Introduction
“On a long and lonesome
highway, east of Omaha…”
-Bob Seger
erkshire Hathaway has been the largest position in
Oak Value Fund for several years, since the late 1998 merger of Berkshire with then publicly traded
portfolio holding General Reinsurance, Inc. (Gen Re). Its relative importance to the performance of
the Fund, our enthusiasm for the Berkshire investment thesis, and our view of a
general lack of good understanding of Berkshire’s business model among the
investing public have prompted us to periodically summarize our thoughts in
reviews, similar to this one, focused solely on Berkshire. This is the third annual (and quite possibly
last - we seem to have reached magnum opus proportions) installment in that
series, roughly coinciding with a follow up to our annual attendance at Berkshire’s annual meeting in Omaha.
“Back by popular demand” may be overstating the case
some, but we do know from calls and emails that there are a few patient souls
out there waiting for this our third year adding to the serial. We encourage review of prior installments for
background and context on Berkshire and our historical thoughts on the
company. Clearly, unfolding events, not
to mention a changing stock price over the course of the time in question,
impact Berkshire as an investment in ways
that we must account for. Still, as of
this publication, we believe Berkshire’s stock remains sizably undervalued in
spite of the greater than 60%¹
appreciation in its stock price (in
startling opposition to a broad market that has been dropping like a stone)
over the past two plus years since the bull market ended.
We have taken note of popular opinion expressed in
the financial media that appreciation of that magnitude means “the bloom is off
the rose” and Berkshire is no longer cheap relative to its value. We respectfully disagree. In fact, we believe that very “logic” has
cost people a lot of money over the years as Berkshire has always appeared
expensive in the absolute but often turned out to be undervalued relative to
its long term earning power and the value of its businesses. Our view is that this remains the case
today. Clearly, there has been
appreciation from ridiculously low prices achieved in the 2000 bubble market;
investors are only now beginning to recognize the magnitude of price/value
discrepancies created during that time.
We have seen many highfliers from that time laid low with massive price
depreciation to bring them back to reality.
While most of the oddities from that time created inflated stock prices
for less valuable companies, we think Berkshire has actually been through
the inverse of that. The company has
stood out like Superman in a universe of Bizarro impostors, and investors have
bid up Berkshire’s stock in response. But we maintain that Berkshire’s upward stock
price move during the grinding bear market period has simply put the stock
price back (almost) where it was when we started the exercise of holding it at a 9.9%
weighting in the Oak Value Fund portfolio - in a word, undervalued. Okay, two words: very undervalued.
Summary
The great white shark is an eating machine. All it does is swim, and eat, and make baby
sharks.”
- Matt Hooper, the young
scientist character in Jaws
We metaphorically described Berkshire
as the “Perfect Storm” of investments, the title of our 2001 update on the
company. This year it occurred to us that in our view Berkshire Hathaway is the
investment world’s analog to the great white shark. Berkshire is an
investing machine. Almost all of its
operating businesses produce prodigious amounts of cash, and Berkshire
reinvests that cash in other cash generating activities. Over the past few decades, with increasing
magnitude and frequency due to greater availability of internally generated
cash from prior acquisitions and float, Berkshire has
added one operating company after another to its collection of wonderful
operating businesses.
We present herein our 2002 progress report related
to Berkshire’s three critical strengths
(size, discipline, and integrity), which we have become most focused on
through:
1. our
recent attendance at Berkshire’s annual meeting in Omaha,
2. a similar trip to Wesco
(Berkshire’s 80% owned subsidiary)'s
annual meeting in Pasadena,
where Charlie Munger, Berkshire’s vice chairman, holds
court, and
3. the
ongoing analytical and valuation work we have performed.
(While we have some additional thoughts to offer
herein (shocking, we know) we aren’t necessarily going to state the investment
case for Berkshire any better than we have in those prior venues, by simply
attempting to say it differently here.
We encourage readers to review those earlier write-ups for a description
of Berkshire’s business model and our
view of the company’s strengths.)
Berkshire at its core is an insurance
company - the largest in the world based on capital. Insurance produces sixty percent of Berkshire’s total revenue, but
surrounding the insurance companies are other operating companies representing
the other forty percent. The
non-insurance businesses have combined sales of $15 billion, and employ the
great majority of Berkshire’s more than 100,000 worldwide employees. The combination of insurance and operating
businesses adds up to a mammoth $100 billion in market capitalization.
