7/19978/27/19984/14/20003/12/20016/14/20019/17/20016/3/20028/2/200210/4/2002
308.70305.25431.37478.61509.98445.19515.82419.70389.47
12/24/199710/26/19986/14/20005/9/20018/13/200111/13/20017/31/200210/3/2002Open
319.28322.30489.55510.71501.93479.45441.27399.18Open
3.415.5613.476.69−1.607.67−14.47−4.9115.18
414141414141414140
Source: Trade Like a Hedge Fund, James Altucher. Copyright © 2004 John Wiley &Sons, Inc.
C H A P T E R 14
Life andDeath
he idea of paying someone for his or her life insurance policy, in thehopes that the individual dies fast enough to generate financial gainfor the purchaser, seems oddly unsettling. And yet, the secondarymarket for life insurance policies has blossomed, going from $50 million tenyears ago in acquired policies to over $1.8 billion by 2002. This is preciselywhen Warren Buffett, through a division of Berkshire Hathaway called GenRe Securities, entered the game. In February 2002 the division announcedthat it would provide financing of up to $400 million to a Minnesota firm,Living Benefits Financial Services. This company would in turn use themoney to buy life insurance policies of senior citizens.The “life-settlement” business is an extension of the earlier viaticalbusiness. A viatical was the purchase of the life insurance policy of a terminally ill patient, typically an AIDS patient. Investors would put up money andviatical firms would aggregate many of these policies almost in the samemanner that firms specializing in mortgage-backed securities aggregatemany mortgages into one security. The early problem with viaticals wasthat improvements in AIDS medicines elongated the life of AIDS patients,forcing the viatical firms to continue making payments longer than theirinvestors were willing to fund those payments. This drastically reduced thereturns of those companies and forced many of them into insolvency.
T
221
222
TRADE LIKE WARREN BUFFETT
After that, the industry switched focus to life-settlement—buying thelife insurance policies of seniors over 65 who had experienced a suddendecline in health. As morbid as this may appear, the addition of a secondarymarket in life insurance policies greatly increased the economic value oflife insurance policies to seniors who preferred having the money. Priorto the creation of a secondary market, the life insurance market was similar to what the housing market would be if you could only sell your houseback to the person who sold the house to you. In other words, it was noncompletive and often reduced the benefits to the policyholder, particularlyif the policyholder needed to access the economic value of the policybefore his or her death.How do you determine the value of a policy? The same way WarrenBuffett calculates the investment value and margin of safety of every othertransaction: by using a combination of interest rates and probabilities. Ifthe risk-free rate is eight percent and a policy is worth $10 million, then thevalue of that policy is $10 million discounted using the risk-free rate overthe expected lifespan of the policyholder. And companies like Gen Re havespent countless hours in building models of life expectancies for every typeof demographic and medical condition. In a secondary market, you get anincreased margin of safety if you have a better model than your investors fordetermining life expectancy. Also, the ability to aggregate policies and diversify across various demographics and medical conditions also increases theprobability that, in aggregate, your models will pay off as expected.Although this is a small part of Buffett’s overall investment portfolio,it does exemplify his ability to seek out and find uses of capital that areuncorrelated to the traditional modes of investing. At the same time, hestill has his sought-after margin of safety. To get involved in this secondarymarket, visit the Viatical and Life-Settlement Association of America atwww.viatical.org for a list of brokers and firms that participate in thismarketplace.
