser.? Who has a consistently good macroeconomic model?? No one that I know.? Estimates of future GDP growth and inflation are regularly wrong, and no one calls turning points well.
Far from offering high price appreciation, it is far easier to cheat many people by offering a high yield, because average people look for ways to stretch their limited resources with a tight budget.
Yes, I wrote them both, but they complement each other.? Yes, most average people get skinned investing in common stocks, but if you apply yourself assiduously to investing, it will improve your performance in other jobs, by broadening your skill set.
The latter of (part 1) these was my highest day and month for access of my blog.? I came close to eclipsing the monthly total last month, but missed by 2%.? These pieces take up asset allocation via valuation, and momentum.
A story of how Roy and I disobeyed orders a little, and created a lot of growth for the company that we served.? Personally, I think this is a great story… I never created more value than when I worked for Provident Mutual.
The smaller the range of choices is, the better people do in choosing.? One way to facilitate that is to break down decision making into a series of choices with each having few options.
Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?? Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.? Perhaps another possibility is when a country?s currency is being used more and more as a shadow currency, like the US in the Third World.? But even that will come home someday.
This is probably one of the most important articles I have written, because investment returns are lumpy, and we need to learn to live with it.? For those of us that are smart, we need to take advantage of it.
Now after all of this, it?s not so much a question of rationality but ethics.? Who will do the right thing for the one he ultimately serves?? Working for those people is a joy, and is beneficial to those that own. Doing right does well for many.
If you have time, there are two long articles that are worth a read.? The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.? It was written in three parts — one, two, and three, corresponding to three phases:
Growth of a clever enterprise, AIGFP.
Expansion into default swaps.
Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.
What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”? There is no free money, but the lure of “free money” brings out the worst in mankind.? This is not just true of businessmen, but of politicians, as I will point out later.
My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.? Boy, were they arrogant!? It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.
As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.? The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.? Again, the AIGFP people were arrogant — but what was I to say?? They were more successful, seemingly.
The last era, as AIG got downgraded, was while I wrote for RealMoney.? After AIG was added to the Dow, I was consistently negative on the stock.? I had several worries:
Was AIGFP properly hedged?
Were reserves for the long-tail commercial lines conservative?
Why had leverage quadrupled over the last 15 years?? ROA had fallen as ROE stayed the same.? The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
Was AIG such a bespoke behemoth that even Greenberg could not manage it?
My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.? (I was privy to a number of significant reserving errors 1989-1992).
In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.? AIG fit that mold well.
Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.? This is only an opinion, but I think AIG stock is an eventual zero.? Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.? Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.
The second article is from Bethany McLean of Vanity Fair.? I remember reading her writings during the accounting scandals at Fannie Mae.? She was sharp then, and sharp now.? There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:? I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.
Again, there is a growing bubble, as with AIG.? The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.? It also leads them to buy the loans made by their competitors.? It leads them to lever up even more.? It leads them to dilute underwriting standards.? Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.
One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.? On a cash flow basis, that might not happen for a long time, but it would happen.? Defaults would be well above what was their worst case scenario, and too much for their thin capital base.
The last article is another three part series from the Washington Post that is about the failure of our financial markets.? (Here are the parts — one, two, three.)? What are the main points of the article?
Bailing out LTCM gave regulators a false sense of confidence.? They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
Because of turf and philosophy conflicts, derivatives were left unregulated.? (My view is that anything the goverment guarantees must be regulated.? Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.? The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.? Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.? Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
Standards fell everywhere as the party went on, and the bad debts built up.? It was a “Devil take the hindmost” situation.? But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.? Cash, cash, who’s got cash?!
In the aftermath, regulation will rise.? Some will be smart, some will be irrelevant, some will be dumb.? But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.
A few final notes:
Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
This could never happened as badly without the misapplication of monetary policy.? Greenspan enver let the recessions do their work and clear away bad debts.
Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
The investment banks relied too heavily on risk models that assumed continuous markets.? Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.? But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.? We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.? Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”? And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.? I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.? For that, I apologize.? It is what I hate most about investment writing — people losing because they listened to me.
