Buffett Says Bonds Among Most Dangerous Assets on Inflation - Businessweek

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Buffett Says Bonds Among Most Dangerous Assets on Inflation - Businessweek

Buffett Says Bonds Among Most Dangerous Assets on Inflation

By Noah Buhayar February 09, 2012 7:23 PM EST

(Updates with Buffett’s gold comment in 10th paragraph.)

Feb. 9 (Bloomberg) -- Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc., said low interest rates and inflation should dissuade investors from buying bonds and other holdings tied to currencies.

“They are among the most dangerous of assets,” Buffett said in an adaptation of his annual letter to shareholders that appeared today on Fortune magazine’s website. “Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as these holders continued to receive timely payments of interest and principal.”

Buffett, 81, who built Omaha, Nebraska-based Berkshire from a failing textile maker into a firm selling insurance, energy and jewelry through acquisitions and stock picks, echoed Laurence D. Fink, chief executive officer of BlackRock Inc. Fink said this week that investors should be 100 percent in equities, because of depressed stock valuations and the Federal Reserve’s pledge to keep interest rates low.

“High interest rates, of course, can compensate purchasers for the inflation risk they face with currency-based investments -- and indeed, rates in the early 1980s did that job nicely,” Buffett wrote. “Current rates, however, do not come close to offsetting the purchasing-power risk that investors assume. Right now bonds should come with a warning label.”

The Fed has kept borrowing costs near zero, and said last month that economic conditions may warrant “exceptionally low levels” for rates through at least late 2014 to boost the economy and put more Americans back to work. Buffett said other currency-based investments that may pose a risk include money- market funds, mortgages and bank deposits.

IBM, Coca-Cola

Berkshire still holds bonds, primarily Treasuries, for liquidity, and has a preference to invest in companies by buying them outright or acquiring stock, Buffett said. The firm purchased Lubrizol Corp. for about $9 billion and took a more than $10 billion stake in International Business Machines Corp. last year.

Berkshire had more than $68 billion of equities as of Sept. 30 including the largest stakes in Coca-Cola Co. and Wells Fargo & Co., the biggest U.S. bank by market value. Fixed-maturity investments of about $34 billion included holdings of government debt, corporate bonds and mortgage-backed securities. Cash and cash equivalents were about $34.8 billion.

The Standard & Poor’s 500 Index has climbed 7.3 percent this year through yesterday after being little changed in 2011. Yields on 10-year Treasuries rose above 2 percent for the first time in two weeks yesterday after touching a record low of 1.67 percent in September.

‘The Fearful’

Buffett said investors should avoid gold, because its uses are limited and it doesn’t have the potential of farmland or companies to produce new wealth. Achieving a long-term gain on the metal requires an “expanding pool of buyers” who believe the group will increase further, he said.

“What motivates most gold purchasers is their belief that the ranks of the fearful will grow,” he wrote. “During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth -- for a while.”

Gold prices have climbed to more than $1,700 an ounce from less than $300 in the last decade, as investors sought safety in bullion.

Buffett uses his annual letter to Berkshire shareholders to opine on the economy, the firm’s operating units, corporate governance and other issues. The full document accompanies financial statements and will probably be released later this month.

--Editors: Dan Kraut, William Ahearn

To contact the reporter on this story: Noah Buhayar in New York at nbuhayar@bloomberg.net

To contact the editor responsible for this story: Dan Kraut at dkraut2@bloomberg.net

Wealthy Investors Shrug at Facebook IPO After Private Purchases

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Wealthy Investors Shrug at Facebook IPO After Private Purchases

(Bloomberg News) Wealthy investors aren't clamoring for a piece of Facebook Inc.'s initial public offering because some own the stock through private transactions while others shy away from risky technology deals, according to advisors. "It's kind of the late arrivals who get excited around the time of the IPO," said Jason Thomas, chief investment officer of Aspiriant, whose clients on average have about $10 million under management with the Los Angeles-based firm. "Our clients remember the tech bubble very well, and are appropriately skeptical of being the last money in."

Facebook, the world's biggest social-networking service, filed yesterday to raise as much as $5 billion in the largest Internet IPO. Morgan Stanley, Goldman Sachs Group Inc., JPMorgan Chase & Co., Bank of America Corp., Barclays Plc and Allen & Co. were hired to handle the deal for the Menlo Park, California- based company. The $5 billion figure is a placeholder used to calculate fees and may change.

