Notes from the 3rd Annual New York Value Investing Congress by Marcelo Lima

Notes from 5 speakers: http://blog.valueinvestingcongress.com/2007/12/

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Mark Sellers at the 3rd Annual New York Value Investing Congress by Marcelo Lima

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Mark Sellers of Sellers Capital spoke at length about the Kelly Criterion (you can read all about it in the book Fortune’s Formula). It’s essentially a betting system that guarantees that (1) you never go broke and (2) you compound your bankroll at the fastest, most optimal rate possible.

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Of course, because it’s a formula that requires you to handicap odds and payoffs, it’s subject to the to the garbage in / garbage out pitfall of any model, and can give seemingly ridiculous results – like “bet 500% of your bankroll on this stock” – if you make incorrect assumptions about the likelihood and magnitude of winning or losing on a stock investment. It could also mean that betting 500% of your bankroll is the optimal thing to do. The strength of your assumptions really matter.

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To mitigate the risk of making mistakes in handicapping the odds and payoffs, Mark limits his purchases to situations where the expected return of a stock exceeds 20%, the upside is 3x greater than the downside, and the Kelly Formula tells him that he should bet.

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Mark still likes Contango (MCF), quite a bit actually, since he’s put 50% of his fund’s NAV in the stock. He considers Ken Peak, the CEO of MCF, the “Warren Buffett of the natural gas industry.” My favorite part of the story is that Ken owns 25% of the company, has never sold a share, and his ex-wife gets his salary. He’s about $10m in debt – he borrows money to live – but since his stake is worth close to $200m, he’s not so worried.

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[Mark’s] made quite some money on Contango, but with the stock at $47, he thinks that $42 is the worst case, $57.50 the base case, and $70 the best case. The company has recently hired Merrill Lynch to explore alternatives.

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Mark’s second idea, which is “only” 25% of his fund’s NAV, is Lowe’s (LOW). Mark believes that the odds of LOW trading forever at a forward P/E of 11 are essentially nil. Over time, one gets earnings growth plus multiple expansion. In his estimation, the base case for LOW is a value of $30 per share, with $20 being the worst case and $42 the best case. The probabilities for these scenarios are 35%, 50%, and 15% respectively.

Jean-Marie Eveillard & Peter Bernstein on WealthTrack

In a rare appearance, two financial legends join Consuelo Mack to discuss investment philosophy and strategy. Jean-Marie Eveillard, who recently came out of retirement to retake the helm of First Eagle funds talks about his lessons learned as one of the world's best value investors. And, in a television exclusive, financial guru, risk expert and best selling author Peter Bernstein shares a secret of the modern money masters: the most important question an investor can ask to achieve financial success.

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Video (12/28/2007): http://www.wealthtrack.com/video_player.html

CFA Conference Webcasts - Mauboussin and Zweig

The Prime Directive, Sharks, and the Wisdom and Whims of the Collective

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In this webcast, Michael J. Mauboussin discusses the following:

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-The metrics of market efficiency: mean–variance efficiency and arbitrage opportunities.
-Necessary conditions for an efficient market: diversity, incentives, and mechanisms for aggregations.
-Diversity breakdowns and other market malfunctions.

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This webcast comprises a 51-minute presentation and a 9-minute question-and-answer session.

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What Can We Learn from Neuroeconomics? How the Investing Brain Predicts the Future

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In this webcast, Jason Zweig discusses the following:

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-The prediction addiction: Why do you think they call it "dopamine?"
-What happens in your brain when your expectations are confirmed — or shattered by surprise

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This webcast comprises a 51-minute presentation and an 11-minute question-and-answer session.

Oakmark Select - Update

I wish I had better news to report, but The Oakmark Select Fund’s investment losses have continued since I last corresponded with you in September. Given this weak performance, I thought that reviewing why we own what we own might be helpful since many of you use year end as a time to re-evaluate your investments. I’d like to address our holdings by categorizing them into four groups. Be aware that new information could cause us to quickly change our opinion on any stock.

