He finally decided to do it.  He’s going to buy back stock.

Don’t get me wrong.  I am not a critic here, nor an admirer; I am just an observer.

Buffett is a rational guy. Hyper-rational.  More rational than I am.

He thinks that his stock is a good buy below 1.1x unadjusted book value.  I don’t know that he is right there, but I give him and Whitney Tilson the benefit of the doubt.

My friend Josh Brown said:

Full disclosure, I’m long Berkshire Hathaway B shares for client and family accounts and have been forever and a day, so of course I’m thrilled with the news this morning.

Normally I detest buybacks.  The primary reasons are:

They usually occur at the top of a cycle and are a sign of a top when they peak en masse

They usually are used to mask massive stock option issuance to enrich insiders while doing nothing other than offsetting dilution to shareholders

They are financial engineering and are thus suspect

They are inferior to dividends

They can be a sign that management has no idea what to do to grow or improve a business

But Buffett is not masking stock issuance, he is purely concerned with building shareholder value and sees an investment in his own stock (and hence the various companies he owns) as the best use of capital.  This is very different from when Cisco issues 50 million in options and then announces the requisite buyback that would offset it.

As far as buybacks go, this is a good one, but the question remains, how good is it?  If Buffett had better uses for cash, he would not be buying back stock, and this is at a time when all equity valuations are depressed.

To me this indicates that Buffett does not have any large places to deploy cash superior to the cost of capital of Berkshire Hathaway, which is pretty low, aside from investments with an inadequate margin of safety.

That doesn’t mean the whole market is overvalued, but it does mean that a bright guy like Buffett anticipates no more large productive places in the near future to put large amounts money to work than by shrinking his own balance sheet.  Not a good sign for the economy.

He could sit on the cash and wait.  He has done it before at valuation levels like this in the mid-2000s.  It’s not as if the compression in valuations has only hit BRK.  Many companies seem cheap now on a current earnings basis.  This is especially true of many insurers, of which BRK is one.

Buffett was willing to expend cash to make a superior offer for Transatlantic Reinsurance at a little more than 70% of book, and 8x forward earnings.  Granted, that would have only deployed $3B+, and given him more float to invest.  Still, it shows the cheapness of the environment.  But perhaps there is more uncertainty around the valuations of less well-capitalized firms than BRK, so buying back higher quality BRK stock is preferred to buying in the liabilities of companies of which Buffett has less knowledge.

There is the more radical act: Buffett could buy the stock outright himself.  He has significant personal outside holdings; why not sell them and buy more BRK?  That would make an even greater statement then the buyback.  An insider buy from the ultimate insider at BRK would say a lot more than shrinking BRK’s balance sheet through buybacks.  Think of it this way: Buffett’s interest in BRK increases 4 times as fast if he uses his own money versus the corporation doing the buyback.

As an investor in insurers here, I have better places to put money than BRK.  I like BRK, but the whole industry is cheap amid the uncertainty of the macroeconomic environment.  BRK deserves the higher valuation because it is a diversified industrial/insurance conglomerate, and not merely a despised insurer.

I will sit and own my cheap insurers because their cash flows will more than justify higher valuations eventually.

PS — there had to be a better way to do this.  BRK could have struck a deal to do an accelerated share repurchase, without jolting the market, and pushing up the price of a repurchase.  Perhaps it could have been done by simply announcing that the Board has approved buybacks, should the price ever become favorable for that, and then repurchase slowly and quietly.

I read an article by Zacks on RGA.  I thought it was poorly reasoned.  Here’s what I wrote as a comment:

“However, the primary factors to our Neutral recommendation are Reinsurance Group’s reliance on availability for affordable retrocession. The company had increased the maximum amount of coverage that it retains per life in the U.S. from $6.0 million to $8.0 million. This reduces the amount of premiums it pays to retrocessionaires, but increases the maximum effect a single death claim can have on its results, and therefore may result in additional volatility to its results.

