Warren Buffett’s latest portfolio moves: the 4Q14 13-f

Investment managers subject to SEC regulation (meaning basically everyone other than hedge funds) must file a quarterly report with the agency detailing significant changes in their portfolios.  It’s called a 13-f.  Today Berkshire Hathaway filed its 13-f for 4Q14.  I can’t find it yet on the Edgar website, but there has been plenty of media coverage.

Mr. Buffett has built up his media and industrial holdings, as well as adding to his IBM.  The more interesting aspect of the report is that it shows him selling off major energy holdings–ExxonMobil, which he had acquired about two years ago, and ConocoPhillips, which he had been selling for some time.  Neither has worked out well.

There’s also a smaller sale of shares in oilfield services firm National Oilwell Varco and a buy of tar sands miner Suncor–both presumably moves made by one of the two prospective heirs working as portfolio managers at the firm (whose portfolios are much smaller than Buffett’s.  Buffett has told investors to figure smaller buys and sells are theirs.)

Three observations:

–the Buffett moves would have been exciting–maybe even daring–in 1980.  Today, they seem more like changing exhibits in a museum.

–if I were interested in Energy and thought it more likely that oil prices would rise than fall, I’d be selling XOM, too.  After all, it’s one of the lowest beta (that is, least sensitive to oil price changes) members of the sector.

But I’d be buying shale oil and tar sands companies that have solid operations and that have been trampled on Wall Street in the rush to the door of the past half-year or so.  That doesn’t appear to be Mr. Buffett’s strategy, however.  His idea seems to be to cut his losses and shift to areas like Consumer discretionary. (A more aggressive stance would be to increase energy holdings by buying the high beta stocks now, with the intention of paring back later by selling things like XOM as prices begin to rise.)  NOTE:  I’m not recommending that anyone actually do this stuff.  I’m just commenting on what the holdings changes imply about what Mr. Buffett’s strategy must be.

–early in my career, I interviewed for a job (which I didn’t get) with a CIO who was building a research department for a new venture.  I was a candidate because I was, at the time, an expert on natural resources.   The CIO said the thought there were three key positions any research department must fill:  technology, finance and natural resources.  All require specialized knowledge.    I’d toss healthcare into the ring, as well.  I’d also observe that stock performance in these more technical areas is influenced much less by the companies’ financial statements than is the case with standard industrial or consumer names.

Mr. Buffett is an expert on financials–he runs a gigantic insurance company, after all.  On tech and resources, not so much, in my opinion.  Financials are the second-largest sector in the S&P 500, making up 16% of the total.  Tech makes up 19.5%; Energy is 8.3%; Healthcare 14.9%.  The latter three total 42.7% of the index.  As a portfolio manager, it’s hard enough to beat the index in the first place.  Being weak in two-fifths of it makes the task even harder.

investment wildcard: Grexit

My first employer on Wall Street had an unusually aggressive negotiating style.  At one time, a big brokerage firm wanted to buy the company he founded.  They agreed on a price after lengthy negotiations.  Two weeks later, my boss reopened the negotiations and successfully raised the bid.  Then he did it again.

On the day the contracts were going to be signed, he asked for another 5%, figuring, I think, that the buyer would have no choice but to acquiesce rather than see all the time and effort it had put into the deal go up in smoke.

The buyer walked out the door instead.

According to the Japanese companies I’ve talked to over the years, Chinese government officials use the same psychological ploy–agree, let the other side relax and celebrate  …and then ask for more.  The one difference with China is that twenty years ago manufacturing there gave you both a labor cost and a capital cost advantage over making things elsewhere (the only instance of this I’ve seen in thirty years as an analyst).  So there was no question of going elsewhere.

From my casual observation, Greece has been using this same negotiating style with the rest of the EU over the past few years.  I suspect, however, that Greece’s position is closer to that of my old employer rather than China’s.

How so?

–Greece is small, representing only about 3% of the EU’s GDP.  Arguably, the most important thing it brings to the union is the cachet of once having been the cradle of democracy.

–EU financial institutions are much better able to withstand the shock of a Greek exit from the union than they were in the depths of the financial crisis.

