OnCubic

For you Warren Buffett Fans

2011-03-03T10:29:39-08:00

And so the pursuit of active management magicians goes on. Mr. Wellington again delights us with his insightful take on Mr. Buffett. I think the most profound concept he offers is that any advantage Mr. Buffett has is already in the price. So investors in today's Berkshire Hathaway have no advantage at all because the share price has already been bid up to reflect the Warren magic...

-Christopher

Deconstructing Berkshire Hathaway

Weston Wellington, Vice President, Dimensional Fund Advisors

Berkshire Hathaway released its 2010 annual report last weekend, including the letter to shareholders from Chairman Warren Buffett that is always eagerly awaited by the investment community. We are gratified to find that Mr. Buffett's legendary ability to simplify complex issues remains undiminished and his trademark wit is as sharp as ever.

Financial journalists, eager for clues that might reveal Buffett's thoughts on where markets are headed, focused on his optimistic outlook for the future ("America's best days lie ahead") and his appetite to make further large acquisitions ("my trigger finger is itchy").

We prefer to focus on a number of issues touched on in the letter that offer investment wisdom that is equally useful today or ten years from now.

As of year-end 2010, Berkshire held positions in excess of $1 billion in fourteen common stocks. Five of these were non-US firms: BYD Company Ltd. (China), Munich Re (Germany), POSCO (South Korea), Sanofi-Aventis (France), and Tesco plc (UK). Five years ago a similar list of twelve companies contained just one non-US firm, and ten years ago there were none. In his comments about the future of America, Mr. Buffett remarked that "human potential is far from exhausted" and that, despite many setbacks, the American system "has worked wonders for over two centuries." Judging by Berkshire's portfolio, it appears this notion applies with equal force throughout the world.

Berkshire has willingly shouldered some unusual risks over the years. It acquired building products maker Johns Manville in 2000 despite the stigma of asbestos-related liabilities, invested over $15 billion in various financial firms in the tumultuous weeks following the Lehman Brothers bankruptcy in 2008, and once insured an internet firm against the possibility of awarding a $1 billion prize associated with a marketing promotion. Many investors might assume that such adventurous and unconventional thinking in equity assets would be matched by an equally unorthodox approach in fixed income. On the contrary, Buffett's strategy for investing Berkshire's cash ($38 billion at year end) is so conservative that some might accuse him of excessive caution. We suspect any institutional money manager with a balanced account mandate who maintained most of the fixed income assets in Treasury bills despite yields approaching zero would be fired for lack of imagination. Such an approach only makes sense if the role of fixed income is to preserve liquidity and limit the potential damage associated with riskier equities, rather than to generate satisfying returns. Mr. Buffett cites an observation from financial writer Raymond DeVoe that "more money has been lost reaching for yield than at the point of a gun."

For those who ponder why it is that stocks are expected to provide a positive rate of return even if they pay no current dividend, one number cited in the letter offers a clue: $1 billion. That is the approximate amount of cash that shows up in Berkshire's mailbox each month from its collection of seventy-six businesses. Mr. Buffett's job is to invest that cash in new projects that carry an attractive rate of return, and history shows that these may come in a variety of shapes and sizes. Last year, for example, Berkshire spent $50 million to buy Alabama's largest brick manufacturer and $22 billion to complete its acquisition of the nation's largest freight railroad. Mr. Buffett reports that the rail acquisition is working out "even better than I expected," and to the extent any chief executive can invest a firm's profits more profitably than we can, dividends are not just unnecessary, they are undesirable.

Since taking control of a floundering Massachusetts textile mill in 1965, Warren Buffett has an extraordinary record of business success. While many have focused on his facility with numbers and ability to identify attractive business opportunities, it seems to us that the untold story is his astute judge of character and his ability to quickly identify individuals whose business acumen and character will make a good fit within the Berkshire organization.

What are the investment implications to this appealing story of long-run excellence? Mr. Buffett's oft-stated goal is to grow Berkshire's book value at a faster rate than the total return of the S&P 500 Index. He has succeeded in the past, and we think it probable that Berkshire will continue to do so in the future.

The more interesting question is to what extent Mr. Buffett's skills are already reflected in Berkshire Hathaway's stock price, and whether the S&P 500 Index is the most useful basis of comparison. Berkshire's long-run price performance relative to the S&P 500 is sensational—over the last twenty-five years, it has compounded at 16.9% per year compared to 9.93% for the S&P 500 Index with reinvested dividends. The margin of superiority relative to the S&P 500 narrows for more recent time periods, however, and disappears altogether in comparison with broader-based equity strategies. Over the last fifteen years, for example, Berkshire shares have outperformed the S&P 500 by 276 basis points per year and are essentially even with a globally diversified Dimensional Balanced Equity Index (actually 16 basis points behind). Over the last ten years, Berkshire shares have underperformed the balanced index by 295 basis points per year.

