Portfolio Management – Page 34

On the Structure of Berkshire Hathaway, Part 2, the Harney Investment Trust

Posted on 14 March 201414 March 2014 by David Merkel

In Omaha, there is Farnam Street. ?Among value investors, it is well-known, because the small main office of Berkshire Hathaway [BRK] is located there. ?Less well known is Harney Street, but from an insurance standpoint it is important, because Berkshire Hathaway’s largest insurance subsidiary, National Indemnity, is located there. ?One of the major assets of National Indemnity is the Harney Investment Trust, of which National Indemnity is the sole beneficiary.

Before I go further, I want to say there is a lot I don’t know about what I am going to write. ?Let me tell you what sources I have looked at:

SEC filings of companies where the Harney Investment Trust was a greater than 5% shareholder.
Legal documents from Bankruptcies and other corporate legal events where Harney Investment Trust was a party.
All of the statutory filings for Berkshire Hathaway’s primary insurance companies in 2012.
All of National Indemnity’s statutory filings on assets 2002-2013.
All of National Indemity’s statutory audits, 2002-2012.

Now, if you read through BRK’s filings to the SEC, you won’t find many mentions of the Harney Investment Trust. ?You have to read the insurance regulatory documents to find it, and even if you do that, you will still be puzzled. ?Why?

Over the last 12 years, the National Association of Insurance Commissioners does not require “Other Assets” on Schedule BA to provide enough data so that an external user can make the change in book value or market value make sense. ?It has gotten better over time, but it is still not enough. ?You want to have enough data such that it explains the change in market and book value to the nearest thousand dollars.
There are a few errors that are obvious. ?Some easy calculations don’t add. ?Current year starting values are not the same as last year’s ending values.
A few numbers between the statutory filings and audits don’t agree.

Now, some of that is due to bad regulation. ?The data reported for schedule BA assets could be streamlined such that it reports the change in the balance sheet for each asset on a book and fair market value basis.

But more of it is due to BRK’s lack of willingness to discuss/mention the Harney Investment Trust. ?I did a lot of digging on this, and found ?little that was definitive. ?One seemingly intelligent opinion I found here. ?I will quote the most relevant portion from “globalfinancepartners”:

Regarding the large surplus at Berkshire – it is largely because many subsidiaries are owned inside the insurance companies – especially within National Indemnity.? 100% of the stock of BNSF, for example, valued at BRK’s cost of $34 Billion – is owned by National Indemnity and counts towards the statutory surplus.? Also, National Indemnity owns 100% of the shares of GEICO.? Then in addition there are the securities, of course.

GEICO, in turn, owns 100% of the shares of Clayton, McLane, TTI, as well the marketable securities.

I’ll attach an NAIC filing if you really want to geek out.? But unfortunately, the mystery stock Buffett has been accumulating and receiving confidential status on through the SEC is hidden like always inside the “Harney Investment Trust” – Buffett’s go-to vehicle for keeping stock trading hidden from regulatory filings.? (Harney Street is in Omaha)

He gets it, mostly, and concludes that Buffett uses the Harney Investment Trust to hide his buying and selling of positions. ?Assets inside the Trust do not get reported one-by-one on the insurance Schedule D.

Now, before I close, I want to share the data that I have harvested from the Statutory statements, and make a few more comments.

Year	2001	2002	2003	2004	2005
Cost		?? 8,063,249,239	?? 6,098,184,425	??? 4,345,049,427	????? 7,566,419,887
Addl Investment					????? 4,314,851,219
Fair Value					?? 10,532,124,694
Book	?? 9,814,864,000	?? 9,325,481,908	?? 8,326,636,998	??? 5,326,049,532	????? 9,524,818,329
Change		???? (220,350,768)	?????? 859,931,290	? (1,141,017,994)	????? 1,958,398,441
Accretion
OTTI
FX Change
Inv Income					????????? 455,078,969
Book Sold		?? 5,405,086,442	?? 4,640,112,416	??? 2,934,268,712	????? 1,121,718,176
Change					?????????? (40,084,139)
Consideration		?? 6,156,977,208	?? 5,492,507,843	?? ?3,827,449,032	????? 1,561,718,363
Gain		?????? 751,890,766	?????? 852,395,427	???????? 893,180,320	????????? 399,916,048
income
% Assets		25.77%	18.33%	10.45%	15.36%
Am Cost	?? 8,355,067,000	?? 8,063,249,000	?? 6,098,184,000	??? 4,345,049,000	????? 7,566,420,000
URGC	?? 1,459,797,000	?? 1,711,427,000	?? 3,810,157,000	??? 2,316,272,000	????? 2,965,705,000
URCL	????????????????????????????????? –	?????? 144,894,000	????????????????????????????????? –	?????????????????????????????????? –	???????????????????????????????????? –
Fair Value	?? 9,814,864,000	?? 9,629,782,000	?? 9,908,341,000	??? 6,661,321,000	?? 10,532,125,000
Comments		Disagreeing figs

Year	2006	2007	2008	2009
Cost	????? 6,964,633,697	?? 20,139,079,483	????? 5,921,482,114	????? 5,786,018,179
Addl Investment	????????? 982,768,239	?? 15,783,905,450	????? 9,781,668,840	?? 10,865,269,974
Fair Value	?? 12,117,706,779	?? 21,921,621,265	????? 4,923,093,676	????? 6,769,046,868
Book	?? 11,123,440,646	?? 21,921,621,265	????? 4,801,843,191	????? 5,800,502,260
Change	????? 3,098,256,653	????? 1,751,436,622	??? (2,840,908,667)	????? 1,108,867,879
Accretion			????????? 119,595,243	????????? 197,707,597
OTTI			????????? 288,188,143	????? 2,590,146,282
FX Change			?????????? (57,873,620)	???????????? 36,966,246
Inv Income	????? 1,261,755,231	????????? 663,463,512	????????? 987,469,687	????????? 826,207,723
Book Sold	?? ???1,746,959,239	????? 2,653,395,647	?? 24,830,673,311	????? 8,645,957,509
Change	??????? (100,447,051)		????????????? (3,398,147)	???????????? 37,662,286
Consideration	????? 1,999,993,027	????? 6,522,527,452	?? 24,010,303,351	????? 9,017,341,154
Gain	????????? 353,480,839	????? 3,869,131,805	????????? 179,640,040	????????? 371,383,645
income			??????????????? 3,658,670	???????????? 62,505,008
% Assets	16.56%	29.56%	7.78%	7.39%
Am Cost	????? 6,964,634,000	?? 20,139,079,000	????? 5,921,482,000	????? 5,786,018,000
URGC	????? 5,153,073,000	????? 1,782,542,000	???????????????????????????????????? –	????????? 983,029,000
URCL	????????????????????????? ???????????-	???????????????????????????????????? –	????????? 998,388,000	???????????????????????????????????? –
Fair Value	?? 12,117,707,000	?? 21,921,621,000	????? 4,923,094,000	????? 6,769,047,000
Comments		Bought out other trusts	Cleaned House