The 2007 Legg Mason Symposium - Transcript

The 2007 Legg Mason Symposium
December 4, 2007

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Corporate Speakers
• Chip Mason Chairman, President and CEO, Legg Mason
• Ken Leech Chief Investment Officer, Western Asset Management
• Patrick Tan Chief Investment Officer, Legg Mason International Equities - Singapore
• Isaac Souede Chairman and CEO, Permal
• Bill Miller Chairman and CIO, Legg Mason Capital Management

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Moderator
• Consuelo Mack Anchor and Managing Editor, WealthTrack

Buffett Buys Reinsurer; Bond Venture Rumored

The Oracle of Omaha is picking up a Dutch reinsurance business on the cheap.

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Dutch financial services firm ING on Friday announced the sale of its NRG reinsurance unit to billionaire investor Warren Buffet's Berkshire Hathaway for 300 million euros ($440.7 million), resulting in a capital loss after tax of 100 million euros ($146.9 million) in 2007.

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The acquisition could have something to do with plans by Buffett to launch a municipal bond insurance company. The Wall Street Journal reported that Buffett will launch a bond insurance business Friday in New York, aiming to capitalize on instability in that sector.

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If true, it could spell trouble for the leading bond insurers Ambac Financial Group and MBIA.

Berkshire Hathaway Inc. to Acquire 60% of Pritzker Family Company, Marmon Holdings, Inc.

This is Berkshire's largest-ever acquisition outside of the insurance industry.

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Berkshire Hathaway Chairman and CEO Warren Buffett and Tom Pritzker, Chairman of Marmon Holdings today announced that Berkshire will purchase 60% of Marmon Holdings, Inc., a private company owned by trusts for the benefit of members of the Pritzker Family of Chicago.

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The closing is anticipated to occur in the first quarter of 2008. Prior to closing, Marmon will make a substantial distribution of cash and certain assets to the selling shareholders. At closing Berkshire will acquire 60% of Marmon for $4.5 billion. The remaining 40% will be acquired through staged acquisitions over a five to six year period for consideration to be based on the future earnings of Marmon. The transaction remains subject to customary closing conditions, including regulatory approvals.

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Marmon is a private company that was acquired in 1953 by two brothers, Jay and Robert Pritzker, when it was a small ailing manufacturing operation in Ohio. In 2002 Jay’s son Tom became Chairman of Marmon. He then recruited John Nichols to become CEO of Marmon and in 2006 John was succeeded by Frank Ptak who is currently CEO of Marmon.

Fat Tails and Nonlinearity - Mauboussin

• Avoid the problem of induction. Humans like to generalize about a system based on a limited sample. The problem of induction reminds us that falsification serves us better than verification. When an asset price is going up, the natural assumption is it will continue to do so. Indeed, prosperity can breed an unhealthy sense of security.

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• Be mindful of diversity breakdowns. There is no simple way to measure the degree of diversity in the real world. But if a large group of investors seem to all be doing well pursuing a similar strategy, chances are there is a great deal of invisible vulnerability.

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• Watch for the non-linear reaction. Critical points are endogenous to financial markets, as they are in other complex systems. When diversity levels are low, small perturbations lead to outcomes completely out of proportion with their size.

At 71, Physics Professor Is a Web Star

Walter H. G. Lewin, 71, a physics professor, has long had a cult following at M.I.T. And he has now emerged as an international Internet guru, thanks to the global classroom the institute created to spread knowledge through cyberspace.

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Professor Lewin’s videotaped physics lectures, free online on the OpenCourseWare of the Massachusetts Institute of Technology, have won him devotees across the country and beyond who stuff his e-mail in-box with praise.

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Professor Lewin delivers his lectures with the panache of Julia Child bringing French cooking to amateurs and the zany theatricality of YouTube’s greatest hits. He is part of a new generation of academic stars who hold forth in cyberspace on their college Web sites and even, without charge, on iTunes U, which went up in May on Apple’s iTunes Store.

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In his lectures at ocw.mit.edu, Professor Lewin beats a student with cat fur to demonstrate electrostatics. Wearing shorts, sandals with socks and a pith helmet — nerd safari garb — he fires a cannon loaded with a golf ball at a stuffed monkey wearing a bulletproof vest to demonstrate the trajectories of objects in free fall.

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He rides a fire-extinguisher-propelled tricycle across his classroom to show how a rocket lifts off.

