The Digest #152
Revisiting I Bonds, Reinsurance, Buffett in 1979, Private Equity, Why Inflation Matters, Justifying Optimism, Jim Simons, Jay Gould, Fred Martin
Quote of the Week
“When I was a kid at Woodrow Wilson High School in Washington, another kid and I started the Wilson Coin-Operated Machine Co. I was 15 years old. We put reconditioned pinball machines in barber shops. In Washington, you were supposed to buy a tax stamp to be in the pinball machine business. I got the impression we were the only people who ever bought one. The first day we bought an old machine for $25 and put it out in a shop. When we came back that night it had $4 in it! I figured I had discovered the wheel. Eventually we were making $50 a week. I hadn’t dreamed life could be so good”.
— Warren Buffett, 1979 Interview
Revisiting I Bonds
Over the past couple of years, I have written about Series I Savings Bonds on several occasions. In late 2020, I explained potential uses of both Series EE and Series I Bonds and in late 2021, I wrote that I Bonds offered returns far superior to short term treasury bills and savings accounts — in other words, I Bonds could serve as a cash substitute. I was not the only one writing about this opportunity and the general public eventually joined the party and even overloaded TreasuryDirect’s website.
My primary argument in late 2021 was that I Bonds could serve as a cash alternative for those willing to give up liquidity for at least one year. Do I Bonds still make sense as a “cash substitute” given that short-term U.S. Treasury Bills now yield over 4.5%?
The good news is that the fixed rate for I Bonds has increased from 0% to 0.4%, so investors can now expect to earn 0.4% plus an inflation adjustment represented by CPI-U. For I Bonds issued prior to April 30, 2023, the combined rate is 6.89%. This rate will adjust as the CPI-U changes, but the 0.4% fixed baseline will not change.
The 6.89% combined rate is higher than one can expect to earn on short-term treasury bills and bank savings accounts over the next year, and that will likely be the case even if the CPI-U adjustment later this year results in a lower combined rate, as might be the case given that reported inflation has been declining in recent months.
However, those interested in using I Bonds as a cash alternative must also account for the loss of three months of interest if the bonds are cashed in prior to five years. An investor who buys an I Bond today and cashes it in one year might expect an effective interest rate of ~5% which is not that much higher than the one year treasury bill.
The overall case for using I Bonds as a cash alternative has substantially weakened over the past year. In terms of using I Bonds as long term inflation protection, the case has also weakened because the real yield offered by TIPS has substantially increased. An investor with a five year holding period could purchase TIPS at a real yield of 1.45%, over a full percentage point greater than the fixed rate on I Bonds.
While TIPS offer a higher real yield for longer term investors, one should note that TIPS can fluctuate in value prior to maturity. If real yields go up further, price quotations for TIPS will decline even though they will still be redeemed at full value plus the inflation adjustment upon maturity. Therefore, there is some risk of loss of principal with TIPS that does not exist with I Bonds. When held in a taxable account, one must also pay taxes on TIPS coupon payments and the inflation adjustment, known as phantom income, which is not received until maturity. TreasuryDirect has a useful article explaining the differences between TIPS and I Bonds.
I Bonds have a $10,000 annual purchase limit per social security number. However, an additional $5,000 can be purchased via a tax refund. Those who might want to take advantage of the tax refund path to invest more than $10,000 in I Bonds this year still have an opportunity to overpay 2022 taxes to generate a refund. The final day to pay fourth quarter 2022 estimated taxes is Tuesday, January 17.
It is also worth noting that an I Bond buyer gets credit for the current month of interest no matter when in the month you make the purchase. By purchasing I Bonds toward the end of a month, it is possible to capture an extra month of interest vs. purchasing the I Bond at the beginning of a month.
Disclaimer: This content is provided as a follow up to prior articles on I Bonds. It is not investment or tax advice. Please consult professional advisors before making any decisions.