Year	2010	2011	2012	2013
Cost	????? 9,457,498,340	????? 7,464,877,852	?? 7,064,639,865	?? 5,004,510,446
Addl Investment	????? 7,068,414,613	?? 12,784,563,299	?? 4,186,877,510	?? 3,254,233,606
Fair Value	?? 11,700,226,848	????? 7,807,366,099	?? 9,066,610,408	?? 7,675,070,719
Book	?? 10,720,330,531	????? 7,450,894,712	?? 8,417,129,742	?? 7,511,081,043
Change	????? 1,271,863,576	??? (1,276,652,476)	?? 1,332,026,027	?? 1,163,420,948
Accretion	???????????? 17,914,824	?????????? (25,309,149)	???????????? 2,759,586	???????????? 2,810,400
OTTI	????????? 476,659,635	????????? 190,142,457	?? ????115,680,863
FX Change	????????????? (5,766,223)	?????????????????? (911,734)	???????????? 1,296,067	????????????????? 659,774
Inv Income	????????? 554,369,500	????????? 719,996,080	?????? 389,469,312	?????? 403,093,171
Book Sold	????? 2,944,738,747	?? 14,566,437,847	?? 4,479,185,215	?? 5,214,644,823
Change	??????????????? 7,728,019	??????????????? 4,705,665	???????????? 4,970,996	???? (102,528,623)
Consideration	????? 3,576,396,272	? ?14,738,706,689	?? 4,833,798,698	?? 5,785,003,373
Gain	????????? 631,657,525	????????? 141,268,842	?????? 354,613,478	?????? 570,358,551
income	???????????? 76,920,680	???????????? 25,137,655	????????? 11,091,687	?????? 118,147,838
% Assets	9.60%	6.45%	6.59%
Am Cost	????? 9,457,498,000	????? 7,464,878,000	?? 7,064,640,000
URGC	????? 2,343,171,000	????????? 866,984,000	?? 2,083,717,000
URCL	????????? 100,442,000	????????? 524,226,000	????????? 81,747,000
Fair Value	?? 11,700,227,000	????? 7,807,636,000	?? 9,066,610,000

Notes: OTTI: other than temporary impairments. ?URCG: Unrealized Capital Gains. URCL: Unrealized Capital Losses. ?Other categories are hard to define, though I am sure the NAIC has definitions, though they don’t give complete changes in balance sheets.

Another thing that I could not make to match from the statutory statements was the securities that went in and out of the trust. ?Aside from some Treasury bonds ?in 2002, here are all of the reported transactions where securities moved from National Indemnity to the Trust, and vice-versa.

Year	Action	Ticker	Shares	Value	Consideration	Capital Gain (loss)
2003	In	MTB	???????? 927,760	????????????? 3,655,241
2003	In	WFC	???? 6,138,800	???????? 127,795,056
2003	In	AXP	???? 5,308,500	???????? 101,902,002
2003	In	MCO	?? 16,140,300	???????? 340,631,841
2003	Poof	LVLT	?? 32,691,065	???????? 100,000,000
2004	In	TMK	???????? 872,200	?????????? 20,268,837
2004	In	HRB	?? 14,350,600	???????? 222,546,836
2004	In	CDO	???? 1,195,274	????????????????????????????? 1
2004	In	COST	???? 5,254,000	???????? 146,595,428
2004	In	GCI	???? 3,447,600	?????????? 81,873,173
2004	In	MLI	???? 1,361,900	?????????? 30,408,193
2004	In	SEE	???? 1,113,300	?????????? 32,102,292
2004	In	USG	???? 6,500,000	?????????? 37,180,000
2005	Out	TMK	???????? 872,200	?????????? 20,268,837	???????? 49,826,080	?????????????? 29,557,243
2005	Out	HRB	?? 14,350,600	???????? 222,546,836	?????? 703,179,400	???????????? 480,632,564
2005	Out	CDO	???? 1,195,274	????????????????????????????? 1	???????? 26,666,563	?????????????? 26,666,562
2005	Out	COST	???? 5,254,000	???????? 146,595,428	?????? 254,346,140	???????????? 107,750,712
2005	Out	GCI	???? 3,447,600	?????????? 81,873,173	?????? 281,668,800	???????????? 199,795,627
2005	Out	MLI	???? 1,361,900	?????????? 30,408,193	???????? 43,853,180	?????????????? 13,444,987
2005	Out	SEE	???? 1,113,300	?????????? 32,102,292	???????? 59,305,491	?????????????? 27,203,199
2005	Out	USG	???? 6,500,000	?????????? 37,180,000	?????? 261,755,000	???????????? 224,575,000
2008	In	USB	?? 20,768,728	???????? 657,202,698
2008	In	WFC	?? 52,372,788	???? 1,819,017,267
2008	In	COP	?? 71,896,273	?? ??5,878,643,401
2008	In	COST	???? 5,264,000	???????? 146,595,428
2008	In	KFT	?? 89,222,400	???? 2,957,096,963
2008	In	PG	?? 17,200,318	???? 1,026,726,674
2008	In	USG	?? 10,102,918	??????? ?202,419,056
2008	In	WMT	?? 18,998,300	???????? 901,731,797
2008	Out	PG	?? 20,000,000	???? 1,193,846,154	?? 1,468,400,000	?????????? (274,553,846)
2009	In	COP	?? 29,711,330	???? 1,163,495,683
2009	In	MTB	???????????? 6,300	???????????????? 447,467
2009	In	PG	?? 14,328,093	???????? 855,276,936
2009	In	TMK	???? 1,656,900	?????????? 60,572,017
2009	In	WMT	?? 14,892,842	???????? 746,046,432
2009	In	WFC	?? 21,030,680	???????? 473,941,080
2009	In	GSK	???? 1,510,500	?????????? 78,918,016
2009	In	PKX	???? 1,087,000	?????????? 44,260,228
2009	In	SNY	???? 2,896,133	???????? 119,233,280
2009	Out	COP	?? 71,896,273	???? 5,690,321,498	?? 3,724,226,941	???????? 1,966,094,557
2009	Out	MCO	?? 15,000,000	???????? 163,880,137	?????? 284,850,000	?????????? (120,969,863)
2009	Out	PG	? ?26,000,000	???? 1,552,000,000	?? 1,607,320,000	???????????? (55,320,000)
2010	In	JNJ	?? 13,274,736	???????? 851,173,066
2010	Out	COP	?? 25,227,450	???????? 987,906,942	?? 1,288,365,871	?????????? (300,458,929)
2010	Out	KFT	?? 57,684,645	???? 1,885,271,843	?? 1,567,868,651	???????????? 317,403,192
2010	Out	MTB	???? 4,680,322	?????????? 36,930,716	?????? 216,105,603	???????????? 179,174,887
2010	Out	PG	?? 15,000,000	???????? 895,384,615	?????? 909,450,000	?????????????? 14,065,385
2011	In	COP	?? 21,109,637	???????? 826,653,385
2011	In	GCI	???? 1,740,231	?????????? 13,921,848
2011	In	IBM	?? 63,905,931	?? 10,856,339,550
2011	In	MTB	???? 4,671,245	?????????? 38,003,193
2011	In	PG	?? 12,669,252	???????? 756,256,889
2011	In	WFC	?? 28,446,437	???????? 718,140,133
2011	Out	JNJ	?? 12,951,761	??? ?????829,897,088	?????? 801,466,418	?????????????? 28,830,670
2012	In	WFC	?? 32,872,641	???? 1,090,916,624
2012	Out	PG	?? 29,754,036	???? 1,776,087,072	?? 1,984,891,742	???????????? 208,804,670

In means assets came into National Indemnity, and out means the reverse. ?Poof means something came into National Indemnity, and left in the same calendar year.

