Thursday, April 24, 2008

Pilgrimage, Part III: When the Math Doesn’t Work

Note to readers: This was originally published May 11, 2007 as part of a series on the Berkshire Hathaway annual meeting. We republish it here as we prepare for the upcoming 2008 Berkshire Hathaway annual shareholder meeting.

We will resume regular posts, with interruptions for further commodity hoarding bulletins, following the Berkshire meeting in early May.

The mark of an original thinker may be that you never know how they’re going to answer a question you’ve never heard them get asked.

And when the first shareholder asks Buffett about his views on the current private equity mania sweeping the world’s capital markets—specifically, “What could cause it to bust?”—I expect him to offer a pithy warning about the silliness of running with the herd and the possible future dislocations from just such a bust—dislocations he will be happy to take advantage of, given the fabulously large cash reserves at his disposal, not to mention his eye for a bargain.

As it turns out, however, Buffett doesn’t think the private equity mania is a bubble, despite, in my view, all the evidence to the contrary, what with everything from deeply cyclical semiconductor companies to fashion-dependent retailers being leveraged up with the kind of debt loads that would make Donald Trump nervous.

It isn’t really a bubble,” he says. It is a boom, certainly, and one in which Buffett sees little to gain from blindly jumping on board. “The math has to make sense to us.” Furthermore, as if all 27,000 people in attendance don't know it already, Buffett is not into flipping companies the way private equity flipped Hertz, or Burger King, or Dominos...

"We own them forever."

As to private equity not being a bubble, Buffett points out that in order for a mania like private equity to go “bust,” as the margin-fed bull market did during the 1987 crash, it must have investors who can pull their money out quickly to trigger the kind of panic selling that both causes a crash and marks its nadir.

Private equity investors, he notes, are locked in. “It takes many years for people to take their money out” of private equity funds. Thus Buffett makes the subtle distinction between a mania that might well end in disappointment for all concerned, and one likely to end in a crash.

As for the bull run of 1987, which did end in a crash, Buffett puts the blame squarely on a mania altogether different from private equity funds: it was called ‘portfolio insurance.’

For those of you too young to remember, the wonderfully-misnamed ‘portfolio insurance’ was a financial engineering tool foisted upon institutional money managers eager to participate in the bull market of that era as it gathered steam—without the commensurate downside risk—by financial consultants eager to generate outsized compensation fees.

I still recall the day I first heard the term ‘portfolio insurance’ at one of those same institutions being pitched its wonders by the very firm that had dreamed it up.

It was some time in 1984, and I was an analyst at a plain-vanilla pension-fund shop. By “plain-vanilla” I do not mean “mediocre”: we had a lot of bright people and a great framework for investing our clients’ money. We just didn’t do anything exotic or out of the ordinary.

In fact, ‘portfolio insurance’ was about the most exotic thing I recall us ever looking at. The idea seemed goofy on the face of it—somehow, by shifting money between treasury bills and index futures, an institutional money manager could supposedly ‘insure’ a portfolio against market declines of a certain size over a certain period of time.

But I was merely a lowly stock-picker, not the chief portfolio manager. In fact, the chief portfolio manager was the smartest guy I’d ever worked with up to that point, and the decision whether to even think about the concept was his.

I recall him seated at the table in the Monday morning research meeting, stroking his long sideburns and declaring he had studied the research on portfolio insurance over the weekend.

The math works,” he said.

And, yes, it did “work,” if by the definition of “work” you mean, "Completely failed to do what it was supposed to do."

For not only did ‘portfolio insurance’ end up not insuring anybody of anything, it actually triggered the panic selling that culminated in a 22.6% one-day drop on Black Monday—October 19, 1987.

Now, by that time I had moved on to help identify acquisition candidates for a large industrial company, and later joined one of the best money management firms that ever existed, before it was subsequently purchased and destroyed by a large Wall Street firm that shall remain nameless.

Consequently, I have no idea if my former shop had actually engaged in ‘portfolio insurance,’ and, if it had, whether it was still involved when the "math" stopped working on October 19 and the forced mass selling resulted in that very Black Monday.