Based on recent IPOs, investors who are able to buy in at the offering price once it's determined could be looking at below-average returns if they seek to buy and hold. They may face a large tax bite if they sell into an early run-up in the stock price.

Ed Reinhart, 41, holds about 5 percent to 10 percent of his personal portfolio in Facebook after buying shares in 2010 through SharesPost Inc., a secondary market for private-company stock. He said he likes the company's revenue-growth prospects and isn't looking to increase his position in the initial offering.

Buying the Hype

"You don't want to buy into the hype," said Reinhart, who lives in Yakima, Washington, and is a managing partner for Capital Advisors Wealth Management, which works with institutional retirement plans. "I think it would be very wise for individual investors to stay back and let some of this steam escape, and see where all of this shakes out."

SharesPost and SecondMarket Holdings Inc. facilitate transactions in private-company stock for accredited investors. That generally means individuals with assets of greater than $1 million, excluding a primary residence, or those earning more than $200,000 annually. SharesPost has offered transactions in Facebook shares since 2009.

Investors holding private-company stock at the time of an IPO generally are not permitted to sell their holdings for a certain period of time after the offering, generally as long as 180 days, according to Tim Sullivan, managing director of SharesPost.

Venture Capital Firms

Goldman Sachs in January 2011 halted a planned offering of Facebook shares to U.S. investors on concerns that media attention about the deal could violate rules limiting the marketing of private securities. Instead Goldman Sachs restricted the offering to non-U.S. investors, with Facebook raising $1.5 billion through Goldman Sachs clients and funds along with Digital Sky Technologies.

Some clients of Constellation Wealth Advisors LLC have invested in Facebook through venture-capital funds or the secondary market, said David Arizini, a managing director and partner at the firm in Menlo Park, California, whose investors generally have at least $10 million in investable assets.

Signature, which oversees about $2.1 billion for families, has been invested in private equity and hedge funds that have owned Facebook for a few years, said Andrew Gorczyk, a portfolio manager for the Norfolk, Virginia-based firm. He declined to name the specific firms or funds.

Most clients haven't expressed an interest in Facebook, said John Jennings, senior vice president of St. Louis Trust Co., a multifamily office based in St. Louis, which oversees about $3 billion for clients with an average of $75 million under management.

‘Quick Buck'

"It's more exciting than having another muni bond in your portfolio," Jennings said. "But the way we invest, we're not going to load up on Facebook and try to make a quick buck."

While some companies go public and do extremely well, the "odds are against you," as some firms start trading at a high price point and then underperform or fail, said Scott Schermerhorn, chief investment officer at Granite Investment Advisors in Concord, New Hampshire, which manages about $500 million.

Shares of Groupon Inc. gained about 31 percent in their first day of trading after the firm's November IPO, and have since fallen about 22 percent as of Jan. 31, according to data compiled by Bloomberg.

Stocks of companies that held U.S. IPOs in 2011 lost about 1.1 percent on average from their offerings through Jan. 30, according to data compiled by Bloomberg. The Standard & Poor's 500 Index returned about 5.1 percent over the year through Jan. 30, including reinvestment of dividends.

Google Shares

Shares of Google Inc. jumped 18 percent on their first day of trading after the company went public in August 2004 and have risen more than 500 percent since, Bloomberg data show.

Many investors may already have exposure to Facebook even if they haven't deliberately acquired shares through the secondary market or a private fund. About 50 mutual funds have reported stakes in the company, according to Chicago-based Morningstar Inc.

Funds managed by T. Rowe Price Group Inc. held about $408 million in Facebook at the end of December, according to spokesman Robert Benjamin. Morgan Stanley Institutional Fund Opportunity Portfolio held about 3.7 percent of assets in Facebook as of December, making it the fund's ninth largest holding, according to the Morgan Stanley website.

Asking for Shares

Fidelity Contrafund held about $87 million in Facebook's Class B shares in December, according to the fund's monthly holdings report. That amounts to about a 12 basis-point allocation for the fund, which had assets of about $73 billion in December, according to spokeswoman Sophie Launay. A basis point is 0.01 percentage point.

People who have a broker may be able to ask for shares and the allocation may be determined by how much business they did at that investment banking or brokerage firm, said Todd Morgan, senior managing director at Los Angeles-based Bel Air Investment Advisors, which manages about $6 billion. Investors trying to obtain shares now may not gain access to a large enough allocation to have an impact on their portfolios, he said.

