• Phronimos

concentration or leverage, but not both

During the March quarter we sold our remaining holdings of Discovery, prior to the sudden collapse in the share price in late March.

We still believe that the company's best days are ahead of it. With its deep library of popular lifestyle and unscripted content that is relatively cheap to produce, we continue to see a place in household entertainment budgets for the new Discovery+ streaming service. In fact, Discovery’s decision to go direct-to-consumer opens up a universe of potential new viewers, both cord-cutters in the US who never had access to the firm’s linear Pay-TV networks, and viewers overseas who never previously had access to Discovery’s large library of content.

The fact that its content remains so widely viewed on traditional cable is one indication that consumers still find the content worth spending time with. Or perhaps there are other reasons why viewers spend such long hours tuned in to Animal Planet.

As a recent article in The Atlantic put it:

Nature documentaries have never been more popular, in part because they offer easy escapism during a rough time, and in part because marijuana has been legalized in much of the United States. The combination is hard to resist, as my experience with A Perfect Planet proves. The stoned attention span perfectly matches the length of each vignette, in which Attenborough’s soothing, avuncular voice guides you through a simple story about animal life. In between, you are treated to epic, empty landscapes and intense close-ups of the rich colors and textures of the nonhuman world, which pop off like fireworks in your wide-open mind. The effect is awe-inspiring but also surprisingly chill.

I imagine that if Elon Musk starts tweeting about watching David Attenborough while high the Reddit crowd will promptly send Discovery's share price to $300!

Although we are long-term investors, at the levels reached back in mid-March our view was that Discovery's share price no longer held any margin of safety. The valuation had moved well beyond the improved outlook for the business.

The extraordinary decline in the share price in late March, down 27% on one day, was noteworthy not just because we were previous holders of the shares, but because the sudden collapse was linked to the implosion of a firm called Archegos Capital, run by Bill Hwang – someone we met several times a number of years ago.

Apart from a deep understanding of the businesses in which he was invested, what I recall most from meeting Bill was his calm, quiet demeanor and a near perfect equanimity in the face of large portfolio concentration risk and volatility in returns. His returns at the time were exceptional.

Like many of the investment greats, the hallmark of Bill’s investment style was to own relatively few securities and hold them in significant size.

The world's best investors don't manage money relative to an index or benchmark – overweighting or underweighting certain sectors, regions, styles or company size. Their focus is always entirely on finding great businesses with attractive economics, whose share prices do not reflect the underlying value of that business. The day-to-day volatility in share prices neither excites them nor causes them to despair.

The grand master of investing, known to all of us, put it as follows:

Our policy is to concentrate holdings. We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts.

I will freely admit this is one area at Phronimos (and just one of them) where we fall short. We are not concentrated enough, not by a long shot! As of this writing, we hold 18 investments and our largest five investments represent 26% of capital. Over time we expect to drive that number to between 40% to 50%.

This approach of holding only a handful of large individual stocks can substantially increase the volatility of a portfolio as movements in individual share prices tend to be much greater than the market as a whole. But if you reject the premise that ‘risk’ is synonymous with ‘volatility’ (and throw out financial academic concepts such as the non-diversifiable risk, or ‘beta’ of a stock) then holding a concentrated portfolio of carefully selected securities is no more likely to expose you to permanent capital loss than holding a diversified portfolio.

It wasn’t portfolio concentration by itself that led to the large, permanent loss of capital at Archegos. It was concentration and something else. And that something else is a tale as old as time: leverage.

From what we understand, Archegos made extensive use of total return swaps where they were able to retain the gains or losses on an enormous quantity of underlying shares with only minimal amounts of cash or collateral lodged with their investment banking counterparties. Some reports have suggested leverage ratios of around five to one.

