2.01.2013

One of Warren Buffett's Greatest Trades

On May 29th, 1969, Warren Buffett wrote to the limited partners of the Buffett Partnership, stating:

"The investing environment I discussed at that time (and on which I have commented in various other letters) has generally become more negative and frustrating as time has passed. Maybe I am merely suffering from a lack of mental flexibility...

However, it seems to me that: (1) opportunities for investment that are open to the analyst that stresses quantitative factors have virtually disappeared, after rather steadily drying up over the past twenty years; (2) our $100M of assets further eliminates a larger portion of this seemingly barren investment world, since commitments of less than about $3 million cannot have a real impact on our overall performance, and this virtually rules out companies with less than about $100 million of common stock at market value; and (3) a swelling interest in investment performance has created an increasingly-short term oriented and (in my opinion) more speculative market."
He then goes on to note that he is retiring from running the partnership and alerting partners to the option of maintaining proportionate interests in two controlled companies - one being Berkshire Hathaway.

Full text here: http://www.rbcpa.com/WEB_letters/1969.05.29.pdf

By exiting the market (he sold most of his marketable positions) he relieved himself and his limited partners the anguish that followed in the early seventies (monetarily and emotionally). He was putting up a ridiculous track record:


And he just hung it up.

Of course, he wasn't just sitting around. He was making the best out of the declining business that was Berkshire Hathaway and harvesting the cash flows of that entity and other entities that he had purchased. And when the market really took a snag and plummeted in the following years, he was ready.

One of the more interesting behavioral finance biases out there is the heuristic of believing what just happened will happen again. Some people call it recency bias. If you saw the world nearly coming to an end in 2009, you probably thought the world was coming to an end again in 2010 despite that fact that world was a completely difference place.

If Warren had kept investing during the years of 1969-1972 his results would have surely been better than the market as a whole given his investment prowess. The question I ask myself: Would the tumultuous period of those three years had a long term impact on his investment psyche and consequently his ability to generate returns well in excess of the market for the following 40+ years?

To be honest - I don't know the answer to that question. The alternative (i.e. hanging it up) obviously worked well for him.

More and more managers have done the sort of ride off into the sunset thing the last few years, hanging off the reigns of their money management empires to #2s or kin. Frankly, I'm surprised we haven't seen more of it in the credit markets.

Simply put: The returns on the high yield asset class are in no way compensating investors for the various risks they are assuming (duration, spread, etc).

Here's what scares me: If 2009 was year when things really started getting better in credit, we could similarly compare that to 2003. The returns in HY were very impressive both years. Let's take that a step further.

2003=2009
2004=2010
2005=2011
2006=2012
...
2007=2013

 A few questions I get often:
  • Are the level of excess in the credit markets comparable to that in 2007? I would say not yet, but we are getting there.
  • Is credit overvalued? ABSOLUTELY
  • Are there things still to do? Of course - THQ bonds are a triple from the lows. But for larger funds its getting harder and harder (to note - its interesting in the quote above from WEB that Warren wanted a 3% position as a minimum size). With that said EVERY single basis point of alpha is valuable to a fund these days
  • What about Europe? 2013 might be a bit early. But its going to happen when banks do not have spigots of liquidity flowing into them
As I've noted before, credit can just keep grinding tighter and tighter and because the way flows change the bid/ask dynamics in the asset class, returns beget inflows with beget more returns. Underwriters push the needle on terms and then before you know it, you are underwriting 7% holdco PIK toggle dividend loans.

Some of the best distressed funds out there also have a mandate to run long only money - buying par bonds because in essence, they have to. It's in essence a game of "Buy the best of the worst possible opportunities out there." And many of those bonds will return in excess of the market for the foreseeable future as these analyst are very good at what they do. The problem of course is that when an asset class is down 20%, and you are down 10%, LPs are still going to be angry.

The duration of the asset class scares me. The spreads scare me. The ferocity of inflows scare me. The terms are downright obnoxious. I can legitimately paint a scenario where with a little rate pick up combined with widening of spreads (it absolutely could happen), on the run high yield will trade in the low to mid 80s. And if you start really seeing stress appear in spreads the new par for high yield could be in the 50s.

Things have felt a shade weaker the past few days. And rightly so. Proceed with caution.

2 comments:

Anonymous,  2/02/2013  

Personally I'm not as bearish on the quality of recent issuance. If nothing else, I have more confidence that the companies coming to market right now are not dressing themselves up on the back of a once-in-a-lifetime boom in consumer credit. Yes terms are very generous and absolute yields are laughable. But I think the prospect of a duration-induced collapse in HY is much less scary than the prospect of a severe default cycle, which I don't expect with these refreshed runways, barely-there interest expense, etc.

For big long only managers with good track records, a default cycle has more potential to blow up the track record since your bad picks will become illiquid to move - easier, I think, to manage duration against an index and peers, and to do so proactively. Retail investors I do think will be disappointed with what they are signing up for at these price levels.

Sean Holmes 2/09/2013  

Warren buffet may have been hated but he was a genius when it came to goldprice.

Email

hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.