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He was No. 1 on the most downloaded list at iTunes U for a while, but that lineup constantly evolves. The stars this week included Hubert Dreyfus, a philosophy professor at the University of California, Berkeley, and Leonard Susskind, a professor of quantum mechanics at Stanford.

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Last week, Yale put some of its most popular undergraduate courses and professors online free. The list includes Controversies in Astrophysics with Charles Bailyn, Modern Poetry with Langdon Hammer and Introduction to the Old Testament with Christine Hayes.

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M.I.T. recently expanded its online classes by opening a site aimed at high school students and teachers. Judging from his fan e-mail, Professor Lewin, who is among those featured on the new site, appeals to students of all ages.

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Some of his correspondents compare him to Richard Feynman, the free-spirited, bongo-playing Nobel laureate who popularized physics through his books, lectures and television appearances.

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This article relates to Charlie Munger's Mental Model approach to life and learning, of course. From Mr. Munger's 1994 speech:

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You've got to have models in your head. And you've got to array your experience - both vicarious and direct - o­n this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You've got to hang experience o­n a latticework of models in your head.

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What are the models? Well, the first rule is that you've got to have multiple models - because if you just have o­ne or two that you're using, the nature of human psychology is such that you'll torture reality so that it fits your models, or at least you'll think it does. You become the equivalent of a chiropractor who, of course, is the great boob in medicine.

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It's like the old saying, "To the man with o­nly a hammer, every problem looks like a nail." And of course, that's the way the chiropractor goes about practicing medicine. But that's a perfectly disastrous way to think and a perfectly disastrous way to operate in the world. So you've got to have multiple models.

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And the models have to come from multiple disciplines - because all the wisdom of the world is not to be found in o­ne little academic department. That's why poetry professors, by and large, are so unwise in a worldly sense. They don't have enough models in their heads. So you've got to have models across a fair array of disciplines.

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You may say, "My God, this is already getting way too tough. "But, fortunately, it isn't that tough - because 80 or 90 important models will carry about 90% of the freight in making you a worldly-wise person. And, of those, o­nly a mere handful really carry very heavy freight.

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Books Related to Physics:

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Mr Tompkins in Paperback
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Einstein: His Life and Universe
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Isaac Newton
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Surely You're Joking, Mr. Feynman!
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What Do You Care What Other People Think?
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Genius: The Life and Science of Richard Feynman
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Six Easy Pieces: Essentials of Physics Explained by Its Most Brilliant Teacher
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Six Not-So-Easy Pieces: Einstein's Relativity, Symmetry, and Space-Time

In Search of Schrödinger's Cat: Quantum Physics and Reality
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The Martians of Science: Five Physicists Who Changed the Twentieth Century

First Eagle reopens two mutual funds

First Eagle joins Longleaf and Third Avenue in opening previously closed funds recently.

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Arnhold and S. Bleichroeder Advisers said on Tuesday it will reopen two of its First Eagle mutual funds that invest in overseas markets.

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The $21 billion First Eagle Global Fund SGENX.O invests in a range of asset classes in the United States and overseas. That fund was closed to new investors in March 2005.

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The $10 billion First Eagle Overseas Fund SGOVX.O invests mostly in non-U.S. stocks. That fund was closed to new investors in February 2004.

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The funds will be reopened effective Jan. 14.

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Arnhold and S. Bleichroeder, adviser to the funds, said the funds had been closed because of rapidly increasing cash flows at the time.

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Jean-Marie Eveillard, fund manager of First Eagle Funds, said the current volatile market environment may offer significant investment opportunities.

Buy Bill Miller Now

If you look beneath the surface, Miller is doing the same things that he has always done. For now, they're failing abysmally, and they may continue to fail for some time. But, in my view, Legg Mason Value (LMVTX) and Legg Mason Opportunity (LMOPX), a member of the Kiplinger 25, are both keepers. Better than keepers: Indeed, this is an ideal time to invest in them.

A big deal: Poker is getting younger, cleverer, duller and much, much richer

At the highest level, decisions about betting, bluffing and folding are based on the complex juggling of probabilities. “What drew me to poker is that it is essentially an academic endeavour,” says Ms Duke. She is one of a growing group of full-time players who came to poker through game theory and mathematics, not through any love of a flutter. (Indeed, she never plays craps or roulette.) Others include Mr Lederer (her brother) and Mr Ferguson, who has a doctorate in computer science and writes academic papers on probability theory with his father, a statistician at UCLA.