Some might be tempted to conclude from these results that Mr. Buffett's legendary skills are waning, but if markets are working properly, the numbers should come as no surprise. Berkshire's book value has grown from $48 million in 1965 to $157 billion in 2010, making it larger by this measure than oil giant ExxonMobil. Mr. Buffett has gone from piloting a speedboat to commanding an aircraft carrier; the ever-increasing amount of capital Berkshire oversees makes it increasingly difficult to earn above-average returns. Moreover, Berkshire Hathaway is not a mutual fund, but a public company with a share price that reflects expectations for the future. Now that Mr. Buffet's admirable qualities are understood and acknowledged by so many market participants, it seems likely that his perceived value is already reflected in Berkshire's stock price, just as Apple's current stock price reflects the genius of founder Steve Jobs.

We wish Mr. Buffett well and hope to be reading his letters for many years in the future. And investors who have a soft spot for Berkshire Hathaway shares can take comfort in the knowledge that if they own a truly diversified equity strategy, they own a piece of Berkshire.

Berkshire Hathaway Inc. 2010, 2005, and 2000 shareholder letters. Available at http://www.berkshirehathaway.com (accessed February 27, 2011).

So how DO you choose a financial advisor?

2011-02-21T06:46:09-08:00

For those of you (or those with friends/family) wondering what process to use when choosing a wealth management advisor, the National Association of Personal Financial Advisors has released this helpful guide.

- Christopher

Check out NAPFA's new Pursuit of a Financial Advisor Field Guide, which will walk you through all tof the steps to finding qualified financial advice.

Should You "Fix Up" Your House Before Selling?

2010-12-28T17:06:31-08:00

I get asked this question all the time. "My realtor says I need to do all these things before I sell", people say.

Well, as it turns out there is only one thing with a positive return on investment as far as remodeling goes... Ready: changing the front door has a 2% return. If you subtract the value of your time... well you do the math.

For every other home project, you are better off lowering your price by the amount of the remodel. Realtors, of course, want you to invest in the property to raise the price, and the size the of the commission they earn. The link below will allow to look at these numbers for your region.

- Christopher

http://www.remodeling.hw.net/2010/costvsvalue/division/west-south-central/city/austin--tx.aspx

Here's Why Pros Don't Beat the Market

2010-12-28T17:04:56-08:00

For those of you who are going to spend your time finding mis-priced securities so you can beat the market like a "mini Warren Buffett", give this Wired Magazine story a read. Computers are taking information off the news wires and impacting prices in fractions of a second. Deep Blue has long ago beaten Gary Kasparov...here too.

- Christopher

Algorithms Take Control of Wall Street

Last spring, Dow Jones launched a new service called Lexicon, which sends real-time financial news to professional investors. This in itself is not surprising. The company behind The Wall Street Journal and Dow Jones Newswires made its name by publishing the kind of news that moves the stock market. But many of the professional investors subscribing to Lexicon aren’t human—they’re algorithms, the lines of code that govern an increasing amount of global trading activity—and they don’t read news the way humans do. They don’t need their information delivered in the form of a story or even in sentences. They just want data—the hard, actionable information that those words represent.

Lexicon packages the news in a way that its robo-clients can understand. It scans every Dow Jones story in real time, looking for textual clues that might indicate how investors should feel about a stock. It then sends that information in machine-readable form to its algorithmic subscribers, which can parse it further, using the resulting data to inform their own investing decisions. Lexicon has helped automate the process of reading the news, drawing insight from it, and using that information to buy or sell a stock. The machines aren’t there just to crunch numbers anymore; they’re now making the decisions.

More...

Bill Gross Chasing Returns?

2010-12-17T12:10:33-08:00

Here the "Warren Buffett" of bonds, Bill Gross of Pimco, decides to chase equity returns. Folks, I don't know about you but I expect one the most famous active managers to do better than this.

NOW that the global equity market has essentially increased 100%, he's going to go into equities, which he's not known for. This is classic "return chasing" behavior. I agree that bonds don't look like the place to be, but are we paying Gross, an asset class specialist, to allocate our portfolios for us?