Also interest rates are likely to remain low in 2011 and spreads narrow further. We expect to see additional pressure on the Reinsurance Group’s investment income. Moreover, management’s conservative positioning of the investment portfolio is expected to exert pressure on yield.”

I hate to say this, but you don’t know life reinsurance that well if this is your reasoning. Interest spreads are not a major factor in RGA’s profitability. Also, the retrocession cartel charges an arm and a leg for coverage. The earnings will be more volatile, but they have always been volatile with RGA. The time to buy is after a bad quarter, because mortality is random, but RGA underwrites well.

Let me get this straight. This company has a big moat; it’s part of the life reinsurance oligopoly. It’s trading at a forward P/E of 6, a trailing P/E of 5.5, and 65% of unadjusted book. This company is a leader in its industry globally, and you rate it a hold?

Let me tell you a secret. You almost never lose on companies with little debt, trading at single digit P/Es, and trading below book, conservatively stated.

I own this stock, and so do my clients.

RGA is trading cheap enough that I am considering making it a double-weight in my portfolio.  It is a single-weight at present.  It is genuinely rare that one finds such a quality company with protected boundaries trading at such levels.  There are five companies that dominate life reinsurance globally, and in my opinion, RGA is the best, though they are a close number 2 by most measures of market share.

I don’t like writing about individual companies, because when you are right, one person praises you.  When you are wrong 10 people criticize you.  But for all that I simply say that I am long RGA for myself and my clients.

The insurance industry is badly regulated, but it is much better regulated than the banking industry.  Consumers have better protections under state regulation.  The states are closer to consumers, and further away from insurers.

In order to change policy in a given state, an insurer would have to develop leverage over legislators, and that is tough, unless you are an in-state insurer.  But at the federal level, there is only one target, and a lot of resources can be deployed, because the payoff will be big.

Beyond that, state regulators are not so smart, and that is a good thing.  That means they will resist sophisticated schemes for solvency and consumer protection on which a sophisticated national regulator would sign off.

It is a lot easier to beat one gorilla than 50 monkeys.  Regulatory capture is a lot harder at the state level, so my recommendation would be to hand banking regulation over to the states.  After that, we can reduce the Fed down to the FOMC and NY Fed, and break their stranglehold on macroeconomics given all that they fund in academia.  End the regional Feds; they don’t do much anyway.

The idea is to get the government out of the lending business, because they aren’t very good at it.

If we would be more radical, end interstate banking.  This is a simple solution to the too big to fail problem.  If JP Morgan becomes 50 banks tomorrow, guess what?  None of those 50 banks would be big enough to cause a systemic crisis.  Same for Citi and Bank of America.  Too big to fail would be solved instantly.

My main point is this: if you don’t want banking regulation corrupted by the banks, then decentralize regulation, making it much harder for banks to aim at a single target.

Disproportionately, value managers are buyers of financial stocks.  This is a result of index construction, because financials trade at relatively low multiples of book value.  Financial stocks led the rally from 1987-2007, and for the most part, it was a good era for value investors.  Value investors tend not to focus on macro concerns; they just want to pick good stocks.

But what the value managers did not appreciate was that a lot of the outperformance of financials stemmed from the willingness of the Fed to engage in a reckless monetary policy that never allowed recessions to clear away the bad debt, and thus the debt/GDP ratio kept on building.  Along with that, poor bank regulation, led by the Fed, drove a decline in underwriting standards.

Well, no surprise that value managers did badly 2007 to the present.  And they will still do badly as debts are deflated, to the extent that they own banks.  There will come a time to own banks, but I think we have to go through one or two more macro-shocks before overall debt levels are reconciled.

I own no banks or REITs.  I own a number of insurers, all of which are conservatively managed.

I’m not an expert on game theory, but the rule of thumb I have run across is to win in games with more than two parties, you must assemble a coalition that has more than 51% of the aggregate power within the game.

Practical rule number two is that the one on the winning side that arranges/controls the communications/relationships tends to walk off with a larger proportion of the stakes won in the game.