Insurance drives Berkshire’s value creation, primarily through its Gen Re, GEICO, and National
Indemnity (unique risks and super-catastrophe reinsurance) operations. To make
use of the cash that the insurance operations make available, Berkshire periodically adds to its
impressive collection of operating businesses and, to a lesser degree, invests
in publicly traded equities. Producing
massive amounts of cash and intelligently deploying it is “all Berkshire does” in its pursuit of long-term
wealth creation. The acquired individual operating units fit into the fold by
continuing to operate as they did before acquisition, without interference from
headquarters. They just send the cash they produce to Omaha, which begins to feed the
cycle anew.
This has created a rock solid balance sheet with
relatively little debt, an enormous capital base, which when coupled with
conservative management principles for committing that capital represent
important risk mitigating features. The unique ability to invest significantly
in equity instruments, including wholly owned businesses, represents an evolved
performance edge versus its competition.
It all adds up to Berkshire as an investing machine, and as the great
white shark has no peer at sea, we suspect no amount of reverse engineering
will allow competitors to ever replicate Berkshire’s set of unique advantages.
Most importantly, these advantages are growing and should be of particular
value in the current market environment.
Berkshire’s Relevant Competitive Strengths
We have come over the course of two decades of studying
the company to believe there are a lot of interesting things about Berkshire
as an investment. The critical elements
of success that are most germane to an
investment in Berkshire going forward rest, in our view,
on a foundation of three related pillars.
• First,
Berkshire’s massive capital base is
an advantage of scale and stability for them to exploit in the market for
reinsurance and risk transfer, and in investments. Its management team is uniquely suited to
pursue profitable growth and to intelligently allocate massive amounts of
capital.
• The second advantage is the management
team’s incredible culture of discipline, an absolutely essential sister quality
to Berkshire’s size in that it
counterbalances the otherwise difficult task of growing, profitably, from an
already large base.
• Finally, investors today find themselves
facing a financial backdrop that is rightly skittish and skeptical in the face
of many public companies’ betrayal of trust through a pattern of obfuscation,
scandal, and fraud. Berkshire management’s candor,
integrity and long track record of practicing and championing those qualities
provides a trust factor in its accounting representation and business dealings
that is sorely lacking in other potential investments. They are the gold standard for
credibility.
We review these three important advantages, and why
we think they matter, below in detail.
We also provide separate thoughts on the twin engines of Berkshire’s machine, insurance and
investments, as well as reviewing our valuation methodology and some risk
considerations.
Scale / Stability
The shrewd pricing of risk, both investment and
insurance, over four decades has allowed Berkshire to amass a prodigious pool
of capital, far beyond that which is required to serve as reserves for its
insurance payouts. It’s hard to
overstate the scale and strength of Berkshire’s capital position and the
advantage that creates for both Berkshire chairman Warren Buffett in pursuing
investments, as well as for Berkshire’s individual insurance businesses in plying
their trade. Mr. Buffett reported at the
recent meeting that Berkshire has $37 billion in insurance float, around 9% of the domestic property
casualty float of $400 billion. To place
it in perspective, that is a percentage that so skews industry comparisons that
we have been told that ratings agencies and regulators compute industry ratios
on both a with- and without-Berkshire basis to compensate for Berkshire’s 800 pound gorilla status.
Though the
entries that represent insurance float appear in the liability section of Berkshire’s balance sheet, the long
life over which Berkshire holds that capital means that it actually represents a very valuable
asset to Berkshire shareholders. [For an expanded discussion of this concept, see the
Insurance section below, and last year’s Berkshire report, The Perfect Storm,
in the section titled “Liabilities & Stuff That Looks Like Them (But Aren’t)”]. Looking at recent numbers helps tell the tale
of Berkshire’s tape. At March 31,
2002,
Berkshire’s balance sheet carried a
gigantic $60 billion in book value of shareholder’s equity against no
meaningful ($3.7 billion, or 6% of equity capital) debt position, net of the
debt of finance businesses, which are
matched off with corresponding assets. Importantly, that equity capital has
been largely created over decades through the astute investment and insurance
decisions rather than through the dilutive issuance of large amounts of new
stock. Consolidated cash and invested
assets, excluding assets of finance and financial products businesses totaled
approximately $76.5 billion (also March 31). During all of 2001 and the first
quarter of 2002, respectively, Berkshire deployed $4.7 billion and $1.1 billion in
internally generated cash for business acquisitions. For these reasons, Berkshire is both well known and well
regarded by investors, rating agencies, and regulators alike as the “Rock of
Gibraltar” in the insurance world.
Why does this matter?
