Warren Buffett: Investing In Common Stocks, Bonds And Arbitrage Situations

Dec. 08, 2011 |
Article from Guru Focus

Dated back in 1986, Warren Buffett had discussed different categories of investment and his simple reasoning following each type of investments. It would be extremely helpful with only several page of reading for any Buffett wannabes. At that time, Buffett’s insurance arms had purchased around $700 million of tax-exempt bonds, with the maturity from 8-12 years. Readers might think that huge amount of money indicated his enthusiasm for bonds. But that was not the case. He explained that at best, the bonds were mediocre investments. They just seemed to be the least objectionable alternative at the time he bought them. 

As any new money came in, Buffett said that there would have only five choices: (1) long-term common stock investments; (2) long-term fixed income securities; (3) medium-term fixed income securities; (4) short-term cash equivalent; and (5) short-term arbitrage commitments. Buffett seemed to prefer common stock the best. He commented: “Common stocks, of course, are the most fun. When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs. But we currently find no equities that come close to meeting our tests. This statement in no way translates into the stock market prediction: we have no idea – and never have had – whether the market is going to go up, down, or sideways in the near – or intermediate term future.” 

He believed on the boom and burst cycle, happening occasionally in the market, along with the fear and greed, which he described as “two super-contagious disease." That would forever occur in the investment community. However, even knowing it would happen, no one can predict the timing of those events accurately, it was so unpredictable. That is why he never try to anticipate the arrival or departure of either disease. A simple goal was stated once again: "To be fearful when others are greedy and to be greedy only when others are fearful.”

Even in the short-run, the bull could make the stock market advance like crazy, and everybody loved the market just so much. But the very fundamental truth was that the stock couldn’t outperform businesses indefinitely. Actually, the stockholders as the whole over the long run would underperform the companies that they own if taking into account the transaction costs and the investment costs they have to bear. “If American business, in aggregate, earns about 12% on equity annually, investors must end up earning significantly less. Bull markets can obscure mathematical laws, but they cannot repeal them.”

The second investment category was the long-term bonds. Buffett said he didn’t get interested in those type of investments except it was very special situation such as the Washington Public Power Supply position that Berkshire Hathaway had purchased before. He stated: “Our aversion to long-term bonds relates to our fear that we will see much higher interest rates of inflation within the next decade. Over time, the behavior of our currency will be determined by the behavior of our legislators. This relationship poses a continuing threat to currency stability – and a corresponding threat to the owners of long-term bonds.”

In addition, Berkshire Hathaway sometimes employed cash in the arbitrage field. But according to Warren Buffett, it was not like common arbitrageurs, who purchased a lot of securities each year. Berkshire only bought a few, restricting to some large deals that have been announced publicly and not betting on the outcome. That was why the potential profits might be apt to be small, but along with the luck, the disappointments would also be few.

He discussed that arbitrage could be considered to be the alternative to Treasury bills as a short-term packing place for money — a choice that combined potentially higher return with higher risks. Till the time of writing, the returns for Berkshire Hathaway from arbitrage positions had been many times higher than if leaving it into Treasury Bills. But the risk was that “one bad experience could change the scorecard markedly.”

Buffett at that time view medium-term tax-exempt bonds as an alternative to short-term Treasury holdings. Buying those bonds, he would run a risk of significant loss if he had to sell many of them well before maturity. Nevertheless, he believed that the risk was more than counter-balanced because of several points. 

First was because much higher after-tax returns currently realizable from these securities in the comparison to Treasury bill, and second, because the possibility that sales would produce an overall profit rather than a loss. “Our expectation of a higher total return, after allowing for a possibility of loss and after taking into account all tax effects, is a relatively close call and could well be wrong. Even if we sell our bonds at a fairly large loss, however, we may end up reaping a higher after-tax return than we would have realized by repeatedly rolling over Treasury Bills.”

About the author:

Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Article from Guru Focus

Bond vigilantes buy the silence of our banks

By ABC's Alan Kohler

Article from ABC Net
Updated December 07, 2011 08:52:01

In August 1982 the Australian 10-year Government bond yield peaked at 16.5 per cent, having roughly tripled since 1970.