"It is difficult for most investors to access shares at the IPO price," Kathleen Smith, principal of IPO investment adviser Renaissance Capital LLC, said in an e-mail. "Even the best institutional clients of Wall Street only get a small portion of their order filled at the offering price."

‘Feeding Frenzy'

Interested investors should study Facebook's financial information in the prospectus, including its growth rate, sales margins and cash on the balance sheet, and wait until the Facebook IPO has begun trading, Smith said. Facebook is considering a valuation of $75 billion to $100 billion, two people with knowledge of the matter said last week.

"People get caught up in the feeding frenzy that surrounds these opportunities," said Gerri Walsh, vice president of investor education for the Financial Industry Regulatory Authority, the self regulator for the securities industry. "When a potential IPO is highly publicized and well-covered, people think that any way into that deal might be a legitimate way."

The U.S. Securities and Exchange Commission in November filed an emergency enforcement action to stop what it said was a fraudulent scheme targeting investors trying to gain access to pre-IPO technology companies such as Facebook and Groupon.

Higher Tax Rates

Managers of the Praetorian Global Fund falsely claimed that their fund and related entities owned "shares worth tens of millions of dollars in privately held companies that were expected to soon hold an initial public offering," according to an SEC statement. The individuals claimed that client funds were held in escrow while in fact they were being transferred to the managers' personal accounts, the SEC said in the statement.

While investors should be aware of the risks of trying to get a piece of the Facebook action this late in the game, their interest is understandable, said Aspiriant's Thomas.

"Our Silicon Valley clients have been outbid for houses by Google employees often enough," Thomas said.

Those who do obtain shares at the offering price and sell into an initial jump could face higher tax rates on their profits. Gains on stocks held one year or less generally are taxed at an individual's ordinary rate, currently as high as 35 percent, while long-term gains usually are taxed at a maximum levy of 15 percent, according to the U.S. Internal Revenue Service.

"Who knows if it's going to be the next Google," said Reinhart, the individual investor. "But even if you bought Google in the first year, you've still done well."

Analysis: Equity risk premium set to shrink

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Analysis: Equity risk premium set to shrink

By Simon Jessop and Clare Kane

LONDON (Reuters) - The extra return demanded by holders of European equities over safe-haven sovereign debt is set to retreat from record highs unless investors' worst fears over global growth come true.

That return, known as the equity risk premium, is a measure of relative value between stocks and bonds and stands at twice its long-term average, Thomson Reuters data showed. While various measures of earnings growth and bond yields will produce slightly different figures, the trend remains the same.

One part of the risk equation relies on stock prices, which many think have fallen too much, while the other rests on the yield offered by countries such as the United States, the UK and Germany on their debt, and here things are far from normal.

Central bank stimulus efforts in the first two countries and safe-haven flight to German debt by investors seeking to preserve capital in the euro zone crisis, have driven returns on bonds to record or multi-year lows.

Against this backdrop, analysts said share prices have taken too big a hit - double-digit declines in 2011 - and so should begin to adjust, leading to a paring in the hefty premium over the coming weeks and months.

"I would take this as a mispricing and I take it to be a buying opportunity for equities," Tom Elliott, global strategist at JPMorgan Asset Management, said.

Euro zone blue chips (.STOXX50E) fell 17 percent last year, largely on macro-economic concerns, but dividends are healthy, companies are cash-rich and many can tap into growth around the world, analysts said.

That makes them attractive in income terms for investors shopping around and finding a negative real return on UK gilts, U.S. Treasuries and German Bunds when inflation is factored in.

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For a graphic comparing regional equity risk premia, click here: http://link.reuters.com/mum95s

For asset performance in 2012, click here: http://link.reuters.com/nyw85s

For global government bond yields, click here: http://link.reuters.com/ser95s

For S&P equity earnings yield vs 10-yr Treasury yield (live graphic), click here: http://link.reuters.com/sed23s

For developed country comparison (live graphic), click here: http://link.reuters.com/ved23s

For global sector comparison (live graphic), click here: http://link.reuters.com/bud23s

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POLITICAL RISK

The risk premium can vary depending on the measure of equity value and what is considered "risk-free" - a notion eroded by the debt crisis.

"The concept of risk-free appears to be under attack across financial markets," Jonathan Stubbs, European equity strategist at Citi, said. "Credit risk is rising across many sovereign bond markets."