Notably, in 2008, Buffett had most of the assets exit the trust into National Indemnity, when they were in a position of unrealized capital loss. ?I don’t fully understand the tax and capital effects here, but it seems that Buffett found it to his advantage to move assets out of the trust, and into National Indemnity once the assets were unrealized capital losses.

I think the guy I quoted is correct. ?Buffett uses the Harney Investment Trust to hide his acquisitions and dispositions of stock. ?The NAIC should end this, and make Schedule BA assets that are easily separable appear on Schedule D, where they belong. ?Schedule BA should be for assets that are not publicly traded. ?Partnerships with assets that would fit on Schedule D should ?be on Schedule D.

Summary

Buffett tries to take an ethical stance in investing, and makes many statements about the way investing ought to be done. ?Using a trust to avoid disclosure of holdings and transactions is not in the spirit of GAAP or statutory accounting/disclosures. ? This practice should be ended. ?Warren, step up your game before you have to and end the Harney Investment Trust. ?I write this as a fan who owns BRK/B shares.

And, to my dedicated readers, if you have more data, or a better means of analysis of the data I have gathered, by all means offer your help. ?Thanks, David

Full disclosure: long BRK/B for clients and me

The Rules, Part LXI (The End… of the Past)

Posted on 11 March 2014 by David Merkel

Rule: every rule has exceptions, including this one

In the long-run, and with hindsight, most actions of the market make sense. ?Sadly, we live in the short run, and our lives may only see one to 1.5 full macro-cycles of the market in our lives. ?We live in a haze, and wonder what useful economic and financial rules are persistently valid?

We live in a tension between imitation and thought, between momentum and valuation, between crowds and lonely reasoning, between short-term thinking and long-term thinking.

It would be nice to be like Buffett, who has no constraint on his time horizon, managing to the infinite horizon, because he has so much that setbacks would mean little to him. ?But most of us have retirements to fund, college expenses, a mortgage, and many other things that make us far more subject to risk.

Does valuation matter? ?You bet it does. ?When will it matter next? ?Uh, we can’t answer that. ?When we come up with a good measure of that, people begin using it, and the system changes.

My personal asset allocation for most of my life has been 75% risk assets/25% cash. ?Especially now, when bond yields are so low, I don’t see a lot of reason to extend the maturities of my bond portfolio, aside from a small position in ultra-long Treasuries, which is a hedge against deflation.

Investment reasoning is a struggle between the short-term and the long-term. ?The short-term gets the news day-by-day. ?The long term silently gains value.

If you invest long enough, you will have more than your share of situations where you say, “I don’t get this.” ?It can happen on the bull or bear sides of the market, and you may eventually be proved right, but how did you do while you were waiting?

Thus, uncertainty.

Is there a permanent return premium to investing in equities? ?I think so, but it is smaller than most imagine, particularly if compared against BBB/Baa bonds.

I’m not saying there are no rules. ?Far from it, why did I write this series?! ?What I am saying is that we have to have a firm understanding of the time horizon over which the “rules” will work, and an understanding of market valuations, sensing when valuations are high amid a surging market, and when valuations are low amid a plunging market. ?There are times to resist the trends, and times to embrace the trends.

The rules that I embrace and write about are useful. ?They reduce risk and enhance return. ?I once said to Jim Cramer before I started writing at RealMoney that the rules work 65% of the time, they don’t work 30% of the time, and 5% of the time, the opposite of the rules works. ?This is important to grasp, because any set of tools used to analyze the market will be limited — there is no perfect set of rules that can anticipate everything. ?You should expect disappointment, and even embarrassment with some degree of frequency. ?That’s the way of the market even for the best of us.

Hey, Buffett bought investment banks, textiles, shoes and airlines at the wrong times. ?But we remember the baseball players who had seasons that were better than .400, and Buffett is an example of that. ?In general, he made errors, but he rarely compounded them. ?His successes he compounded, and then some.

The rule I stated above is meant to be a paradox. ?In general, I am a long-term oriented, valuation-driven investor who seeks to maximize total return over the long haul, with significant efforts to avoid risk. ?Do I always succeed? ?No. ?Do I make significant mistakes? ?Yes. ?Have my winners more than paid for my losers over the 20+ years I have been an active investor? Yes, yes, and then some.

But this isn’t about me. ?Every investor will have days where they will have their head in their hands, like I did managing the huge corporate bond portfolio in September 2002, where I said to the high yield manager one evening as we were leaving work, “This can’t keep going on like like this, right? ?We’re close to this burning out, no?

He was a great aid to my learning, an optimist who embraced risk when it paid to do so. ?At the time, he agreed with me, but told me that you can never tell how bad it could get.

As it was, that was near the bottom, and the pains that we felt were those of the market shaking out the crud to reveal what had long lasting value. ?Or at least, value for a time, because?the modus operandi of the Fed became inflating a financial/housing bubble. ?That would not work in the long run, but it would work for a time. ?After that, I worked at a place that assumed that it would fail very soon, and was shocked at how far the financial excesses would eventually run. ?I was the one reluctant semi-bull in a bear shop that would eventually be right, but we had to survive through 4+ years of increasing leverage, waiting for the moment when the leverage had gone too far, and then some.

Being a moderate risk-taker who respects risk is a good way to approach the markets. ?I have learned from such men, and that is what I aim for in my investing. ?That means I lag when things are crazy, and that is fine with me. ?I don’t play for the last nickel — that nickel may cost many bucks. ?Respect the markets, and realize that they aren’t here to serve you; they exist to allocate capital to the wise over the long run. ?In the process, some will try to profit via imitation — it’s a simple strategy, and time honored, but when too many people imitate, rather than think, bad things happen.

The End, for Now

This post is the end of a long series, and I thank those who have read me through the series. ?I think there is a lot of wisdom here, but markets play havoc ?with wisdom in the short run, even if it wins in the long run. ?If I find something particularly profound, I will add to this series, but aside from one or two posts, all of the “rules” were generated prior to 2003. ?Thus, this is the end of the series.