The government was facing a crippling budget deficit just to pay interest on existing debt.

With the benefit of hindsight, that was the end of a 30-year global bear market for bonds (as the yield rises, the price falls).

In 1970 a 6 per cent return for a risk-free government investment seemed little short of fabulous, but thanks to the Great Inflation of the 1970s, it turned out to be dreadful: 10 years later the yield was 10 per cent higher and bonds were worth a fraction of the price. Fixed interest investors were wiped out, leading to a generation of over-investment in equities.

"Bond vigilantes" - a term coined in the 1980s - forced governments around the world to control inflation. Never again would they allow politicians to slowly rob them through the expansion of money and rising prices.

Fast forward 30 years and the bond vigilantes are at it again, except this time they are demanding monetary expansion. Governments that don't print money are ferociously punished, and those that do are richly rewarded with yields below 2 per cent, or even 1 per cent.

For example, in early September the Swiss National Bank said it was "prepared to buy foreign currency in unlimited quantities" to enforce an exchange rate of 1.2 francs to the euro. Having thus promised to print unlimited amounts of money, Switzerland was given a cut in its 10-year bond rate from 1.3 per cent to 0.9 per cent.

The UK has had four rounds of quantitative easing (QE), or money printing, and its 10-year bonds, or gilts as they are called there, have fallen from 3.8 per cent to 2.3 per cent in six months. The US Fed has had the TARP, QE 1, QE 2 and the Twist, printing money like there's no tomorrow and yet the 10-year Treasury bond is stuck at 2 per cent yield.

The Eurozone, on the other hand, is being tormented by the bond vigilantes, who are using the lash of bond yields to demand that the European Central Bank (ECB) falls into line and prints money. The ECB has bought €209 billion worth of bonds since May 2010, in the past three months its balance sheet has expanded at an annual rate of 77 per cent, but it's not enough.

With €1.2 trillion of European government debt to be refinanced in 2012, the bond market is putting intolerable pressure on the ECB and Germany to abandon their "conservative" ways and print more money. If the December 9 summit doesn't produce a capitulation to the bond vigilantes, their fury could be catastrophic for global markets.

How on earth did we get to this point, where the bond market vigilantes have gone from demanding monetary discipline to demanding the exact opposite?

The answer is both simple, and frightening. The world's marginal fixed interest investors have gone from being long-term risk managers to short-term yield arbitrage slurplers.

What they want is cheap money. They don't give a monkey's about inflation or deflation - just give us a fix of near-zero interest rates so we can make easy profits on the carry.

They don't care whether the euro stays together. They have very little interest in fiscal policy - in fact deficits are good because it means there are more bonds to play with. Their only concern, and the reason they want better fiscal policies, is the prospect of a hard default, but that's not really much of a concern: they know the firestorm they would unleash on those responsible would be so horrendous that it's very unlikely to happen.

What they want is to be bailed out with money created from thin air by the ECB. Inflation? Who cares?

The only Western government immune from the bond market's predations is Australia because it has little sovereign debt and a plan to return to surplus, such as it is. But we are directly vulnerable to what happens because our banks rely on wholesale debt from the same sources as Europe's miserable governments. Close one bond market and you close them all.

Yesterday's failure to pass on the RBA rate cut is a consequence of that reliance.

There was a time when European and American governments might have satisfied bond markets and lowered the interest rate on their long-term debt simply through tight, responsible fiscal policy.

Not any more. What's required now is a willingness to create euros and dollars, and to keep the price of money down in the short term so the hedge funds that control marginal pricing can continue to get rich - at least until the inflation catches up with them. But they'll be long gone by then, or so they believe.

As the newsletter Grant's Interest Rate Observer wryly observed last week:

"We hew to the doctrine that the place in which you find real money is a mine."

Alan Kohler is Editor in Chief of Business Spectator and Eureka Report, as well as host of Inside Business and finance presenter on ABC News.