• Sheer
scale and ultimate capital flexibility leaves the company in position to
swiftly and profitably capitalize on opportunities in both investments and in
insurance situations where competition for the capital may be somewhat limited
to those who can credibly make a commitment on short notice. In a number of financial transactions, Berkshire has benefited from its
ability to close a deal quickly, on cash terms with no doubt about availability
of financing. There are several
important facets to being able to act quickly: 1) access to capital, 2) ability
to effectively compute an offer price that makes economic sense to both
parties, and 3) willingness to commit. Berkshire has decided advantages in all
these critical areas. Berkshire often finds itself either a
self-selected home for a certain type of business acquisition, or at least in
the position of being among a very select few bidders who can legitimately get
a deal done. The pricing advantage of
that enviable position accrues to the long term benefit of Berkshire shareholders in the form of
high reinvested returns on the prodigious cash that the company produces.
• There
are fewer than ten² U. S. companies with a “AAA”
credit rating, out of roughly 8000 public companies (market capitalization >
$1 million). Berkshire Hathaway is one
of them. It seems to us that such a
pristine, self-financing balance sheet will be a decided competitive weapon in
the tight economic and tumultuous financial environment in which we find
ourselves circa 2002. As Exhibit A we note that Berkshire recently raised $400
million in a novel negative interest rate convertible security in 24 hours
through Goldman Sachs, an offering that was significantly oversubscribed in
terms of investor appetite.
• Mr.
Buffett recently ruminated on his assessment that Berkshire could withstand a $10
billion insured loss and suffer no long term diminution in net worth, absent
the follow on equity market effects likely induced by that size
catastrophe. Such an exposure for Berkshire implies a $250 billion
industry-wide event, one in which many companies would surely cease to be
solvent. That is five World Trade Center magnitudes of loss from a
single event, and Berkshire’s chairman, known for both his good word and his math skills,
estimates that the company would go forward with an intact balance sheet. That is simply a colossal statement. Almost no other company, financial or
otherwise, could survive that type of loss, let alone go forward
“undiminished.” That kind of ability to
make good on financial commitments became massively more valuable on September
11; purchasers now care about whether their reinsurer will be around to pay. Berkshire maintains a reputational advantage
of being the “only game in town” for certain large risk transfer transactions
in the form of an absolutely rock solid ability and willingness to pay. The
value of that advantage recently went up.
• This
solidity is decidedly important in the insurance arena, an industry fairly
plagued over time by overcapacity and the attendant price competition. Prices have firmed in the wake of 9/11, which
is a better alternative than the soft market that persisted for the decade or
so before that. Still, capital can and
will be raised in the industry and weaker pricing will ultimately return. Meanwhile, Berkshire’s insurance subsidiaries
are writing profitable business in a market that is better than it has been in
some time. And importantly, Berkshire
has some special advantages in insurance related to its size, stability,
discipline and pricing acumen that will allow it to earn attractive returns
that are better than average.
• In
certain of the large transactions into which Berkshire enters, those in
reinsurance and super catastrophe in particular, it is not the commodity
aspects of the insurance business that dictate pricing. Rather, it may be an absolute ability and
willingness to pay, or, in other situations, Berkshire’s readiness to accept
unpleasant accounting treatment in exchange for favorable economics that
dictates advantageous pricing.
Berkshire is often in essence capitalizing on its AAA balance sheet and
reputation, i.e., it is simply the Berkshire “seal of approval” needed to get
third parties comfortable with completing a deal that creates a special,
profitable niche in an otherwise commodity priced industry. Mr. Munger indicated at the Wesco meeting,
that while he would prefer an unregulated monopoly to having such “special talents,”
he thinks Berkshire will do very well over time with the latter in the absence of the
former in the insurance business, an industry where average financial results
will be unimpressive (at best).
Discipline
Berkshire is highly astute at evaluating
risks, conservative in its accounting, and most importantly unaffected by an
ongoing need for capital. The company is
therefore largely immunized from the associated compromises that others must
make to appease Wall Street, lenders, or security holders. One key to investing is not losing capital,
and in this regard the ability to NOT take action is an asset. It is clear to us that Mr. Buffett is not
compelled to make capital or risk allocation decisions by either financial
constraint or impetuous temperament.
While not entirely free of errors in the insurance business, Berkshire remains largely unimpaired
by the plethora of pitfalls of the past few years in insurance and more
importantly in the now widely lamented investment environment. Many investors dismissed Mr. Buffett’s
investment approach as irrelevant not too long ago; we haven’t heard that
criticism of late.
Why does this matter?
· Mr.
Buffett has a decades-long history of doing the right things for the right
economic reasons, often on a scale and in a way that is unavailable or
unpalatable to other sizable investors subject to other influences and
constraints. Despite the discomfort we feel from the recent imploding
investment environment, circumstances indicate to us that the opportunities are
increasing for profitable deployment of capital. What many people need right now is capital,
and we know of no other company in such a position as Berkshire, with an enviable
combination of liquidity and investment acumen.