The Rules, Part LX

Posted on 8 March 20149 March 2014 by David Merkel

Rapid upward moves in volatility almost always presage a bounce rally.

Again, I am scraping the bottom of the barrel, but this is a common aspect of markets. ?When things get tough, scaredy-cats buy put options. ?That pushes up option implied volatilities. ?The same doesn’t happen when prices are rising, because that happens slower. ?Prices fall twice as fast as they rise in the stock market.

Emotions play a big role with options, and many do not use them rationally. ?Rather than using them when the market is rising in order to hedge, more commonly they hedge after the market has fallen.

As implied volatility rises, the ability to make money from hedging falls, as the cost of insurance goes up. ?As a result, hedging peters out, and the market will be receptive to positive news, given that most who want to hedge have hedged. ?Their pseudo-selling is over, and a bounce rally will happen.

Volatility tends to mean-revert, and as the reversion from high levels of volatility happens, the value of stocks rise. ?People buy equities as fears dissipate.

Volatility, both actual and implied, are tools to have in your arsenal to help you understand when markets might be overvalued (low volatility) or undervalued (very high volatility). ?Use this knowledge to guide your portfolio positioning. ?At present, it is more reliable then many other measures of the market.

Next time, I end this series. ?Till then.

The Rules, Part LVIII

Posted on 7 March 2014 by David Merkel

Can contingent claims theory for bond defaults be done on a cash flow/liquidity basis?? KMV-type models seem to fail on severely distressed bonds that have time to breathe and repair.

We’re getting close to the end of this series, and I am scraping the bottom of the barrel. ?As with most aspects of life, the best things get done first. ?After that diminishing marginal returns kick in.

Here’s the issue. ?It’s possible to model credit risk as a put option that the bondholders have sold to the stockholders. ?As such, equity implied volatility helps inform us as to how likely default will be. ?But implied volatilities are only available for at most two years out, because they don’t commonly trade options longer than that.

Here’s the scenario that I posit: there is a company in lousy shape that looks like a certain bankruptcy candidate, except that there are no significant events requiring liquidity for 3-5 years. ?In a case like this, the exercise date of the option to default is so far out, that the company can probably find ways to avoid bankruptcy, but the math may make it look unavoidable. ?Remember, the equity has the option to default, but they also control the company until they do default. ?Being the equity is valuable, because you control the assets.

Bankruptcy means choking on cash flows out that can’t be made. ?Ordinarily, that happens because of interest payments that can’t be made, rather than repayment of principal. ?If interest payments can be made, typically principal payments can be refinanced, unless credit gets tight.

The raw math of the contingent claims models do not take account of the clever distressed company manager who finds a way to avoid bankruptcy, driving deals to avoid it. ?The more time he has, the more clever he can be.

This is a reason why I distrust simple mathematical models in investing. ?The world is more complex than the math will admit. ?So be careful applying math to markets. ?Think through what the assumptions and models mean, because they may not reflect how people actually work.

On the “770” Account

Posted on 6 March 201427 December 2016 by David Merkel

A letter from a reader:

Dave,

My Mom asked me about 770 accounts (apparently, she wants to open one). I’ve reserched [sic] them, but can’t quite figure out if it’s legit or not. So much, what I’ve found is that it is really some kind of insurance policy, it’s tax free, and it’s not openly advertized [sic].

Do you know anything about these accounts? Are they safe? Are they worth it?

Dear Friend,

We are talking about permanent life insurance here. ?I’ve written about this at least once before. ?The types of policies they talk about maximize the savings element inherent in permanent life insurance, and minimize the death benefit. ?Monies in the insurance policy accrue tax free, and at death they escape estate taxes. ?What could be better?

Well, permanent insurance is laden with fees, and agents love to sell it if they can, because the commissions are huge. ?Mortality charges are significant as well. ?As I often say with this kind of product, insurers love to create complex products because average people can’t tell whether they are getting a good deal or not. ?(Hint: usually, you are not getting a good deal.)

Life insurance is a very expensive way to manage assets, between the agents and the operating costs of the company. ?At present, insurance company assets yield more than market rates, which gives a subsidy to customers, but the day will come, like the late 70s — early 80s, where it was very much the reverse.

Aside from scamming the tax man, and providing protection to loved ones at your death, life insurance is a lousy vehicle for building wealth. ?If you have built?wealth already, it is an excellent way to preserve it for your heirs. ?But it won’t make you rich, and all of those advertising such accounts and those like them, make huge commissions off of permanent life policies if they are the agent. ?They make out far better than you will.

Are they safe? ?Yes, life insurance is safe. ?Are they worth it? ?No. ?Not that I am bullish on the stock market now, but under most conditions, the stock market outperforms the returns that insurance companies before expenses, much less after expenses.

This can make a lot of sense if you are rich already, but it will never make you rich. ?Having reviewed many of the advertisements for these products, they use a Madoff-like technique that tells you that you are being let in on a secret way of wealth. ?It’s all garbage, because permanent life insurance has been around for over 100 years.

Hey, let me tell you a secret. ?Did you know that insurance stocks ?have outperformed most other industry groups over the last 40-50 years? ?Buffett will tell you, insurance is a great business. ?Now, maybe I can give this a cryptic name, like a 321 fund, and tell people that owning the 321 fund is a way to wealth. ?(Psst… the same is true of the stocks of money managers… they do much better than mutual funds.)

Sadly, you would likely do better with my 321 fund, than the 770?account, especially if it is held within a tax-deferred account.

Be wary of any pitch that is too good to be true. ?Don’t buy what someone wants to sell you. ?Buy what you have researched and want to buy. ?Oh, and buy the 321 fund — really, buy it. 😉 ?(I feel ashamed.)

Final Note

THERE ARE NO SECRETS IN MONEY MANAGEMENT! ?THERE ARE NO SECRETS IN MONEY MANAGEMENT! ?THERE ARE NO SECRETS IN MONEY MANAGEMENT!

There is no secret club. ?There are no secret formulas. There are a lot of clever lawyers, accountants, and actuaries that the wealthy employ, but for average people, the high fixed costs won’t make it work.

If you want to be wealthy, you have to run your own firm, run it well, providing value to many. ?Don’t listen to those who say they have an easy way to wealth. ?They are lying, and are looking to make money off of you. ?Those who give you free advice are using you in some way. ?(Wait, what does that make me to be? Sigh.)

Signing off, your servant David, who does this for his own reasons…

On Finding Neglected Companies

Posted on 5 March 20145 March 2014 by David Merkel

While at RealMoney, I wrote a short series on data-mining. ?Copies of the articles are here: (one, two). I enjoyed writing them, and the most pleasant surprise was the favorable email from readers and fellow columnists. As a follow up, on April 13^th, 2005, I wrote an article on analyst coverage — and neglect. Today, I am writing the same article but as of today, with even more detail, and comparisons to prior analyses.

