Showing posts with label economic hedging. Show all posts
Showing posts with label economic hedging. Show all posts

Wednesday 31 March 2010

Buffett (1994): Don't get bogged down by near term outlook and strong earnings growth; look for the best risk adjusted returns on a long-term basis


Warren Buffett highlighted, in his 1994 letter to shareholders, the futility in trying to make economic prediction while investing. Let us go further down the same letter and see what other investment wisdom the master has to offer.

One of the biggest qualities that separate the master from the rest of the investors is his knack of identifying on a consistent basis, investments that have the ability to provide the best risk adjusted returns on a long-term basis. In other words, the master does a very good job of arriving at an intrinsic value of a company based on which he takes his investment decisions. Indeed, if the key to successful long-term investing is not consistently identifying opportunities with the best risk adjusted returns than what it is.

However, not all investors and even the managers of companies are able to fully grasp this concept and get bogged down by near term outlook and strong earnings growth. This is nowhere more true than in the field of M&A where acquisitions are justified to the acquiring company's shareholders by stating that these are anti-dilutive to earnings and hence, are good for the company's long-term interest. The master feels that this is not the correct way of looking at things and this is what he has to say on the issue.

"In corporate transactions, it's equally silly for the would-be purchaser to focus on current earnings when the prospective acquiree has either different prospects, different amounts of non-operating assets, or a different capital structure. At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but that would have reduced per-share intrinsic value. Our approach, rather, has been to follow Wayne Gretzky's advice: "Go to where the puck is going to be, not to where it is." As a result, our shareholders are now many billions of dollars richer than they would have been if we had used the standard catechism."

He goes on to say, "The sad fact is that most major acquisitions display an egregious imbalance:

  • They are a bonanza for the shareholders of the acquiree; 
  • they increase the income and status of the acquirer's management; and 
  • they are a honey pot for the investment bankers and other professionals on both sides. 
  • But, alas, they usually reduce the wealth of the acquirer's shareholders, often to a substantial extent. That happens because the acquirer typically gives up more intrinsic value than it receives."


Indeed, rather than giving in to their adventurous instincts, managers could do a world of good to their shareholders if they allocate their capital wisely and look for the best risk adjusted return from the excess cash they generate from their operations. If such opportunities turn out to be sparse, then they are better off returning the excess cash to shareholders by way of dividends or buybacks. However, unfortunately not all managers adhere to this routine and indulge in squandering shareholder wealth by making costly acquisitions where they end up giving more intrinsic value than they receive.

To read our previous discussion on Warren Buffett's letter to shareholders, please click here - Lessons from the master

http://www.equitymaster.com/detail.asp?date=2/7/2008&story=2

Sunday 28 March 2010

Asset Allocation and Economic Hedging in Various Economic Environment


Asset Allocation

This is also referred to as economic hedging and can be defined as a conservative method of diversifying assets so they will react different under various economic conditions.

Successful investing can be based on 4 key characteristics as follows:
  • Discipline
  • Patience
  • Historical Prospective
  • Common Sense Strategy
Reasons for using asset allocation:
  • History repeats itself
  • No one can predict the future – not even the experts
  • Comfort in knowing you have not painted yourself in a corner
  • Acts as a hedge against financial risks you cannot control
To protect against risks, the risks must first be identified and then investments set up to diversify around them. Listed below are the main types of economic environments.
  • Hyper Inflation (100%+/year)
  • Double Digit Inflation (10%+/year)
  • High Inflation (5 to 9%/year)
  • Normal Inflation (2 to 4%/year)
  • Recession
  • Depression
Now lets look at a couple examples of how various investment types do in these differing environments.

In a depression we see the following:
  • Stocks go way down (85-90%)
  • Real Estate – Also tends to go down
  • Interest Rates – drops to very low rates
  • Unemployment – this goes way up
  • Property – material things tend to lose value
  • Bonds – These do well, as bonds tend to vary inversely with interest rates.
Recommended investment in a depressed economy then would be high quality, intermediate term (2-4 year), discounted corporate bonds.

On the other hand in a Hyper-Inflation economy the situation would be completely different.
  • Stocks – do well for a while, then collapse
  • Real Estate – depends, because it is often bought with debt
  • Gold – this has done well in keeping its value in hyper-inflation conditions
Of note, the last time the US was in a hyper-inflation economy was during the civil war. However several other countries have been in this situation in recent years.

Now that we know how the environment can affect different investments, let's look at what investments are best for each environment and how to protect your investments in these changing economic times with economic hedging.

http://www.nassbee.com/wealthy/asset_allocation.html



Economic Hedging

Following our discussion on asset allocation, below is a list of the best types of investments for each type of environment.

Economic EnvironmentBest Investment
Hyper InflationGold
Double Digit InflationReal Estate
High InflationReal Estate / Stocks
Normal InflationStocks
RecessionCash
DepressionHigh Quality Corporate Bonds

How you will allocate your assets will depend on if you are in or near retirement as well as other personal circumstances. Below are two basic allocation structures. You should review your own needs to decide what type of allocation meets your needs best.

Aggressive
CashBondsREITStocksGold
15-20%15-20%30%30%2-5%

Retired
CashBondsREITStocks
25%25%25%25%

(These percentages can be vaired slightly to fit in 2% Gold for better hedging.)

Over the past 30 years, average yields for these types of investments has been about as follows:
InvestmentAvg Yield
Cash4%
Bonds7%
REIT8%
Stocks10%

For the retired plan then this would have yielded a safe 7.25% annual return. For the aggressive investor it would closer to 8%.

Rebalance

In order to keep the advantage of asset allocation you should rebalance your investments every year. When this is done is not important as long as it is done at least once per year. By taking profits from the investment types that are doing well and putting the money in those that are down, you are buying low and selling high without any emotional input that may cloud your decision. Rebalancing should then be done as follows:
  • Periodically (at least once per year)
  • If there is a major change in your life
  • If there is a major change in the financial market