Our First Research Project
by Dale Wettlaufer (TMF Ralegh)
ALEXANDRIA, VA (Dec. 2, 1998) -- Our First Research Project is Berkshire Hathaway (NYSE: BRK.A and BRK.B)
Like a toddler lurching forward, taking its first steps, or a foal arising for the first time on spindly legs, we embark today on our first research project on a prospective acquisition for the Boring Portfolio. What is it that intrigues us about Berkshire? Is it the reputation of legendary businessman Warren Buffett, the company's Chairman and CEO? Is it that we want a mutual fund of Nifty Fifty stocks and that we couldn't care less about the other parts of Berkshire? Do we buy into the Buffett mystique and want to pay a premium to net asset value for this closed-end mutual fund?
These are all strawman sorts of questions for us. They're pretty easily knocked down, but they're also rolled out by the financial press in attempting to sum up what it will become upon the closing of its merger with General Re -- the publicly traded company with the second-highest amount of equity capital in the world. We'll deal with these questions in our look at the company because people will probably be wondering about them.
That's pretty amazing considering there are no major sell-side firms covering this company and the mentions of Berkshire that do appear in the news are more like something that you would see on Entertainment Tonight than in serious news reports. Make no mistake about it, this company is not the mutant freak that it's portrayed to be in the news. It is different, though.
What the Company Does
Berkshire is a diversified holding company with interests in the insurance and reinsurance, flight training and ships' captains training, aircraft leasing services, media, furniture and home furnishings retailing, jewelry retailing, shoes manufacturing, quick-serve restaurant franchising, and confections. Among the insurance segment, we can further break down the company into: supercatastrophe, property & casualty, credit, life, commercial trucks and truckers, public auto, special types, garage and dealer, prize indemnification, general liability, and inland marine cargo.
The largest member of the Berkshire Group of insurance companies, by premium volume, is GEICO Direct Auto Insurance, a company that was built on the proposition that government employees are safer drivers and thus better risks. Thus the acronym that stands for Government Employees Insurance Company. The company was also built on the proposition that direct marketing would save on overhead, giving the company a competitive advantage over other insurance underwriters that used the traditional agency distribution channel.
When people say such-and-such a company is the "Dell Computer of industry X," one could correctly substitute GEICO in that sentence. Dell is the GEICO of the PC industry, and Amazon.com is the GEICO of the book retailing industry. To sharpen the point I'm making just a bit, GEICO is the low-cost leader in auto insurance and thus has quite a competitive advantage over other companies.
At this point, GEICO has about 3.85% of the U.S. auto insurance market (my estimate, using an A.M. Best midyear report and annualizing GEICO's Q3 earned premiums). Here's an interesting thing about GEICO: It's TOO PROFITABLE. How many times do you see that said about a company? Not too often. But from this year's 10-K:
"GEICO's underwriting performance during 1997 was exceptional and better than its pricing targets. Generally, the results produced by the industry with respect to private passenger auto insurance during this period have been good as well. GEICO has taken certain rate reductions in 1997 and will take further rate reductions in 1998 to adjust its rates to its pricing targets. Premium rates are also subject to downward pressure through competition and through the ordinary rate regulation processes of state insurance departments. In addition, while the level of claim costs (including catastrophe losses) in 1997 and 1996 have been relatively low, there is no assurance that these favorable conditions will continue. Accordingly, management expects that GEICO's underwriting profit margins will return to more normal levels as losses increase faster than premiums. Notwithstanding, Berkshire's management believes that GEICO's underwriting results will remain better than industry averages."
Once again, in the third quarter, the company missed its profit targets:
"Policy growth over the past twelve months was 15.7% in the preferred-risk auto business and 38.6% in the standard and non-standard auto lines. The in-force policy growth resulted from GEICO's ongoing marketing efforts and competitive prices. It is expected that voluntary policies in-force will continue to grow at the same or greater annual rates over the remainder of 1998 and into 1999. Premium rate reductions were taken in certain states during 1998 with the intention of better aligning premium rates with profit targets. Such reductions will be fully reflected in premiums earned over the next twelve months and are expected to reduce profit margins."
Think for a moment how many GEICO ads you see. Since the majority of GEICO that was not owned by Berkshire was acquired by Berkshire in 1996 (the merger was agreed to in 1995), the company's marketing message has become almost ubiquitous. You can't escape it. Sorry about that. We shareholders don't mind it, though.
More on Berkshire on Friday. One housekeeping note, though. As we start off with out look at Berkshire, it occurs to me that we should explain briefly how we will go about our decisions on a company once we've completed our initial research on it. Unlike the other portfolios in the Fool besides the DRiP portfolio, we tell you what we're looking at while we're looking at it and open up the process as we do so. We don't tell you we're going to buy something and then buy it.
As an extension of that, the natural end to some of the research will be that we won't like the results. The company under review wouldn't be attractive to us at any price other than "ridiculously cheap." And that's not really our game, anyway, so in effect, there are some companies we won't like at any price. Very often, though, there will be companies that we like at a certain price that happens to be below the current market price. We believe that buying beneath intrinsic value is as important to returns as the quality of the business.
To generate super-normal returns on equity, you can do a number of things. You can buy great companies and hope the intrinsic growth of those companies will be enough. Or you can buy great companies below their intrinsic value and look for the market price to catch up to the intrinsic value of the company as well as gain from the intrinsic growth of the company. To use the second allows a margin of error, because we're not always going to be correct on the intrinsic growth of a business. As I've said, we like to shoot for the middle of the green rather than challenge the pin on every approach.