As it was, in my Finacorp years, I wrote a similar piece to this but it has been lost; I can?t find a copy of it, and Finacorp is in the ash-heap of financial firms. (Big heap, that.)

For a variety of reasons, sell-side analysts do not cover companies and sectors evenly. For one, they have biases that are related to how the sell-side analyst’s employer makes money. It is my contention that companies with less analyst coverage than would be expected offer an opportunity to profit for investors who are willing to sit down and analyze these lesser-analyzed companies and sectors.

I am a quantitative analyst, but I try to be intellectually honest about my models and not demand more from them than they can deliver. That’s why I have relatively few useful models, maybe a dozen or so, when there are hundreds of models used by quantitative analysts in the aggregate.

Why do I use so few? Many quantitative analysts re-analyze (torture) their data too many times, until they find a relationship that fits well. These same analysts then get surprised when the model doesn’t work when applied to the real markets, because of the calculated relationship being a statistical accident, or because of other forms of implementation shortfall — bid-ask spreads, market impact, commissions, etc.

This is one of the main reasons I tend not to trust most of the “advanced” quantitative research coming out of the sell side. Aside from torturing the data until it will confess to anything (re-analyzing), many sell-side quantitative analysts don’t appreciate the statistical limitations of the models they use. For instance, ordinary least squares regression is used properly less than 20% of the time in sell-side research, in my opinion.

Sell-side firms make money two ways.They can make via executing trades, so volume is a proxy for profitability.They can make money by helping companies raise capital, and they won?t hire firms that don?t cover them.Thus another proxy for profitability is market capitalization.

Thus trading volume and market capitalization are major factors influencing analyst coverage. Aside from that, I found that the sector a company belongs to has an effect on the number of analysts covering it.

I limited my inquiry to include companies that had a market capitalization of over $10 million, US companies only, and no ETFs.

I used ordinary least squares regression covering a data set of 4,604 companies. The regression explained 82% of the variation in analyst coverage. Each of the Volume and market cap variables used were significantly different from zero at probabilities of less than one in one million. As for the sector variables, they were statistically significant as a group, but not individually.Here’s a list of the variables:

*Variable*	*?Coefficients*	*?Standard Error*	*?t-Statistic*
?Logarithm of 3-month average volume	?0.57	0.04	?15.12
?Logarithm of Market Capitalization	?(2.22)	0.15	(14.69)
?Logarithm of Market Capitalization, squared	?0.36	0.01	?31.42
?Basic Materials	?(0.53)	0.53	?(1.01)
?Capital Goods	?0.39	0.54	?0.74
?Conglomerates	?(0.70)	1.95	?(0.36)
?Consumer Cyclical	?0.08	0.55	?0.14
?Consumer Non-Cyclical	?(1.40)	0.55	?(2.52)
?Energy	?2.56	0.53	?4.87
?Financial	?0.37	0.48	?0.78
?Health Care	?0.05	0.50	?0.11
?Services	?(0.30)	0.49	?(0.61)
?Technology	?0.82	0.49	?1.67
?Transportation	?2.92	0.66	?4.40
?Utilities	?(1.10)	0.60	?(1.82)

In short, the variables that I used contained data on market capitalization, volume and market sector.

An increasing market capitalization tends to attract more analysts. At a market cap of $522 million, market capitalization as a factor adds no net analysts. At the highest market cap in my study, Apple [AAPL] at $469 billion, the model indicates that 11 fewer analysts should cover the company. The smallest companies in my study would have 3.3 fewer analysts as compared with a company with a market cap of $522 million.

Market Cap	?Analyst additions
?10.00	?2.30
?30.00	?3.40
100.00	?4.61
300.00	?5.70
522.20	?6.26
?1,000.00	?6.91
?3,000.00	?8.01
10,000.00	?9.21
30,000.00	?10.31
100,000.00	?11.51
300,000.00	?12.61
469,400.30	?13.06

The intuitive reasoning behind this is that larger companies do more capital markets transactions. Capital markets transactions are highly profitable for investment banks, so they have analysts cover large companies in the hope that when a company floats more stock or debt, or engages in a merger or acquisition, the company will use that investment bank for the transaction.

Investment banks also make some money from trading. Access to sell-side research is sometimes limited to those who do enough commission volume with the investment bank. It’s not surprising that companies with high amounts of turnover in their shares have more analysts covering them. The following table gives a feel for how many additional analysts cover a company relative to its daily trading volume. A simple rule of thumb is that (on average) as trading volume quintuples, a firm gains an additional analyst, and when trading volume falls by 80%, it loses an analyst.

Daily Trading Volume (3 mo avg)	Analyst Additions
3	0.6
10	1.3
30	1.9
100	2.6
300	3.2
1,000	3.9
3,000	4.5
10,000	5.2
30,000	5.8
100,000	6.5
300,000	7.1
1,000,000	7.8
3,000,000	8.4
4,660,440	8.7

An additional bit of the intuition for why increased trading volume attracts more analysts is that volume is in one sense a measure of disagreement. Investors disagree about the value of a stock, so one buys what another sells. Sell-side analysts note this as well; stocks with high trading volumes relative to their market capitalizations are controversial stocks, and analysts often want to make their reputation by getting the analysis of a controversial stock right. Or they just might feel forced to cover the stock because it would look funny to omit a controversial company.

Analyst Neglect

The first two variables that I considered, market capitalization and volume, have intuitive stories behind them as to why the level of analysts ordinarily varies. But analyst coverage also varies by industry sector, and the reasons are less intuitive to me there.

Please note that my regression had no constant term, so the constant got embedded in the industry factors. Using the Transportation sector as a benchmark makes the analysis easier to explain. Here’s an example: On average, a Utilities company that has the same market cap and trading volume as a Transportation company would attract four fewer analysts.

Sector	?Addl Analysts	?Fewer than Transports
?Transportation	?2.92
?Energy	?2.56	?(0.37)
?Technology	?0.82	?(2.10)
?Capital Goods	?0.39	?(2.53)
?Financial	?0.37	?(2.55)
?Consumer Cyclical	?0.08	?(2.84)
?Health Care	?0.05	?(2.87)
?Services	?(0.30)	?(3.22)
?Basic Materials	?(0.53)	?(3.46)
?Conglomerates	?(0.70)	?(3.63)
?Utilities	?(1.10)	?(4.02)
?Consumer Non-Cyclical	?(1.40)	?(4.32)

Why is that? I can think of two reasons. First, the companies in the sectors at the top of my table are perceived to have better growth prospects than those at the bottom. Second, the sectors at the top of the table are more volatile than those toward the bottom (though basic materials would argue against that). As an aside, companies in the conglomerates sector get less coverage because they are hard for a specialist analyst to understand.