C H A P T E R 15
Fixed-IncomeArbitrage
espite Buffett’s aversion to both derivatives and leverage, he hason occasion made the decision to dip into these areas by allocatingto fixed-income arbitrage strategies. In 1998, Buffett made aninvestment of several hundred million dollars in the hedge fund run byMark Byrne, son of former GEICO CEO Jack Byrne. West End CapitalManagement, Mark Byrne’s fund, focuses on several fixed-income strategies. Nor was this Buffett’s only foray into fixed-income arbitrage.During the Long Term Capital Management (LTCM) disaster, of whichthe largest losses were in the fixed-income arbitrage portions of the portfolio, Buffett made an offer to buy the assets of the firm. The offer wasrejected, but this shows that Buffett saw that there was some value there;he was willing to accept the risk of a highly leveraged fixed-income portfolio. Even before the LTCM doings, Buffett had been involved in fixedincome arbitrage when he became chairman of Salomon Brothers. Thiswas shortly after the scandal that had erupted on their fixed-income deskinvolving a trader working for John Meriwether, who later started LTCM.Fixed-income arbitrage is not one strategy, but a family of strategiesinvolving the buying and selling of fixed-income instruments in order tocapture a very small gain, usually a difference in yield between the twoinvestments.
D
223
224
TRADE LIKE WARREN BUFFETT
As a very simple example, if a corporate bond is yielding six percentand a U.S. Treasury note that expires the same time as the corporate bondis yielding five percent, then it is possible to go long the corporate bond andshort the Treasury note, capturing the one percent difference. Why do thisand not just go long the corporate bond? Leaving aside the issue of defaultrisk for a second, both notes are at risk if interest rates change. If you wereto go long the corporate bond and interest rates rose, the face value of thatcorporate bond would fall. However, assuming the hedging is done correctly (and this is no simple matter), hedging the interest rate risk inherentin owning a corporate bond by shorting the Treasury note would allow youto capture the one percent in a relatively risk-free manner (assuming thereis no default risk on the corporate note).There are several types of fixed-income strategies:• Government versus corporate spread trades, as described above.• Yield curve bets, where the investor goes long one part of the yieldcurve and short another part, making a directional bet on where he orshe thinks the yield curve is heading.• Municipal versus treasury spread trades.• Cash versus futures trades. For whatever reason, there are momentswhen demand for bond futures as opposed to demand for the actualbonds creates an inefficiency that can be exploited.• Various spread trades between asset-backed securities and other typesof fixed-income instruments. An example of an asset-backed security isa mortgage-backed security.Risks that need to be hedged in a fixed-income arbitrage strategy include:• Credit risk: the risk that one of the counterparties can default.• Interest rate risk: the risk that interest rates can rise.• Foreign exchange risk: If you are short a bond in one currency and longa bond in another currency, then changes in the relative values of thosecurrencies can affect the return on the strategy.• Prepayment risk: If you are short a Treasury bond and long an assetbacked bond and the seller of the asset-backed bond pays early, thenan investor in the spread trade can be stuck making the payments on
Fixed-Income Arbitrage
225
the Treasury bond without the corresponding payment on the assetbacked bond.As can be seen in the previous example, the possible returns (here, onepercent annually) can be quite small, and so heavy amounts of leverage areoften used (10 to 25 times or more). For instance, when trading the spreadthat sometimes occurs between a bond and its corresponding bond futurescontract, the spread might be just a few basis points (each basis point is 1⁄100of one percent). In LTCM’s case, it was using up to 100:1 leverage. MyronScholes—Nobel Prize winner, developer of the Black-Scholes model formodeling options, and one of the founders of LTCM—described it as“as if it were vacuuming nickels that others couldn’t see.” The issue is this:Is the fixed-income arbitrageur picking up those nickels in the face of anupcoming steamroller? Exhibit 15.1 shows the returns for the CSFB/TremontHedge Fund Index for Fixed-Income Arbitrage.