Articles, January 6, 2023. This article about the reinsurance industry initially focuses on the annual contract renewal cycle that kicks off every September. About half of reinsurance contracts come up for renewal every January, and the process of setting prices consumes much time during the fourth quarter. Rubinstein goes on to discuss Berkshire Hathaway’s reinsurance business at length, focusing on Warren Buffett and Ajit Jain’s uncommon approach to risk management. With reinsurance, it is possible to underprice risks for years and show annual "profits" before an inevitable reckoning eventually arrives. (Net Interest)
What Taleb Has to Say About Insurance, October 15, 2015. Mark Rubinstein’s article contains a link to this article covering Nassim Taleb’s comments at an industry event in 2015. “Predictive modeling works beautifully for Mediocristan,” Taleb said, noting that much of the risk that property/casualty insurers take on can, in fact, be effectively modeled. Reinsurance—not so much, he said. “Reinsurance has fat tails. But they know it. The more you are in Extremistan, the less these things work,” he said. “The good thing about insurance is that they [underwriters] know where [the models] don’t work.” (Carrier Management), January 10, 2023. This is a transcription of an article written by John Train. "In 1979 a man named John Train profiled a young(er) Warren Buffett, aged 48 at the time, in a publication called Financial World to promote his upcoming book; The Money Masters, which would publish the following year. Spanning a 5-page spread in the newspaper, the conversation that Train had with Buffett covers his coming of age as a young adult, his relationship with mentor Ben Graham, and flecks of how his investment process transformed over the years. Perhaps unsurprisingly, not a great deal has changed some four decades later.” (Investment Talk), January 6, 2023. Aswath Damodaran launches his annual effort to provide readers with global industry and macroeconomic data. Most of the data updates occur in January and there are several years of archives in addition to the current year’s data set. Damodaran plans eight more articles to explain various aspects of his data sets. (Musings on Markets)
Why Does Private Equity Get to Play Make-Believe With Prices? by Cliff Asness, January 6, 2023. Managers of traded securities report results based on quoted values whether they agree that quotes reflect intrinsic value or not. Private equity managers have more flexibility to report based on their views of intrinsic value rather than the market value if a business had to be sold in the current environment. Cliff Asness argues against playing “make-believe” and advocates for marking illiquid assets down to plausible values in communications with investors. (Institutional Investor)
Related Podcast: Cliff Asness — FTX, Hedge Funds and the Value Spread, January 12, 2022. 1 hour, 3 minutes (Infinite Loops)
AI and the Big Five by Ben Thompson, January 9, 2023. In this detailed article, Ben Thompson explains recent developments in artificial intelligence and considers how AI will impact Apple, Amazon, Meta, Google, and Microsoft. (Stratechery)
With Tesla trailing in China, Musk unleashes price war with BYD by Christiaan Hetzner, January 6, 2023. BYD is not a presence in the U.S. automobile market but is a major competitor in China. Tesla recently cut the prices of its Model 3 and Model Y vehicles in China in response to intensifying competition. “The latest weekly insurance data showed BYD sold 55,706 cars in the final week of last year to Tesla’s 4,338. Even stripping out the plug-in hybrids that make up a portion of BYD’s volumes, it is still outselling Tesla on a like-for-like basis.” (Fortune Magazine), January 8, 2023. This post is a great tribute to Lou Simpson who passed away a year ago at the age of 85. Here is an excerpt from the article on Simpson's process: “My approach is eclectic. I try to read all company documents carefully. We try to talk to competitors. We try to find people more knowledgeable about the business than we are. We do not rely on Wall Street-generated research. We do our own research. We try to meet with top management… What we do is run a long-time-horizon portfolio comprised of ten to fifteen stocks.” (The Science of Hitting)
Lou Simpson’s Life and Legacy, January 11, 2022. Comments about Lou Simpson’s life and career plus links to several articles. (Rational Reflections)