Anyway, the upshot of this will be that we'll do often do research on companies and then come to the conclusion that the price isn't attractive to us. However, you get periods such as this October, the fall of 1990, July of 1996, or March of 1997 (not to mention some of the really ugly periods in market history) that take down the price of things you like. In such instances, the market will offer you the easy 4-foot putt straight uphill for the birdie. Lately, most of the putts have been 60-foot double-breakers on Augusta National-like greens.
Also, industry-specific or company-specific short-term problems can come along that don't really effect the long-term economics of a business but that cause short-term drops in the company's stock price. In the short-term, there are a lot of things that can cause prices to drop. If we've done our research correctly, then we can be prepared to act quickly during those periods. When we have completed research on a company but don't like the price that the market is offering, we'll just set it aside and keep an eye on it. So don't be surprised when we pull that out of the woodwork. In this we differ in method and ideology from other portfolios run by Fool managers.
A friend mentioned the other day that we started with our look at Berkshire on Wednesday by focusing on GEICO Direct because that's the largest value driver of the wholly owned Berkshire businesses. I didn't consciously make that decision, though the observation is correct. GEICO is the largest single contributor to underwriting results for the company among its short tail lines of insurance (by the way, this link takes you to Rupp's Insurance Glossary. Also, see below for insurance industry links). Super-cat (insurance and reinsurance covering primary insurers and reinsurers' losses in the event of major catastrophic losses) underwriting results beat GEICO by $2.7 million in fiscal 1997 while GEICO's underwriting gain in fiscal 1996 bested super cat underwriting results by $4.4 million.
Both of these categories of insurance grew year-over-year in 1997, but super cat underwriting results are definitely more lumpy than GEICO. The beauty of GECIO is that it provides a fairly predictable (that's relative in the insurance business) and growing stream of cash in the form of the underwriting earnings and in the form of float.
We had better deal with this issue before we go on to anything else, since in the 1997 annual report Chairman Warren Buffett says that "Unless you understand this subject, it will be impossible for you to make an informed judgment about Berkshire's intrinsic value."
Float: Insurance premiums that have been collected, but not yet distributed as payments for insured losses.
The reason why insurance companies are often under-appreciated is this feature of the industry called float. It's capital that a company can use to invest that otherwise would have to come from the issuance of bonds, commercial paper, or equity, all of which have their costs. Looking at how a company is financed, the balance sheet tautology is the place to start. A = L + OE. The left side of the balance sheet -- assets -- is financed by the right side of the balance sheet -- liabilities and owners' equity. From this tautology, we can also re-arrange the terms to show that Owners' equity = Assets minus liabilities.
In the way we look at things, insurance float is an equity equivalent. Maybe that's a misnomer, but that's a term we use to describe something other than debt and other than owners' equity on the right side of the balance sheet that funds the company's assets. In last year's annual letter to shareholders, Chairman Buffett explained: "Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had."
The impact very well-run insurance companies have had on the value added for shareholders is enormous. Every year, this sum of capital on the right side of the balance sheet has grown at an average of 21.7%, creating similar yearly growth in new assets attributable to the additional float. If this were debt and you assumed an average interest rate over this time period, then interest expenses attributable to this capital would have increased at a compound annual growth rate of 21.7%.
If that capital showed up on the balance sheet in the form of new equity every year, then Berkshire would not have been able to maintain the glacial rate of growth in outstanding shares that it has over the last few decades. In fact, shares outstanding have only grown at an approximate rate of 1.012 percent per year over the last twenty years (through the end of 1997). In addition, when you bring perpetual equity capital onto the balance sheet, you've brought perpetual cost of equity to the corporation until the day that equity is re-acquired by the company.
While Mr. Buffett may go about thinking about this in a different way than I, float is more valuable than equity capital not just because there is typically no cost to the float but because there is an implicit cost to the equity capital. If you issue new equity, then the new shareholders are going to demand some return on that equity. Historically, that has been around 11% pre-tax over the course of this century. Berkshire's average float last year was $7,093.1 million. If that were equity capital, the after-tax cost of that capital would be about $780 million. Financed by short-term debt, the after-tax cost of that capital would be at least $230 million.
This matters because float is almost like perpetual capital. The discounted present value of this avoided cost is anywhere from $2.1 billion in the case of short-term debt to $7.1 billion in the case of equity. Thus, the comment that the float has "a value to Berkshire greater than an equal amount of net worth would have had," in the opinion of the company's Chairman. The opinion on value is Mr. Buffett's. I have no idea about the logic that I just laid out. I really try to stay away from assuming a special insight into his thinking, since he agrees with Vice Chairman Charlie Munger pretty often and since I disagree with Mr. Munger on some things. That includes the cost of capital, though I don't use beta in the way I look at the cost of capital and beta is a big hang-up for Mr. Munger.
Anyway, the company's float is a huge value driver for the company and it's a significant component in the way we look at Berkshire's intrinsic value.Specialty Insurance Ops
Over the last couple of reports, we've talked about Berkshire Hathaway's (NYSE: BRK.A) GEICO Direct Auto Insurance unit, its largest single insurance unit by premiums earned and, in some years, by underwriting gains. For 1997, GEICO's $3.48 billion in premiums earned accounted for 91.7% of premiums earned by Berkshire's direct insurance units. Through nine months of 1998, GEICO's $2.96 billion in premiums earned accounted for 92.3% of premiums earned by Berkshire's direct insurance businesses.
