Friday, February 20, 2009

flation - In or De?

"I don't know" is where I will begin (and end). But in between, let me present some differing views. Everyone (and I mean everyone) is convinced that Fed's actions will produce massive inflation going forward. I am sure you have seen the charts showing money supply a year ago and today and the chart is off the charts. The popular view is that we'll face some deflation and then massive inflation. OK, but my problem here is that when everyone is convinced something will happen, it usually doesn't!

Barron's recently interviewed Ray Dalio of Bridgewater Associates (excellent interview) and asked him the inflation question. He said, "A wave of currency devaluations and strong gold will serve to negate deflationary pressures, bringing inflation to a low, positive number rather than producing unacceptably high inflation -- and that will last for as far as I can see out, roughly about two years." So no inflationary worries there! Furthermore, a Matin Wolf article in the Financial Times (another excellent article) compared the current recession to Japan's and drew some lessons. He is more worried about deflation, than about inflation. The argument here is that this is balance sheet recession (similar to Ray's point) and these ones (a) take time (b) inflict pain (c) are not easy to tackle. But again, no inflationaly worries..

On the other hand a handful of very respected value investors including Seth Klarman, David Einhorn and Mohnish Pabrai are really worried about inflation and are putting their money where their mouth is! Seth Klarman as I mentioned in a previous post said, "We think inflation could become out of control in 3 to 5 years. Yet, we might not wait for that position. Hence, perhaps early, we have a large inflation hedge. We don't own gold as a commodity. We won't disclose our inflation hedge, yet with enough work, you can find true inflation hedges." David Einhorn of Greenlight Capital in his latest shareholder letter said, "Our current chairman of the Federal Reserve, Ben Bernanke, is an "inflationist". When times were good, he supported an easy money policy. Even when the Fed raised rates...bubble formation...money printing...Our guess is that if the chairman of the Fed is determined to debase the currency, he will succeed. Our instinct is that Gold will do well either way: deflation will lead to further steps to debase the currency, while inflation speaks for itself." Mohnish Pabrai in this annual letter to his investors went a step further and gave his macro view on the economy going forward. I mean this is an ardent Buffett follower and hes talking about the macro view and the massive inflation and high interest rates in the future. He has geared his portfolio towards hard assets like low cost barrels in the ground, low cost iron ore reserve etc. Said another way - hes buying commodities!

Only time will tell what will happen. This is a time when many wonderful business are selling for way below their intrinsic values. The challenge in this market is to identify and buy the safest and the cheapest stock (or debt). The macro world can change very fast; are you agile enough? As a value investor if you are overly worried about the macro view, a smart hedge I can understand, a core holding - not so much!

Friday, February 13, 2009

Value Investor and Shorting

This is somewhat of a tricky subject for Value investors. Warren Buffett (WB) doesn't short - for very good reasons. Most of the seasoned value investors that we emulate are long only portfolio managers. Berkshire Hathaway shareholder letters are said to be everything one needs to know in order to make money in the markets but WB lists no rules for shorting. Ben Graham on the other hand pair traded, but WB dint copy that practise because he observed that for every 4-5 'wins' there was a 'loss' which would more or less wipe out the 'wins'. On the other hand, there are many enterprising investors Paulson, Watsa et. all that successfully shorted in the past 2 years and made a killing. Anyone who was long only in the last 2 years has lost money. Anybody who was short anything has made money. This means that the outcome was favorable, but was the decision right? If the decision was right the process must have been right. On the other hand, if the decision was wrong, then 'luck' must have all the credit and not the process. Lets look at this.

Now why doesn't WB short? As Keynes said, "Markets can remain irrational longer than you can remain solvent". WB has said that, Charlie and him had identified a lot of securities which were overvalued and would correct, but could never determine when they will correct. This is the essence of it. When a bunch of long/short hedge fund managers were asked to identify some mistakes - 90% answered that one of their biggest mistakes have been shorts going against them (the thesis was that the security is overvalued). A very good example would be VolksWagen, u'd probably be having nightmares if you were short VolksWagen!

One thing is clear, with the advent of large pools of capital the markets have been and will be a lot more volatile. Long only portfolio managers will probably have to suffer short (or long) periods of under performance. (A) There is nothing wrong with this (B) Volatility is good for the value investor because it creates opportunity. The catch here is that you can take advantage of this opportunity only is you have dry powder. So a lesson here could be that holding some amount of cash is good, you don't have to be 100% invested all the time. A more aggressive lesson could be to find out ways to capitalize on the volatility - to learn from Paulson, Watsa and Ben Graham.

In Security Analysis, Ben Graham says that if a bond is trading for 100 and its callable at 102, it would be a mistake to go long at 100 as the downside is way more than the upside (opposite of what a value investor wants). Well, but what about shorting the bond at 100? The downside now is $2 plus the interest and the upside is $100 (the bond was trading in the mid 60's a few months later). If the whole idea here is to make 'bets' with heads I win and tails I don't loose that much, then this makes sense. Today credit default swaps (CDS) are available which isolate the credit risk in the bond which is exactly what we are interested in. In a lot of these cases the downside to these instruments for a lot of companies in early 2007 was very little and the upside much much greater. It is a neat way to bet against a company or a sector, given that the CDS's are cheaply priced. Anybody thinking should study Paulson, Watsa and Ackman and their trades over the years.

Another possible solution here is LEAPS. Having determined that shorting a stock is a bad idea, a PUT might be useful in achieving the desired trade. This however reminds me of the guy who bought PUTs on Yahoo! in 1999 just to have them expire one month before the 2000 crash. In addition, yours truly shorted Countrywide Financial (CFC) in 2007 when it was at $35 using PUTs just to sell at a loss (around $38) on rumors that Bank of America will acquire them at around $45. But if one is convinced that a particular stock is a good short, a put strategy can be devised whereby the person starts with the small position and increase the 'bet' if the stock goes higher, use the increasing weight of bets to your favor - Kelly formula. These are also, heads I win and tails I don't loose that much investments, albeit if done properly.

In my opinion, shorting should be done very selectively and when the odds are greatly in your favor. Yes, same applies to going long, so maybe super selective is the right word. Another takeaway here could thinking about shorting stocks vs. shorting sectors (wherever your circle of competence falls). Having said all this, I am a novice when it comes to shorting and what is involved is another post. This post was meant to argue that shorting is within the value investing framework.