Mr. Buffett may not get to his 1974 description of feeling like “an
oversexed man in a harem,” but the opportunities for profitable investment are
better than they were two and a half years ago.
· Berkshire spent roughly $10 billion
on business acquisitions over the past three years, a sum that we suspect
rivals commitments by most LBO or private equity funds over that time. And Berkshire has an appetite for more,
with plenty of cash available, ample borrowing capacity should they need it,
and the internal ability to produce cash via existing businesses. Mr. Buffett has reiterated his roughly 13%
target hurdle for return on his target investments. Using that number in a valuation model more
than adequately indicates a much higher price at which Berkshire’s shares should change
hands. Note: we use a lower number in
our valuation model.
· In
the wrong hands, a huge investment pool often spells trouble in terms of bad
acquisitions, ill conceived business expansion into less profitable business,
and other wealth destroying activities.
It’s no good having access to capital if it is reinvested in low return
or capital destroying activities. But,
again, Berkshire management’s focus, while
eclectic in implementation, has been singular in focus on generating
non-dilutive growth in aggregate. And
its management team’s track record in opening up the capital spigot at times
when superior opportunities abound in investments and insurance is unequaled,
and today’s Berkshire reaps the benefits of past exploits in this regard. Mr. Buffett and his team know well how to lie
in wait for money making opportunities and to pounce when they appear.
Integrity
“Trust I seek, and I find in
you”
- Metallica
The financial strength embodied in Berkshire’s
“Fort Knox”
balance sheet, coupled with Mr. Buffett’s sterling reputation for both
intellectual and personal integrity, rounds out the list of strengths
bolstering its current investment case. Berkshire
has been talking straight and presenting results forthrightly (not to mention
both lampooning and warning about much of today’s accounting shenanigans with
remarkable prescience) for literally decades.
Bill Gross of PIMCO recently labeled Mr. Buffett the “Honest Abe” of the
investment community. Mr. Buffett has
dealt honestly with problems and mistakes, and elevated the principle of
fairness toward shareholders to that of practically religious virtue. Mr. Buffett has long indicated that his
aversion to leverage probably had cost Berkshire chances
to make money over time, but that it never made sense to him to risk “what he
had and needed for that which he didn’t have and didn’t need.” That attitude is born of an almost
hard-wired conservatism, a discipline people either have or don’t, and we have
all lately been bearing witness to the sometimes tragic consequences of its
lack playing out in current financial headlines.
Instructive examples abound on this point. For one, Messrs. Buffett and Munger have
commented in the past and recently that they recognize that many Berkshire shareholders have a
significant portion of their wealth invested in Berkshire, and that they operate the
business in consideration of that fact.
Not every management team feels that obligation to its shareholder
group, and if you don’t recognize the value of that attitude, there are surely
plenty of impoverished former shareholders in Clinton, Mississippi and Houston, Texas (home of Worldcom and
Enron, respectively) and elsewhere who probably do just about now. Integrity not only matters, as investors are
coming to realize, it also counts.
We’ll bore you with one additional fascinating
example wherein Mr. Buffett highlighted the 1974 time period as one in which
his conservatism about insurance reserves had prevented him from taking full
advantage of available equity bargains.
This is a time period when Mr. Buffett has indicated he pretty much knew
he was right about the absurdly low valuations available in publicly traded
equities. It was during this period that
he made the Washington Post purchase, a subsequent “hundred plus bagger” for
him, and a purchase of which he has commented to the effect that you could have
held an auction at 2AM in the middle of the Atlantic Ocean and gotten bids far
above market quotations at the time. He
knew he was right about the intended stock purchases. To be that sure, and still hold off on
additional purchases out of a sense of fiscal responsibility and fiduciary duty
toward shareholders and policyholders is almost inhuman discipline. We found it to be a hugely instructive
insight into the level of conservatism inherent in Berkshire’s management. It frankly helps us sleep better.
Why does this matter?
· Pardon
us if we’re being impolitic, but has there been a time in the past few decades
when such “intangibles” mattered more?
Investors have clearly been “buffetted” by the bad outcomes flowing from
a lack of corporate virtue elsewhere.
Enron anyone? Adelphia? Worldcom?
We don’t want to get off on a rant here but…don’t these things matter
more now than ever? Against a backdrop
of corporate disclosure and executive behavior that is altogether too
frequently reprehensible, veracity is a category where Berkshire management stands literally
without peer. Berkshire represents to us a paragon
of transparency, conservatism, prudence, and management reliability. Such qualities have always been valuable; of
late, they are traits to be treasured, and one might hope, more dearly
valued. We think the trust factor is
worth a premium, and maintain hope that the market at large may be more willing
to value, well, values, over time.
