The Beauty of Broken Moats

When I wrote this post on Berkshire Hathaway, the main point I was going for was that the price of Berky was not unreasonable if one attributed value to what Berky could do in a crisis. When I trotted out the Ambac scenario, the idea was to illustrate how Buffett could if he wanted to, take advantage of a situation where values are depressed because the moats of competitors have been broken. (Think of what he did in manufactured housing finance after all the competitors were nearly destroyed. He bought the one healthy remaining company inexpensively.)

Now, had I been more thorough, I also would have pointed to pieces referencing Buffett and his experience with Gen Re Financial Products. The thing is, Buffett doesn’t like to be an external money manager or lender (for the most part), and
does not like structured finance exposure (even in its infancy, a la Salomon Brothers), he does recognize where there can be a clean, core business with defensible boundaries (a moat), where he can earn above average returns over time — insuring municipal bonds.

One key decision that any businessman must come to when entering a new field is build versus buy. Buy can be more attractive when there might be synergies between the acquirer and the target, or if the purchase price is sufficiently low. Build can be more attractive when the necessity of having something new that is unaffiliated with the old order is more attractive (no legacy liabilities), and where your competitors are viewed as being compromised, whether in balance sheet terms, or ethically. For the latter, think of the revenue lost by major insurance brokers after the Spitzer investigations. New players ate into the business models by avoiding conflicts of interest.

So, the announcement of Berkshire Hathaway Assurance Corp [BHAC] is no surprise here. Warren sees an opportunity, and he will pursue it.

Now here are three weaknesses of doing it this way. Buffett is not going to be the low cost provider, in a business where basis points matter as to who gets the business, and who does not. This strategy implies that he suspects that the major bond insurers have problems more severe than have been discounted by the equity and debt markets, and that their AAA bond ratings will remain under threat for some time. Second, it assumes that the managements of his competitors won’t take some action that significantly dilutes their equity in order to retain the solvency of their franchises, benefitting their own bondholders, those guaranteed by their firms, and management themselves (assuming they aren’t ousted). So far, the infusions to the financial guarantors have been significant, but not significant enough to remove doubt. The purpose of a AAA rating is that it is beyond doubt.

Third, a new startup will have higher fixed costs to amortize over the new business written. Mr. Buffett wants to charge more. Well, he will need to charge more, though perhaps that disadvantage is minimized because his competition faces higher costs in a different way from financial stress:

  • Distraction of management over structured finance exposure
  • Distraction with the rating agencies
  • Distraction over shoring up the capital structure
  • A much higher cost of capital than was previously available
  • Shareholder lawsuits (coming)

But, if I were in the seat of the competitors, I would tell my municipal divisions to ignore the problems of the company as a whole, and keep writing good business at pricing levels below that of BHAC. That will contribute to the value of the firm, and, the ratings agencies know that the marginal amount of capital needed to write that business against a mature block is almost zero. So keep writing, and protect the franchise.

Finally, it looks like this subsidiary is separately capitalized, and not guaranteed by Berky. It likely gets a AAA on its own, with only implicit support from the holding company. This gives Buffett the option to write a lot of business by providing more capital as needed, preserving flexibility at the holding company, while limiting downside if that subsidiary should ever run into trouble (very unlikely, given their business plan).Tickers mentioned: BRK/A, BRK/B, ABK

19 Comments

  • If I were to suggest to you that I had a financial stock pick, which:

    (1) had risen over 55% in price over the last two years

    (2) was up 25% YTD

    (3) had a f/w P/E of 23, far higher than S&P 500’s estimated f/w P/E

    (4) had a price/book of 2.4

    (5) had a price/sales of 2.8

    (6) and paid no dividends, preferring to spend its cash by growing through acquisitions

    I would expect that you, and most value investors, would laugh at my suggestion as having run up too far, too fast, being relatively expensive, and not representing a good addition from an income standpoint due to its use of cash in acquisitive growth – a risky strategy.

    So I wonder why more people don’t laugh when BRK/A is suggested as a good buy here …

  • Well, Bill, then you missed one of the main points of my earlier articles — I thought the stock price of Berky was reasonable in the present environment. I don’t think it is cheap, though. Even Warren and Charlie don’t think that.

  • Colin Barr says:

    hi david,

    insightful post as always. what do you make, regarding mbia and ambac, of the nouriel roubini argument that any business model that’s predicated on maintaining a triple-a rating isn’t worthy of that rating by definition? perhaps wall street has too much riding on these outfits to let them fail, but it does seem like a compelling concept. thanks.