According to reports (and perhaps there is more to this story yet to emerge), when one or two of Archegos’s large holdings declined in value, it received calls from its prime brokers to place more collateral, i.e., it received a margin call. Media reports suggest that at some point the prime brokers started dumping the shares backing these total return swaps to protect themselves from further losses, leading to the wild price declines seen in the likes of Discovery and ViacomCBS. Those who moved last suffered the worst. Credit Suisse has reported it will suffer a $4.7bn loss – an extraordinary amount for exposure to one client!

Many hedge funds and trading firms use lots of leverage. What appears to have made the Archegos situation so explosive was the combination of leverage AND portfolio concentration.

You can do one or the other, but you can’t do both.

Concentration does increase the swings in portfolio value, or volatility. That is not the same thing as ‘risk’ per se. No one is forcing you to sell your securities to the manic-depressive Mr. Market at an artificially low price. Unless of course you acquired those securities with borrowed funds on terms that allow the lender to sell your stocks with no notice whatsoever, which is what margin lending is.

Margin debt is a variable rate, short-term debt facility, that allows the lender to accelerate repayments (by increasing margin requirements) or effectively recalling the loan with no notice by simply selling the underlying shares without the investor’s permission, locking in potentially devastating losses.

This is what the SEC’s website has to say about margin loans:

Understand Margin Calls – You Can Lose Your Money Fast and With No Notice

If your account falls below the firm's maintenance requirement, your firm generally will make a margin call to ask you to deposit more cash or securities into your account. If you are unable to meet the margin call, your firm will sell your securities to increase the equity in your account up to or above the firm's maintenance requirement.

Always remember that your broker may not be required to make a margin call or otherwise tell you that your account has fallen below the firm's maintenance requirement. Your broker may be able to sell your securities at any time without consulting you first. Under most margin agreements, even if your firm offers to give you time to increase the equity in your account, it can sell your securities without waiting for you to meet the margin call.

Borrowing on these terms takes control out of the hands of the investor. The investor’s analysis might be dead right, and the stock worth multiples of the price paid, but if he or she is forced to sell when the price temporarily falls 30%, what good is it?

This loss of control is why the massive rise in margin debt for the stock market as a whole is concerning. As the Wall Street Journal reported recently, money borrowed to buy stocks has increased by 49% over the year to February to $814 billion.

As the Journal notes, the last time it rose that fast was 2007 and 1999 – those dates should give any investor pause. Any withdrawal by lenders, be it via a shrinkage in total lending, an increase in required collateral or higher rates, could result in forced sales of securities regardless of price or intrinsic worth.

To be clear, not all leverage is as dangerous as margin debt. Used in moderate quantities and structured correctly, debt can be quite beneficial. The nature of the debt is often a critical variable that is overlooked.

Even Warren Buffet is an avid user of one particular kind of debt, despite his affinity for running concentrated equity portfolios. The difference is that Berkshire Hathaway is in the fortunate position of being able to borrow for less than nothing with no obligation to ever repay! As he has explained many times in his annual letter to shareholders, insurance ‘float’ is just that kind of (liability?). The company receives insurance premiums up front, with a promise to pay claims at some point in the future under certain circumstances. In the interim, Berkshire gets to invest that money for itself. To the extent that Berkshire’s underwriting operation generates a profit (i.e. claims paid out are less than the premiums received), the cost for obtaining those funds for its own investment is less than nothing.

Now if Berkshire were to stop writing new insurance tomorrow and wind up the firm, the insurance liabilities would need to be paid out of reserves. In other words, the liability would come due. But the nature of the business is that new policies are written day in, day out, and the insurance ‘float’ continues to grow. In effect, the liability has no fixed maturity as long as the insurance business is a growing concern. The likelihood that Berkshire is a forced seller of Apple shares because its insurance operation shut down is vanishingly small.

Few investors have access to the kind of no-cost, semi-permanent liabilities that an insurance operation provides, and so it behooves them to use leverage only modestly and on the most advantageous terms as possible.

And be extremely wary of combining leverage and portfolio concentration.

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