Random Market Questions Answered III

Dave commented on one of my blog posts entitled Random Market and Order Flow Thoughts.

Dave asked:

Dave asked a very good question.  Here is my response.

Warren Buffett is a long term investor.  Everyone requires order flow to validate their analysis and investments.  Most people don’t consider themselves order flow traders.  Buffett certainly doesn’t.  He calls himself a “value investor”.

Warren Buffett is not looking to catch the next 1% move or 2% move in a stock.  Heck, he isn’t trying to catch the next 5% or 10% move.  Buffett has tens of billions of dollars that he needs to put to work and invest.  Because he has all this money, he can’t or doesn’t want to daytrade with the money.  He can’t or doesn’t want to swing trade with the money.  Heck, he doesn’t even want to hold positions for a few months.  He prefers to hold investments for a few years.

His big capital base along with his value investing mindset forces him into attempting to take advantage of inefficiencies that exist over multi year time frames.  Buffett is not a trader.  He is a value investor.  And as such, he position sizes to take this into account.

Warren Buffett made a $5 billion bet on Bank of America.  He believes its value is higher than that.  He believes that over a multi year time frame the stock can trade much higher.  He is willing to ride through the short term fluctuations in the market.  So if Bank of America drops to $2.50, Buffett is most likely not going to sell.  He will hold onto the investment and hope that over the course of a few years, the stock will trade much higher above $7.14 per share that his warrants can convert into.

For example, if the stock rises to $15 in two years, then his warrants at $7.14 pay off big time and he makes hundreds of millions or billions of dollars.  Warren Buffett is willing to ride through the short term or medium fluctuations to achieve that potential objective.

Warren Buffett doesn’t care about market timing like a lot of traders and speculators do.

Buffett is not going to decipher the news/sentiment/macro/fundamental order flow to determine whether BAC is still going to head downward a bit more over the course of a few days, a few weeks, or a few months.  Buffett doesn’t care about those types of inefficiencies.  Buffett cares about the longer term multi year inefficiencies that exist in markets.

He probably just did his value investing analysis on BAC.  He looked at whatever fundamentals, balance sheets, management, etc that he looks at to help him determine what the “intrinsic value” of Bank of America was.  If Buffett felt that the instrinsic value of BAC was above $7.14 per share and the stock is trading below that, then he felt that he was getting a bargain.  He felt that he was getting a bargain so he bought the $5 billion preffered shares and got the free warrants with the deal.  Buffett isn’t playing the common stocks.  He is getting a sweet deal on the preffered shares that pay a dividend.  And he gets the upside bonus if the warrants pay off.  All the retail investors are playing the common stock of BAC.  Buffett, because of his size and reputation can structure a nice investment for himself.  Buffett gets the 6% return every year on the $5 billion in preffered shares and can participate in the upside of the stock if it happens with the warrants he has.

Buffett isn’t going to try to time the market and attempt to wait a few days to see if the stock goes lower.  If he thinks it is a bargain, he will pull the trigger, even if the stock goes lower.  All Buffett is looking for is that over a multi year basis his investment will pay off.

Position Sizing

Warren Buffett realizes what types of inefficiencies he is taking advantage of and position sizes accordingly.

So if Berkshire Hathaway has $150 billion in assets, and allocates $5 billion to the BAC deal, that represents only 3.3% of the total assets.  This does not mean that he is risking 3.3% of his “account.”  The investment represents 3.3% of his total account.  So in the worst possible situation, if BAC declares bankrupcy and the preferred shareholders get absolutely zero, then Buffett loses all his $5 Billion investment, thus taking a 3.3% loss on his “account.”

If BAC stock just stays stuck around $7.14 below the warrant strike price for the next ten years and the options expire worthless, then Buffett collects the 6% dividend, which is $300 million per year.  A gain of $300 million per year on an “account” of $150 billion is only a 0.20% return per year on that particular investment.

If BAC stock rises above $7.14 and rises above $7.14 over the next ten years, then the warrants have a lot of value and Buffett can make billions of dollars over the next ten years.  Therefore, from his perspective Buffett doesn’t care about the short term volatility or medium term volatility.  As long as BAC doesn’t go bankrupt, and the stock trades above $7.14 at some point over the next ten years, then Buffett is walking away with a profit of a few hundred million or billions of dollars, while at the same time collecting the $300 million dividend per year.