  • No, I saw your point, I just found it incongruous with your stated investing style. I suspect this deviation from method is the result of an emotional attachment to BRK/A because of idealization of the CEO, and I suspect that I will receive a flood of commentary about this note – for that very reason.

    This is a momentum stock at the moment, +25% YTD and +55% in two years; you avoid momentum as a general rule; the KIE (insurance industry SPDR) has returned +3% over the last two years, meaning that this stock is WAAAYYY out of line with its industry. The price metrics are above average for its category and for the market, something you avoid as a general rule; P/E much higher than any other P&C insurer with cap > $3 bil, higher than all but two with cap > $1 bil. Similarly it is expensive in Price/Sales, Price/Book, and Price/Free Cash Flow in its category. Their 12-month trailing ROE is BELOW that of its industry.

    I seriously think that, if I had presented these facts to you (expensive relative to industry, valuation above market, huge runup in price, low ROE relative to competition) about ANY OTHER STOCK you would have dismissed it as a potential investment, without a second thought, and without even asking me what the ticker was.

    So I think the deviation from normal considerations of valuation and momentum isn’t so much about BRK/A the company as it is an emotional judgment based on W.E.B. the man.

  • I see your point, Bill, but my view is different here because of real options theory. In a crisis, cash is worth more than its stated value. I have seen that with Berky after major disasters, like Katrina. It is the easy play at those points. This is like Katrina, but it is on the other side of the balance sheet. That’s why I can justify BRK for now.

    I have been critical of BRK’s valuation in the past during non-crisis periods. But a true AAA balance sheet is worth more in a crisis. Hey, I’m a value investor. I like hidden assets, like cash and unused borrowing capacity, and can be flexible in my thinking.

    That said, if the eventual crisis is worse than anticipated, Berky is worth more. If the crisis burns out soon, it is worth less in relative terms. The real option will remain out of the money, and they will just have too much slack cash.

  • Louis Hill says:

    Hi David

    From Mr. Buffet’s past history, he has rarely started a new business from scratch just to be in a market he likes. I suspect that he feels confidant enough in a future purchase that he needs an already licensed vehicle to buy someone like ACA Capital in 2008.

    Happy New Year, Louie

  • Colin, Roubini has a point, but a AAA guarantor can exist so long as it keeps its underwriting discipline. That means shrinking in the face of competitors when they get to non-economic pricing levels. The trouble is, AAA guarantors were willing to fudge on what acceptable leverage, risk acceptance, and pricing levels are, which is why they got to this point.

    Louis, as for ACA, I haven’t written about it (or touched it) because I was in touch with material nonpublic information, and so I didn’t say or do anything. That MNI has possibly expired, but it is safer for me not to comment.

  • James Dailey says:

    Hello David,

    I see and respect your point on BRK but did have a question. Obviously the liquidity of the balance sheet is like call option on picking up distressed assets, but isn’t that at least significantly offset by the impact of a slowing/recessionary economy on BRK’s other operating businesses? Also, as you have argued it is difficult to believe that the re-insurance business can be as utopian going forward as it has been since Katrina. So we have potentially flat to down earnings in the insurance business + operating units vs the upside of the liquid balance sheet. Seems like a big mess to try and analyze to me!

  • amccabe says:

    James,

    For similar reasons to those you mentioned (as well as share price), I invested in LTR earlier this year instead of BRK-B as call on liquidity. Outside of CNA, it looks like their subsidiaries are a well positioned in the shorter term. Do you have any thoughts on Loews as a liquidity play?

  • James Dailey says:

    amccabe,

    I confess to not being as good of an individual stock analyst as I probably should be. With my firm I simply don’t have the time or resources to commit, so there are more names I am not current on than I am. I actually only know BRK from a macro level. I feel like I know enough about the general nature of its businesses to get a sense for the stock.

    I wouldn’t know the difference between the accounting for life vs P/C insurance reserves, for example. I focus more on macro and asset allocation issues and then drill down to preferred areas for “satellite” positions. LTR appears interesting at first glance, but I can assure your judgment on the name would be better than mine!

  • amccabe says:

    Thank you for the reply, James – I didn’t mean to put you on the spot for an analysis.

    At the time I bought LTR, I was interested in the natural gas assets they purchased from Dominion because I was looking to replace COP. Later in the summer as the credit problems became more apparent, I started looking at them as a company that benefit picking up distressed assets. If I was going to choose another, the list would also include BRK, LUK, and IEP (maybe BX).

  • PaulinKansasCity says:

    amccabe; LTR is a company I’ve never looked at but sounds like an idea worth explloring.