Coming off a great year in 1997, in which earned premiums grew 12.6%, 1998 should conclude with an even better record. Through nine months of the year, premiums earned increased 15.6%, "reflecting a 19.1% increase in policies in-force offset slightly by the effects of certain premium rate reductions. Policy growth over the past twelve months was 15.7% in the preferred-risk auto business and 38.6% in the standard and non-standard auto lines," according to the Q3 1998 10-Q. So GEICO is definitely still the cash-generating growth gem of Berkshire Hathaway. Its value plays a large part in determining the overall value of Berkshire Hathaway -- we'll get to that after looking at what the company does and figuring out the important considerations in valuing the company.
As long as we're on direct insurance subsidiaries, we'll stick with that theme. Other than GEICO, Berkshire's direct insurance businesses "are comprised of a wide variety of smaller property/casualty activities. These businesses include: National Indemnity Company's traditional commercial motor vehicle and specialty risk operations; five companies collectively referred to as 'homestate' operations that provide primarily standard commercial coverages to insureds in an increasing number of states; Cypress Insurance Company, a provider of workers' compensation insurance in California and other states; Central States Indemnity Company, a provider of credit card credit insurance to individuals nationwide through financial institutions; and Kansas Bankers Surety Company, an insurer for primarily small and medium size banks located in the Midwest." (1997 Annual Report, Management's Discussion and Analysis). These companies reported earned premiums of $313 million last year and were $247 million through the first nine months of 1998.
National Indemnity underwrites lots of specialty lines of insurance, which is one of the best prescriptions for fighting deterioration of pricing in property and casualty insurance underwriting (I wrote about this last month). Specialty lines are niche businesses where your experience in underwriting gives you a competetive advantage in risk management. It also gives you something of a marketing advantage if the agents you deal with know you and your capabilities and know the customers well after dealing with them for a number of years. If you can price more effectively, then you'll be able to take share when your competitors pull back and you'll also know when to pull back when your competitors are pricing coverages irrationally.
Let's look at some of the specialty lines of business at National Indemnity and the types of risks they underwrite:
Commercial trucks and truckers
- Contractors - Light Dumps, Boom, and Bucket Trucks
- Food Delivery
- Specialized Delivery
- Courier Service Vehicles
- Waste Oil Transporters
- Waste Disposal - Physical Damage Only
- Salvage Haulers
- Farm Vehicles
- Cement Mixers
- Dump Trucks - For Hire, Not For Hire and Municipally Owned
- Coal Haulers
- Lawn and Tree Service Trucks - Includes Landscapers and Sod Layers
- Snow Removal - With or Without Permanently Attached Blades
- Logging and Pulpwood Haulers - For Hire and Not For Hire
- Mobile Home Transporters (Toters)
- House Movers and Winch Trucks
- Moving Operations
- Tow Trucks - Full-Time or Incidental Use
- Tiltbed and Rollback Auto Haulers
- Auto Repossessors
- Gasoline, Diesel Fuel, and Airplane Fuel Transporters
There are a bunch more here, too. Think of all the special risks that affect these sorts of truckers. Waste oil transporters and airplane fuel transporters? You're in deep trouble if your waste oil truck overturns and spills its contents somehow into a schoolyard or an environmentally sensitive wetlands area. Your underwriters and adjusters should probably know something about this, and learning about assessing the safety of fuel trucks or knowing all the EPA regulations aren't two things you pick up over coffee.
- Taxicabs - Multiple Unit and Single Unit Accounts
- Kiddie Transportation Vehicles
- Limousines - Stretched and Luxury Autos
- Airport Stretched Limousines
- Airport Shuttles and Transportation Service Autos
- School Buses - Private or School District Owned Units
- Church Buses - Owned Operated Religious
- Urban Buses
- Trolley Buses
- Inter-City Buses
- Bingo/Casino Transportation - For Hire and Not For Hire
- Charter Buses - Inter and Intrastate
- Off-Road Four Wheel Drive Auto Tours
- Sightseeing Buses
- Athlete Buses
- Musician and Entertainer Buses
So, what if the bus the customer operates crashes and causes the wrongful deaths of Bill Cosby, Jerry Seinfeld, Adam Sandler, and Oprah Winfrey? Who knows the possibility of that? I'm sure National Indemnity's underwriters know that better than me.
- Ambulances - Privately Owned and Owned by Hospitals and Political Subdivisions
- Private Passenger Rentals - Sedans, Minivans, Vans, Jeeps, and Sport Utility Vehicles
- Commercial Rentals - Vans, Light & Medium Trucks, Moving Vans, Utility Trailer Rentals
- Driver Training Autos - Private Passenger Autos, Trucks, Tractors, Trailers, and Buses
- Salesperson Autos
- Police Cars and Law Enforcement Vehicles
- Security Patrols
- Bookmobiles, Bloodmobiles, Mobile Stores, Etc.
- Non-Emergency Ambulances and Medivans
- Rescue Squads
- Fire Department Vehicles
- Funeral Director Vehicles - Limos, Hearses, Flower Cars, Escorts
- Hearses & Limos Owned and Operated For Hire to Funeral Directors
Police cars and fire trucks probably entail special risks that any fly-by-night underwriter just can't underwrite effectively. Most customers, such as municipalities, also probably don't want to deal with fly-by-night operators. They would rather work with a company that knows what it's doing.