That risk recently saw France's credit rating downgraded along with those of eight other euro zone sovereigns.

Using Bunds, traditionally seen as Europe's risk-free rate and now offering rock bottom yields, the euro zone's ERP stands at 11.1 percent, but in Italy, where the rate on government bonds has spiked in recent months, the ERP is 9.4 percent.

Unlike at the height of the financial crisis when banks' balance sheets were in focus and the risk premium rose as stocks fell, investors are now more inclined to price in political risk, which has contributed to the inflated ERP.

"Investors are much more aware this time of the capacity for credit events to severely impact global economic growth and therefore earnings," Ian Scott, global head of equity strategy and quantitative research at Nomura, said.

That said, the outlook for stocks is not a one-way bet.

In spite of a positive start to the year, with global shares .MIWD00000PUS up 5 percent, Garry Evans, global head of equity strategy at HSBC, said in a note he expected 2012 to be a volatile year that ends flat.

"The news that France and others had their credit ratings cut and the near-failure of the Greek negotiations should remind investors that risks still lurk."

GLOOMY MARKETS

The degree to which equities are undervalued depends on the growth outlook, but while global growth is still being revised down, with the World Bank just the latest to do so, data shows stock markets are even more bearish.

Germany's DAX (.GDAXI), the leading euro zone index by market capitalization, is priced as if compounded earnings per share growth will fall 5 percent every year for five years, StarMine data showed

Peter Oppenheimer, chief equity strategist at Goldman Sachs, said that at current levels of return on equity and expected growth, the STOXX Europe 600 (.STOXX) should be trading at around 420 points. It traded close to 255 points on Friday.

Signs the global industrial cycle is bottoming out, "which tends to be supportive for equities," could help close the gap, Oppenheimer said.

If that feeds into equity market sentiment and market pessimism wanes, the equity risk premium will be trimmed even if the other key input - bond yields - stay low.

Nomura's Scott said he would be looking for the ERP to come down over the first half of 2012 "unless we see things in the euro zone deteriorating considerably."

(Additional reporting by Pratima Desai, graphics by Scott Barber and Vincent Flasseur, editing by Nigel Stephenson)

Risk Bites Back: Lessons Learned From The Harvard Endowment

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Risk Bites Back: Lessons Learned From The Harvard Endowment

The success of Harvard's endowment in recent decades helped popularized a new approach to university endowment investing that generated enormous gains. But when the 2008 financial crisis hit, Harvard's fund took a bath and exposed weaknesses in its asset management approach. Harvard’s experience offers lessons for financial advisors increasingly interested in alternative investments.

During the period when Jack Meyer managed the Harvard Management Company (HMC), the university’s endowment went from $4.7 billion in 1990 to $22.6 billion when he left in 2005. That included 15% average annual returns during his final ten years at the fund. Meyer used a model similar to the approach articulated by David Swensen, the head of the Yale endowment, in his book Pioneering Portfolio Management. One of the chief tenets of this approach, often referred to as the Yale model, was the view that liquidity was not always desirable because liquid assets generally have lower returns.

Both Meyer and Swensen de-emphasized stocks and bonds, and added alternative assets such as hedge funds, private equity, commodities, real estate and timber acreage.

Meyer was succeeded by Pimco's Mohamed El-Erian, who left after less than two years. His replacement, Jane Mendillo took the helm in July 2008, or just in time for the financial meltdown. In the fiscal year ending June 2009, Harvard’s endowment fund lost 27.3% and sank in value by an eye popping $11 billion. That forced layoffs at both HMC and at Harvard University, which curtailed planned campus expansions and prompted re-examinations of the portfolio and its underlying philosophy. (Yale’s endowment plunged 24.6% during the same period.)

What went wrong? Well, many things. An attempt to lock in low interest rates backfired, and HMC lost more than $550 million on a series on interest-rate swaps. Alternative assets fell, as did public-equity holdings. Attempts to sell private-equity fund stakes were unsuccessful, and with more than $11billion in potential capital calls from private-equity firms, HMC was forced to sell more than $2 billion in stocks. It also issued debt to boost liquidity by selling $2.5 billion in bonds.

Since then, Mendillo has worked to trim commitments to private-equity funds, and announced last fall that some real estate holdings were on the block for sale. Leverage has been eliminated and Mendillo has introduced a modest cash allocation. In it’s most recent report for the fiscal year ending June 2011, the endowment said it returned 21.4% and boasted assets of $32 billion, which remains below its pre-crisis peak of $36.9 billion.