  • Mike C says:

    Disclosure: I am long Berkshire at a 15% allocation for myself and client portfolios. I had a 30% allocation up until just about a month ago when I sold 1/2 at around 4500ish. It has been a major source of outperformance the last 2 years.

    FWIW, my own philosophy is that the best-performing stock-picks tend to happen when one marries reasonable or undervaluation with price momentum because one is buying value that the market is in the process of actively recognizing as opposed to sitting on dead money or worse something that will continue to fall.

    Having said all of that:

    “2) was up 25% YTD

    (3) had a f/w P/E of 23, far higher than S&P 500’s estimated f/w P/E

    (4) had a price/book of 2.4

    (5) had a price/sales of 2.8″

    Your valuation numbers here are just plain wrong. First off, when looking at Berkshire if you are going to use P/E you have to use the “look-through” earnings. The best approach is probably the one Buffett lays out which is the two column approach of market value of investments + reasonable multiple of operating business earnings. Look at the growth rate of the operating businesses over the past 5 years. Blows the S&P 500 out of the water.

    Not sure where you got P/B of 2.4 from. Off the top of my head, I think the latest P/B off the last quarter’s book value is like 1.8 to 1.9. Towards the high end of the historical range, but certainly not unreasonable.

    As David points out, there is the option value of the cash in terms of picking up bargains when the sh*t hits the fan which is becoming clear in the past couple months. Then you have the fact that he is often the preferred purchaser of private businesses for those who want/need to cash out. Look at the deal he got on Marmon.

    In terms of “intrinsic value”, even conservative estimates yield upside from current prices

    http://creativeacademics.com/finance/IV.html

    Do you really believe the S&P 500 is more attractively valued then Berkshire? I’ll gladly take the bet from anyone that Berkshire outperforms the S&P 500 over the next 5 years. Berkshire should be able to grow book value at a rate well above what the S&P 500 can grow EPS.

  • Frankel says:

    David, You mention that BHAC isn’t the lowest cost provider however, isn’t their guarantee worth more than the other guys?

  • James Dailey says:

    Mike C,

    First congrats on such an outstanding position for you and your clients over the past couple of years.

    I wanted to throw a couple of thoughts at you. First, your discussion of BRK is of a relative nature – i.e. it will do better than the SPX. I think, while important, that is not a great way to assess investment merit. Any reasonable mean reversion methodology over a 5 year period would have the SPX flat to down, so beating that could still result in disappointing results!

    Second, it seems to me that the “Buffet Booya” is reaching dangerous levels both on CNBC and elsewhere. You yourself admit it is trading year the upper end of its historical valuation range. I would argue that the “what is BRK worth if it was broken up” is effectively a worthless argument, as that would only potentially occur when Mr. Buffet dies – probably not a multiple expanding event and likely to be well into the future.

    Finally, when the stock reached comparable valuation levels in 1997 the stock did ascend into the 1998 peak (score one for your momentum argument!), but it still took until the break out in 2006 until the stock doubled from the 1997 level – or about a 7% per year return. Again, that isn’t horrible but it is not very good on a risk adjusted basis.

    My proprietary price analysis suggests that the $151,000 level was significant and the shares have since registered what we call a “daily sell signal”. The stock fulfilled the initial downside target at $131,800 and is now re-testing the area of the intial sell signal. If the stock is repelled by that area, then we would expect the stock to visit the $111,700 area.

    The last time the stock was in a comparable situation was in mid December 2006. We also had a daily sell signal at that time but the completion of the signal was very lethargic – taking 38 trading days and never violating the initial downside price area. The stock proceeded to “re-charge” and consolidate before the next big move higher.

    In contrast, the current “daily sell signal” took just 2 days to hit the initial downside area and just 7 days to bounce back to the critical initial area. The current price behavior suggests to me there is a high probability that the stock is likely to head lower – by about 20% from its current price.

    You don’t know me from Adam, but as a trader I would be far more interested in shorting BRK.A with a stop at about $145k and a downside target of $112k-$115k.

  • Mike C says:

    James,

    Thanks for the thoughtful response! It is always useful to get another intelligent perspective that differs from your own.

    Couple of things.

    From a valuation perspective, Berkshire is certainly less attractive now then it was 1-2 years ago when you could pick it up at a P/B ratio below the historical median with BV growth accelerating. Part of the reason I sold 1/2 the position.