There are a couple other lines, but here's an interesting one:
- Basketball Shots
- Bowling 300 Games
- Grand Slam Home Run
- Hockey Puck Shots
- Paper Airplane Tosses
- Record Size Fish
Special Events Coverage:
- Art Shows
- Sporting Events
Too bad the markets for these types of coverages were not larger, because this business is wonderfully profitable. Last year, National Indemnity's "traditional business" ran a combined ratio of 32.9%, meaning it paid out $0.671 in losses, underwriting expenses, and adjustment expenses for every dollar of premiums it earned. Expressed as a percentage of float, the pre-tax cost of this capital would be negative 32.9%. If the company can generate a return on that capital of 15%, the spread between the cost of capital and return on capital (after tax) would be an eye-popping 36.4%.
Alternatively, you could look at the underwriting gain after tax as return on capital and treat the capital as having no cost. The spread would still be 36%+. That's better than about 99% of the S&P 500 companies out there. The economics of this sort of business, when run by intelligent and motivated people, are incredibly good over the long-term. These are the sorts of things that demonstrate that the "closed-end mutual fund" arguments offered to explain Berkshire are wrong.Super-Catastrophe Insurance
Before going forward today, I wanted to get the bad news to you. The bad news is that I committed an error in logic the other day. In talking about combined ratio, I went on to conflate that with return on capital. The underwriting loss or gain expressed as a percentage of earned premiums is not return on float or cost of float, as expressed as a percentage, unless the average float was exactly the same as earned premiums. Which would be a coincidence.
The point that I did want to make was that you can treat the after-tax underwriting gain or loss, as a percentage of the average float, as either a return (positive or negative) on float or you can treat it as a cost of the float. Looking then at the after-tax return on investment the float earns in stocks, bonds, or whatever gives you a further return on float measure. To ascertain the spread between return on capital and cost of capital, you can either treat cost of float as zero and add the return on float provided by the underwriting gain to the return on float from investments and look at that at the spread between cost of capital and return on capital. Or, you can treat the underwriting gain or loss as a cost of float (in the case of an underwriting gain, the cost of float will be negative) and compare that with investment returns attributable to the float. Either way, for the purposes of Economic Value Added analysis, the spread between cost of capital and return on capital will be the same.
Say, for instance, a company generates an after-tax underwriting gain of $100 million and has an average float of $5 billion. The cost of that float will be a negative 2%. And say the company generates an after-tax investment return on the float (including unrealized capital gains) of 15% over the course of the year. If you treat the cost of capital as -2% and the return on capital of 15%, then the difference between return on capital and cost of capital will be 17 percentage points.
If you treat the cost of capital as zero and treat the underwriting gain and the investment return as a 17% return on capital, then the spread between return on capital and cost of capital will be 17 percentage points.
Sorry for the confusion, if there was any.
Continuing with Berkshire
OK, on with other things. We've talked about GEICO Direct and other lines of specialty insurance at Berkshire. Let's talk about super-cat underwriting. Super-cat is super-catastrophe insurance, which primary insurers such as Allstate (NYSE: ALL) or reinsurers such as PartnerRe (NYSE: PRE) take out to cover themselves against a very large catastrophic loss event such as a hurricane or an earthquake. For instance, Berkshire underwrote the California Earthquake Authority when other financial interests couldn't give the CEA an answer quickly enough. In this instance, Berkshire received very large premiums (which are now part of the float) in exchange for a promise to cover the CEA above and beyond a certain layer of losses it will cover. What Berkshire super-cat super-genius Ajit Jain saw in this opportunity was that it would take a rare, very large earthquake for the losses to reach the layer of coverage for which Berkshire is responsible. The large premium Berkshire received for the coverage, if invested wisely, would more than offset the company's exposure over the life of the contract.
The maximum exposure Berkshire faces for this contract is about $1 billion pre-tax and $600 million after tax. Here's part of the story on that from Berkshire's 1996 Chairman's Letter to Shareholders:
"A few facts about our exposure to California earthquakes - our largest risk - seem in order. The Northridge quake of 1994 laid homeowners' losses on insurers that greatly exceeded what computer models had told them to expect. Yet the intensity of that quake was mild compared to the "worst-case" possibility for California. Understandably, insurers became - ahem - shaken and started contemplating a retreat from writing earthquake coverage into their homeowners' policies.
"In a thoughtful response, Chuck Quackenbush, California's insurance commissioner, designed a new residential earthquake policy to be written by a state-sponsored insurer, The California Earthquake Authority. This entity, which went into operation on December 1, 1996, needed large layers of reinsurance -- and that's where we came in. Berkshire's layer of approximately $1 billion will be called upon if the Authority's aggregate losses in the period ending March 31, 2001 exceed about $5 billion. (The press originally reported larger figures, but these would have applied only if all California insurers had entered into the arrangement; instead only 72% signed up.)
"So what are the true odds of our having to make a payout during the policy's term? We don't know -- nor do we think computer models will help us, since we believe the precision they project is a chimera. In fact, such models can lull decision-makers into a false sense of security and thereby increase their chances of making a really huge mistake. We've already seen such debacles in both insurance and investments. Witness "portfolio insurance," whose destructive effects in the 1987 market crash led one wag to observe that it was the computers that should have been jumping out of windows.
"Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man's precise age to know that he is old enough to vote nor know his exact weight to recognize his need to diet. In insurance, it is essential to remember that virtually all surprises are unpleasant, and with that in mind we try to price our super-cat exposures so that about 90% of total premiums end up being eventually paid out in losses and expenses. Over time, we will find out how smart our pricing has been, but that will not be quickly. The super-cat business is just like the investment business in that it often takes a long time to find out whether you knew what you were doing."