· Berkshire has none of the problems of
misleading financial representation that are sadly prevalent in both today’s
headlines and in actual company financial statements. In fact, there are numerous examples where Berkshire has chosen to ignore
allowable financial reporting practices that paint a better picture in favor of
compliance with a spirit of fair representation of its business
activities. They have written down
goodwill immediately that could arguably have been expensed more slowly, as in
the example of Dexter shoes a few years ago.
Berkshire has increased insurance
reserves where necessary in order to be conservative, consistent with their
longstanding practice, and Mr. Buffett regularly reminds financial statement
readers that these figures are estimates subject to revision. The company is light years away from the
mainstream in the treatment of stock options: they don’t have any. Instead, Berkshire pays cash compensation to
retain employees. (To our knowledge, Berkshire has never had the CEO of an
acquired business leave, except for Rose Blumkin at Nebraska Furniture Mart,
and she came back!). Berkshire’s all cash compensation approach avoids the
insidious dilution of existing shareholders which occurs as stock option
programs give away pieces of the company over time. The downside appears in a perversity of
financial accounting. Accounting
principles inexplicably allow companies to avoid recognizing stock options as
compensation expenses. Berkshire’s insistence on cash
compensation, in our opinion clearly the right thing to do from the perspective
of a shareholder-oriented management, forces the full recognition of those
expenses in Berkshire’s financials in a way few management teams choose. As a final example we note that Berkshire
recently shut down a derivatives trading business because it made clear
economic sense to them to do so in order to mitigate a long term risk they
didn’t think they could measure or be adequately compensated for. In the Alice in Wonderland that is GAAP
accounting, that decision negatively impacted current financials in a way that
continuing it would not have, risk management and economic arguments against it
aside.
· None of
this means there won’t be surprises, shortfalls, or business disappointments at
Berkshire. Mr. Buffett himself has said repeatedly that
there will be, especially in insurance where surprises tend to be
negative. But where they occur they will
be honest mistakes of judgment, dealt with both quickly and openly. And both Mr. Buffett and other astute
investors will continue to focus on the relevant reality of underlying
economics, rather than purely on accounting representations, always imperfect
even in honest situations, when evaluating progress. Reported revenues will be real, expenses
honestly reflected as such, and the reporting process will be shepherded by
management that is ultimately believable, conservative, intelligent, honest and
ethical. The price tag for all this is
extremely modest executive salaries ($100,000 annually for both Mr. Buffett and
Mr. Munger), rather than the “looting of the company store” via exorbitant
stock option programs that are so commonplace in other parts of corporate
America. Of course that’s just our
opinion.
Taken together, these advantages - massive low cost
capital combined with the preternatural discipline and impeccable reputation of
management - allow Berkshire to, as Mr. Buffett recently put it “do almost anything intelligent in
risk taking (i.e., insurance) or on the asset side that we want to.” Which circles back around to size and
stability. This virtuous circle has
allowed Berkshire to periodically ratchet up and expand its massive capital, adding even
more heft to its already solid infrastructure, beginning the cycle anew. Low cost funds generated from insurance
businesses and existing investments fueling one side, additional capital
reinvestment opportunities on the other.
All of it on a grand scale, and directed by the world’s most talented
investor. It is on the specifics of
these two sides to Berkshire’s coin - 1) insurance and 2) investments - that we focus in evaluating
and quantifying Berkshire’s merits as an investment.
Insurance
A well-known periodical recently indicated, “…most
folks don’t hold Berkshire because they want to own an insurance company…” That’s a pretty
sizable error in purpose in our view, since insurance is far and away the
company’s most important business. It
is the engine that creates the funds to drive economic value creation within Berkshire. Understanding this fact and evaluating Berkshire’s insurance operations and
prospects are critical to appraising the investment merit of the company.
We believe that financial results and operating
conditions in this critical area are improving substantively at Berkshire. Mr. Buffett presented figures indicating that
Berkshire added $1.8 billion in new
insurance float during the first quarter of 2002, to a total of $37
billion. That’s fully 5% of the entire
float the company has ever created, now added to the investment pool in a
single three-month period. We’d call
that progress. The results were reported
in a first-ever slide presentation at the beginning of the meeting, a relevant
subtext we think. Mr. Buffett plainly
focused on the most important driver of value at Berkshire, and he put the progress
front and center at the meeting before taking a single question. (So much for the view of those folks who
don’t want to own an insurance company.)