My summary reason is that “cooler” sectors attract more analysts than duller sectors. To the extent that this is the common factor behind the variation of analyst coverage across sectors, I would argue that sectors toward the bottom of the list are unfairly neglected by analysts and may offer better opportunities for individual investors to profit through analysis of undercovered companies in those sectors.

Malign Neglect

Now, my model did not explain 100% of the variation in analyst coverage. It explained 82%, which leaves 18% unexplained. Some of the unexplained variation is due to the fact that no model can be perfect. But the unexplained variation can be used to reveal the companies that my model predicted most poorly. Why is that useful? If my model approximates “the way the world should be,” then the degree of under- and over-coverage by analysts will reveal where too many or few analysts are looking. The following tables lists the largest company variations between reality and my model, split by market cap group.

Behemoth Stocks

Ticker	Company	Sector	Excess analysts
BRK.A	Berkshire Hathaway Inc.	07 – Financial	(25.75)
GE	General Electric Company	02 – Capital Goods	(20.47)
XOM	Exxon Mobil Corporation	06 – Energy	(19.32)
CVX	Chevron Corporation	06 – Energy	(14.64)
PFE	Pfizer Inc.	08 – Health Care	(14.57)
MRK	Merck & Co., Inc.	08 – Health Care	(12.76)
GOOG	Google Inc	10 – Technology	(11.44)
JNJ	Johnson & Johnson	08 – Health Care	(11.39)
MSFT	Microsoft Corporation	10 – Technology	(10.39)
PM	Philip Morris International In	05 – Consumer Non-Cyclical	(10.21)

Too many

Ticker	Company	Sector	Excess analysts
V	Visa Inc	09 – Services	?2.58
DIS	Walt Disney Company, The	09 – Services	?2.95
SLB	Schlumberger Limited.	06 – Energy	?4.15
CSCO	Cisco Systems, Inc.	10 – Technology	?5.22
QCOM	QUALCOMM, Inc.	10 – Technology	?5.34
ORCL	Oracle Corporation	10 – Technology	?5.98
FB	Facebook Inc	10 – Technology	?8.28
AMZN	Amazon.com, Inc.	09 – Services	?9.34
AAPL	Apple Inc.	10 – Technology	?10.57
INTC	Intel Corporation	10 – Technology	?11.85

Large Cap Stocks

Ticker	Company	Sector	Excess analysts
SPG	Simon Property Group Inc	09 – Services	(16.15)
BF.B	Brown-Forman Corporation	05 – Consumer Non-Cyclical	(16.03)
LUK	Leucadia National Corp.	07 – Financial	(15.93)
L	Loews Corporation	07 – Financial	(15.90)
EQR	Equity Residential	09 – Services	(15.87)
ARCP	American Realty Capital Proper	09 – Services	(15.75)
IEP	Icahn Enterprises LP	09 – Services	(15.50)
LVNTA	Liberty Interactive (Ventures	09 – Services	(15.36)
ABBV	AbbVie Inc	08 – Health Care	(15.01)
GOM CL	Ally Financial Inc	07 – Financial	(14.87)

Too Many

Ticker	Company	Sector	Excess analysts
UA	Under Armour Inc	04 – Consumer Cyclical	?16.68
BRCM	Broadcom Corporation	10 – Technology	?17.29
RRC	Range Resources Corp.	06 – Energy	?17.33
SWN	Southwestern Energy Company	06 – Energy	?17.70
RHT	Red Hat Inc	10 – Technology	?18.08
NTAP	NetApp Inc.	10 – Technology	?19.82
CTXS	Citrix Systems, Inc.	10 – Technology	?19.84
COH	Coach, Inc.	09 – Services	?20.87
VMW	VMware, Inc.	10 – Technology	?21.60
CRM	salesforce.com, inc.	10 – Technology	?22.64

Mid cap stocks

Ticker	Company	Sector	Excess analysts
FNMA	Federal National Mortgage Assc	07 – Financial	(13.84)
UHAL	AMERCO	11 – Transportation	(12.23)
O	Realty Income Corp	09 – Services	(12.06)
CIM	Chimera Investment Corporation	07 – Financial	(11.49)
SLG	SL Green Realty Corp	09 – Services	(11.46)
NRF	Northstar Realty Finance Corp.	09 – Services	(11.34)
FMCC	Federal Home Loan Mortgage Cor	07 – Financial	(11.14)
EXR	Extra Space Storage, Inc.	11 – Transportation	(10.97)
KMR	Kinder Morgan Management, LLC	06 – Energy	(10.94)
CWH	CommonWealth REIT	09 – Services	(10.51)

Too Many

Ticker	Company	Sector	Excess analysts
AEO	American Eagle Outfitters	09 – Services	?17.00
DRI	Darden Restaurants, Inc.	09 – Services	?17.40
RVBD	Riverbed Technology, Inc.	10 – Technology	?17.50
CMA	Comerica Incorporated	07 – Financial	?17.74
GPN	Global Payments Inc	07 – Financial	?18.30
WLL	Whiting Petroleum Corp	06 – Energy	?19.67
DO	Diamond Offshore Drilling Inc	06 – Energy	?21.57
URBN	Urban Outfitters, Inc.	09 – Services	?24.06
RDC	Rowan Companies PLC	06 – Energy	?24.48
ANF	Abercrombie & Fitch Co.	09 – Services	?26.02

Small cap stocks

Ticker	Company	Sector	Excess analysts
BALT	Baltic Trading Ltd	11 – Transportation	?(7.96)
ERA	Era Group Inc	11 – Transportation	?(7.45)
PBT	Permian Basin Royalty Trust	06 – Energy	?(7.42)
SDR	SandRidge Mississippian Trust	06 – Energy	?(7.18)
PHOT	Growlife Inc	02 – Capital Goods	?(6.79)
SBR	Sabine Royalty Trust	06 – Energy	?(6.74)
CAK	CAMAC Energy Inc	06 – Energy	?(6.64)
FITX	Creative Edge Nutrition Inc	09 – Services	?(6.57)
BLTA	Baltia Air Lines Inc	11 – Transportation	?(6.53)
VHC	VirnetX Holding Corporation	10 – Technology	?(6.49)

Too many

Ticker	Company	Sector	Excess analysts
WLT	Walter Energy, Inc.	06 – Energy	?12.19
ANGI	Angie’s List Inc	10 – Technology	?12.31
FRAN	Francesca’s Holdings Corp	09 – Services	?12.58
ZUMZ	Zumiez Inc.	09 – Services	?13.49
GDP	Goodrich Petroleum Corp	06 – Energy	?15.02
DNDN	Dendreon Corporation	08 – Health Care	?15.89
ACI	Arch Coal Inc	06 – Energy	?16.04
HERO	Hercules Offshore, Inc.	06 – Energy	?16.19
AREX	Approach Resources Inc.	06 – Energy	?17.64
ARO	Aeropostale Inc	09 – Services	?20.80

