How to earn 300% in a global credit crunch

Interesting articles about hedge funds were able to make billions during the recent meltdown in the credit derivatives market

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Cheers,
Manpreet

Buffett's stock picks in the aftermath of the Credit Crunch

In the aftermath of the credit crunch, speculation was rife that Buffett would purchase stock of ailing mortage lender country wide financials and come to the rescue of Bear Sterns.In fact,quite the opposite has taken placed.Looking at Buffett's most recent purchases in Wells Fargo and US Bankcorp, Buffett has stayed within his circle of competence and stuck with companies with good ,rational managements who avoided playing risky financial instruments.In fact, a line from the 2004 BRK Shareholder meeting gives us some insight into Buffett's thought process regarding his recent stock purchases...

On Wells Fargo and Its Derivatives Risk [A shareholder asked why Buffett felt comfortable owning Wells Fargo stock, and even buying more, given its exposure to derivatives. Buffett replied:]

WB:I don’t have Wells Fargo’s annual report here, but I’d bet that J.P. Morgan Chase is far larger [in terms of exposure to derivatives]. I don’t think of them [Wells Fargo] as being a big player in the derivatives game.

It's clear that Buffett has made use of Mr Market's recent mood swings to buy well managed good businesses at attractive prices.With his cumulative knowledge built up over the years reading annual reports, it seem almost intuitive to purchase these companies..

Here is a link to his most recent stock purchases

In addition, here are his most recent comments about the recent turbulence in the financial markets and how he approaches it

WB:It is the nature of capitalism to periodically have recessions. People overshoot. So, it isn't the end of the world. I mean, as a matter of fact, for an investor, you know, it turns out to be the times when you make your best buys. I made by far the best buys I've ever made in my lifetime in 1974. And that was a time of great pessimism and the oil shock and stagflation and all those sort of things. But stocks were cheap.

Guess it's time to start digging through all those 10ks and 10qs

Cheers,
Manpreet

Mathematicians' role in market mayhem

Interesting article about how quants are behind the chaos in the financial markets.Paul Wilmott is a leading authority and well respected figurehead in the field of quantitative finance with several widely used textbooks to his name

Here is an excerpt

"Paul Wilmott is someone with privileged access to the usually secretive world of the quants.

He runs a website where quants discuss mathematical problems and can watch lectures on quantitative finance 24 hours a day. He talks regularly to those working in a wide range of banks and hedge funds.

He believes the accusation that many banks use the same models is true: "The way in which quants are compensated encourages them to use the same strategies as everyone else."

He claims that many quants calculate that if they lose money as a result of following a novel strategy they will be fired.

However, if they lose money as a result of following the same strategy as everyone else, they will not get the blame.

"The problem with this," says Mr Wilmott, "is that if something bad happens, it happens across the board."

Consumer benefits

Another problem, according to Mr Wilmott, is that academically trained mathematicians are more used to modelling sound physical principles than difficult-to-predict financial markets:

With finance you are essentially modelling human beings which is much more tricky."

Here is the link to the entire article

Using the Graham-Dodd-Buffett framework,one gets a clear perspective into the psychology of financial markets and human behaviour.Instead of relying on overpaid quants, Buffett in a gist gives us all we need to succeed as successful investors.

Amazingly,Buffett reveals this priceless piece of wisdom when he was just 21 years old while lecturing a group of students at night time classes

"I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful."

Timeless piece of advice...

Cheers,
Manpreet

Leverage is not for the faint hearted

Following the recent gyrations in the financial markets, one does worry about the degree of financial leverage some of these market players take to achieve better returns.One favorite play by such market players is the yen carry trade.What makes the yen carry trade so dangerous? Read on....

Highly leveraged yen carry trade makes the prospect of financial tsunami more real. Due to the thin spread between currencies, traders have to use leverage in order to realize profits to justify the enormous risks in currency trading. For example, a trader borrows 1000 yen from a bank and converts the funds into US dollars and buys a bond with that amount. Assuming that the bond pays 5.0% and the Japanese interest rate is set at 0.25%, the trader makes a profit of 475 bps. However, using leverage can reward the trader very handsomely. If he uses leverage with a factor of 10:1, he can stand make a profit of 47.5% provided if the exchange rate remains stable.

However, if the yen gains strength and gains from120 yen to 110 yen, the trader now makes a loss. His loss is now 8.3% (120-110/120).But in this case, he has used a leverage factor of 10, so his actually loss is 83%.Clearly this strategy is fatalistic if the Japanese Yen gains strength which can be worse if the investor has made investments into dubious financial instruments such as subprime CDOs, CDS.

In the financial markets, it’s often difficult to measure the size of such carry trades as they involve several currencies. Compounding the already bad situation is the use of swaps, derivatives and futures. Given the increasing diversity of the trades, even seasoned market watchers are unable to predict the next sudden unwinding of the yen carry trade.