Those of you with heavy bond portfolios may wish to take note of the potential for a stampede out of bonds, and into stocks.

- Christopher

Stocks Lure Bond-Giant Pimco

Bill Gross is Among Fixed-Income Investors Branching Out

By ELEANOR LAISE

The world's biggest bond fund may be losing its appetite for bonds.

Pimco Total Return Fund, managed by Bill Gross of Allianz SE's Pacific Investment Management Co., is expanding its investment guidelines, according to a regulatory filing made Thursday.

The giant bond fund run by Pimco's Bill Gross is expanding its investment guidelines to include stocks and convertible securities.

As early as the second quarter of next year, the fund will be able to invest as much as 10% of its assets in preferred stock, convertible securities and other equity-related holdings.

Pimco Total Return, which has more than $250 billion in assets, lost 4.3% from Nov. 4 through Wednesday, according to investment-research firm Morningstar Inc., amid a broad selloff in the bond markets.

Investors pulled $1.9 billion from the fund last month after pouring $18.3 billion into the fund in the first 10 months of the year.

The fund held 43% of assets in mortgage securities and 30% in government-related holdings as of Nov. 30. The Federal Reserve's bond-buying program "will likely signify the end of a great 30-year bull market in bonds and the necessity for bond managers and, yes, equity managers to adjust to a new environment," Mr. Gross wrote in investment commentary published last month.

More...

The "New Normal" Question

2010-12-15T20:06:59-08:00

In this video, Dartmouth's Dr. Ken French discusses what kinds of returns we can expect during times of slow GDP growth... if that's what we have in the future. I think the answer will surprise you.

- Christopher

From the NYT, a Wall Streeter Comes Clean

2010-12-06T14:02:18-08:00

Great piece about a former Goldman banker, currently suffering from cancer, admitting it was all a lie.

- Christopher

A Dying Banker’s Last Instructions

New York Times

There are no one-handed push-ups or headstands on the yoga mat for Gordon Murray anymore.

No more playing bridge, either — he jokingly accuses his brain surgeon of robbing him of the gray matter that contained all the bidding strategy.

But when Mr. Murray, a former bond salesman for Goldman Sachs who rose to the managing director level at both Lehman Brothers and Credit Suisse First Boston, decided to cease all treatment five months ago for his glioblastoma, a type of brain cancer, his first impulse was not to mourn what he couldn’t do anymore or to buy an island or to move to Paris. Instead, he hunkered down in his tiny home office here and channeled whatever remaining energy he could muster into a slim paperback. It’s called “The Investment Answer,” and he wrote it with his friend and financial adviser Daniel Goldie to explain investing in a handful of simple steps.

More...

Roth IRAs - To Convert or Not

2010-11-10T07:20:01-08:00

All of a sudden, it seems like everybody in the wealth management world is talking about Roth IRAs and Roth conversions. In fact, an article in Financial Planning magazine--one of the trade magazines in our world--recently proclaimed 2010 "The Year of the Roth."

What's the big deal? Roth IRAs are interesting to professionals for several reasons. With traditional IRAs (and qualified plans like 401(k)s), the money goes in untaxed, and you pay ordinary income taxes whenever you take money out of the account--which might be years in the future. The Roth reverses this; your contribution is made with after-tax dollars, but then there's no tax whenever the money is distributed. If you believe (I personally make no assumption about future rates. History has shown this to be impossible to predict.) that tax rates are going to go up in the future, then paying taxes now and eliminating future taxes provides a net gain.

It could get better. Having money in a Roth account gives you a lot more control over your tax bracket in retirement. For instance, you might take out just enough from your IRA distributions to fill the 15% bracket, and then take the rest of your living expenses out of your taxable accounts and Roth. Another version of this kind of planning might help higher-income retirees avoid the brackets where Social Security income is taxed. This flexibility certainly argues for a partial conversion.

Another interesting thing about Roths is that, unlike traditional IRAs, they don't have any minimum distribution requirements once you turn age 70 1/2. So long as the money remains in the account, both Roths and traditional IRAs give you the benefits of tax deferral, which eliminates a significant drag on the growth of your money. If you can afford to keep your money in the Roth account, and take retirement income from other sources, then the deferral can go on longer.

Alas, the Roth account will still be subject to estate taxes, and your heirs (not your spouse) will have to take required distributions each year once they inherit your Roth account. But they won't have to pay taxes on the distributions they receive--a nice additional gift for your children or grandchildren. Furthermore, money used to pay the taxes caused by the conversion will not be subject to estate tax. Once you've sent the tax money off to Uncle Sam, it is no longer a part of your estate. This is, to me, the most compelling reason to convert your IRA to a Roth.