Buffett doesn’t care if the stock drops to $5 or $4 or $3 or $1.  As long as the company stays in business and performs decently well over the next ten years he will make a lot of money.

Buffett has positioned sized for this investment accordingly.  He only invested 3.3% of his total “account” assuming the account has $150 billion dollars.  Buffett is absolutely happy with a 10% return and thrilled with a 20% return.

Buffett isn’t trying to make 50% a year or 100% a year like some retail speculators are trying to.

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Retail Traders Thinking

Retail traders typically don’t structure the investment the same way as Buffett did.  They don’t have access to the preferred shares or free warrants that Buffett got.  So they have to play the position in the BAC common stock.

If a speculator decides to invest in BAC, very few will allocate 3.3% of their account to BAC.

For example, lets say a speculator sees the Warren Buffett news and wants to coattail Buffett and buys BAC @ $8.30 a share.  The speculator has $100,000 in his account.  The speculator buys 12,000 shares and allocates his whole account to the trade.

Nevermind that Buffett only allocated 3.3% of his account to the trade, the speculator wants to allocate 100% of his account to one stock.

That is a big difference between the two.  Buffett and the speculator position size differently.  Buffett allocated 3.3% of his capital to the investment.  The speculator allocated 100% of his capital to the trade (or a number above 3.3%).

The next big difference is their pain tolerance and investment/trade timeframe.  Buffett is comfortable holding for years.  He is not going to get shaken out because he has only allocated a 3.3% of his account to the trade.  In the worst case scenario and horrible scenario, Buffett loses 3.3% of his account.

The speculator on the other hand has allocated 100% of their account and thus if BAC goes bankrupt, the speculator loses 100% of his account.  Also, chances are the speculator is not going to hold through the stock dropping down below support at $6.00 and watch it ride down all the way to $4, and then to $3, and then to $2.  They will cut the trade and take catastrophic losses.

Position Sizing Matters.

And since the speculator cut the trade, their timeframe differs with that of Buffett.  Buffet can wait 10 years for the investment to play out because of his position sizing, time frame and access to special deals.

The speculator can’t hold for 10 years because they have not position sized appropriately for the 10 year time frame period.  They allocated 100% of their account, while Buffett only allocated 3.3%.

Position Sizing and Time Frame Matters.

If the speculator only allocated 3.3% of their account to the BAC trade, then they could ride out the small fluctuations and play the trade along with Buffett.

The problem is the speculator is not trying to make 10% a year or 20% year.

The speculator wants to make 50%, 100% or 1000% in a year.  And as such, they like to take concentrated positions.  They like to use leverage.

Buffett doesn’t use leverage.  Buffett doesn’t want to risk too much to make 50% a year.  He is comfortable with 10% or 20% a year.

The speculators because they want to make a huge % return is willing to play the small fluctuations, the day trades, the swing trades with all of his account, or even use leverage, no matter what market they are trading in.

They could be allocated 100% of their account to a BAC trade.

Or they can do a forex trade and place a trade using 5:1 or 10:1 leverage.

That is what most forex traders do constantly!

When you have $25,000 in your account and you place a trade for 1 standard lot, you are using 4:1 leverage.

If you place a trade for 3 standard lots, you are using 12:1 leverage.

These are all concentrated in one single position and one single trade.  That is how most speculators act.  They want to make 100%+ per year and thus can use leverage.

While Warren Buffett is sitting there allocating only 3.3% of his account to a single investment.  Warren Buffett would never allocate 4:1 leverage or $500 billion dollars to a single trade or investment.  Firstly because it is impossible.  Secondly, because it would be stupid to take on that amount of risk since he already has billions of dollars and doesn’t want to bet his lifestyle.

But the 4:1 leverage and concentrated trades are exactly what retail forex traders do every day.  They are trying to get big and make a million dollars in a year with a small account.  To do that requires use of leverage.  Nothing wrong with the speculator approach.  They just need to know exactly what to do and have a mastery of order flow and liquidity.

Big Differences.

Here is an example of the types of market moves that Buffett doesn’t care about, but speculators can make money on and care about:

Buffett may or may not be right in the end.  I don’t know, nor do I care, for I do not plan to hold a trade for years.

The short term speculator doesn’t care much either.  For they are looking to get in and out.  Sometimes it can be a day trade.  Sometimes it can be a swing trade.  Other times the speculator can hold the trade for a few weeks or few months.

I hope that answered your question Dave.

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