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Thomas Bihl, winner of a recent HORSE tournament, in which players have to show mastery of five different styles of poker, thinks the game has more in common with finance than it does with basic forms of gambling, because it requires the constant pricing and repricing of risk. Mr Bihl, a former stock trader, says the move from his old job into poker was a natural progression. Though his £71,000 win was “a huge lift”, he says that he is motivated not by money but by the chance to use his brain to outfox opponents. This is a common refrain among regular players. As Ms Coren put it in a recent article: “Cash is nothing more than chips, just the tools of the trade, like fishing rods to an angler. The game is all about money, and nothing to do with money.”

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Books:

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Doyle Brunson's Super System: A Course in Power Poker

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No Limit Hold 'em: Theory and Practice

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The Theory of Poker

Simons at Renaissance Cracks Code, Doubling Assets

Certainly not the Graham/Buffett/Munger type of value investor (Renaissance is all quant), but an interesting story nonetheless. What is also interesting is that if you search for RENAISSANCE TECHNOLOGIES CORP on the NASDAQ web site, it appears Renaissance's biggest purchase during the third quarter was Berkshire Hathaway (when you add up the A and B shares)!

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Renaissance is on fire: Its Medallion Fund -- which uses computers and trading algorithms to invest in world markets -- returned more than 50 percent in the first three quarters of 2007. It had about $6 billion in assets as of July 1.

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Medallion's returns are no anomaly. The fund, which trades everything from soybean futures to French government bonds in rapid fire, hasn't had a negative quarter since early 1999. From the end of 1989 through 2006, it returned 38.5 percent annualized, net of fees.

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In quant funds, mathematicians and computer scientists mine enormous amounts of data from financial markets looking for correlations among stocks, bonds, derivatives and other instruments. They search for predictive signals that will foretell whether, say, a palladium futures contract is likely to rise or fall.

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"There are just a few individuals who have truly changed how we view the markets,'' says Theodore Aronson, principal of Aronson + Johnson + Ortiz LP, a quantitative money management firm in Philadelphia with $29.3 billion in assets. "John Maynard Keynes is one of the few. Warren Buffett is one of the few. So is Jim Simons."

The Crowd: A Study of the Popular Mind by Gustave Le Bon

One of the greatest and most influential books of social psychology ever written, brilliantly instructive on the general characteristics and mental unity of a crowd, its sentiments and morality, ideas, reasoning power, imagination, opinions and much more. A must-read volume for students of history, sociology, law and psychology.

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The complete English text is available for free in PDF format HERE.

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Or (for $8.95) on Amazon: The Crowd: A Study of the Popular Mind

Mark Sellers: Rational investors should rejoice

Two months ago in my Financial Times column, I listed some of the things I have learnt about the stock market over the years. I likened the market to a game of online poker, with anonymous opponents and continuously evolving probabilities. I received some good reader feedback, so this month I’ve decided to revisit the topic. Here are a few more things I’ve learnt about the stock market.

Death, Taxes, and Reversion to the Mean - Mauboussin

Analysts modeling future corporate financial performance should use past return on invested capital (ROIC) patterns, including a strong tendency toward mean reversion, as an appropriate reference class but rarely do. Full consideration of the difficulty in sustaining high returns should temper the optimism inherent in many models.

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Some companies do post persistently high or low returns beyond what chance dictates. But the ROIC data incorporate much more randomness than most analysts realize.

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We had little luck in identifying the factors behind sustainably high returns.

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This analysis has concrete implications for modeling. We unveil some of the common errors in discounted cash flow models and offer some thoughts on how to improve them.

Tulane 2005 Commencement Address - Michael Lewis

Michael Lewis, esteemed columnist and author of such bestsellers as "Liar's Poker" and "Moneyball: The Art of Winning an Unfair Game" delivers the Tulane University Class of 2005 Commencement Address.

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"Do what you love before you figure out how much what you love is gonna cost you."