    On the relative valuation, I think you and I are coming from similar perspectives on what the returns of the S&P 500 might be the next 5 years, especially in terms of potential downside risk (combination of earnings and multiple contraction). So what do you do? What do you buy? I sold most of my REITs in May 2007, and that asset class doesn’t look good to me. I have still have a hefty allocation to commodities, but they’ve run up recently and could have downward pressure in a slowing global economy.

    IMO, Berkshire is a good place to “hide” instead of holding a ton of cash waiting for market valuation levels to come down to compelling buy levels.

    From a technical perspective, I think we are operating in somewhat different time frames. My use of technical analysis is more oriented around capturing the big moves that happen over a 12 month+ or multi-year time frame, and not necessarily catching the short-term moves up and down over a couple of months.

    I see a substantial sideways consolidation/base having been built from early 2004 through late 2006 (almost 3 years). Standard TA theory is the length and magnitude of the uptrend is often proportional to the previous base. The magnitude of the move from Aug 07 to the recent peak of 5K for the B shares was excessive and we needed a correction to work that off. I think the pullback to 4.5K on the B shares accomplished that. There is a support level at 4K on the B shares, but frankly I don’t think we are going to see it.

    Philosophically, I would never short a quality company with a history of being a LT winner, arguably still a reasonable valuation, and positive LT technicals just to capture a possible short-term downside correction. I don’t like the risk/reward on that trade. I would think the current enviroment offers up much better candidates for shorting.

    Final point on valuation. The Fairholme Fund which I own and which has an outstanding performance record since inception in 1999 has a fair value price target on Berkshire well north of the current price. The P/B multiple may be less relevant then in the past and substantially understate the intrinsic value because the wholly owned operating companies make up a much larger percentage of Berkshire versus marketable securities compared to 5-10 years ago.

    I don’t expect “shoot out the lights” performance over the next 3-5 years, but I think the upside potential versus the downside risk is significantly better then the broad stock market. I’m not a Buffett sycophant, but I think one should be careful to not underestimate his ability to create value in a turbulent environment. I know he is a helluva lot smarter then me, so I feel comfortable essentially having him run part of my portfolio for much cheaper then the average mutual fund or hedge fund manager.

  • James Dailey says:

    Mike C,

    My work suggests that the last 2 days trading in BRK will usher in the very decline I forecasted. I respect that your timeframe is longer than mine may be, and I would not and am not short BRK. However, for those of us who did not have your excellent foresight in owning the stock over the past couple/few years, my analysis provides a decent blueprint (I think anyway!) for a good risk/reward entry point over the intermediate term.

  • Mike C says:

    FWIW, here are some IMO excellent posts on Berkshire’s business model and valuation from Motley Fool

    http://boards.fool.com/Message.asp?mid=26262286&bid=101158
    http://boards.fool.com/Message.asp?mid=26262337&bid=101158
    http://boards.fool.com/Message.asp?mid=26262987&bid=101158

    I don’t think I could say it any better than the author of those posts who I will quote below:

    “It is my belief that any attempt to value Berkshire that does not include some effort to place a value on this float is a waste of time, and displays a serious lack of understanding of the company. Yet we continue to see pundits ignore this issue. The recent Barron’s article said that Berkshire was overpriced because it was selling a fifteen times earnings, but the authors did not take the trouble to place any value on Berkshire’s float even though it provides almost 50% of the company’s cash flow. This is certainly not the only example we have of sloppy work by people attempting to value Berkshire, but it is the worst I can remember were the author rated a cover story in a major publication.

    Buffett tried to address this issue early on with the concept of look-through earnings and more recently with his “Two column” Approach to valuing Berkshire. In my next post I will address the latter approach in some detail.

    Currently Berkshire is selling at a larger discount to that intrinsic value than it was in 2000 when Buffett offered to buy the stock, but the company is much larger today so it is harder to move the needle and Buffett is eight years older.”

    I continue to hold a 15% allocation to Berkshire

  • Mike C says:

    James,

    Just wanted to follow up here. We’ll see but it looks like you may turn out correct on your technical forecast. I think the LT uptrend is still in place, but there is a clear ST downtrend with a couple of lower highs and lower lows.

    I think your $111,000 price target is one potential support level, but I think another is a bit higher at around 120K which is where the 200 DMA and last sideways consolidation sits.

    Either way, if the stock does hit those levels I would look at that as being an ABSOLUTE GIFT from the market to pick up a top-tier, high-quality company run by excellent capital allocators at a very attractive fundamental valuation.

    Any purchases done at those price levels would most likely set the stage for both LT strong absolute and relative outperformance.

    If we get to 4K on the B shares, I’m definitely upping my allocation.