We emphasize the value of this humongous low to no
cost pile of cash that can be used for investment purposes. Mr. Buffett himself highlighted its
importance several years ago by indicating that he wouldn’t swap an equal
amount of cash for the float. In the
past, he has discussed the different types and “layers” of float, and most
recently in Omaha, he compared the insurance
float to an oil field, in that it was depleted in certain areas over time and
developed in new ones. But he pointed
out that in aggregate, he expected that Berkshire’s float had probably the
longest average life (longest “tail” in industry jargon) of any insurance
business. That has important
implications for attaching a value to Berkshire Hathaway; that value can be
quantified by making a reasonable range of assumptions about average long term
investment returns compared to the cost and size of that capital.
Speaking of cost of the float, it is critically
important to note that those funds were generated in 2002’s first quarter at a
negative cost to Berkshire, an outcome almost entirely attributable to strong results
at National Indemnity. This return to
underwriting profitability is an important milestone in our view. Mr. Buffett has long maintained that cost of
float is the crucial variable in measuring the value of an insurance
operation. Size of float matters, but
its cost is the main element to measure success; if the cost of funds exceeds
that available elsewhere, the business suffers.
Berkshire’s ability to control its
funding cost ultimately impacts its long term value, because it influences the
spread they earn on their massive capital - in much the same way that lower
production costs improve profit margins at a manufacturing business. Long term, Mr. Buffett has indicated he
expects low cost float, achieving better than market rates for raising funds,
though not necessarily the negative cost that was Berkshire’s long history and outcome
for the recent quarter.
Mr. Buffett was crystal clear in Omaha about the relative
importance of generating low cost float versus striving for growing float
consistently for its own sake. In the wake of some missteps at Gen Re and the
sizable financial hit of the World Trade Center attacks, underwriting
discipline has returned and insurance results are getting meaningfully
better. He pointed out that it would be
“suicidal” for insurers to hit predetermined growth targets, as that would
inevitably lead them to bad pricing decisions in certain environments. Mr. Buffett again focused on having the
discipline (there’s that word again) to wait for opportunity and then and only
then to act aggressively. Smooth,
consistent growth targets are anathema to that methodology. Mr. Buffett discussed the importance of
nurturing the proper incentives, such as not penalizing insurance businesses
with headcount reductions when premium revenue falls. For example, he explained that at Berkshire’s National Indemnity
subsidiary, they periodically tolerate large reductions in premium revenues,
without laying off a single underwriting employee. They do so because layoffs would send the
wrong message - that keeping premium volume high is more important than pricing
business wisely, which of course would set up costly unintended consequences in
downstream financial results.
Based on this philosophy and discipline, we
recognize that float will not grow smoothly over time, but that it is rather
likely to lurch upward over the long run in a manner that is discrete rather
than continuous, expanding aggressively in better environments and growing more
slowly (or even shrinking) in poorer ones.
We believe the current pricing environment is favorable for profitable
growth, and expect that Berkshire’s astute insurance team is acting
accordingly. This is an environment
wherein the great confidence we have built up over time in the team across Berkshire’s insurance portfolio
becomes meaningful, and the discipline imposed by Mr. Buffett’s culture
invaluable.
Messrs. Buffett and Munger fairly gushed with praise
for Joe Brandon, head honcho at Gen Re, in whom they have great confidence to
get things better at that important subsidiary.
Ajit Jain at National Indemnity is literally legendary in insurance for
his abilities. We’re quite sure he will
put them to good use in a pricing environment for reinsurance that is better
than it has been in a decade. Many
industry participants we’ve interviewed, most of whom are quick to pay homage
to him, have long indicated to us that Mr. Buffett doesn’t at all exaggerate when
he praises Ajit in the annual report and at the Berkshire annual meeting. Finally, GEICO remains a great contributor to
the insurance business at Berkshire. We
have detailed the long term strengths of Tony Nicely’s operation in the past,
and were pleased to see its recent growth statistics improving. The sum of these activities combine to create
the formidable asset (in the economic sense if not the accounting one) called
float. It represents Berkshire’s all-important low cost
(if they do it right) source of funds for capital investment. While we can’t predict the precise path of
float growth, we are reasonably confident that growth will occur over time, and
profitably so, which creates compelling long term value for the Berkshire shareholder.
We feel compelled here to point out that economic
results in Berkshire’s insurance operations are even better than they look in reported
financials due to the peculiarities of some accounting items that Mr. Buffett
highlighted in Omaha. Certain transactions make the accounting
appear worse than the true economics for a subset of Berkshire’s written reinsurance
business. The earnings penalty is on the
scale of hundreds of millions of dollars depressed from Berkshire’s GAAP reported earnings
for years into the future. Mr. Buffett
describes these as “pain today, gain tomorrow” transactions, and has indicated
that because the economics are so favorable (even if the accounting treatment
is not), he is more than happy to do more of them in the future. Fortunately, Berkshire is uniquely suited to do
things that look bad on paper, but actually help create significant long term
economic value for shareholders. (This
is one of numerous examples where accounting presentation understates Berkshire’s true earning power,
making its financial position appear less good on paper than it actually
is. Somewhat opposite of the well known
“objects in the rearview mirror may appear closer than they are,” Berkshire’s
true economic results are perennially better than what is visible to the
untrained eye, a view we incorporate in many ways when estimating its intrinsic
value range.)