As things stand now, in January each person will be able to shelter just $1,000,000 from the estate tax. For those of you with large IRAs and an estate value greater than $2,000,000, you may want to consider a conversion.

In the past, the only people who could set up a Roth IRA were those with less than $100,000 in taxable income, which eliminated a lot of the taxpayers who would benefit the most from all these features. But now, as of January 1, anybody can open up a Roth IRA. Most of the conversation in professional circles is about Roth conversions; that is, converting the money in your IRA to a Roth or taking a rollover distribution from a company retirement plan directly into a new Roth that you set up.

Should you do this? Unfortunately, that's a complicated question, since any money moving from a traditional retirement account to a Roth requires you to pay taxes on the money in the traditional account. Some of that can be deferred; with any conversion that takes place in 2010, the tax obligation can be split between the 2011 and 2012 tax returns, which represents a (very) short-term loan from the IRS. So professional advisors are looking at individual situations, looking for portfolio losses that can be used to offset the tax burden, projecting tax brackets over the next three years and a host of other issues, including how long each person will have the money in the Roth account, and where the money to pay the taxes will come from. (If you have to pay the taxes out of the IRA, then you lose the value of future deferral--not good.)

Another issue is: Do we trust Congress to keep its promise not to tax Roth distributions in the future? Few of us ever expected to pay taxes on Social Security payments.

Fortunately, the law allows for partial Roth conversions--moving some of the money over, rather than all of it--and also lets you reverse the conversion (professionals call it a recharacterization) any time before October 15 of the year after the conversion. All of this means that the conversion decision, and the amount to convert, will probably be different for you than it is for the person next door, whose decision will be different from the family down the street.

Meanwhile, you have to wonder how alert are the people who write our tax laws. Under the current rules, single persons earning more than $105,000, and joint filers over $167,000, are sternly prohibited from making a full contribution to their Roth account. If you earn more than $120,000 (single) or $177,000 (joint), you're forbidden to make them at all.

But... People in these income brackets are perfectly free to make a traditional IRA contribution--and the law says they can immediately turn around and convert the money into a Roth account. Does that make sense to you?

*This article was adapted from one written by Bob Veres

Active Investment Management Fails Again

2010-10-13T13:02:54-07:00

Below is a story from the WSJ that perfectly illustrates one of the major problems with active investment management (trying to beat the market by foretelling the future). The story focuses on DE Shaw, a firm that, since its inception in 1988, focused on letting a computer decide when to buy and sell securities. I guess they had good (or lucky) results prior to 2006.

All of the sudden, in 2006, the managers decided to abandon the computer-as-crystal-ball concept and invest in raw land in New Mexico?????? What does a firm who purports to have a computer that knows the future about stocks and bonds know real estate development? Apparently nothing as they are soon going to lose all of their clients' $100 m investment on this boondoggle.

We call this "manager risk" or the risk that your active (the opposite of an active investment manager is a passive one who simply accepts the market rate of return rather than betting on certain outcomes) investment manager goes haywire and invests in something entirely different than you expected. The solution to this problem is to use a passive manager and to have a written investment policy statement (IPS) to guide your advisors. The IPS constrains investment managers to certain asset classes and performance standards. To me, the DE Shaw affair is another nail in the coffin of the scam that is active investment management.

- Christopher

D.E. Shaw Land Bet Proves a Quant's Quagmire

By LINGLING WEI

For more than 300 years, a huge swath of land in what is now New Mexico endured the rise and fall of empires, the arrival of settlers and development of the surrounding area into the city of Albuquerque.

But the Atrisco Land Grant, handed down by Spain's king and queen in 1703, has never seen anything like the real-estate disaster now gripping hedge-fund firm D.E. Shaw & Co.

Known for its obsession with computer-driven investing, the New York company surprised many real-estate deal makers in late 2006 by teaming up with developer SunCal Cos. to buy the 55,000-acre property—twice the size of Boston—for $250 million.

The two companies planned to create a new town with residential, commercial and industrial areas. But the nationwide real-estate slump left the project stuck on the drawing board. Last month, lenders led by U.K. bank Barclays PLC foreclosed on the property. D.E. Shaw and SunCal have only a few weeks to come up with the money needed to pay off the lenders, or else the hedge-fund firm could see its roughly $100 million investment wiped out.

Read the full article...