Justifying Optimism by Morgan Housel, January 5, 2023. Readers of Morgan Housel’s articles and his book, The Psychology of Money, know that he has an optimistic view of the world. In this article, Housel concedes that “the sole fact that things improved in the past offers no assurance of the future” and proceeds to explain why he still feels justified in being an optimist. I agree with Housel’s overall argument, but with the important caveat that we must avoid the “game over” risk of nuclear war, a risk that has only existed for a very short period of human history. (Collaborative Fund)
Book review of The Psychology of Money, October 11, 2020. (The Rational Walk)
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Gregory Zuckerman: The Man Who Solved the Market, January 9, 2023. 1 hour, 3 minutes. “Gregory Zuckerman is an investigative reporter at The Wall Street Journal and the author of several books. Since he joined The Journal in 1996, he has received the Gerald Loeb award three times. The focal point for our discussion is his book The Man Who Solved the Market, which tells the story of how Jim Simons launched the quant revolution and created the greatest money-making machine in financial history.” (Investing by the Books)
Review of The Man Who Solved The Market, December 28, 2019 (Rational Walk)
Review of A Shot to Save the World, March 24, 2022 (Rational Walk)
How Jay Gould Built Wall Street's Biggest Fortune, January 10, 2023. “American Rascal shows the complex and quirky character of the nineteenth century's greatest robber baron. He was at once praised for his brilliance by Rockefeller and Vanderbilt and condemned for forever destroying American business values by Mark Twain. He lived a colorful life, trading jokes with Thomas Edison, figuring in Thomas Nast's best sketches, paying Boss Tweed's bail, and commuting to work in a 200-foot yacht.” (Founders Podcast)
The Disciplined Growth Investor w/Fred Martin, January 7, 2023. 2 hours. “William Green speaks with Fred Martin, the lead portfolio manager at Disciplined Growth Investors. Here, at 76, he looks back on half a century as a hugely successful investor & shares hard-earned lessons on how to survive & thrive over the long haul by mitigating risks, understanding the laws of investing, & persevering.” (Richer, Wiser, Happier)
Ian Leslie on Being Human in the Age of AI, January 9, 2023. 57 minutes. “When OpenAI launched its conversational chatbot this past November, author Ian Leslie was struck by the humanness of the computer's dialogue. Then he realized that he had it exactly backward: In an age that favors the formulaic and generic to the ambiguous, complex, and unexpected, it's no wonder that computers can sound eerily lifelike. Leslie tells EconTalk host Russ Roberts that we should worry less about the lifelike nature of AI and worry more that human beings are being more robotic and predictable.” (Econ Talk)
Ben Franklin and George Washington: The Founding Partnership, June 13, 2022. 57 minutes. Most of us remember George Washington and Benjamin Franklin as the old men that appear on our currency. In this podcast, David Senra discusses what he learned from Franklin & Washington: The Founding Partnership by Edward Larson, a book that covers Washington and Franklin’s history decades before both men played pivotal roles as Founding Fathers in the American Revolution. (Founders Podcast)
This is an interesting thread on how the architecture of skyscrapers changed over the past century. In my opinion, ornamentation adds to the aesthetic appeal of buildings even if there is no functional purpose. Today we have slight variations of the “walls of glass” concept for most newer skyscrapers. It can get a little boring.
First Balloon Crossing of the English Channel
On January 7, 1785, Frenchman Jean-Pierre Blanchard and American John Jeffries crossed the English Channel in a hot air balloon, traveling from England to France in two and a half hours. They barely made it:
“With sufficient buoyancy to just lift the two aeronauts and their equipment, the Channel crossing was made at a very low altitude. During the flight, all ballast, their equipment and most of their clothing were jettisoned. They crossed the French coast at about 3:00 p.m. and at 3:30, came to rest in a clearing in the Felmores Forest, near Guînes.”
This account of early lighter than air travel was described in one of the chapters of Flight of Fancy: Defying Gravity by Design and Evolution by Richard Dawkins. I enjoyed reading this well illustrated book last week. Without oversimplifying flight, Dawkins succeeds in explaining the mechanics in an approachable and non-technical manner.
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