I learned this early as a young actuary working on my pricing models, and noted that those that really made out well in insurance were the successful agents.  They brought two parties, insured and insurer together, who most of the time would not have found each other.  Then, they did policyholder service for the company and the customer controlling the flow of information in the process.  There were times when I thought it would be useful for the company to talk more directly to the insured, but marketing sometimes objected, and so we didn’t.  The agents owned all the loyalty in the transactions.

As an older actuary, I saw this writ large when I was running an annuity division.  Using regression, I did what I think was one of the industry’s most advanced studies of deferred annuity withdrawal.  The Society of Actuaries produced a similar (but broader) study roughly one year behind me.  One of the main results of the study was that withdrawal rates spike when the surrender charge ends.  The reason is because most agents try to roll the business to a new product so that they can earn another commission.  (Trivia note: I learned that those policyholders that did not roll along with the agent were very sticky business.)

Multiparty transactions exist because there is something complex going on, and the multiple parties each serve a need, providing a service, or eliminating a risk.  Let’s move to the concept of buying a house.  Here is my informal list of all of the parties:

1. Buyer
2. Seller
3. Realtor for the Seller — helps convince the buyer to buy.
4. Realtor for the Buyer, or, sub-agent for the seller — helps the buyer find a good property to buy.
5. Title insurer — assures that there are no mistakes in the transfer of title.
6. Mortgage insurer — insures mortgage lender against default when there is little equity for the buyer.
7. Property & Casualty insurer — protects the lender and buyer against losses from property damage, or injury to people on the property.
8. Mortgage lender (first lien) — provides most of the money for the purchase
9. Mortgage lender (second lien and beyond) — provides some money for the purchase, but in foreclosure gets paid after the first lien lender.
10. Appraiser — gives an estimate of the value of the property so that the first lien lender does not lend too much.
11. Home Inspector — finds defects in the property so that the buyer can adjust his price down.
12. Taxation authorities — collect taxes, so that services that make the community livable are provided.
13. Community Association — enforces neighborhood standards, so that property values are enhanced.
14. There are more, but I can’t think of them…

Note: I did the “smiley-face” version of the roles parties play in the process.  I could have done the cynical version, but didn’t.  Also note that not all of the parties are needed on a given transaction.  The complexity erupts because the buyer needs to borrow to complete the transaction, and the lender wants protection.

Now, going back to my earlier thoughts, in this case, the first-lien mortgage lender has things set up to his advantage.  Many of the parties to the sale of a house exist to protect his interests.  It is the dominant party in this sort of transaction.  This leads to two current problems:

• Mortgage reinsurance captives owned by banks originating the loans.
• P&C Insurance that is forcibly placed by the lender when the buyer does not make P&C insurance payments.

On the first point there was an article today that I found surprising because it is so late to the game.  Don’t get me wrong, it is a good article, but for an insurance analyst that spent time analyzing the mortgage insurers, it is old news.  As I wrote back in 2003 (and published in 2010):

In addition, lenders that originate low down payment mortgages often force the mortgage insurers to cede low-risk parts of the business to reinsurance captives controlled by the lenders. This is a continuing problem, with many of the mortgage insurers refusing to go along with the most uneconomic reinsurance deals.

It got worse from there, with more mortgage insurers giving in, and lenders demanding a larger proportion of the profits.  Nominally they were reinsurance premiums, but for the most part they were closer to being commissions.  Why did the mortgage insurers go along with this?  Because the first-lien lenders were the dominant party in the transactions, controlling most of the other parties.  As a result, borrowers putting small amounts of money down ended up paying more for their mortgage insurance because of the pseudo-commission paid to the mortgage lender because of the captive reinsurer.  As I have sometimes said, “Reinsurance is the ultimate derivative; it can obscure almost any transaction.”