Article from ABC Net

How to pad your stock returns with corporate bonds

Dec. 2, 2011, 2:25 p.m. EST
Article from Market Watch

Find value in lower-rated firms with strong cash flow

By Deborah Levine, MarketWatch

NEW YORK (MarketWatch) — Some top money managers are recommending that investors shift a bit more into bonds and out of stocks as rising yields and a slower economic growth outlook make fixed income more attractive.

But U.S. Treasury bonds offers paltry yields nowadays, and the income from corporate issues isn’t much higher. Income-hungry investors are left with the unpleasant choice of taking more interest-rate risk by holding longer-term bonds or moving down in credit quality.

Many bond-market experts say corporate bonds, especially those at the lower end of the investment-grade universe, are a reasonable option. Only a handful of U.S. firms carry the highest-possible AAA credit rating, with a large number of issues two levels lower in the single-A range.

By moving down the ladder a little more to companies rated BBB, investors can find credits that are still investment grade but yield noticeably more. That’s the point where bond strategists are looking for A-type financial strength. Read more: How to own a triple-A portfolio.

“U.S. companies are in pretty good shape and have done a nice job of cutting jobs and generating cash,” said Lon Erickson, a portfolio manager at Thornburg Investment Management. “That’s a pretty good environment for fixed-income investors. Some BBB-type names are more interesting because they come with a little [yield] spread.”

Company cash counts

This circumstance is a byproduct of the economic recession. U.S. companies have continued to shore up their balance sheets through the downturn and have been frugal even when seeing signs of recovery.

“If there is anything out there that is remotely close to ‘recession proof’ it is corporate balance sheets,” said David Rosenberg, chief economist and strategist at Toronto-based asset manager Gluskin Sheff + Associates, in a recent report to clients. “Be selective and identify those entities that have a single-A balance sheet but pay out a BBB yield.”

As a result, many firms have both ample cash on hand and good cash-flow streams — two key criteria when buying corporate bonds, said Hans Olsen, head of Americas investment strategy at Barclays Wealth.

If the economy stays out of recession and corporate profits remain strong, “as a bondholder, you look pretty good,” he said. “A number of firms are generating excess cash so without any problem can get their debt paid.”

Bonds with ratings between Aaa and Baa3 ratings from Moody’s Investors Service, or AAA to BBB-minus from Standard & Poor's, are considered investment grade.

At the highest end of the rating scale, companies have strong market positions, a stable or growing business, good corporate governance and impeccable liquidity, said Mark Gray, managing director in the corporate finance group at Moody’s.

“They’ll have enough cash, cash-flow or external liquidity to get through a couple of years,” he said.

Some examples of AA-rated companies are Wal-Mart Stores Inc. WMT -0.89%   , 3M Co. MMM -0.67%  and General Electric Co. GE +0.19%   

Companies rated Baa may be in a more cyclical business, but still have relatively stable margins, Gray noted.

“We expect them to have the ability to cut back on spending if we entered a rough, recessionary period,” he said. “You wouldn’t expect an investment-grade company to have to run out and sell assets to make ends meet.”

Examples of Baa-rated issuers include media companies Time Warner Inc. TWX +0.58%   , Comcast Corp. CMCSA +3.50%   , and CBS Corp. CBS +0.55%    and railroads CSX Corp. CSX +1.10%   and Union Pacific Corp. UNP -0.23%   

Several big asset management firms also see opportunities for yield pickup in below-investment-grade debt as the outlook for U.S. and global growth becomes clearer.

‘Adding weight to junk’ allocation

“I have an optimistic view of the world,” said Phil Orlando, chief equity market strategist at Federated Investors and chairman of the money management firm’s asset allocation committee. “We had a very defensive allocation over the summer, but we’re at a point where we feel we have better visibility in terms of the direction of the economy, and we think Washington and Europe are moving in the right direction but the market isn’t giving them credit for it yet.”

“We’ve added weight to junk bonds and to corporate” and slightly longer-term debt, Orlando said. Those will likely return more than Treasurys, he predicted.

Corporate bonds have returned 5.3% so far this year, according to an index compiled by Bank of America Merrill Lynch. The effective yield on the index is 4.09%.