–Greece has complied with virtually none of the dozen-plus structural reform mandates required by the current bailout, which expires at the end of this month.  This gives the EU no reason to believe that Greece will follow through on any terms it agrees to now

–allowing an unrepentant Greece to remain in the EU under far more relaxed standards than afforded to, say, Spain, could easily prove more destabilizing to the EU than cutting ties

–the negative economic consequences for Greece of Grexit could be enormous–enough to provide a cautionary example for other states, or regions within states to reconsider separatist movements.

my take

I think Greece is holding a much weaker hand than is commonly perceived.  I think that the chances Greek government negotiators will take the one step too far that will cause the other side to leave the room are significant–although I have no idea how to quantify that.  Finally, I think any negative reaction to an actual Grexit, ex Greek stocks, which I imagine would do very poorly, would be shorter and milder than the consensus thinks.

what will a soft dollar-less world look like

Yesterday I wrote about an EU regulatory movement to eliminate the use of soft dollars by investment managers–that is, paying for research-related goods and services through higher-than-normal brokerage commissions/fees.

Today, the effects of a ban…

hedge funds?

I think the most crucial issue is whether new rules will include hedge funds as well.  The WSJ says “Yes.”  Since hedge fund commissions are generally thought to make up at least half of the revenues (and a larger proportion of the profits) of brokerage trading desks, this would be devastating to the latter’s profitability.

Looking at traditional money managers,

 $10 billion under management

in yesterday’s example, I concluded that a medium-sized money manager might collect $50 million in management fees and use $2.5 million in soft dollars on research goods and services.  This is the equivalent of about $1.6 million in “hard,” or real dollars.

My guess is that such a firm would have market information and trading infrastructure and services that cost $500,000 – $750,000 a year in hard dollars to rent–all of which would now be being paid for through soft dollars.  The remaining $1 million or so would be spent on security analysis, provided either by the brokers themselves or by third-party boutiques (filled with ex brokerage house analysts laid off since the financial crisis).

That $1 million arguably substitutes for having to hire two or three in-house security analysts–and would end up being distributed as higher bonuses to the existing professional staff.

How will a firm pay the $1.6 million in expenses once soft dollars are gone?

–I think its first move will be to pare back that figure.  The infrastructure and hardware are probably must-haves.  So all the chopping will be in purchased research.  The first to go will be “just in case” or “nice to have” services.  I think the overwhelming majority of such fare is now provided by small boutiques, some of which will doubtless go out of business.

–Professional compensation will decline.  Lots of internal arguing between marketing and research as to where the cuts will be most severe.

smaller managers

There’s a considerable amount of overhead in a money management operation.  Bare bones, you must have offices, a compliance function, a trader, a manager and maybe an analyst.  At some point, the $100,000-$200,000 in yearly expenses a small firm now pays for with soft dollars represents the difference between survival and going out of business.

Maybe managers will be more likely to stick with big firms.

brokers

If history is any guide, the loss of lucrative soft dollar trades will be mostly seen more through layoffs of researchers than of traders.

publicly traded companies

Currently, most companies still embrace the now dated concept of communicating with actual and potential shareholders through brokerage and third-party boutique analysts.   As regular readers will know, I consider this system crazy, since it forces you and me to pay for information about our stocks that our company gives to (non-owner) brokers for free.

I think smart companies will come up with better strategies–and be rewarded with premium PEs.  Or it may turn out that backward-looking firms will begin to trade at discounts.

you and me

It seems to me that fewer sell-side analysts and smaller money manager investment staffs will make the stock market less efficient.  That should make it easier for you and me to find bargains.

 

 

 

the demise of soft dollars

This is the first of two posts.  Today’s lays out the issue, tomorrow’s the implications for the investment management industry.

so long, soft dollars

“Soft dollars” is the name the investment industry has given to the practice of investment managers of paying for research services from brokerage houses by allowing higher than normal commissions on trading.

Well understood by institutional, but probably not individual, clients, this practice transfers the cost of buying these services–from detailed security analysis of industries or companies to Bloomberg machines and financial newspapers–from the manager to the client.  In a sense, soft dollars are a semi-hidden charge on top of the management fee.

In the US, soft dollars are reconciled with the regulatory mandate that managers strive for “best price/best execution” in trading by citing industry practice.  This is another way of saying:   whatever Fidelity is doing–which probably means having commissions marked up on no more 15%-20% of trades.