On force-placed insurance I have written as well, and it sounds a lot like this post.  The similarity is that the insurance is primarily designed to protect the mortgage lender, and the mortgage lender again collects a commission in the process because it is at the hub of communications.  The mortgage agreements give them discretionary power.

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My simple rule to average people when involved in complex transactions is this: be cynical.  No one is interested in your well-being, and most of the transactional terms are skewed against you.  To the extent that you can borrow less, and eliminate some of the parties that would be a part of the transaction, it is to your good that you do so.  The best situation is that you buy for cash, if you have it.

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Now, this same sort of analysis can be applied to securitizations, and other multiparty transactions.  Watch for who has control; it is a valuable option to have.  But that is an essay for another day.

I was too bold in my prior statements on Hurricane Irene.  Though ordinarily forecast errors persist, as of early Thursday, the errors have straightened out and the path of the storm is clear.  That said, I think the risk of large insured losses are still not high.  The picture above is for 39+ mph winds over the next five days.  That won’t do much to most of the east coast.  Here, look at a graph of Hurricane force winds:

Not so much, huh?  There are a lot of insurers and reinsurers worth buying in this environment.

I invest in a lot of insurance companies.  It is the industry I know best.  When I worked for a hedge fund as an insurance analyst, they called me the weatherman.  I subscribed to a wide variety of services on hurricanes, but I eventually concluded that the forecasts of major hurricane analysts have a bias, and the best thing to do is to look at the error versus the forecasts, because when the error goes to the left, it tends to go further to the left, and vice-versa for the right.  In this case, the storm Irene is rightward biased versus the forecasts.

That’s why I said this two days ago.  It’s easy to panic over hurricanes, but harder to analyze the situation and suggest that the estimate are wrong.

At worst, I think Hurricane Irene will clip the easternmost point of North Carolina at worst, and very possibly miss the US entirely.  Little risk to the insurance industry.

In my e-mail, I received this tawdry message:

Hi David,

Why is every so in love with Warren Buffett and his financial advice? He used to be a great investor. Not anymore.

Here’s a good article I saw on it from a newspaper in Oregon while I was on vacation there.

http://www.salem-news.com/articles/may182011/warren-buffett-bg.php

That’s Mister Buffett to you, lady.  The garbage article you cited doesn’t have the faintest idea of what Warren Buffett does.  Warren Buffett is not a mutual fund manager, he runs a conglomerate with a real balance sheet and real profitability.  With his friend Charlie Munger, they are wiser than 99% of all the investment advisers out there.  I have my criticisms of Mr. Buffett, but they regard ethics, rather than talent.  Warren needs to repent, he doesn’t need more talent.  There is a difference.

But as for the lousy article, what has the S&P 500 earned over the last ten years — around 1%.  Guess what, of all the big stocks that BRK owns, they have done better than that.  It is irrelevant to cite companies so small that it would not make a difference to BRK if they took a position at favorable prices.

The greater problem is that the article does not understand what Berkshire Hathaway is.  It is an insurance company that owns a lot of businesses.  Whole businesses, not parts of them.  That is 80% of what he does, the rest is like managing a huge mutual fund.

Think of Buffett as a private equity manager with a reputation for not intruding on acquired company cultures.  He is the best place to sell a profitable business to where you want to leave the people you employed intact.

That is a clever niche strategy for private equity.  Give the Buffster some props!

Warren Buffett is deservedly one of the greatest investors of all time.  He made the transition from hedge fund manager, to CEO, but really an investment manager, to CEO of a conglomerate.

Those are three different skills, and Buffett has proved adequate to meet all of the challenges, even after reaching “retirement age.”

I tell you, avoid the envy of articles that want to downplay the results that Buffett has achieved.  He is a master, together with his team, and more than able to manage his company well.  Ignore the naysayers who don’t get it.  Listen to value investors.

I consider myself a lesser light compared to many following Warren Buffett.  Yes, I am a value investor and an actuary, so I guess I have some punch in attempting to analyze the actions of one far greater than me.