More qualitatively, aggregating the comments made
during the two meetings by Messrs. Buffett and Munger about insurance, we’d say
they were about as bullish as we’d ever heard about insurance and Berkshire’s prospects therein. Mr. Buffett went so far as to say, “I think
you are going to see terrific results in insurance.” Mr. Munger was somewhat more sober, saying he
was “mildly optimistic” about insurance, but that comment was the equivalent of
Mr. Buffett’s comment in our view, factoring in Mr. Munger’s well-known
curmudgeonly reputation. He added that
it is “nearly impossible to grow intelligently off of a very large base - but
we intend to do it anyway.” As we have
indicated elsewhere, insurance is a competitive, capital intensive business
with historically low industry margins, but Berkshire has unique advantages that
we believe have allowed and will continue to allow it to earn attractive returns
therein.
There were also significant statements about
improvements in business practices at Gen Re.
Mr. Buffett has been both public and harsh in his criticism of
underwriting inadequacies at Gen Re that cost Berkshire dearly. Mr. Munger indicated that Gen Re had a good
culture of underwriting, but one that needed improvement. Both clearly believe that Joe Brandon is the man to
implement that improvement, and both of them fairly lionized him during the
recent annual meeting. (Mr. Buffett even joked about asking Mr. Brandon’s mom
if there were any more like him at home.)
Messrs. Buffett and Munger are not people given to effusive praise for
its own sake. If they believe in
someone, it says a lot about their abilities and character. For our part, and we were shareholders in Gen
Re before Berkshire acquired it, we have been fans of Mr. Brandon for some time
and recognize his abilities in insurance as well above average. While we frankly had expected underwriting
improvement at Gen Re sooner, it appears to have taken longer to implement than
we would have preferred to close out older, inadequately priced business. We are sure Mr. Buffett agrees, and we remain
confident that senior management at Gen Re recognizes the importance of
underwriting discipline to Berkshire’s overall results, and that their
financial incentives will be aligned with achieving success in that
regard.
Investments
Investments of course also matter to understanding
and valuing Berkshire. A variety of points are
relevant considerations in this area. First, marketable securities are not a
primary focus for Berkshire. Messrs. Buffett and Munger again reiterated in Omaha and Pasadena that they didn’t find
anything particularly compelling at current equity valuations. We have argued for some time that the size of
Berkshire’s available investment pool
limits its meaningful opportunities in the public markets, though of course
additional market volatility (we’ve had plenty) could provide attractive
opportunities to deploy capital. We’d
go so far as to say that absent any significant break in the equity market and
exclusive of allocations that are small relative to the total available,
Berkshire is essentially out of the marketable securities investing business in
any way that is truly meaningful to its future financial results.
For example, with little fanfare, Berkshire has progressed to the point
where even the formerly large “sacred cow” existing portfolio holdings (Coke, Gillette, Washington Post) have less influence
over its future results. By virtue of
the company’s intelligently gathered growth in insurance float and its
operating businesses’ relentless gusher of cash flow, each legacy equity
holding becomes a smaller piece of the total pie as time progresses. We never bought into “Berkshire is a big closed-end mutual
fund” silliness, but the argument, very weak for nearly a decade now, looks
more anemic with each passing quarter.
Conversely, making good selections in purchasing
whole businesses is where Berkshire’s capital will primarily be spent, and
acumen in that endeavor will be the driver of results for Berkshire going forward. Mr. Buffett
reiterated several times during the shareholder weekend that his hurdle rate
for such investments was a “13% or so” return (“not as good as equities in
1974,” he quipped, “but better than the alternative”), an outcome that he was
selectively getting and committed to maintaining. He indicated that he isn’t
interested in 7-8% return opportunities.
Getting returns in the 13% range on a large percentage of Berkshire’s investable capital could
have a significant upside impact on Berkshire’s intrinsic value; we don’t
count on that outcome, but it doesn’t reside in the realm of total fantasy. We note that Berkshire has put roughly $10 billion
to work in the past three years, largely in wholesale acquisitions or
structured investment transactions such as Finova, and Mid-American Energy,
etc.
