Last year, I wrote and ill-timed piece at RealMoney entitled, “Life in Warren’s World Is Expensive,” and a follow-up, “Buffett the Businessman.” I claimed that Berkshire Hathaway was overvalued. It has since risen by 15-20%. I am eating my crow, and wish that I had more salt.
Trouble is, I think that my thesis is still correct. I view Berkshire Hathaway as an insurance company that uses its liability structure to fund its operating businesses. To me, the performance of the insurance enterprises is a critical aspect of whether Berkshire is a good or bad investment.
In 2006, Berky wrote some of the riskiest coverages that the rest of the insurance industry would not touch on the property side of the business. Then came a “no catastrophe” year. Is it any surprise that the stock is higher? Give Buffett credit for the AAA balance sheet that allowed him to be the last man standing in writing risky property coverages. Even in this year’s letter, he says he is willing to lose $6 billion in a single event. Pricing is slipping, and I have no doubt the Berky won’t chase the pricing down below levels where they can’t make their profit on average. That may mean that Berky will have a lot of idle cash.
Warren has changed his tune regarding retrocessional coverages in the last few years. In the 2007 letter, he explains how it can be used to ameliorate the risks of other insurers. This is a good and proper use of retro. In years 2005 and prior, he would crow about his riskless deals, which no doubt passed accounting muster, even if they missed the spirit of the regulations.
Berky has $50-70 billion to put to work. I don’t see how they can do that easily. Berky’s acquisition pattern over the past few years is to scrape up a few distressed companies, and a few companies where the owner was willing to sacrifice on price to preserve the culture. Outside of bold moves like acquiring ConocoPhilips outright, I don’t see how they can deploy that much capital.
Give Buffett credit for staying in enough of his foreign currency trade to draw a profit from it. I agree with Buffett over the state of our national finances, and think the dollar is headed lower over the intermediate term. That said, I increased my size of the trade when he lightened up in 2006.
Finally, they are looking for a successor to Buffett. Whoever that man may be, he will have to reckon with a few realities. If the objective is to grow long term book value, what is he best way to do that? Hold onto cash and wait for a crisis? Buy reasonably priced operating businesses with a hope of growth? Wait for utilities to go on sale? Behave like Magellan, Contrafund, or any other large mutual fund? (Not Buffett’s way.)
In summary, I can’t see Berky doing that well over the next twelve months because of the weak pricing environment for insurance, and the difficulty the Buffett will have in deploying the free cash of Berky. It is a more competitive environment for investments, which means that Berky will not deploy much cash.
Full Disclosure: Long COP