But it is a fact that computerized selling triggered by funds engaged in ‘portfolio insurance’ turned a Fed-tightening stock market retreat into a “bust.”

And it is the beautiful simplicity by which Buffett can synthesize complex issues with comprehensible analogies that makes these meetings what they are, for here Buffett provides one: "portfolio insurance" he says, stripping a highly complex set of financial-derivatives established by quantitative models to its essence, was nothing more than a giant “stop-loss order” on the market as a whole.

Thus, institutional money managers, or the computers they relied on to ‘insure’ their portfolios, sold stocks into the decline, causing the crash.

As Buffett says, “the math has to make sense to us,” and in the case of ‘portfolio insurance’ it clearly did not.

Next up, compensation committees, executive pay, a possible credit crisis and “the best of all worlds,” along with a question from the lunatic fringe.

To be continued…

Jeff Matthews
I Am Not Making This Up

© 2007, 2008 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


SiamTwin said...

Just want you to know that I'm thoroughly enjoying this pilgrimage series. Thanks.

Michael said...

I must disagree with The Oracle's take on the private equity bubble. It might be true that PE investors have long lock ups - but the real money used in these deals comes from the banks that provide leverage. And banks are usually the FIRST to reign in credit when they get spooked.

The Epicurean Dealmaker said...

True, Michael, but that only means it will be very difficult (and much more expensive) to fund new buyouts. However, part of the bubble in leveraged finance has been that existing debt financing has been raised with (1) little or no amortization and (2) virtually no covenants.

Therefore, if the economy tanks, or buyout companies begin to suffer cash flow problems for other reasons, there is very little the debt holders can do to force restructuring or recapitalization. The PE guys will have the option either to tough it out and try to turn around their portfolio company's fortunes or simply walk from their investment.

This is a gross generalization, but for many (most?) recent vintage buyouts, there is indeed no trigger to force PE firms to dump their equity investments within their normal investment window of 3 to 7 years.

John said...

Hi Jeff,

Just when I had reached the point in life when the only thing I could count on with 100% certainty as "truth" was the concept of "2 + 2 = 4"....Now you go and destroy my final certainty of belief by pointing out that the math that does adds up will not always "work".....Thanks!

I am really enjoying your detail account of this famous annual gathering that I have never attended and I offer many thanks for taking the time and effort to share it all with us in such detail.

Looking forward to Part 4.

whydibuy said...

Now its your turn to contradict Ken Fisher. He was just featured on a webcast from pontificating on the virtues of private equity. According to ken, ceo's are slow to learn. The private equity guys understand the equity arbitrage between low long term rates and the earnings that can be bought with those borrowed funds. And its a good thing, not a troublesome issue. They've got it down cold and we're going to see more deals and bigger deals. He says that bullish spread will continue untill 1) there is a material rise in long term rates 2) a material fall in earnings or 3) a material rise in equity prices or some combination of the three closes the gap between E-P rates ( the inverse of the PE ratio ) and long term global rates.

Dave said...

Jeff - two for the price of one. First thank you for taking the time and trouble to go to Omaha and put up your running notes. They are both interesting and valuable.

2nd - have to sympathize with the preceeding comment on the LBO thing not being a bubble yet Warren has a strong, major point. It seems to me that this is indeed a carry and cash to leverage and liquidity market that's acceleratatingly frothy. That said unwinding will be sticky as all get out.

But when the chickens re-roost and credit tightens up instead of deflating a bubble those pressures will displace elsewhere. Of course then the interesting questions are when & where, aren't they ?

Allan said...

Keep it coming! Thanks!

Hells_Satans said...

Having sold derivatives in the past, but not Portfolio Insurance, I would take serious issue with the bald assertion that PI 'caused' the Crash of 1987.

First off, talking about PI but not Index Arbitrage is missing half the story.