Mendillo believes she is halfway through turning around the fund, and will continue to improve liquidity. And despite the crisis, HMC has still bested the market over the past decade with average annual returns of 7% from 2001 through 2010 versus the S&P 500 return of 1.7% during that period.

While HMC’s long-term success is noteworthy, cautionary lessons can be drawn from its recent travails? For starters, many of the alternative investments used by HMC––such as private equity and hedge funds––don’t always cushion the blow during bear markets. Specifically, HMC's private-equity investments declined by 31.6% and its hedge funds fell 18.6% fall during fiscal year 2009.

The use of alternatives should not be seen as a risk free form of diversification.“Some of the proponents of the Yale model view it as a diversification decision, which is reasonable,” says Brad Barber at UC Davis, who has studied endowment returns. “But some proponents argue only for the higher returns these models have achieved without acknowledging the inherently higher volatility of illiquid assets. There is no free lunch- you get these returns by giving up liquidity.”

Barber also notes that these alternative investments were crucial to HMC's longer-term success. “Alternative asset class allocation explains much of the out-performance of university endowments. They were in the right place at the right time.”

With the financial crisis now in the rear-view mirror, should alternatives become central to long-term portfolios? Barber is skeptical. “Its dangerous in 2012 to conclude that private equity and hedge funds will replicate the strong performance of the past,” he says. “The evidence on private equity is that there is no out-performance for the asset class as a whole, after adjusting for the liquidity premium.” He believes that private equity returns are largely correlated to public markets, with an additional liquidity premium, meaning there is little diversification benefit in down markets, if any.

While the future returns of alternative assets remains unknowable, one flaw in HMC's approach is clear––liquidity, or lack thereof. Prior to 2008, HMC ran a leveraged portfolio with 105% exposure, and large allocations to illiquid assets. They did this despite their need to provide annual liquidity to university's operating budget. “The main lesson is that liabilities matter and they didn't invest according to their liabilities,” says says Andrew Ang of Columbia University. “One-third of the university's operating expenses were paid by the endowment, but they managed it as though they had no explicit liabilities. Endowments achieved high returns with illiquid investments through 2008, and then that risk bit back.”

The lessons of Harvard are relatively straightforward. Namely, advisors need to make sure that near-term cash needs are not neglected in asset allocation. Diversification helps, but does not prevent losses. Most importantly, the HMC debacle demonstrates the same basic lesson that felled Lehman Bros., which bet on real estate while relying on short term repos for liquidity, and Bear Stearns, which binged on sub-prime mortgage assets while funding itself with short-term paper. For all of these financial giants, the combination of leverage and illiquidity was toxic.

Jefferson National Successfully Completes Management Buyout

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Jefferson National Successfully Completes Management Buyout

Jefferson National Financial has completed a management buyout led by Financial Partners Fund (FPF), a unit of Citi Capital Advisors, the Stephens Group and private investor Eric Schwartz. Jefferson National CEO Mitchell H. Caplan, who led the management team that orchestrated the buyoutl, said the new capital will be used to expand its registered investment advisor (RIA) and fee-based advisor distribution strategy.

As part of the $83 million transaction, Jefferson National, architect of the flat-fee variable annuity, will use its new capital to accelerate growth and target several areas: high-net-worth (HNW) investors, RIAs and fee-based advisors, and new products and services for financial advisors.

“We couldn't be more pleased with the exceptional roster of investors who have put their resources behind us and are extremely fortunate that Eric Schwartz will serve in the role of non-executive chairman of the company,” Caplan said.

Robert Covington, managing director of The Stephens Group, said the transaction furthers the firm's strategy of investing in financial services companies with a fast-growing and unique position in an expanding market.

With a national network of more than 1,500 RIAs and fee-based advisors, Jefferson National is a leading distributor to the fee-based channel. Jefferson National in 2005 launched Monument Advisor, the first flat-insurance fee variable annuity with the industry's largest selection of more than 350 funds.

Schwartz, who has agreed to be a non-executive chairman of Jefferson National, is a private investor who is a former partner and management committee member of Goldman, Sachs who served as Co-CEO of Asset Management.

FPF is a proprietary investment fund that seeks to provide primary, secondary and special situations capital to financial services business.

The Stephens Group LLC is a private, family-owned firm that invests its capital in private and public companies.