226
1.52%
0.81%
1.10%
1.90%
1.48%
1.43%
0.27%
1.30% −2.00% −1.68% −0.20%
1997
1996
1995
1994
0.88%
0.75%
0.93%
0.50%
0.65%
0.70%
1.04%1.04%
1.12%
1.34%1.47%
0.89%
1.14%
1.16%
0.69%
1.68%
1.17%
0.40%
0.82%
1.15% −1.58%
1.09%0.77%
0.52%
1.25%
0.87%
1.55%
0.79% −0.40% −0.18% −0.09%
2.01%
1.09%
1.01%
0.78%
0.91%
0.74%
0.70%
0.48% −1.46% −3.74% −6.96%
0.49% −0.41%
0.29%
0.02%
0.43%
MSCIWorld$
6.29% −9.10% −12.92%
8.04% −11.89% −16.52%
5.75% −22.10% −19.54%
7.97% 28.68% 33.76%
5.09%
Annl
S&P500TotalReturn
9.34% 33.36% 16.23%
0.57%
0.31%
1.32%
5.58%
1.07% 12.50% 37.58% 21.32%
1.75% 15.93% 22.96% 14.00%
0.71%
1.73% −8.16% 28.58% 24.80%
0.97% 12.11% 21.04% 25.34%
0.32%
0.23%
0.18%0.75%
0.64%
1.55% −0.27%
N/A
Dec
1.32%
N/A
Nov
1.23% −1.14% −2.27% −0.53%0.67%
0.55%
0.91%
1.08%
0.46%
N/A
Oct
0.80%
1.16%
N/A
Sep
0.52%
N/A0.21%
Aug
0.70%
Jul
0.34% −0.98%
0.71%
Jun
Index data begins January 1994. Sharpe ratio calculated using a rolling 90-Day T-bill rate.
2.02%
0.65% −0.44%
1.24%
1.35%
0.72%
0.77%
1.06%
1.63%
0.02%
0.52%
1.44%
1.28%
0.63%
May
1.61% −0.01% −0.21% −1.08%
1.34%
0.93%
1998 −0.84%
1.32%
0.24%
1999
1.35%
0.57% −0.15%
0.53%
0.63%
1.34%
1.25%
1.42%
0.87%
0.42%
0.54%
1.03%
2002
0.99%
0.87% −0.49%
Apr
2000
1.26%
2003
Feb
2001
1.23%
2004
Jan
Mar
CSFB/Tremont Hedge Fund Index for Fixed Income Arbitrage
Monthly Performance
EXHIBIT 15.1
227
Avg MonthBest MonthWorst MonthMth Std DevMth Std Dev, Ann’dBeta(vs S&P 500)Sharpe
0.57%2.02%−6.96%1.12%3.87%0.010.77
S&P 500Total Return
HEDG FixedIncome Arb
Statistics
10.43%
6.92%
Incep Avg Annl
0.93%9.78%−14.46%4.47%15.50%0.970.42
0.67%9.06%−13.32%4.16%14.42%0.860.22
MSCI World $
7.19%
−3.24%−0.24%−1.18%18.11%29.13%1.99%0.66%−9.13%−1.90%108.57%
−3.31%−0.08%−1.78%13.17%25.22%−4.37%−1.48%−10.72%−2.24%185.68%
0.70%2.06%3.82%8.45%11.86%22.81%7.09%41.97%7.26%102.98%
1 Month3 Months6 Months1 Year2 Years3 Years3 yr Avg5 years5 yr AvgSince Inception
MSCI World $
S&P 500Total Return
HEDG FixedIncome Arb
Net Performance
228
EXHIBIT 15.1
TRADE LIKE WARREN BUFFETT
(continued)
Correlations
DowMSCI World $MSCI EAFE $S&P 500 Total ReturnNASDAQ
HEDG FixedIncome Arb
S&P 500Total Return
0.050.030.030.030.05
0.930.940.771.000.80
MSCI World $
0.891.000.940.940.78
Source: © 1999–2003 Credit Suisse First Boston/Tremont Index LLC. All rightsreserved. This communication is for informational purposes only. It is notintended as investment advice, or an offer or solicitation for the purchase or saleof any financial instrument. No market data or other information is warranted byCredit Suisse First Boston/Tremont Index LLC or its subsidiaries and affiliates asto completeness or accuracy, express or implied, and is subject to change withoutnotice. Any comments or statements made herein do not necessarily reflect thoseof Credit Suisse First Boston or Tremont Capital Management Inc., or any of itsor their respective parent entities, affiliates or subsidiaries, or any officer oremployee thereof; Credit Suisse First Boston, Tremont Capital Management Inc.,and/or its or their respective parent entities, affiliates or subsidiaries, and/orofficers or employees thereof, may have issued other communications that areinconsistent with, or reach different conclusions from, the information presentedherein. Those communications reflect the assumptions, views, and analyticalmethods of the persons that prepared them.
