Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway’s (BRK.A, Financial)(BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 1995 letter.
Acquisitions
Interestingly, in the 1995 shareholder letter, during the discussion on acquisitions, in which Berkshire made three that year, Buffett said he and Charlie Munger (Trades, Portfolio) were still skeptical about most deals, noting sellers and their representatives invariably present financial projections having more entertainment value than educational value and “in the production of rosy scenarios, Wall Street can hold its own against Washington.”
Buffett also highlighted that Berkshire is not immune from the buyer’s curse, in that it will always face the inherent problem that the seller of a business practically always knows far more about it than the buyer and the seller also picks the time of sale.
Despite this, Berkshire does have a few advantages when making acquisitions. He wrote:
"...perhaps the greatest being that we don't have a strategic plan. Thus we feel no need to proceed in an ordained direction (a course leading almost invariably to silly purchase prices) but can instead simply decide what makes sense for our owners. In doing that, we always mentally compare any move we are contemplating with dozens of other opportunities open to us, including the purchase of small pieces of the best businesses in the world via the stock market. Our practice of making this comparison - acquisitions against passive investments - is a discipline that managers focused simply on expansion seldom use."
One of Berkshire’s strengths has been its unconstrained investment mandate. Even though the conglomerate's performance is often measured against the S&P 500, we see Buffett invest globally, with no constraints on security type, industry or geographic exposure. The only problem he really faces is size, finding deals to move the needle. We can learn that a flexible but disciplined style can certainly help our performance.
Geico
One thing I have learned about Buffett is that he is not given the credit he deserves for his ability to acquire information and knowledge. The perception is that he is just an accounting geek (which, OK, is probably true), reading 10-Ks and annual reports all day long. In fact, he uses the principle of “scuttlebutt,” which was defined by Phil Fisher. What this means is Buffett has not been afraid to pick up the phone or take a trip to meet someone to question them.
Buffett gives a good example of this in the ’95 letter. Discussing when he first learned about Geico, he wrote:
"And thus I met Lorimer Davidson, Assistant to the President, who was later to become CEO. Though my only credentials were that I was a student of Graham's, 'Davy' graciously spent four hours or so showering me with both kindness and instruction. No one has ever received a better half-day course in how the insurance industry functions nor in the factors that enable one company to excel over others."
Buffett was 20 at the time. So, if you are a student, you have the advantage of youth and enthusiasm to ask questions of experienced people. For older investors, I still feel most people like talking about their own business or industry and with the internet and virtual meetings, it has never been easier to talk to smaller companies about their businesses. The point is, one of Buffett’s core strenghs has been his ability to network and learn about businesses by asking questions. Except for stock broking, Buffett did not have his own business experience other than fund management and, over time, board memberships of companies he acquired. Yet, he is so knowledgeable about so many industries, and this did not just come from reading annual reports.
The not generally well-understood float advantage
Returning to Geico, Buffett reminded readers that any company's level of profitability is determined by three items: (1) what its assets earn; (2) what its liabilities cost; and (3) its utilization of "leverage" - that is, the degree to which its assets are funded by liabilities rather than by equity.
He said:
"Over the years, we have done well on Point 1, having produced high returns on our assets. But we have also benefitted greatly - to a degree that is not generally well-understood - because our liabilities have cost us very little. An important reason for this low cost is that we have obtained float on very advantageous terms. The same cannot be said by many other property and casualty insurers, who may generate plenty of float, but at a cost that exceeds what the funds are worth to them. In those circumstances, leverage becomes a disadvantage."
Since Berkshire’s float cost it virtually nothing over the years, it has, in effect, served as equity, except it differs from true equity in that it doesn't belong to Berkshire.
Buffett provided an example to walk through this thinking:
"Nevertheless, let’s assume that instead of our having $3.4 billion of float at the end of 1994, we had replaced it with $3.4 billion of equity. Under this scenario, we would have owned no more assets than we did during 1995. We would, however, have had somewhat lower earnings because the cost of float was negative last year. That is, our float threw off profits. And, of course, to obtain the replacement equity, we would have needed to sell many new shares of Berkshire. The net result – more shares, equal assets and lower earnings – would have materially reduced the value of our stock. So you can understand why float wonderfully benefits a business – if it is obtained at a low cost."
The acquisition of Geico immediately increased Berkshire’s float by nearly $3 billion. Given Buffett also expected, at the time, that Geico would operate at a decent underwriting profit in most years, this would mean the probability that Berkshire’s total float would “cost it nothing” would increase.
Jain and Berkshire’s advantages in insurance
Buffett called Ajit Jain “the guiding genius of our super-cat business” and noted he writes important non-cat business as well. In insurance, the term "catastrophe" is applied to an event, such as a hurricane or earthquake, that causes a great many insured losses. Buffett highlighted Jain’s versatility and creativity, noting he makes other deals that usually cover only a single large loss. He wrote:
"A simplified description of three transactions from last year will illustrate both what I mean and Ajit's versatility. We insured: (1) The life of Mike Tyson for a sum that is large initially and that, fight-by-fight, gradually declines to zero over the next few years; (2) Lloyd's against more than 225 of its 'names' dying during the year; and (3) The launch, and a year of orbit, of two Chinese satellites. Happily, both satellites are orbiting, the Lloyd's folk avoided abnormal mortality, and if Mike Tyson looked any healthier, no one would get in the ring with him."
Buffett went on to say Berkshire is sought out for many kinds of insurance, both super-cat and large single-risk, because:
"(1) Our financial strength is unmatched, and insureds know we can and will pay our losses under the most adverse of circumstances; (2) we can supply a quote faster than anyone in the business; and (3) we will issue policies with limits larger than anyone else is prepared to write."
Berkshire can move quickly to seize investment and acquisition opportunities. Buffett noted in its insurance business, it has the ability to move “with the same exceptional speed.”
As discussed in prior letters, Buffett said Berkshire’s ability to underwrite very large insurance policies, including for single risks, does not frighten it and actually interests it very much. This is because competition in this segment is much reduced, giving Berkshire pricing power in this area of the market. It goes back to the notion of preferring higher but more volatile returns over lower but more predictable returns.
While most investors are not underwriting insurance, similar risk-return principles apply to all investment strategy decisions.