Value's Day Once More

The stock market is falling, or is it the sky? At this writing the answer's debatable. Treasury yields are collapsing, the price of gold is soaring and oil keeps closing in on $100 a barrel. The U.S. dollar is under siege, Fannie Mae and Freddie Mac are on the skids and the economy-stopping word "no" is on the lips of our formerly fearless lenders.

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Is anyone happy? Well, value investors ought to be. To their way of thinking bear markets are heaven-sent. Of all people, the disciples of Benjamin Graham and David L. Dodd understand the investment appeal of everyday low prices. They like it when stocks and bonds go on sale. They are the Wal-Mart shoppers of Wall Street.

Mark Sellers, Intelligent Investor - Motley Fool Interview

Emil Lee: How does your firm go about researching an investment idea?

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Mark Sellers: The first thing we do is figure out what the problem is. Ninety percent of making money in stocks is not losing money, which has to do with knowing what the problem is and how it can be solved. Every company we buy has a problem with it, otherwise it wouldn't be cheap.

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We read sell-side reports, SEC filings, and talk to management. Within one or two days, we decide if we're comfortable that the company can solve the problem. Then we do another week or so of further research.

Berkshire Hathaway Is Poised to Surpass $150,000

"The more chaos there is in financial markets, the better it is for Warren Buffett,'' said Whitney Tilson, managing partner at T2 Partners LLC in New York and a Berkshire shareholder for 10 years. "Investors are fleeing to safety, and Berkshire Hathaway offers the ultimate in safety.''

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Tilson said the Class A shares have an "intrinsic value'' of $167,000, in part because the most recent hurricane season was benign, holding down costs for Berkshire's insurance units.

"People are realizing earnings are going to be astronomical this quarter,'' he said.

Wired for survival on the savannah

James Montier, a top-rated equity strategist who recently arrived at SocGen in London from Dresdner Kleinwort, has been educating clients for years with his reports on behavioural finance. These have now been gathered together in a 700-page tome, Behavioural Investing: A Practitioner's Guide to Applying Behavioural Finance (Wiley). It is quite simply the best and most comprehensive treatment of the subject to date.
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Behavioural finance suggests we overweight our personal, recent experience when arriving at judgments. We also tend to extrapolate from current circumstances into the future. Not only are we prone to overconfidence; we also seek out confirming evidence for our views. We attribute our successes to skill but our failures to bad luck. An ability to respond quickly to perceived danger was a successful strategy in our evolution. But as an investment strategy, fear is self-defeating. It leads to overreaction to irrelevant information and induces investors, who bought at the top of the market, to sell at the bottom.
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The best investors, like Keynes, seem not to have inherited these debilitating psychological traits. They are patient, operate with long time horizons and are prepared to tolerate periods of underperformance.
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Book: Behavioural Investing: A Practitioners Guide to Applying Behavioural Finance

Warren Buffett's Complete Squawk on Street Interview: Video and Transcript

Part 1
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Part 2

An Investing Principles Checklist from Poor Charlie

From Poor Charlie's Almanack:
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An Investing Principles Checklist

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Risk – All investment evaluations should begin by measuring risk, especially reputational

• Incorporate an appropriate margin of safety
• Avoid dealing with people of questionable character
• Insist upon proper compensation for risk assumed
• Always beware of inflation and interest rate exposures
• Avoid big mistakes; shun permanent capital loss
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Independence – “Only in fairy tales are emperors told they are naked”

• Objectivity and rationality require independence of thought
• Remember that just because other people agree or disagree with you doesn’t make you right or wrong – the only thing that matters is the correctness of your analysis and judgment
• Mimicking the herd invites regression to the mean (merely average performance)

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Preparation – “The only way to win is to work, work, work, work, and hope to have a few insights”

• Develop into a lifelong self-learner through voracious reading; cultivate curiosity and strive to become a little wiser every day
• More important than the will to win is the will to prepare
• Develop fluency in mental models from the major academic disciplines
• If you want to get smart, the question you have to keep asking is “why, why, why?”

-Intellectual humility – Acknowledging what you don’t know is the dawning of wisdom

• Stay within a well-defined circle of competence
• Identify and reconcile disconfirming evidence
• Resist the craving for false precision, false certainties, etc.
• Above all, never fool yourself, and remember that you are the easiest person to fool
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“Understanding both the power of compound interest and the difficulty of getting it is the heart and soul of understanding a lot of things.”