Microcap Stocks

Ticker	Company	Sector	Excess analysts
SGLB	Sigma Labs Inc	06 – Energy	?(6.18)
AEGY	Alternative Energy Partners In	10 – Technology	?(5.97)
WPWR	Well Power Inc	06 – Energy	?(5.83)
TTDZ	Triton Distribution Systems In	10 – Technology	?(5.53)
SFRX	Seafarer Exploration Corp	11 – Transportation	?(5.15)
PTRC	Petro River Oil Corp	06 – Energy	?(4.99)
UTRM	United Treatment CentersInc	08 – Health Care	?(4.82)
BIEL	Bioelectronics Corp	08 – Health Care	?(4.80)
DEWM	Dewmar International BMC Inc	01 – Basic Materials	?(4.74)
FEEC	Far East Energy Corp	06 – Energy	?(4.61)

Too many

Ticker	Company	Sector	Excess analysts
PRSS	CafePress Inc	09 – Services	?3.99
SANW	S&W Seed Company	05 – Consumer Non-Cyclical	?4.03
KIOR	KiOR Inc	01 – Basic Materials	?4.06
PRXG	Pernix Group Inc	02 – Capital Goods	?4.08
EYNON	Entergy New Orleans, Inc.	12 – Utilities	?4.17
PARF	Paradise, Inc.	05 – Consumer Non-Cyclical	?4.40
SUMR	Summer Infant, Inc.	05 – Consumer Non-Cyclical	?4.52
LAND	Gladstone Land Corp	05 – Consumer Non-Cyclical	?4.57
JRCC	James River Coal Company	06 – Energy	?6.38
GNK	Genco Shipping & Trading Limit	11 – Transportation	?7.11

My advice to readers is to consider buying companies that have fewer analysts studying them than the model would indicate.? This method is certainly not perfect but it does point out spots where Wall Street is not focusing its efforts, and might provide some opportunities.

Full disclosure: long BRK/B & CVX

Thoughts on the Berkshire Hathaway Annual Letter & Report

Posted on 1 March 20142 March 2014 by David Merkel

I’m going to try to take this topically. ?Here goes:

On Acquisitions

Buffett still has a strong desire for more acquisitions. ?After $18B to buy?52.6% of Heinz (counting in the low strike warrants), and all of NV Energy through MidAmerican, there were additional?bolt-on acquisitions $3.1B after additional payments of $3.5B to buy the rest of Marmon ?and Iscar. ?After all that, the cash level at BRK was virtually unchanged from the beginning of 2013.

He might like to own far more of Heinz in the future:

Though the Heinz acquisition has some similarities to a ?private equity? transaction, there is a crucial?difference: Berkshire never intends to sell a share of the company. What we would like, rather, is to buy?more, and that could happen: Certain 3G investors may sell some or all of their shares in the future, and?we might increase our ownership at such times. Berkshire and 3G could also decide at some point that it?would be mutually beneficial if we were to exchange some of our preferred for common shares (at an?equity valuation appropriate to the time).

And he might want to buy more utilities:

NV Energy, purchased for $5.6 billion by MidAmerican Energy, our utility subsidiary, supplies electricity?to about 88% of Nevada?s population. This acquisition fits nicely into our existing electric-utility?operation and offers many possibilities for large investments in renewable energy. NV Energy will not be?MidAmerican?s last major acquisition.

The Powerhouse Five

MidAmerican is one of our ?Powerhouse Five? ? a collection of large non-insurance businesses that, in aggregate, had a record $10.8 billion of pre-tax earnings in 2013, up $758 million from 2012. The other companies in this sainted group are BNSF, Iscar, Lubrizol and Marmon.

If you look at BRK earnings now, leaving aside derivatives, one-third of earnings come from insurance, and the rest stems from the industrial & utility enterprises. ?[Note: Buffett uses the word “sainted” which he used in the 1980s to describe a group of much smaller private companies that he owned in full then. ?He doesn’t mean holy, but leading and valuable. ?They are driving the economics of BRK.

None of the Powerhouse Five did badly in 2013, though Marmon was a little weak. ?It’s difficult to find any part of BRK that did badly in 2013. ?BNSF was particularly impressive, and I am glad that I thought it was a good move when Buffett bought it, because too many criticized it at the time.

As an aside, it’s interesting how much MidAmerican is pouring onto wind and solar power.

Debt

I’ve always thought Buffett was clever with debt issues. ?He never guarantees the debt when he takes over a company. ?He is willing to live with the complexity of subsidiary debt issues. ?But hear these quotations from the Annual Report:

Berkshire does not guarantee any debt or other borrowings of BNSF, MidAmerican or their subsidiaries.

BNSF?s borrowings are primarily unsecured.

All, or substantially all, of the assets of certain MidAmerican subsidiaries are, or may be, pledged or encumbered to support or otherwise secure the debt. These borrowing arrangements generally contain various covenants including, but not limited to, leverage ratios, interest coverage ratios and debt service coverage ratios.

The borrowings of BHFC, a wholly owned finance subsidiary of Berkshire, are fully and unconditionally guaranteed by Berkshire.?

Buffett only guarantees the debt of a small finance subsidiary, and nothing more. ?The rest of the debt is non-recourse to BRK, and so bondholders take their chances on a subsidiary failing.

Derivatives

Our credit default contracts generated pre-tax losses of $213 million in 2013, which was due to increases in estimated liabilities of a municipality issuer contract that relates to more than 500 municipal debt issues. Our credit default contract exposures associated with corporate issuers expired in December 2013. There were no losses paid in 2013. Our remaining credit default derivative contract exposures are currently limited to the municipality issuer contract.

The equity puts are way out of the money, and only municipal issues remain among his fixed income derivatives. ?BRK “made” $4B on the derivative positions in 2013, something that will be impossible to repeat.

Give Buffett credit, though, because he structured some clever trades that have made a lot of money. ?Value investing won vs option pricing. ?At present, the future performance of the derivatives is?close to immaterial, unless we have significant municipal defaults.

Insurance

A few qualitative notes: Buffett mentions that GEICO has passed Allstate to become #2 in Auto insurance. ?He later mentions State Farm (#1 in Auto, I think the first time he has mentioned it):

Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous?in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in?effect, is what the industry pays to hold its float. For example, State Farm, by far the country?s largest insurer and a?well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012 (the latest year for which their financials are available, as I write this). Competitive dynamics almost guarantee that the?insurance industry ? despite the float income all companies enjoy ? will continue its dismal record of earning?subnormal returns as compared to other businesses.

But after mentioning State Farm’s abysmal underwriting, though Buffett doesn’t say it is such, he mentions how well BRK has done:

As noted in the first section of this report, we have now operated at an underwriting profit for eleven
consecutive years, our pre-tax gain for the period having totaled $22 billion. Looking ahead, I believe we will
continue to underwrite profitably in most years. Doing so is the daily focus of all of our insurance managers who
know that while float is valuable, it can be drowned by poor underwriting results.