In 2007, Fidelity decided to end the practice and began negotiating with brokers to pay a flat fee for research.  As I recall, media reports at the time said Fidelity had offered $7 million in cash to Lehman for an all-you-can-eat plan.  Brokerage houses resisted, presumably both because they made much more from Fidelity under the existing system and because trading departments were claiming credit for (and collecting bonuses based on) revenue that actually belonged to research.

theWall Street Journal

Yesterday’s Wall Street Journal reports that the EU is preparing to ban soft dollars in Europe for all investment managers, including hedge funds, starting in 2017.

not just the EU, however

Big multinational money management and brokerage firms are planning to implement the new EU rules not just in the EU, but around the world.

Why?

Other jurisdictions are likely to follow the EU’s lead.  Doing so also avoids potential accusations of illegally circumventing EU regulations by shifting trades overseas.

soft dollars in perspective

in the US

Let’s say an investment management firm has $10 billion in US equities under management.  If it charges a 50 basis point management fee, the firm collects $50 million a year.  Out of this it pays salaries of portfolio managers and analysts, as well as for research travel, marketing, offices… (Yes, 12b1 fees charged to mutual fund clients pay for some marketing expenses, but that’s another story.)

If the firm turns over 75% of its portfolio each year, it racks up $7.5 billion in buys and $7.5 billion in sells.  Plucking a figure out of the air, let’s assume that the price of the average share traded is $35.  The $15 billion in transactions amounts to about 425 million shares traded.  If we say that the manager allows the broker to add $.03 to the tab as a soft dollar payment, and does so on 20% of its transactions, the total annual soft dollars paid amount to $2.5 million.

foreign trades

Generally speaking, commissions in foreign markets are much higher than in the US, and soft dollar limitations are    …well, softer.  So the soft dollar issue is much more crucial abroad.

hedge funds

Then there are hedge funds, which are not subject to the best price/best execution regulations.  I have no practical experience here.  I do know that if I were a hedge fund manager I would care (almost) infinitely more about getting access to high quality research in a timely way (meaning ahead of most everyone else) than I would about whether I paid a trading fee of $.05, $.10 (or more) a share.

We know that hedge funds are brokers’ best customers.  Arguably, banning the use of soft dollars–enforcing the best price/best execution mandate–with hedge funds would be devastating both to them and to brokerage trading desks.

translating soft dollars to hard

When I was working, the accepted ratio was that $1.75 soft = $1.00 hard.  I presume it’s still the same.  In other words, if I wanted a broker to supply me with a Bloomberg machine that cost $40,000 a year to rent, I would have to allow it to tack on 1.75 * $40,000  =  $70,000 to (the clients’) commission tab.

 

Tomorrow, implications of eliminating soft dollars

 

 

 

 

 

 

a report card for smart beta

Purveyors of “smart beta” equity portfolio strategies have been very popular over the past few years, both with individual investors and with institutions.

The source of the attraction is clear:

smart beta claim to provide better performance than an index fund without engaging in active portfolio management. Actually, it claims to outperform because it doesn’t employ value-subtracting human portfolio managers to muck up the works.  Rather, smart beta operates by reshaping the weightings of stocks in the index according to predetermined computer-managed rules.  (I’ve written about smart beta in more detail in other posts.)

In other words, it’s free lunch.

My observation is that smart beta is a marketing gimmick  …one that has been very successful in bringing in new money, but a gimmick nonetheless.  Basically what it does is to create a portfolio that contains the index constituents, but in different proportions from their index weightings.  The rules for determining the smart beta weightings are set in advance and the portfolio is periodically rebalanced to restore the “correct” proportions.  For my money, the preceding sentence describes active management.  The portfolio managers are just hidden behind a computer curtain.

A simple example of smart beta:  maintain a portfolio of S&P 500 names but have .2% of the money in each stock–rather than having it loaded up with lots of Apple, ExxonMobil, Microsoft, Johnson&Johnson and Berkshire Hathaway.  Historically, this is a strategy that had its best run in the late 1970s – early 1980s, but which followed with a very extended period of sub-par performance.

Anyway,

I was catching up on my reading of the Financial Times over the weekend and came across an article from the FTfm of February 2nd titled,“Smart beta is no guarantee you will beat the market.”

It turns out that of the 10 biggest smart beta ETFs in the US, seven have underperformed over the past three years and five over the past five years.

That’s not that different from what active managers have done.

However, unlike the case for active managers, assets under smart beta management have grown fivefold since 2009.