Secondly, and much more importantly, there were several important news items that came out right before the crash, even if the half of Academia that blames PI pretends there was not:
Burton Malkiel speaks:
'Moreover, a number of events may rationally have increased risk perceptions during the first two weeks of October. Early in the month, Congress threatened to impose a "merger tax" that would have made merger activity prohibitively expensive and could well have ended the merger boom.... Also, in early October 1987, then Secretary of the Treasury James Baker had threatened to encourage a further fall in the exchange value of the dollar, increasing risks for foreign investors and frightening domestic investors as well. '

From the respected UK Investor's Chronicle [as non-partisan as you can get on the topic of the 1987 crash]:
'Lesson 4 - Crashes can have innocuous causes. US Treasury Sec'y Baker's words "The rise in German interest rates is not a trend which we favor..." more than anything else, triggered the collapse...his comments were dynamite at the time...Markets feared the remarks would cause a crash in the US Dollar, causing overseas investors to sell US stocks and prompting the Fed to raise interest rates. Everyone knew a collapsing dollar was a danger and the US trade deficit was increasing...Markets were happy to ignore this threat until Baker reminded them of it.'

As Merton Miller (1991) has written, ". . . on October 19, some weeks of external events, minor in themselves . . . cumulatively signaled a possible change in what had been up to then a very favorable political and economic climate for equities . . . and . . . many investors simultaneously came to believe they were holding too large a share of their wealth in risky equities." - the week recap before the crash: 'October 12, 1987
Confidence among the major investment banks begins to deteriorate. Salomon will dismiss 12% of its municipal bond workforce and will re-examine how much space it needs in New York City. The volatile, downward market in bonds has caused profits at the nation's largest investment bank to plummet....

October 14, 1987

The Dow Jones Industrial Average drops a record 95.46 points to 2412.70. The Dow will tumble another 58 points the next day, taking the venerable index down more than 12% from its all-time high hit on August 25. Pundits blame a widening foreign trade deficit that is fueling the dollar's descent and consequently weighing on bonds. The Japanese yen and the Swiss franc have both risen substantially in the past two months....

October 16, 1987
Iranian missiles hit a U.S.-flagged tanker off of the coast of Kuwait. ... Fears of heightened tensions as a result of the inevitable U.S. retaliation drive the Dow Jones Industrial Average down 108.35 points to 2246.74 on record volume...'

That's 261 points in 3 trading days before the crash. And yet portfolio insurance didn't make the market 'crash' any of those days. Why?

October 19, 1987

In the early morning, two U.S. warships shell an Iranian oil platform in the Persian Gulf....

No news. Ha! Bond yields skyrocketed the week before, equities plummeted, oil jumped over the weekend and Sec'y Baker promised to let the USD keep falling!

'Indeed, the most likely immediate trigger of the 1987 crash was the meeting between then Treasury Secretary James Baker and FRG Finance Minister Gerhard Stoltenberg in which Baker urged a German interest rate cut only to be rebuffed. Well, they got their interest rate cut after all after the crash.'

Given that the market finished still up in 1987, it seems obvious many money managers simply swapped into 10%+ yielding USTs during October to lock in some of those equity gains.
There is no simple and easy answer. No one has yet discovered why markets crash when they do, or when, or by how much.

In short, the blame goes to, imho:
1) Large worldwide concern over the Falling USD and US Deficit
2) Rising Bond Yields
3) Likelihood of War with Iran and higher Oil Prices
4) Large Selling by Overseas Investors
5) Merger 'tax' on corporations
6) Recognition of overvaluation of equities
7) The Brits selling BP at the 'top' and increasing supply of equities
8) EFHutton and a few others going bankrupt, creating massive liquidity concerns among member banks and brokerages.

As Merton said, it was a confluence of things.

There's nothing wrong with selling in a down market. It happens all the time. We've had crashes since then in 1989, 1997[8%], and bigger ones outside of the US. Surely you're not going to blame portfolio insurance for those as well?

loves an academic debate,

HoosierDaddy said...

Maybe I'm batty, but a lot of the private equity/Leveraged Buyout deals seem like a variation on the cash out refinancing of homes in the Housing/Mortgage Bubble. You have an overvalued asset, lots of debt, and lots of equity being "unlocked." Probably the end of the story is similar too, a slow motion collapse of the market, loans gone bad, and carnage on the balance sheets of some overexposed finaciers.