As someone that doesn't know that much about super-cat insurance, I cannot focus on individual contracts and the tiniest details of what Berkshire does here. What we focus on is how the company has conducted itself in the past with respect to risk and reward and how that might play out in the future. We do know this: shareholders are not exposed to one or a few bad decisions with Berkshire's insurance operations. Right now, the CEA exposure represents less than 2% of the Berkshire's tangible asset value and less than 4% of tangible book value as of September 31.
We also know that people at Berkshire think rationally about pricing, which is the component of the reward part of the risk/reward calculus: "The influx of 'investor' money into catastrophe bonds -- which may well live up to their name -- has caused super-cat prices to deteriorate materially. Therefore, we will write less business in 1998." As investors, we're not rooting for the company to show revenue increases or earnings increases year after year. We want people who know how to price risk appropriately, especially in the insurance and banking companies that will eventually be part of our portfolio.
Last year, super-cat underwriting provided $182.7 million in net earnings for Berkshire and $107.4 million the year before. As Chairman Warren Buffett warned, though, the industry has been very lucky with super-catastrophic events. Combined with great conditions in the bond market and a dearth of big super-cat losses, pricing has thus suffered. To learn about Berkshire's response to favorable pricing catalysts, I recommend the "insurance operations" section of the 1989 letter to shareholders.
The GenRe MergerLast week, we discussed Berkshire Hathaway's (NYSE: BRK.A, BRK.B) insurance operations, from GEICO Direct Auto Insurance, to direct specialty insurance, to super-catastrophe insurance. Before we conclude this section on insurance operations, we should talk about General Re (NYSE: GRN), a company with which Berkshire has signed a definitive agreement to merge. GenRe is North America's largest reinsurer and its the world's third-largest reinsurer, according to National Underwriter Property & Casualty, a trade journal. GenRe put together a presentation on some of the thinking behind the merger, which you can find at the company's excellent website at www.genre.com or by clicking this link.
The deal was agreed upon at a price valuing GenRe at 22.3 times its trailing EPS at the time. Even more interesting, however, is price paid (equity value) relative to GenRe's insurance float and invested capital. Relative to insurance float, the price paid for the company was 1.1 to 1.22 times GenRe's float, depending upon how you treat a recoverable that was on GenRe's balance sheet at the time. As a multiple to invested capital however, the price was even more interesting. The equity value to invested capital multiple Berkshire agreed to was 0.565, which is not big at all. Looking at it another way, on the basis of adjusted book value, which is shareholders' equity plus reinsurance balances, unearned premiums, deferred policy benefits, and claims and claim expenses, Berkshire paid 0.74 times adjusted book.
The bottom line on the deal was that GenRe was cheap, even after the 26% premium to which Berkshire agreed. Here's why. Historically, General Re has achieved a combined ratio of 100%. Here are the historical combined ratios for GenRe that the company presented earlier this year:
5 years: 101.0%
10 years: 101.4%
20 years: 102.8%
30 years: 102.2%
40 years: 101.3%
50 years: 100.4%
Historically, then, the capital that comes into the company through underwriting insurance has been virtually cost-free. Combine this cost free source of capital with managers who have the ability to allocate this capital to very good investment opportunities and you have a powerhouse combination. And when I say investment opportunities, we're not just talking about "buy and hold" sorts of stock purchases. I'm talking about outright purchases of entire companies, publicly- or privately-traded, as well as "non-conventional" investments (as Buffett puts it, in addition to taking minority stakes in publicly-traded companies.
In the merger press release the two companies, Warren Buffett, and Vice-Chairman Charlie Munger named four synergies that they believed to justify the price paid:
1. "First, this transaction removes constraints on earnings volatility that have caused General Re, in the past, to decline certain attractive business and, in other cases, to lay off substantial amounts of the business that it does write. Because of both its status as a public company and its desire to maintain its AAA credit rating, General Re has, understandably, been unable to operate in a manner that could produce large swings in reported earnings. As part of Berkshire, this constraint will disappear, which will enhance both General Re's long-term profitability and its ability to write more business. Furthermore, General Re will be free to reduce its reliance on the retrocessional market over time, and thereby have substantial additional funds available for investment."
2. "Second, General Re has substantial opportunities to develop its global reinsurance franchise. As part of Berkshire, General Re will be able to make investments to grow its international business as quickly as it sees fit."
3. "Additionally, General Re will gain tax flexibility as a result of the merger. In managing insurance investments, it is a distinct advantage to know that large amounts of taxable income will consistently recur. Most insurance companies are in no position to make this assumption. Any Berkshire insurance subsidiary can fashion its investment strategy without worry as to the presence of taxable income in the future due to Berkshire's large and diverse streams of taxable income."
4. "Finally, Berkshire's insurance subsidiaries never need to worry about having abundant capital. Therefore, they can follow whatever asset strategy makes the most sense, unconstrained by the effect on the capital of the Company of a sharp market decline. Periodically, this flexibility has proven of enormous advantage to Berkshire's insurance subsidiaries.
"These synergies will be coupled with General Re's pristine worldwide reputation, long-standing client relationships and powerful underwriting, risk management and distribution capabilities. This combination virtually assures both Berkshire and General Re shareholders that they will have a better future than if the two companies operated separately."
In other words, the company can be run more rationally, to satisfy owners with longer-term objectives instead of having to balance the needs of a more diverse shareholder group than General Re currently has. Also, due to its diversified nature, Berkshire has the cash flow necessary to bridge the gap between optimal investment decision-making at GenRe and the need for liquidity to satisfy claims. The timing differences between the point where economic income is generated and taxable income is generated are also bridged by Berkshire's cash flow. What all of this means is that the allocation of General Re's investment portfolio between equities (again, this includes buying entire companies) and fixed income securities can be increased when the investment decision makers at Berkshire feel the time is right.