The book is organized around two main trips that the author made to the Annual Meeting of Berkshire Hathaway, with some notes from the the 2011 tacked on.

This book tries to distill the ideas of Buffett into simple concepts, and largely succeeds.  It also alleges weaknesses  in Buffett’s reasoning.  Why not consolidate similar, less profitable businesses?  Why not invest a little more in existing businesses? I partially agree: I used to call Berkshire Hathaway “a grab bag of undermanaged businesses.”  But I’ve changed my mind, mostly.

The cost of doing the first of those could be considerable.  Buffett gets certain deals because the seller knows that he will leave the business alone.  The unique culture, friendships, family relationships will be maintained.  The seller doesn’t get top dollar, but he gets the satisfaction that he was true to those he worked with and served him.  Getting these businesses cheaply is a competitive advantage for Berkshire Hathaway, even if it means a certain amount of inefficiency.  Personally, I expect the next CEO or two will centralize the company, and turn it into a normal company.

As for investing more in existing businesses, all the manager has to do is put forth the case to his boss, Buffett.  Buffett will give him a quick decision.

But the author is right, in general, Buffett has not focused on organic growth.  He has acquired all of the businesses that the owns, aside from the reinsurance business.

This book has many strengths:

• It recognizes that there is a cult following around Buffett.  He’s a bright guy, no doubt, but few questions get asked him by shareholders about his main duty, that of being CEO of Berkshire Hathaway.
• It points out the significance of Charlie Munger, who got Buffett to think more broadly about value, served as a “Dr. No” to Buffett’s more optimistic demeanor.
• It doesn’t spend a lot of time on Buffett as an investor in public equities, which has contributed much less to the growth of Berkshire than the acquisition of whole companies.
• The demographics of Berkshire’s Annual Meeting are older and white, and in general, are the patient shareholders that Buffett likes.
• Omaha is an unusual place for such a large company, but the isolation is a plus if you are trying to do something different.
• Understands the basic safety rules of Buffett’s investing: margin of safety, patience, think like a businessman, simplicity, read a lot, be a good judge of character, think independently, get the big ideas right, the value of cash, don’t risk the firm, etc.
• Notes the value of ethics at Berkshire, even when significant mistakes are made, like the handling of the David Sokol incident.  Reputation matters; you only get one reputation, and it affects all aspects of your business.

Quibbles

• Berkshire is primarily an insurance company.  I would have spent more time on that.
• I would have spent less time on non-business ethical issues, like abortion, religion, etc.  Buffett is no good guide there; he is merely justifying his past actions.
• The bit about the Hoopa Indians was interesting, but when Buffett said, “I agree that we will not exercise decisions except those ministerial in nature,” he was being very clear and simple.  Buffett is not a Christian, but he was raised in a Presbyterian household.  A minister is one who does things on behalf of another.  The issue is that there are 4 California hydroelectric plants that are old.  If the Federal government destroys them, it may help in salmon production, or farmers might like the extra water for their own use.  Buffett will simply do what the authorities want done if they are willing to pay to do it.  It is not his call in a regulated industry.
• Buffett’s hypocrisy on taxation is not addressed.  He backs high estate taxes and high personal income taxes, but he doesn’t pay those.  The increase in his wealth though Berkshire, which does not pay a dividend is sheltered from tax, because he never sells a share.

Who would benefit from this book: Anyone who wants to invest better could benefit from it. At five bucks, it’s cheap. A Kindle application for my laptop was free with the purchase.  If you want to, you can buy it here: Secrets in Plain Sight: Business & Investing Secrets of Warren Buffett, 2011 Edition (eBooks on Investing Series).

Full disclosure: I bought the e-book with my own money.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Rating agencies grew up rating corporate credit risk.  The nice thing about corporate credit risk is the failures happen at least every seven years.  There was a sideline on municipal credit risk, but since munis rarely defaulted, it was not very relevant.