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Analytic rigor – Use of the scientific method and effective checklists minimizes errors and omissions

• Determine value apart from price; progress apart from activity; wealth apart from size
• It is better to remember the obvious than to grasp the esoteric
• Be a business analyst, not a market, macroeconomic, or security analyst
• Consider totality of risk and effect; look always at potential second order and higher level impacts
• Think forwards and backwards – Invert, always invert
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Allocation – Proper allocation of capital is an investor’s number one job

• Remember that highest and best use is always measured by the next best use (opportunity cost)
• Good ideas are rare – when the odds are greatly in your favor, bet (allocate) heavily
• Don’t “fall in love” with an investment – be situation-dependent and opportunity-driven
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Patience – Resist the natural human bias to act

• “Compound interest is the eighth wonder of the world” (Einstein); never interrupt it unnecessarily
• Avoid unnecessary transactional taxes and frictional costs; never take action for its own sake
• Be alert for the arrival of luck
• Enjoy the process along with the proceeds, because the process is where you live
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Decisiveness – When proper circumstances present themselves, act with decisiveness and conviction

• Be fearful when others are greedy, and greedy when others are fearful
• Opportunity doesn’t come often, so seize it when it comes
• Opportunity meeting the prepared mind; that’s the game
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Change – Live with change and accept unremovable complexity

• Recognize and adapt to the true nature of the world around you; don’t expect it to adapt to you
• Continually challenge and willingly amend your “best-loved ideas”
• Recognize reality even when you don’t like it – especially when you don’t like it
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Focus – Keep things simple and remember what you set out to do

• Remember that reputation and integrity are your most valuable assets – and can be lost in a heartbeat
• Guard against the effects of hubris and boredom
• Don’t overlook the obvious by drowning in minutiae
• Be careful to exclude unneeded information or slop: “A small leak can sink a great ship”
• Face your big troubles; don’t sweep them under the rug
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In the end, it comes down to Charlie’s most basic guiding principles, his fundamental philosophy of life: Preparation. Discipline. Patience. Decisiveness.

Whitney Tilson on Wealthtrack

http://www.wealthtrack.com/video_player.html

Understanding The Numbers

The three pieces which help you put the puzzle together are the Balance Sheet, Income Statement (Profit & Loss) and Cash Flow (+ the footnotes.) These are the key financial statements which together help you fully appreciate a company's current health. In isolation they provide you insight which could be misleading. All three of these statements are related and you need to understand them with respect to the other.

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(If this is your first time, reading these statements, this takes a while initially, and this article is certainly longish, however, my aim is to give you enough in one shot.)

Martin Capital Management - 2006 Annual Report

Like the Buffett discussion on derivatives I posted a couple of days ago, I think it is also a good time to go back and review Frank Martin's discussion from MCM's 2006 Annual Report:

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Martin Capital Management - 2006 Annual Report (pdf)

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To review previous Annual Reports, click HERE.

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Book: Speculative Contagion: An Antidote for Speculative Epidemics

Fall 2007 — CIO interview with Chuck Royce Q307

Q. Do you agree with the idea that we haven’t really seen a correction in the stock market yet?

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A. Definitely. What we did see, especially in July and early August, was a great deal of volatility accompanied by anxious headlines about subprime mortgages, credit issues and leverage. However dramatic the localized, specific effects of these problems have been in their respective areas, they have not yet produced a substantial stock market correction, which we would define as a decline of 15% or more. The downdraft that began in July hit an interim bottom on August 15, and in the third quarter the Russell 2000 saw 24 out of 57 trading days in which it moved 2.0% or more intraday, making it a wildly volatile period, but not a seriously bearish one.

The Structure of “Unstructured” Decision Processes - 1976 Paper

How do organisations go about making “unstructured,” “strategic” decisions? Researchers of administrative processes have paid little attention to such decisions, preferring instead to concentrate on routine operating decisions, those more accessible to precise description and quantitative analysis. As a result, the normative models of management science have had a significant influence on the routine work of the lower and middle levels of organisations and almost no influence on the higher levels. But it is at the top levels of organisations where better decision-making methods are most needed; excessive attention by management scientists to operating decisions may well cause organisations to pursue inappropriate courses of action more efficiently.