Bottom line on the General Re transaction, I believe it's a home run for Berkshire. More than that, I believe it's a Mark McGuire home run. It's a not a high shot that could get blown down or blown foul. This was a line shot straight out of the park.
Since we've talked about what I believe is Berkshire's most important subsidiary in GEICO, let's move on to identifying some of the other companies that are part of the entire package.
If you like Tiffany's-grade jewelry but don't like Tiffany's grade pricing, this is the place to go. Borsheim's offers 100,000 items in inventory and the services of premier gemologists and designers. The other part of Berkshire's jewelry operations is Helzberg Diamonds. Helzberg has expanded at a fast pace over the last couple years. Here's part of the story on that, from Helzberg's website: "The 90s have seen the most aggressive expansion and exciting changes in our company's history. In addition to opening new Helzberg Diamonds stores at an unprecedented pace, a decision was made to venture out of malls to create a much bigger store, and a different name for these new freestanding superstores was selected: JEWELRY3, with three times the selection of any mall jewelry store. The first five years of JEWELRY3 revealed that the public accepted the freestanding store format. However, to build on our successes and to fully communicate the heritage of one company, it was decided to put the Helzberg Diamonds name on the freestanding stores, too."
1996 was something of a disappointment. Helzberg CEO Jeff Comment turned things around last year for a nice mention in the 1997 letter to shareholders. In 1997, Berkshire's share of net earnings for jewelry operations was $18.3 million, up from $16.1 million the year before. On Monday, we'll talk more about Berkshire's retailers and other operations and possibly follow up with an update on Helzberg if I can talk to someone at the company.
Alex will be dealing with Borders (NYSE: BGP) over the next couple of days. The goal there is to put a value on the company. I've done some work on it and I believe it to be undervalued, personally. While I don't like the business, I don't plan to sell something I see as undervalued, either. Looking at the action in the stock price over the last few weeks, I believe the company is probably guiding or going to guide earnings expectations lower.
While its website is probably cooking (the operaters were very busy when I put in an order and their computer crashed as I was on the phone with them due to a surge of data moving through the system at noon), this may take away sales from the stores. If that's what the company is dealing with right now, it will probably make its revenue numbers and miss its earnings estimates. But I'm hardly going to make a move on buying or selling a stock based on what I think it will do for one quarter.
Nevertheless, one quarter makes the year at Borders. Hopefully its strategic planning will deal with the changing dynamics of the bookselling environment. My amateur view of things is that the dynamics are indeed changing and that Borders has not taken that seriously enough. In any case, Alex will deal with these questions over the next few days.
We're coming to the conclusion of our look at Berkshire Hathaway (NYSE: BRK.A, BRK.B). Before we get back to looking at what the company is all about, a note on the price action in Berkshire's shares since the GenRe merger agreement was announced. The decline in Berkshire's and GenRe's price since then is not a concern. Upon the announcement of the merger earlier this year, I calculated what I thought was the fair price for the combined company and came out with an estimate not too far off from where the company was trading at the time. Now, we have gone about calculating the value of the company anew and will not necessarily come to the same conclusion. But we do believe this: That Internet stocks are advancing 30% a day while Berkshire and GenRe and other high quality companies are down since some randomly selected time period is not a problem.
As of this afternoon, Berkshire is up nearly 30% for the year, which seems small if your view of investing was formed exclusively this year and you only own Amazon.com (Nasdaq: AMZN) or something along those lines. If not, you realize what a a good performance a 30% annual return is. General Re is down slightly for the year as of this afternoon (the merger was completed after the bell today and GenRe shareholders will receive Berkshire shares or cash for fractional Berkshire shares), but that's in the face of very tough industry conditions for the property and casualty insurance markets. Early in November, I wrote about this subject (that's what the link above is). Here's how those companies have fared through today for the year (dividends reinvested)
- Allstate (NYSE: ALL): -16.2%
- American Financial Group (NYSE: AFG): -5.5%
- Chubb (NYSE: CB): -12.5%
- Cincinnati Financial (Nasdaq: CINF): -23.7%
- Fremont General (NYSE: FMT): -13.6%
- Frontier Insurance (NYSE: FTR): -41%
- General Re Corp. (NYSE: GRN): -4.3%
- Mercury General (NYSE: MCY): -16.9%
- Old Republic International (NYSE: ORI): -13.8%
- Progressive Insurance (NYSE: PGR): +29.6%
- St. Paul Companies (NYSE: SPC): -11.4%
- Safeco Corp. (Nasdaq: SAFC): -12.8%
- Travelers Property Casualty Corp. (NYSE: TAP): -33%
- Zenith National Insurance (NYSE: ZNT): -5.6%
- S&P Supercomposite Property/Casualty Index: -4.8%
Only one of these companies has seen its stock appreciate this year, and that's auto insurer Progressive Corp. Of the rest, there are some very good companies that succumbed to pricing pressure or perhaps overvaluation late last year. The point is, just because a group is down doesn't make it less attractive. Depending on the company, its stock being down increases its attractiveness if the value of the business has not declined. Too many investors confuse the terms "price" and "value." The Chairman of Berkshire Hathaway said, "Price is what you pay, value is what you get." While I try not to rely on Mr. Buffett's words to explain everything, this one economizes on the words and maximizes their value. You can't say it better.