High-yield debt, meanwhile, has returned 2.2%, according to another BofA Merrill index. But the effective yield is 8.87%.

Treasurys have performed much better, though yields are low. The sector has returned 8.5% this year, with an effective yield of 1.15%.

Credit and dues

It’s no secret to anyone trying to live on a fixed income that bond yields aren’t what they used to be, and probably won’t be for awhile.

“We’re in this stifling desert of no yield,” said Marilyn Cohen, president of Envision Capital Management, a bond-portfolio manager in Los Angeles.

With corporate debt, “2.5% or 3% is the old 5%,” she said. Or worse. Cohen pointed to a double-A-plus rated tranche of Microsoft Corp. MSFT -0.16%   debt due in 2016 yielding 1.14%. In contrast, the company’s stock yields about 3.2%.

Accordingly, for corporate bond investors, she said, “A decent balance sheet going down in credit quality that isn’t as pristine as you may be used to is the way to fly.”

The broadest bond-investing strategy involves mutual funds and exchange-traded funds.

“A highly-rated, well-diversified bond fund or exchange-traded fund is the way to go,” said Paul Zemsky, ING Investment Management’s chief investment officer of multi-asset strategies. Most keep the average credit rating of the fund close to their benchmark index, he noted.

Index-tracking ETFs tend to have lower expenses than actively managed funds, and their holdings are more transparent. Some examples of corporate-bond ETFs include Vanguard Long-Term Corporate Bond Index ETF VCLT +1.44%  , which recently sported a 4.9% yield, Pimco Investment Grade Corporate Bond Index ETF CORP +0.30%  , with a yield of around 3.5%, and SPDR Barclays Capital Intermediate-Term Credit Bond   ITR +0.42%  , recently yielding 3%. 

It’s riskier of course to buy individual credits unless you understand the finer points of bond analysis, or assign your portfolio to someone who does.

Cohen actively searches for BBB or BB companies that are flush with cash. One issuer she favors is DirectTV Group Inc. DTV +3.32%  , which she calls a “best of breed” triple-B credit that both Cohen and her clients own. The company’s bonds maturing in 2016, for instance, yield close to 3%, she said.

Cohen also owns the debt of BB-rated BE Aerospace Inc. BEAV -0.05%  , which manufactures aviation products. As an example, she points to its 8.5% coupon bonds maturing in 2018 that are callable in July 2013, meaning that the company can retire the debt early after that date. Meantime, bondholders pocket a yield to call of almost 5.9%.

Other lower-grade corporate credits on Cohen’s list include BB-plus Tesoro Corp. TSO +0.39%  , BB-rated Royal Caribbean Cruises Ltd. RCL +1.01%   , BB-plus Ford Motor Co. F +0.09%   and Goodyear Tire & Rubber Co. GT -0.21%    

“They’re not bargains,” Cohen said. “But these are absolutely better returns than double-As and single-As.”

Stretching for yield

For the highest-yielding corporate bonds, investors have to delve into the world of so-called junk bonds. Again, the best way to diversify across this area, where default risk is part of the trade-off, is through mutual funds and ETFs.

Olsen at Barclays Wealth said the return potential for high-yield bonds nowadays outweighs the risks.

“While equities are still cheap, in certain credits in the high-yield space you can get total returns that are equity-like while senior in the capital structure and sometimes secured,” he said. Read story on signs to watch before buying junk bonds.

Moreover, Olsen noted that high-yield bonds offer better risk-adjusted returns because what really matters is not earnings growth but whether a company generates cash and earnings to cover its interest payments. When you add the price gains to the coupon, he added, high-yield debt can return in the neighborhood of 12%.

But some strategists caution against venturing too deeply into this dicier area of the bond market. High-yield debt can trade more like stocks than bonds, and can falter along with stocks if global investors lack confidence in a recovery.

So yield players shouldn’t be too quick to swing for the fences. Said Tim Knepp, chief investment officer of Genworth Financial Wealth Management: “Most clients in this environment are fairly guarded in what they’re trying to accomplish.” 

Deborah Levine is a MarketWatch reporter, based in New York.

Article from Market Watch