C H A P T E R 16
Trade LikeBill Gates
ost people think of Bill Gates as the guy who built up a small fortune writing word processing programs and operating systems.But the big question on Gates’ mind when he goes to work everyday is not figuring out the many ways he can outperform Real Networks(RNWK), but How can I diversify my $50,000,000,000.00?Fortunately, his first major investment worked out fine, as shown inExhibit 16.1, which charts Microsoft (MSFT) stock from IPO to the present.
M
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
229
230
TRADE LIKE WARREN BUFFETT
But how has Gates attempted to achieve diversification as well as capital appreciation over the past few years? First, as we will see, he has beengreatly influenced by his friend and bridge partner, Warren Buffett—andthe approach to investing that Buffett takes.There are three primary ways to look at Gates’ investing prowess:1. The investments that Microsoft makes. Microsoft is sitting on a
hoard of more than $20 billion in cash and often makes investments inother companies in the technology sector. From Microsoft’s viewpointon the industry, these investments can be very telling and are probablyworthwhile to analyze. However, it is also hard to tell if these investments are made for the capital appreciation potential or, in some cases,for the strategic potential to Microsoft. An individual investor almostnever makes a strategic investment. For example, McDonald’s is notgoing to give you a deal on their Happy Meals just because you area shareholder.2. The investments of Gates’ charitable foundation. The Gates Foun-
dation is among the largest family foundations in the world with anestimated endowment worth more than $10 billion. Appraising thefoundation’s worth, however, might not be the best way to study Gates’investment style; the foundation is extremely conservative with itsfunds, putting almost 85 percent in short-term government bonds andtreasuries with the occasional AAA corporate bond.3. Cascade Investments represents Gates’ personal money outside
of Microsoft and the Foundation. Run by money manager MichaelLarson, it is this portfolio that seems the most “Buffett-like” in itsapproach, and we will study these investments.The one qualifier, as usual, is that we don’t really know for sure whatCascade has invested in for the simple reason that in most cases, the company is not obligated to tell us. In cases where it accumulates over five percent of a public company, it must do an SEC filing saying so. More recentlyCascade has been filing “Schedule 13-H” forms, detailing all of the investments that represent more than five percent ownership in a firm. That said,we are not privy to the company’s smaller investments.
231
Trade Like Bill Gates
EXHIBIT 16.2
Cascade’s Holdings
Company
Alaska Air GroupAvista CorpBoca ResortsCanadian National RailwayCox CommunicationsExtended Stay AmericaFisher CommunicationsFour Seasons HotelICOS CorpNextel PartnersOtter TailPain TherapeuticsPan American SilverPNM ResourcesRepublic ServicesSchnitzer SteelSeattle GeneticsSix Flags
Value
No. of Shares
$17 million$42 million$26 million$506 million$780 million$76 million$22 million$19 million$201 million$93 million$40 million$11 million$36 million$98 million$409 million$21 million$17 million$69 million
792,4002,982,2002,047,70410,485,00024,463,9865,692,000455,700441,5005,359,50112,766,1061,503,2001,851,7005,105,0003,694,10018,078,000495,2003,521,08810,210,600
Exhibit 16.2 shows the positions listed in Cascade’s more recent 13-HRforms (filed November 14, 2003): airlines, energy companies, hotels andresorts, biotech, steel, and the occasional technology stock. A couple ofvery Buffett-like things to note are:1. He is diversified, but not overly diversified. With more than $5 bil-
lion to put to work, one can clearly own hundreds of stocks. However,Cascade has significant positions in only 18 companies, which is muchless than is needed to really achieve full diversification.2. The companies, on the whole, represent very “boring” sectors of
industry. Republic Services is a garbage collection company. Canadian National Railway operates about 18,000 miles worth of railroad.This is a sector that has not been popular since the 1850s and yet Gates’Cascade has made a significant bet here. One great thing about thecompany is its relatively low correlation to the overall market, asdemonstrated by the five-year chart in Exhibit 16.3—not a bad steadyreturn, even with a few blips.