GenRe's stock price was down further today as S&P 500 and closet indexers sold out their positions in the stock as GenRe was removed from the index at the end of trading today. For our view on how that does not affect the value of the company, click here. So the markdown of Berkshire here pleases us as prospective acquirers of the company's stock.
Other Berkshire Retailers
Perhaps one of the most interesting Berkshire retailers is Nebraska Furniture Mart. Founder Rose Blumkin, who died earlier this year at the age of around 105, was doing the "big box" category killer retail concepts before those phrases came along. Mrs. Blumkin, who did not have a formal education and who spoke no English when she fled Czarist Russia during World War I to come to the U.S, started the company in 1937. Nebraska Furniture Mart, a furniture, electronics, and flooring super-retailer in Omaha, had sales of $500 per square foot in its 200,000 square foot store when Berkshire Hathaway acquired its majority stake in the company in 1983. That was a big, big per square foot sales number in those days. Heck, it's big even today. Sam's Club doesn't even do that. So we know that Mrs. B was pricing low and turning inventory and keeping costs down long before everyone else tried to shoot for that concept. By the way, this disproves the notion that Berkshire only invests in high-margin enterprises.
R.C. Willey is the same sort of store as Nebraska Furniture Mart and reported about the same volume as NFM in 1995 (the year Berkshire acquired it) according to the 1995 Chairman's letter, but generated that volume in five stores, versus NFM's one store. R.C. Willey now has nine locations in Utah and is probably well over the 50% Utah market share Berkshire reported in 1995. Next stop for the company -- Idaho in 1999.
Star Furniture. This is another big-box retailer, this one in Texas. "But allow me to let Mr. Buffett explain, because this is another great story about how Berkshire does things:
"The Star transaction has an interesting history. Whenever we buy into an industry whose leading participants aren't known to me, I always ask our new partners, "Are there any more at home like you?" Upon our purchase of Nebraska Furniture Mart in 1983, therefore, the Blumkin family told me about three outstanding furniture retailers in other parts of the country. At the time, however, none was for sale.
"Many years later, Irv Blumkin learned that Bill Child, CEO of R.C. Willey -- one of the recommended three -- might be interested in merging, and we promptly made the deal described in the 1995 report. We have been delighted with that association -- Bill is the perfect partner. Furthermore, when we asked Bill about industry standouts, he came up with the remaining two names given me by the Blumkins, one of these being Star Furniture of Houston. But time went by without there being any indication that either of the two was available.
"On the Thursday before last year's annual meeting, however, Bob Denham of Salomon told me that Melvyn Wolff, the long-time controlling shareholder and CEO of Star, wanted to talk. At our invitation, Melvyn came to the meeting and spent his time in Omaha confirming his positive feelings about Berkshire. I, meanwhile, looked at Star's financials, and liked what I saw.
"A few days later, Melvyn and I met in New York and made a deal in a single, two-hour session. As was the case with the Blumkins and Bill Child, I had no need to check leases, work out employment contracts, etc. I knew I was dealing with a man of integrity and that's what counted.
"Though the Wolff family's association with Star dates back to 1924, the business struggled until Melvyn and his sister Shirley Toomin took over in 1962. Today Star operates 12 stores -- ten in Houston and one each in Austin and Bryan -- and will soon move into San Antonio as well. We won't be surprised if Star is many times its present size a decade from now.
"Here's a story illustrating what Melvyn and Shirley are like: When they told their associates of the sale, they also announced that Star would make large, special payments to those who had helped them succeed -- and then defined that group as everyone in the business. Under the terms of our deal, it was Melvyn and Shirley's money, not ours, that funded this distribution. Charlie and I love it when we become partners with people who behave like that."
See's Candies is better known to those who live west of the Mississippi, but it's working its way east and is available in a number of locations throughout the holidays. See's is a manufacturer and marketer of premium confections. Its traditional base of business is California, where the company has been building its brand equity since 1921. See's demonstrates a number of attractive attributes about Berkshire.
1. Buying intrinsic value. When Berkshire purchased See's, "value investors" probably would have said it was too expensive. Berkshire's view of value is more complex than the Paleolithic views of value still practiced by those who won't pay more than "X" times earnings and "Y" times book value. Charlie Munger and Warren Buffett recognized the value of the See's franchise in preserving pricing power and the excellent return on capital economics of the company. Since the company was purchased in 1972, pre-tax earnings have grown more than 11% per year while capital investment has grown at a far smaller pace.
2. Re-directing cash flow. If something like See's doesn't have to reinvest cash flow to perpetuate the franchise, then the cash flow can be used elsewhere. This is particularly helpful in market environments such as 1974 or 1981 when Berkshire could use See's cash flow to invest in enterprises where internal rates of return on capital were far greater than See's. See's is a blessed little cash pump that will likely spit out over $40 million in cash flow this year and will be able to maintain this cash flow rain or shine.
The other interesting aspect about See's was that it was purchased using the operating cash flow of Blue Chip Stamps, a company that generated lots of float, or cash inflows the company was able to use for a long period before required cash outflows. At the time of the See's purchase, Blue Chip stamps was near the peak of its business life, but it provided Berkshire with not only See's but also with Wesco Financial (AMEX: WSC), which is headed by Berkshire Vice-Chairman Charlie Munger. Wesco, in turn, has provided Berkshire with giant-sized positions in companies such as Freddie Mac (NYSE: FRE). These are all parts of the Berkshire's puzzle -- where rational allocators of capital send on earnings to Berkshire where the capital is then put to its highest and best use.
