Tuesday, March 30, 2010

Regulating leverage

Does regulating leverage have a future even when value investors believe its the only way to make a decent return?

Value investors love to deride academics and the efficient-market hypothesis, but they can’t deny that stock-screening tools and other analytics have taken away many of the best bargains. At least some managers have lost the will to wait patiently for superdeals and have taken on more risk to get more return. As we walked to dinner through the soft Omaha twilight, a fund manager I had encountered at a “meet and greet” suddenly said, “The only way to make money these days is leverage.”

We had been discussing Mohnish Pabrai, a famous value-fund manager and author, whose portfolio had reportedly declined severely in 2008. Pabrai’s apparent willingness to invest in leveraged situations where a major loss is possible has caused some to argue that he isn’t really a value investor. But here was another Buffett follower essentially defending leveraged investing, because only leverage generates the kind of returns we’ve all come to expect. Investing in a highly leveraged company, or in a bunch of them, exposes you to many of the same risks as taking on leverage yourself. And my dinner companion seemed to be saying that value managers couldn’t compete with other funds without taking at least some of those bets.

This is a controversial position. Yet arguably, even Warren Buffett himself profits from substantial financial leverage. Like banking, insurance is in some sense a leveraged bet. Companies take on large deferred liabilities, in the form of future claims or account withdrawals, in exchange for payment now. They make their money by investing most of the proceeds from the deposits or premiums and keeping a moderate cash reserve, relying on the pooling of many accounts to ensure that at any one time, the demands on their assets will be smaller than the reserves set aside to cover them. Like banks, insurance companies are therefore vulnerable to a sudden mismatch between claims and underlying assets.

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