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Although there is a body of normative literature on techniques for strategic decision making, for example, strategy-planning, models of the firm, cost-benefit analysis, the evidence from empirical studies of their application indicates that all too often these techniques have made little real difference in the decisional behaviour of organisations (Grinyer and Norburn 1975, Hall 1973, Whitehead 1968). These techniques have been unable to cope with the complexity of the processes found at the strategy level, about which little is known.

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This paper defines a decision as a specific commitment to action (usually a commitment of resources) and a decision process as a set of actions and dynamic factors that begins with the identification of a stimulus for action and ends with the specific commitment to action. Unstructured refers to decision processes that have not been encountered in quite the same form and for which no predetermined and explicit set of ordered responses exists in the organisation. And strategic simply means important, in terms of the actions taken, the resources committed or the precedents set. This paper uses empirical research to suggest a basic framework that describes unstructured, strategic decision processes. The suggested framework embodies the results of our own study of 25 such decision processes, as well as evidence from published empirical studies.

Warren Buffett on Derivatives – from 2005 Berkshire Hathaway Letter to Shareholders

In light of recent events, I thought it may a good time to review the brief discussion on derivatives from Mr. Buffett in his 2005 letter to shareholders. Many companies, executives, analysts, and members of the media are claiming that current derivatives losses were unforeseen and totally unpredictable. Mr. Buffett and Mr. Munger have been warning of these "unpredictable" events for YEARS. I'd be willing to bet that they'd also predict there is still a whole lot more that has yet to come home to roost.

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Warren Buffett on Derivatives – from 2005 Berkshire Hathaway Letter to Shareholders:

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Long ago, Mark Twain said: “A man who tries to carry a cat home by its tail will learn a lesson that can be learned in no other way.” If Twain were around now, he might try winding up a derivatives business. After a few days, he would opt for cats.

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We lost $104 million pre-tax last year in our continuing attempt to exit Gen Re’s derivative operation. Our aggregate losses since we began this endeavor total $404 million.

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Originally we had 23,218 contracts outstanding. By the start of 2005 we were down to 2,890. You might expect that our losses would have been stemmed by this point, but the blood has kept flowing. Reducing our inventory to 741 contracts last year cost us the $104 million mentioned above.

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Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

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A business in which huge amounts of compensation flow from assumed numbers is obviously fraught with danger. When two traders execute a transaction that has several, sometimes esoteric, variables and a far-off settlement date, their respective firms must subsequently value these contracts whenever they calculate their earnings. A given contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences – and I’m personally familiar with several that were huge – tend to be tilted in a direction favoring higher earnings at each firm. It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.

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I dwell on our experience in derivatives each year for two reasons. One is personal and unpleasant. The hard fact is that I have cost you a lot of money by not moving immediately to close down Gen Re’s trading operation. Both Charlie and I knew at the time of the Gen Re purchase that it was a problem and told its management that we wanted to exit the business. It was my responsibility to make sure that happened. Rather than address the situation head on, however, I wasted several years while we attempted to sell the operation. That was a doomed endeavor because no realistic solution could have extricated us from the maze of liabilities that was going to exist for decades. Our obligations were particularly worrisome because their potential to explode could not be measured. Moreover, if severe trouble occurred, we knew it was likely to correlate with problems elsewhere in financial markets.

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So I failed in my attempt to exit painlessly, and in the meantime more trades were put on the books. Fault me for dithering. (Charlie calls it thumb-sucking.) When a problem exists, whether in personnel or in business operations, the time to act is now.

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The second reason I regularly describe our problems in this area lies in the hope that our experiences may prove instructive for managers, auditors and regulators. In a sense, we are a canary in this business coal mine and should sing a song of warning as we expire. The number and value of derivative contracts outstanding in the world continues to mushroom and is now a multiple of what existed in 1998, the last time that financial chaos erupted.

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Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

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It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

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When we finally wind up Gen Re Securities, my feelings about its departure will be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”

Warren Buffett's Video Tour of Berkshire Hathaway Headquarters

Video and Transcript:

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Part One

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Part Two