On Monday, we continued with our brief introductions of the various Berkshire business units. Though each one might be brief, there are a ton of individual companies that are part of the Berkshire family. So let's continue with our look at Berkshire's retailers.
We left off with See's Candies and talked about some of the lessons Berkshire's ownership of this franchise property have to teach about the way Berkshire does business. The existence of a cash cow such as this enhances the company's operations in numerous significant ways. For instance, in the reinsurance business, timing differences can exist between the generation of economic underwriting gains and taxable underwriting gains. For long-tail insurance, the taxable event can pre-date the actual earning of the premiums. If the premiums are invested in equities or a non-liquid investment, the timing difference can cause problems in how investment decisions are made with that long-tail insurance float. The existence of that earnings stream and earnings streams like that in other Berkshire businesses allow the insurance business to make optimal investment and underwriting decision- making.
To this point, just having a bunch of real cash earnings from semi-bulletproof businesses such as See's, FlightSafety International (which we'll get to), the Buffalo News, H.H. Brown, etc., allows the management of Berkshire to enter into new businesses either through taking minority positions in publicly traded companies or through buying companies outright. Think about the fact that a dying textiles company like Berkshire Hathaway, which the Buffett limited partnership bought into in the 1960s as a "cigar butt" type of value position, has now become the second-largest publicly traded company in the world, as measured by GAAP net worth. That falls into the category of maximizing what you have. And it also reflects the culture that exists at Berkshire, where cash flow generated by a dying business such as a textile mill doesn't have to be reinvested in the textiles business. The cash flow goes where the company thinks it can generate the best returns. The following quote from the 1992 Chairman's letter shows how they think about things at Berkshire:
"Our look-through earnings in 1992 were $604 million, and they will need to grow to more than $1.8 billion by the year 2000 if we are to meet that 15% goal [by the way, look-through earnings in 1997 were $1,930 million]. For us to get there, our operating subsidiaries and investees must deliver excellent performances, and we must exercise some skill in capital allocation as well.
"We cannot promise to achieve the $1.8 billion target. Indeed, we may not even come close to it. But it does guide our decision-making: When we allocate capital today, we are thinking about what will maximize look-through earnings in 2000."
Just to refute the notion that this is a closed-end fund, it just so happened that Coca-Cola Co. (NYSE: KO) offered the best use of the $1.3 billion dollars in capital Berkshire invested in the company between 1988 and 1994. If there were a similarly attractive or more attractive private company available at that time, Berkshire probably would have taken advantage of that. The division between private companies and public companies that is used to characterize Berkshire is not instructive. A good investment, no matter what the form of Berkshire's ownership in it, will add value. Would Berkshire be a closed-end fund if none of its investments were made in publicly traded equities? No. And it's not now. It just so happens that a couple publicly traded companies have large effects on the economics of Berkshire because they were such good investments. But that isn't a useful model for looking at the company going forward.
Of course, insurance is the biggest service at Berkshire. But there are other significant portions of the company that fall into this rubric. Most notably, FlightSafety International. Behind super-catastrophe insurance underwriting, GEICO, and investment results (including off-income statement investment results), FlightSafety was the largest source of reported income and value added for Berkshire in 1997:
FlightSafety's mission statement includes the following:
"A Singular Corporate Mission
"Since the very beginning, the corporate mission of FlightSafety International has been kept clearly in focus. We are a training company, which means that training is our service, our area of specialization, our reason for being. Training is our business.
"Within the broad realm of training, we have carved a special niche that involves the preparation of our customers for the safe and effective operation of complex, high-risk equipment. In most cases, the context is aviation; we train over 50,000 pilots and aircraft maintenance technicians each year. Through MarineSafety International we also train ships' officers - individuals who, like pilots, rely on proficiency for their safety, as well as the safety of others."
FlightSafety not only trains civilian and military transportation personnel at locations in North America, Europe, and China, but it also designs software and systems used in that training. And this isn't simple software here, either. We're talking about highly complex systems that replicate the operating environments of all major commercial passenger jets, as well as ships.
FlightSafety is a business with a lot of market-position characteristics we like. First, there are barriers to entry afforded by the complexity of the systems a potential competitor would need to put together. To satisfy all the parties involved -- civil and military aeronautics authorities, insurance companies, pilots and various unions, airlines, and aircraft manufacturers -- of the effectiveness and verisimilitude of the systems would take some doing after getting together those systems. Then the competitor would have to be able to locate their simulators in numerous locations throughout the U.S. and abroad. Then it would have to meet FlightSafety's pricing, which does not produce an abnormally high return on capital at the moment.
These are daunting challenges that give FlightSafety a cushion against major competitive incursions against its position as the industry leader. Furthermore, I can't see how civil or military aviation authorities will ever agree to a diminishment in training time for pilots, so there is a natural regulatory barrier that protects the company, in some ways similar to a patent. Finally, Berkshire paid an excellent price for FlightSafety, which is hard not to like. Lifting information I put together for a post on the Boring message board a month or so back, here's some data on FlightSafety from its last full year of operations as a separately traded public company:
Asset turns: 0.398
Operating profit margin: 35.8%
Average leverage: 1.41
Net cash flow from operations: $140 million
Free cash flow: $50 million
Enterprise value to operating profits: 11.5 times
Enterptrise value to invested capital: 2 times
With an acquisition price around $1.5 billion not counting the excess cash that was on FlightSafety's balance sheet at the time of the deal, we like this price, considering the growth potential of commercial aviation globally as well as the characteristics of this business.Related Links
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