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
Great post David (I also can’t sleep at night!! the market is too fascinating). For the readers of the blog I recommend James Altucher’s book on Warren Buffet; it’s a good read about his early years and James deserves credit for adding something new to the “legend”. David; when you get your industry selections finished I hope the blog can discuss a different sector every few weeks to discuss the business variables you find relevent. When I read your comments about industries outside of insurance it’s impressive your depth of knowledge. Oil field/drilling/services is an area I’m looking forward to learning your thoughts behind the allocation/picks. Have a great weekend!
Thanks, Paul. I’ll see what I can do with my limited time. Today I’ll post on Industry Selection, and how last week went for me.
To play devil’s advocate, what should Berkshire Hathaway do with the cash instead – special dividend? It seems contradictory to me that, on the whole, the individual shareholders would do better deploying the capital than Warren Buffet would.
Is it more appropriate to think of BRK more like a continuously operating SPAC… where the goal is to almost always have a large pool of cash to take advantage of extraordinary opportunities? With that view the operating business are there to keep growing that pool, and given the amounts involved the easiest way to get a reasonable return on the idle capital and remain liquid is to write insurance?
I’m not strongly advocating that idea, not as knowledgable as you on the subject, and not tempted to get long BRK right now. Just thinking out loud. But if one believed this was the case then this could be the ideal stage to invest in BRK as it would it would represent a trough of sorts.
My hope with the industry sector selection is have a lot of input from the bloggers and reduce the time burden on you.
What would I do with all of that cash? Here are some possibilities:
1) Buy ConocoPhillips with the excess cash. Since it will cost more than the cash on hand, borrow the excess amount, but place the debt at the COP level, thus preserving the AAA of Berky.
2) Buy MetLife. I know Buffett doesn’t want to get into asset management, but he’s in that business already… float is earning 5%, buying MET nets a growing 10%. It would give him a franchise position in an industry where scale is increasingly a competitive advantage.
3) I would investigate buying companies in Japan. It’s been the odd man out among major financial markets, and some Japanese companies would appreciate an owner that is relatively “hands off,” so long as you are doing well.
4) Buy Cemex and Lafarge. Become the globally dominant cement producer, and enjoy the global demand as the developing world craves more and more cement. Again, a 10% earnings yield which will grow.
5) Sit on my hands, and wait for a disaster to present me with bargains? Okay, that’s Buffett’s current strategy. Not a horrible one, but one that might not come into the money. Are my other ideas too aggressive? Maybe. But I fear that the float keeps building up, when there are some productive places to deploy it, admittedly with some risk.
Full disclosure: long COP MET CX LR