232
EXHIBIT 16.3
TRADE LIKE WARREN BUFFETT
Canadian National Railway
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
Gates’ investment in Pan American Silver came shortly after Buffett’sinvestment in silver. The key difference here is that he bought a mineinstead of the commodity itself. Since Buffett dabbled in Kaiser Aluminum in the early 1980s, he has stayed away from the commoditycompanies, and prefers to buy and store the commodity itself. Gatesand Michael Larson, the manager of Cascade, probably figured thattheir time would be better spent focusing elsewhere rather than worrying about the logistics of storing all that silver.3. Energy companies make up a significant portion of the portfolio.
While Buffett has gone in more for the pipeline companies, Gates hasbecome a pretty big player in the utility sector, owning greater than fivepercent stakes in Otter Tail (a utility in the Dakotas), PNM (a utility inNew Mexico), and Avista (a utility in Washington).4. There is also a shared activism. In Buffett’s early days, if he didn’t like
what was going on in a company he would go in, buy up enough sharesto have a say, and take charge before beginning his usual liquidations.Berkshire Hathaway is a good example of this, as is Dempster Mining.With Schnitzer Steel, Gates has been fighting the Schnitzer family since2002 to nominate more independent directors. A 2002 proposal Cascade
Trade Like Bill Gates
233
made was defeated by stockholders (largely members of the Schnitzerfamily), even though 80 percent of common shareholders approved the proposal. In that proposal Cascade states:In fiscal 2001, Schnitzer Steel paid at least $15.39 million to companies owned and controlled by members of the Schnitzer family. Thesepayments range from leasing major facilities and headquartersoffice space to management and administrative services to shippingcosts. For example, the proxy statement acknowledges that SchnitzerSteel paid $13.5 million for vessel charter expenses to two companiescontrolled by members of the Schnitzer family.Investors need to have confidence that the Schnitzer Steel boardhas the independence necessary to examine closely these conflict-ofinterest and self-dealing transactions. Is the board asking the hardquestions about the payments? Are there competitive alternatives?Should there be competitive bidding for those contracts? Is the statusquo being maintained to protect those contracts?Perhaps as a direct result of this activism the stock has gone up fairlysteadily, allowing Gates to reduce his holdings from 12 percent to 6 percentof the company. Exhibit 16.4 shows the two-year chart on Schnitzer.EXHIBIT 16.4
Schnitzer Steel Industries
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
234
TRADE LIKE WARREN BUFFETT
Of course, the average retail investor is not likely to engage in activistbehavior, but by checking Barron’s each week one can see which stocksare being “plagued” by activist shareholders who are submitting hostileproposals to the board.To be fair, Michael Larson, not Gates, has made most of these stockpicks. Larson has been managing Gates’ portfolio since 1994. Gates hassaid that Larson has total discretion over the funds and most of the stockpicks are his. That said, the two men meet at least once every six weeks anddiscuss every investment so it is likely that Gates is at least sympathetic toLarson’s choices.However, the one area where Gates makes the picks is biotechnology.SGEN, PTIE, and ICOS are all Gates’ picks. At the time of this writing, noneof these companies has developed significant revenues. PTIE, a developerof painkillers, has zero revenues and is burning cash fast. In the biotecharena, Gates seems to be making a basket or VC-style approach as opposedto Buffett-style. If one of these companies achieves a significant medicalbreakthrough, then the results will be well worth it—its stock will appreciate significantly, even if the other companies fail completely.It is also worth noting that like Berkshire Hathaway, Gates and Cascade allocate some of their investing to others including Blue Ridge Capital,a New York hedge fund run by ex-Tiger employee John Griffin and VC firmIntegral Capital Partners.It is difficult to know exactly what positions Gates is in. And while hisportfolio has suffered some changes over the past few years, it is interesting to note that most of his picks are largely uncorrelated to the market.They have not done as poorly as MSFT has during the recent 2000–2002bust in tech stocks as well as the overall market. So, for a diversificationplay (and we should all be so lucky to have to diversify in this manner), theCascade portfolio has withstood the test of time.