BRK had a light year for catastrophes, which inflated their income somewhat. ?It also seems that they put the poor deal that they did with Swiss Re behind them.

Buffett also talked about the “float” growing — assets held for future payment where no interest has to be paid. ?It’s $70B+ now. ?More on that later.

Buffett also trumpeted a move into Specialty Insurance. ?He poached a team from AIG in 2013 to start this. ?Specialty Insurance means niche markets with very careful underwriting guidelines. ?I’m sure that Berkshire will do this well.

Finally, the insurers have good underwriting and reserving. ?BRK still has a underwriting profit over the past eleven years, and they continue to release reserves from prior year claims.

The Structure of Berkshire Hathaway [BRK]

Though insurance no longer provides the majority of income for BRK, it is crucial to BRK’s functioning. ?The insurance companies own almost of the industrial and utility enterprises. ?BRK has little?in fixed income and cash vs insurance reserves. ?Buffett says:

Payments of dividends by our insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, our principal insurance subsidiaries may declare up to approximately $13 billion as ordinary dividends before the end of 2014.

There is a rule of thumb in P&C insurance. ?Claim reserves are funded by high quality bonds of equivalent length ?Unearned premiums are funded by short-term debt like commercial paper. ?Surplus funds are invested in risk assets, like equities.

With BRK, more is invested in risk assets than the rule of thumb would allow. ?I’m not sure how the Risk-based Capital formulas allow this. ?Other insurance companies can’t do this.

Notes

Buffett uses his private investments in?real estate investing to show the difference between private & public investing. ?This explains why we should be slow to trade. ?He also says:

Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.

And as such, an investor in that state of ignorance should index.

Other Notes

Those who want to ask questions at Buffett’s annual meeting should send questions to:?Carol Loomis, of Fortune, who may be e-mailed at cloomis@fortunemail.com; Becky?Quick, of CNBC, at BerkshireQuestions@cnbc.com; and Andrew Ross Sorkin, of The New York Times, at arsorkin@nytimes.com.

Some have complained about a lack of transparency at BRK, and I have to disagree. ?BRK is a collection of small and large businesses. ?The annual report adequately talks about all of BRK, but gives less time to smaller issues. ?BRK is the fifth largest company by market cap, and Buffett reveals more of his intentions then most CEOs.

I have more to say regarding Intrinsic Value & Compounding, but that will have to wait.

Full disclosure: Long BRK/B for myself and clients

Letter from a Reader

Posted on 27 February 2014 by David Merkel

Here’s a letter from a reader on insurance topics:

Hi David. I’ve been following your blog. Just want to say thank you for willing to share your knowledge in the public domain.

I have a question for you – as you know, “climate change” is happening… whether human caused or not, it certainly feels like we are seeing more extreme weathers of late.

How do you see this affecting P&C insurers? Does this give them the chance to start rising prices? ?

Lastly, just wondering if you have an opinion about Markel and Lancashire and Allied world. I owned allied for a long time. Made some gains. But the recent blow up at tower and short attack at Am Trust prompted me to really stick with firms that have a much longer record. Which lead me to Markel and Lancashire. Not that this verifies these guys are clean. I’m not an accountant and nor do I think accountants can catch anything. Nonetheless, their long term record offers me a better sense of security in my mind.?

First, I *don’t* know that climate change is happening, except that it always happens.? Evidence for climate science is weak, like that for economics.? We don’t have a good model yet.? If we had a good model, we would have better predictions on hurricanes, which have been uniformly lousy for the last ten years.? And as for warm climates, the Earth has been warmer than now in the past, and far colder, if the history books are correct.

As to how it affects P&C insurers and reinsurers, for that we do have a simple and reliable model.? Look at industry surplus relative to the past — when it is high, as it is now, premium rates will be lower than the risk demands.? Most P&C pricing is weak now — I have been decreasing exposure to P&C insurers.

Markel and Allied World I know and respect.? Good companies both, though I own neither of them.? I’ve heard of Lancashire, but I do not know them in any detail.? To analyze, look in my On Insurance Investing series.

Thanks for writing.

Conservation of Liquidity, under most Conditions, Coda

Posted on 24 February 201424 February 2014 by David Merkel

I would like to add one more idea to my piece, Conservation of Liquidity, under most Conditions.? This is the concept of an asset-liability liquidity mismatch.? When absolute return managers like Buffett, Klarman, etc. start building up cash, the market should get a little nervous.? They don’t commit capital unless they can meet certain return targets.? When they aren’t investing, it means the markets are likely overvalued.

Think about it: long-term investors accumulating cash.? They are mismatching short with respect to time, and long with respect to liquidity.? Since the world in aggregate is always matched, who is mismatched long with respect to time, and short with respect to liquidity?? I can’t say for certain, but I would look at hedge funds and mutual funds that have to justify their existence quarter-by-quarter.? When they are fully invested, it is a time to be cautious, because a downturn in the market could turn them into motivated sellers.

And so, be wary when valuation-sensitive investors pull back.? It is not a good sign for the markets.

Conservation of Liquidity, under most Conditions

Posted on 24 February 2014 by David Merkel

Have you ever seen the graphs showing “Look at all the money sitting on the sidelines!? This market has to go up!”? Those analyses are bogus.? Why?

Several reasons, but the leading one is that much cash has to be held as part of portfolio margining, securities lending, or derivative agreements.? What would be valuable, maybe is a graph of cash that is free to be spent on new securities.

The word “new” is important.? With most trading, liquidity does not disappear.? Instead, liquidity moves from the account of the buyer to that of the seller.? When is that not so?

With initial public offerings, where the proceeds are not solely going to selling shareholders, liquidity disappears into the coffers of the new company, that it can do business.?? That’s not a bad thing, aside from periods in the ’60s and late ’90s where there was a craze that led people to invest in bogus businesses that sounded cool.

When there is too much liquidity available to invest, Wall Street produces new companies to absorb the liquidity, many of which will be of dubious value, because there is money to be made.? Trot out the speculative stocks and bonds, especially near the end of the boom phase of the credit cycle.

Liquidity disappears into new corporations, and reappears when corporations are bought for cash.? Aside from a few other similar events, secondary trading has no effect on liquidity.? So when you hear that there is a lot of liquidity on the sidelines, review the above arguments and say, “There is almost always a lot of liquidity on the sidelines, but is it buying up new stock issues?”

Therefore, look at the quality of new IPOs.? Quality is a thermometer for whether the market is cold to overheating.? The same applies to corporate M&A to a lesser extent when they purchase poor assets for cash.? On the other hand, if corporate M&A is finding inexpensive assets that they buy for cash, the market as a whole may be cheap.

Secondary trading does not inform us much about market valuations.? Look to the primary markets, where cash creates new assets, and where old assets get sold for cash.? Valuations are on display there, and should inform our investing.