Emerging Markets - Emerging Ideas - Emerging Solutions

2010-10-05T17:25:32-07:00

Emerging markets play an important role in a well diversified portfolio. Risks exist when investing anywhere and especially in emerging markets where higher perceived political risk is an important factor. Volatility can be high, but the potential for return relative to risks and the possibility of reducing correlation (and thus risk) of an overall portfolio, can be an added benefit.

What is an emerging market? The term was coined by Antoine W. Van Agtmael of the International Finance Corporation of the World Bank in 1981. It is generally defined as an economy with low to middle per capita income. These countries happen to constitute about 80% of the global population that represent about 20% of the global economy. It sounds pretty straight forward but believe it or not, China and Peru can both be classified as emerging market economies! So, it’s obvious that how you implement your emerging market strategy is critical due to risks and widely varying characteristics of countries that can be included in this category. How then, is the best way to invest in this asset class?

On September 29th 2010, I searched for ‘emerging markets’ in Morningstar and the first mutual fund that came up is called Aberdeen Emerging Markets (GEGAX). This is a ‘3 Star’ mutual fund with 13.64% ten year annualized return (see morningstar.com for return assumptions), a 1.77% net annual expense ratio, and a 5.75% up front purchase commission (paid by the investor). Great return but those expenses add up. Compare that to Dimensional Fund Advisors (DFA) Emerging Market I (DFEMX) which we utilize for our client portfolios. According to Morningstar, this fund has a ten year annualized return of 13.61%, and an expense ratio of only 0.62%, with no purchase commission. First lesson, investing in emerging markets can be very expensive, or very cost efficient, with similar performance; your choice. As a fiduciary, it’s easy for us to make that choice for our clients.

It doesn’t stop there. Unless you are trying to find opportunities to pay more taxes, you will want to take a look at fund tax efficiency as measured by turnover. For example a 100% turnover for a mutual fund means that 100% of the funds investments were sold for a previous year, this would be very tax inefficient due to pass through gains for fund investors. The lower the turnover, the more tax efficient the fund is. Aberdeen Emerging Markets fund has a turnover of 93%. compared to a much more tax efficient DFA Emerging Markets fund with a turnover of 14%. Higher turnover means less after-tax money in your pocket, and can lead to some surprises. For example, Morningstar lists Aberdeen’s one month before-tax return as -1.83% and it’s tax-adjusted return as -9.33%. This is indicative of some of the strange surprises you can sometimes encounter when you have high turnover.

So, now that we know we would like emerging markets exposure, with low expenses, and low turnover we can just find that one fund with “emerging markets” in its title; correct? Not so fast. Many emerging market funds are large and growth oriented. Picking just one may not give you proper diversification and exposure to companies that my provide superior returns. Just as in domestic equity exposure, you’ll want to ensure you have the proper exposure to both small and value companies as well in order to capture the small and value return premiums that have historically been shown to give higher returns than large growth companies over time. For our clients, we typically do this via three funds diversified in large, growth, small, and value companies utilizing the following three funds. DFA Emerging Markets I(DFEMX), DFA Emerging Markets Value(DFEVX), DFA Emerging Small Cap (DEMSX).

DFA arguably implements the most successful and research oriented investment process for investments. A recent article in Barron’s by Craig Mellow highlights how effective the DFA team led by Karen Umland has been:

“Yet Umland and her six-member portfolio management team have proved to be just about the best in their business over time. Emerging Markets Value I (ticker: DFEVX) ranks third among 204 emerging-markets funds tracked by Morningstar in five-year returns, with an annualized rise of 16.42%. Nicking it for second, at 16.71% is its smaller sister fund, the $1.4 billion DFA Emerging Markets Small Cap I (DEMSX), which Umland also manages. That torrid performance compares to a 10.2% annualized return on the benchmark MSCI emerging-markets index over the past five years, and a depressing annual loss of 2.2% from the Standard & Poor's 500.”

"Strictly By The Book", Barron's August 2010

Emerging markets are dynamic and require continued oversight and updates via a disciplined investment process. Recently, the DFA investment committee added Columbia, Egypt, and Peru for eligibility in their emerging market strategies after evaluating appropriate factors. Opportunities can come from the most unlikely places and we want to ensure our clients capture them when they do occur. To be sure, others may not.

Lastly, DFA manages approximately $161 billion in investments. Your broker will not have access to these investments as they are reserved for clients of vetted fiduciary investment advisers like us.

If you would like to learn more about the advantages of emerging markets in a well diversified portfolio, please feel free to contact me at any time.