The BOJ’s policy of keeping interest rates may cause “distortions” in asset allocations and flows of capital globally. Recently, the Bank of Japan decided to raise interest rate by 25 bps to 0.5 %.This created fears among government officials who felt any increase in interest rates may affect Japan’s slowly recovering economy which is estimated to grow at 2% this year. In Japan’s case, a weak economy needs to keep interests low in order to “stimulate enterprise and investment in economic growth”. Thus, any further increases would be "very gradual" according to the Bank of Japan, leading market players to continue borrowing yen to invest in higher yielding assets abroad. This will only further exacerbate the already worsening situation.

A recent study by Barclay capital raised a few eyebrows. In the study, Barclay stated that “"The magnitude of Japan-funded carry is reaching scary levels, in our opinion," and added that "even if the macro environment remains benign for carry trades, we cannot rule out the possibility of a sudden unwinding of positions that simply feeds on itself.". Even a small fluctuation in exchange rates would cause traders to unwind their positions as they would be unable to afford the losses due to the large amount of leverage that they have employed.

Types of investors

Japanese Insurance companies: Insurance companies make profits through 2 ways

1) Underwriting. Using actuarial science to help quantify risks and determine how much to charge for the insurance policy being underwritten.

2) Investing the premiums from the insurance policies. The insurance companies earn
returns by investing the “float” into a portfolio of equities and bonds

Given the zero interests rates environment, insurance companies were forced to invest abroad in higher yielding assets.

Japanese retirees: Due to the ageing population, more and more Japanese are living longer. However, these retirees need increased returns to meet their old age needs. Investing in the Japan would be difficult given the deflationary environment and low interest rates. Hence, these retirees are forced to invest abroad to seek better returns.

Speculators: The speculators borrow large amounts in yen and aim to use leverage to help generate large profits. Their investment horizon is normally short term and are quick to close money losing trades. This can have an adverse effect especially when the yen carry traders are rushing back to convert foreign currencies back to yen. This can cause the yen to gain in strength, causing further losses to traders who are still holding their position. A sudden influx of financial flow back to Japan can destabilize the foreign currencies and lead to sharp drops in the global financial markets as these traders unwind their positions suddenly.

Time to time,such fluctuations in the market will lead to good value investing ideas.Being patience and waiting for those fat pitches is what investing is all about.

Cheers,
Manpreet

Time to turn bearish

The markets have been crazy i think.

With the Dow Jones Industrial Average moving from 11000 to 13 556 levels, the Nasdaq composite moving from 2000 to 2500 and the S&P moving from around 1200 to 1522 over the last one year or so, It is not hard to conceive that the market might just go into a recession soon. To be honest, we don't know when but when it happens, it might just be one big market correction ahead.

Firstly, although i am not much a fan of economics, i have to admit that the twin deficits in the US might just cause US to go into recession. When that happens, the whole world will fall alongside the US too.

In China, the stock markets have been overheated for a while now in my opinion. In india too, ordinary folks are rushing to open brokerage accounts to capitalize on the booming indian market and the ever rising stock prices of indian equity which seem to have no ceilings.

In fact, across all markets right now, when you start seeing companies with PE ratios of 40 and above, one should start to get scared. I can never imagine paying for companies with PEs of 40 and above. Standards of valuation just don't justify such high mulitples. But the thing is that people are doing it, loving every moment of it.

Bail out slowly people. Be conservative. Live to fight another day. It is simply a matter of time before the world market corrects. When that happens, be ready for it.

With that i leave you with a quote from Warren Buffet: We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.


Better and better,
Lucas

Diversification - How many stocks to own?

Diversification is a controversial topic. The academics advocate diversification while value investors advocate some for of concentration. In fact, Warren Buffet did say: Wide diversification is only required when investors do not understand what they are doing.

I won't say that i am right but i am am definitely of the opinion that diversification really can affect your investing results. To have better results, i feel that one must learn to pick their spots.

The sole purpose of diversification is to reduce non market risk which is risk inherent in a certain stock. An example of non market risk is fires in the company factory or when a particular product is not selling as well. This has to be differentiated from market risk. Market risk is the risk of being in the market. If the market drops, your portfolio drops as well and i doubt there is nothing you can do to aviod that kind of risk.

That being said, what is the optimum number of stocks that one should have in their portfolio? Statistics say that owning 2 stocks help eliminate the non market risk of owning just 1 stock. This risk is reduced by 72 % with 4 stocks in the portfolio and further reduced by 81 percent with 8 stocks. 93% is further shaved off with 16 stocks and, 96 % with 32 stocks and 99% with 500 stocks.

As you can see, you need not own many stocks. Above 8 stocks, diversification does not add much incremental benefit in the for of lowered non market risk. Hence i opine that 8 stocks is a good number. In fact, 6 - 10 is a great number to own. Another advantage of owning a lesser number of stocks is that you have more time to focus on the portfolio.



Cheers,
Lucas