Pilgrimage, Part III: When the Math Doesn’t Work

Note to readers: This was originally published May 11, 2007 as part of a series on the Berkshire Hathaway annual meeting. We republish it here as we prepare for the upcoming 2008 Berkshire Hathaway annual shareholder meeting.

We will resume regular posts, with interruptions for further commodity hoarding bulletins, following the Berkshire meeting in early May.
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The mark of an original thinker may be that you never know how they’re going to answer a question you’ve never heard them get asked.

And when the first shareholder asks Buffett about his views on the current private equity mania sweeping the world’s capital markets—specifically, “What could cause it to bust?”—I expect him to offer a pithy warning about the silliness of running with the herd and the possible future dislocations from just such a bust—dislocations he will be happy to take advantage of, given the fabulously large cash reserves at his disposal, not to mention his eye for a bargain.

As it turns out, however, Buffett doesn’t think the private equity mania is a bubble, despite, in my view, all the evidence to the contrary, what with everything from deeply cyclical semiconductor companies to fashion-dependent retailers being leveraged up with the kind of debt loads that would make Donald Trump nervous.

“It isn’t really a bubble,” he says. It is a boom, certainly, and one in which Buffett sees little to gain from blindly jumping on board. “The math has to make sense to us.” Furthermore, as if all 27,000 people in attendance don’t know it already, Buffett is not into flipping companies the way private equity flipped Hertz, or Burger King, or Dominos…

“We own them forever.”

As to private equity not being a bubble, Buffett points out that in order for a mania like private equity to go “bust,” as the margin-fed bull market did during the 1987 crash, it must have investors who can pull their money out quickly to trigger the kind of panic selling that both causes a crash and marks its nadir.

Private equity investors, he notes, are locked in. “It takes many years for people to take their money out” of private equity funds. Thus Buffett makes the subtle distinction between a mania that might well end in disappointment for all concerned, and one likely to end in a crash.

As for the bull run of 1987, which did end in a crash, Buffett puts the blame squarely on a mania altogether different from private equity funds: it was called ‘portfolio insurance.’

For those of you too young to remember, the wonderfully-misnamed ‘portfolio insurance’ was a financial engineering tool foisted upon institutional money managers eager to participate in the bull market of that era as it gathered steam—without the commensurate downside risk—by financial consultants eager to generate outsized compensation fees.

I still recall the day I first heard the term ‘portfolio insurance’ at one of those same institutions being pitched its wonders by the very firm that had dreamed it up.

It was some time in 1984, and I was an analyst at a plain-vanilla pension-fund shop. By “plain-vanilla” I do not mean “mediocre”: we had a lot of bright people and a great framework for investing our clients’ money. We just didn’t do anything exotic or out of the ordinary.

In fact, ‘portfolio insurance’ was about the most exotic thing I recall us ever looking at. The idea seemed goofy on the face of it—somehow, by shifting money between treasury bills and index futures, an institutional money manager could supposedly ‘insure’ a portfolio against market declines of a certain size over a certain period of time.

But I was merely a lowly stock-picker, not the chief portfolio manager. In fact, the chief portfolio manager was the smartest guy I’d ever worked with up to that point, and the decision whether to even think about the concept was his.

I recall him seated at the table in the Monday morning research meeting, stroking his long sideburns and declaring he had studied the research on portfolio insurance over the weekend.

“The math works,” he said.

And, yes, it did “work,” if by the definition of “work” you mean, “Completely failed to do what it was supposed to do.”

For not only did ‘portfolio insurance’ end up not insuring anybody of anything, it actually triggered the panic selling that culminated in a 22.6% one-day drop on Black Monday—October 19, 1987.

Now, by that time I had moved on to help identify acquisition candidates for a large industrial company, and later joined one of the best money management firms that ever existed, before it was subsequently purchased and destroyed by a large Wall Street firm that shall remain nameless.

Consequently, I have no idea if my former shop had actually engaged in ‘portfolio insurance,’ and, if it had, whether it was still involved when the “math” stopped working on October 19 and the forced mass selling resulted in that very Black Monday.

But it is a fact that computerized selling triggered by funds engaged in ‘portfolio insurance’ turned a Fed-tightening stock market retreat into a “bust.”

And it is the beautiful simplicity by which Buffett can synthesize complex issues with comprehensible analogies that makes these meetings what they are, for here Buffett provides one: “portfolio insurance” he says, stripping a highly complex set of financial-derivatives established by quantitative models to its essence, was nothing more than a giant “stop-loss order” on the market as a whole.

Thus, institutional money managers, or the computers they relied on to ‘insure’ their portfolios, sold stocks into the decline, causing the crash.

As Buffett says, “the math has to make sense to us,” and in the case of ‘portfolio insurance’ it clearly did not.

Next up, compensation committees, executive pay, a possible credit crisis and “the best of all worlds,” along with a question from the lunatic fringe.

To be continued…

Jeff Matthews
I Am Not Making This Up

© 2007, 2008 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.