C H A P T E R 17
Jealousy
et’s face it: Many people are jealous of Warren Buffett. AlthoughFreud insists that all emotional problems stem from feelings aboutsexuality, the reality is that money is either a close second or, morelikely, a winner by a long shot. And when a guy from the middle of Nebraskaaccumulates the sum of $42,000,000,000.00, well, that stimulates a lot ofjealousy.We have all heard that money cannot buy happiness. But, in fact, this isnot really true. As my father-in-law tells me, “Money doesn’t solve all ofyour problems, but it does solve your money problems.” And money problems are not trivial. Money buys the two basic needs, food and shelter. And$42 billion buys a lot of food and shelter.The most common statement said about Warren Buffett is that he waslucky. The other day, a friend of mine who is a stockbroker at Morgan Stanley said this to me. He also said, “Anybody who put their money in the market 47 years ago made a ton of money.” This is certainly correct, althoughthere are a lot of things wrong with this statement, which we will seeshortly. However, I partly agree with my friend’s statement. Warren Buffettcertainly is lucky. Among top-ranked chess players there is a saying, “Onlythe good players are lucky.” People tend to find their luck and Buffett hascertainly spent a lot of time looking for the pot of gold at the end of the rainbow. That time spent searching has paid off.
L
235
236
TRADE LIKE WARREN BUFFETT
For instance, in 1963, Buffett placed a very large bet (40 percent of hispartnership) on American Express in the middle of the Salad Oil Scandal.There was a potential for American Express to go bankrupt, or at least tohave major financial problems for years to come. If American Express hadgone bankrupt, I most likely would not be writing this book about WarrenBuffett right now, nor would you have any interest in reading a book abouthim. And yet the company did not go bankrupt; within two years he hadmade about 100 percent on his investment. Since nobody knows the future,it is quite possible to say Buffett was “lucky” when he bought the stock thatAmerican Express did not go bankrupt later. However, there are two important reasons why I don’t think this is the case:1. He saw the strength of the brand when he sat behind the cashier at
Ross’s Steakhouse in Omaha and saw that people were still using theirAmerican Express card despite the scandal in the news.2. He analyzed the value of the float generated by the American Express
traveler’s checks. People pay for the traveler’s checks and then it mightbe months or even years before they cash those checks and spend thatmoney. In the meantime, American Express is like a hedge fund that getsto keep 100 percent of the profits on the money they make from investing that float. Nor is Buffett lucky that he stumbled into a companywith such great economics as American Express had with their float.Buffett has staked his 50-year career on investing in companies withsimilar float characteristics. This pattern started in 1951 when he visited GEICO to understand more about the interest that his mentor BenGraham had in such companies.But now let’s look at the statement “Warren Buffett is lucky” from botha quantitative and qualitative view. Exhibit 17.1 shows his returns from hispartnership days.Buffett returns, after partnership fees, an average of 25.3 percent peryear; the Dow Jones Industrial Average returned an average of 10 percent.Buffett beat the Dow every year but one. Assume that the average stock isable to return more or less what the Dow does each year. Randomly throwing a dart at the stock charts in the New York Times will give an investor a50-50 shot at beating the Dow