As a corollary, finding such compelling investment
ideas of size is Berkshire’s challenge, and Mr. Buffett’s admitted Achilles heel - it’s just
harder to move the needle these days with such large sums to invest. Mr. Munger was referring to insurance when he
said that it’s “nearly impossible to grow intelligently off of a very large
base - but we intend to do it anyway,” but much the same logic could be leveled
at Berkshire’s investing challenge. Significantly, different comments the two men
made separately over the course of the two meetings made it clear that while
neither felt that the task was easy, it was achievable. Mr. Buffett said at one point that “I think
we will get other opportunities to put large amounts of capital to work at very
attractive rates of return,” and indicated that “you will get big opportunities,
but you don’t know when.” We don’t know
when either, but we have complete confidence that Mr. Buffett will recognize
opportunity when it presents itself. And
that he will act accordingly, to the benefit of Berkshire shareholders. Mr. Munger indicated something along the
lines of all large enterprises eventually finding it “hell on earth” to
continue to grow. He followed up with
the observation that if “eventually” meant next year or fifteen years from now,
that would lead one to different conclusions.
We interpret his statements to mean that while it won’t be easy and
isn’t a fait accompli, he isn’t ruling out the possibility of continued success
for Berkshire in investing, despite its
handicap of size. We think it’s
important to remember just how high the benchmark is when these, two of
history’s greatest investors, indicate that they can’t do as well in the future
with large sums as they did in the past with smaller ones. They can be reasonably successful in the
future rather than wildly so and still have Berkshire be a fine investment from
here. That the five or ten year hence
record won’t compare to Mr. Buffett’s “superman” results from when he was in
his thirties and forties may be interesting, but it isn’t necessarily relevant
to earning profits by owning Berkshire from here.
We note two related points about opportunities for
the current deployment of capital. First, the “fallout” investing environment
we have been witnessing for the last few years creates additional opportunities
both in publicly traded markets and private transactions. Second, competition for those opportunities
seems to us relatively diminished in the current economic environment. Debt and risk have both been branded as four-letter
words, and other capital constrained potential acquirers simply can’t keep pace
with Mr. Buffett’s perpetual motion machine of cash production. Others will continue to have difficulty
matching Berkshire’s evaluation prowess, speed of decision making, and willingness and
ability to commit, in cash, without complicating requirements of further
approvals or contingent financing. And,
Mr. Buffett is shouting from the rooftops that he is ready, willing and able to
be an acquirer under the terms he has defined.
(In fact, the negative interest rate security Berkshire recently issued through
Goldman was, Mr. Buffett indicated, at least partly designed to generate
awareness of Berkshire as an acquirer.) We recommend
that if you are reading this and are a
private business owner considering a sale, read the acquisition criteria published
in Berkshire’s annual report and give
Mr. Buffett a call.
Valuation
“Truth is a gem that is found at a great depth; while on
the surface of the world, all things are weighed by the false scale of custom.”
- Lord Byron
So what is all this worth? Competitive strengths are interesting and
enviable, but if they aren’t available to investors at a price offering
attractive future return potential, what good are they? We’ve always said that it’s much easier (not
easy, but easier) to identify solid businesses than it is to find them at
bargain prices. The value we bring to
the table is a sensible method for valuing businesses and the discipline to
pursue only those where the rest of the world has ignored or mis-valued them
for some reason. If we can’t do that,
we’re no different than the folks who bought Cisco at $80 during the tech
mania.
For starters, we point out that there are numerous
examples where accounting presentation understates Berkshire’s earning power, rendering
typical valuation shortcuts such as current p/e comparisons useless as a method
of determining Berkshire’s value. (This is also true of
other investments we evaluate as well.)
This viewpoint, not a common one we know, renders totally benighted
those who rely on such measures today to recognize Berkshire’s intrinsic value. That’s part of the advantage that we believe
will accrue to those who can figure out Berkshire today. As Berkshire grows reported earnings per
share over time, through its increasing acquisitions of operating businesses
that generate additional cash flows, the traditional p/e comparison may become
more valid, making Berkshire appear more like a traditional “value” play. Conversely, we have expended a great deal of
effort in order to gain an understanding of and appreciation for Berkshire’s economic strengths and to
be in a position to attach a reasonable value to them today. In our view, the passage of time will make
clear the full extent of cash generating power inherent in Berkshire’s business model as astutely
assembled by its management team. We
therefore see profitable opportunity in acting ahead of other investors who
will ultimately figure out Berkshire when its value becomes plain even when
measured by the simple benchmarks of conventional investment wisdom. In fact, we look forward to it.
Having made those appropriate caveats, we can tell
you that our valuation methodology for Berkshire considers a variety of
factors in estimating intrinsic value.
The math essentially runs in this fashi