Guess what?  Moody’s, S&P, and Fitch are very good at predicting corporate default.  Some new players are better still, but their ratings change more rapidly, which has pluses and minuses.  They are faster to identify failing entities, but they also have more “false positives” where they signal failure, and it does not happen.

GICs

Go back to the late ’80s.  The rating agencies were trying to evaluate the newly popular 401(k) investment Guaranteed Investment Contracts [GICs].  Guess what?  No GICs had ever failed.  What’s the right rating for all the companies offering them?  If the history is so positive shouldn’t everyone be AAA?

Though some of the larger companies had corporate debt that traded, GICs were not obligations of the holding company, but of the insurance subsidiary.  Not only that, unlike bonds, GICs (in most states) were policyholder obligations, not debt per se.  GICs were often super-senior obligations of subsidiaries of the company.

So, how to rate them?  Since there were few historical losses, and the rating agencies lacked a forward-looking view of what might happen, they rated most GICs AAA or AA.

After a few GIC-issuing companies went into insolvency, those ratings changed rapidly over the next seven years, leading to many exits by marginal players who did not default, a few defaults (with almost no losses), and a much smaller GIC industry dominated by synthetic GICs that relied upon insurance company derivatives.

Securitization

Because the regulators required ratings, the rating agencies were willingly drawn in to rating structured products.  With the GSEs it was easy — there is no credit risk, so they are AAA.  With the non-guaranteed whole loans, it was tougher — no GSE guarantee.  How to rate?  This was a new product, a new risk, and so the rating agencies looked at resident mortgage default rates in the past.

Very much like the error of health insurers in the ’60s, where they tried to calculate utilization of healthcare services from the non-insured and apply that to the insured, mortgages retained by originators defaulted less frequently than those that were sold to third parties.

The rating agencies could get the math right on securitization, but could not get the parameters right.  All of their loss data came from an era where lenders held onto their loans.  Selling loans, and having servicing as a separable function was totally unknown to the past.

Much as those who implemented securitization were relatively farsighted, they did not take into account the agency problems involved in “selling to securitize.”

The rating agencies did the best that they could in a competitive environment, with little relevant loss data to guide them.

I suspect that they will do better before the next cycle of failures transpires.

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In short, my point is this: the rating agencies, blundered with ratings on securitization.  They will be better in the future, because they finally have real data to work with.  They are trying to be more forward looking on sovereign issuers, with some degree of pushback.  My view is that those that object more should be downgraded further, within reason.  I differ from the rating agencies, because I am more skeptical, and imaginative.

“Figures don’t lie, but liars will figure.” Issuers are not objective with respect to their own debts.  Rating agencies should ignore the issuers, and work off  of publicly available data, lest they be subverted by the issuers, as has happened.

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I don’t fault the rating agencies much with respect to sovereign ratings.  They seem mostly rational to me, though  there is little real default data to guide them.

That’s the crux of the issue here — they don’t have many sovereign fiat currency defaults to guide them.  Does that mean the odds are low?  By no means.  A larger model, including political motivations, and using game theory would indicate that there are possibilities where no coalition governs that debts will be paid.

I hate the simplistic models of the Keynesians and their bastard progeny.  One has to think more broadly, and consider the wide range of what might happen, because (surprise!) people/institutions aren’t always rational as economists view them.

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I leave you with this: imagine that you run a rating agency, and your clients ask you to rate debts that you don’t have a good model to use.  You have competitors, and they are seeking advantage as well.  Add into the mix that the issuers can choose who they want.  How do you react to a new class of credit?  The question is a hard one.

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And thus, to those who trash the rating agencies because of bad past decisions, I say, “Could you have done better, you have the benefit of hindsight?”

The rating agencies are flawed but are mostly honest dealers who used bad models on structured credit, because no one knew better.  They took the risk and put forth some bad ratings.

For this reason I say to the fools who argue against the S&P downgrade of the US, “How do you know?”  For once a rating agency is trying to be proactive, and they get a lot of abuse.  Watch the trading in the market, it will tell you a lot more than the downgrade.