Short Post on Berkshire

While there are a lot of commentators out there commenting on Berkshire’s results, here is a short different take on it.

  • In 2018, Berkshire took a pre-tax mark to market losses of $22.4B on investments and derivatives and $17.8B on a post tax basis
  • Berkshire reinsurance group did not have a great year and lost $1.1B pre-tax driven by property casualty and retroactive reinsurance.
  • Berkshire’s portion of the Kraft Heinz goodwill impairment was $2.7B in 2018
  • $19.8B of Fixed Income securities compared to $172B of equities
  • $109B in Cash and treasury bills
  • Offset by strong earnings in the rest of the operating businesses and insurance companies resulting in a book value increase of 0.4% and net income of $4B for the year.

If on a year like this, Berkshire does not lose money, it talks a lot about the fortress balance sheet and the resiliency of the business model. I know that Buffett talks about not using BVPS any more. I look at it differently. It was an understated proxy for intrinsic value. Now, it is vastly understated for the intrinsic value.

It is often about return of capital before return on capital. There are a lot of commentary about Berkshire being an index fund. It might be but the risk profile is completely different.

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Blast from the Past: Timely reminder to think for yourself — Munger on Valeant

This is a dated post but fun nevertheless.

It all started in April 2015 when Valeant Pharma was the toast of town.

And then Charlie said this: “Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time.”

No one really understood what Charlie meant at that point. There were some speculations but no one was sure. This was way before the entire Valeant thing unraveled. Pause a moment to think. A lot of us had access to the same information and Munger came to a radically different conclusion than the rest of the market. Bill Ackman tried to reach out to Charlie and convince him otherwise here. Charlie turned out to be correct. How many times as investors have we had a radically different opinion than the rest of the market put together and been right? Are the markets always efficient? What qualitative factor is the market not pricing in that is not evident in the numbers?

In November in 2015, he explained himself further when Valeant started to come apart. Look at the initial response from Munger.

Later, of course, Munger ended up comparing Valeant to a sewer.

Here is how Valent played out finally. They now trade as Bausch Health Companies (BHC).

Now, Charlie also said Ackman was right on Herbalife; that has not proven out yet. Independent thinking….

Fairfax –Actions and Results Speak Louder than Words

Fairfax is a global P&C insurance company led by its charismatic CEO, Prem Watsa, often dubbed as the Warren Buffett of Canada. Fairfax has compounded book value by 20.4% CAGR since inception and the stock price has closely followed it at a 19.4% CAGR. However, the recent performance has been anemic and  events have left a lot of questions unanswered about Fairfax.

frfhf-performance

Picture Source: 2015 Fairfax Annual Report

Fairfax Macro Position:

Fairfax has had a long history of making bold macro calls and producing returns for its investors. The most recent successful macro bet was during the great financial recession between 2007-2009. Fairfax was early in the macro call before the recession but profited handsomely when shocks permeated through the financial world.

gfr-position

Source: 2013 Annual Report

Coming out of the recession in 2010, Fairfax saw similarities between the 2008 recession and the 1929 depression and took a position based on the assumption that the recession story had not been completely played out. Fairfax took a bearish stance in two different ways, through derivatives linked to CPI’s and equity hedges on its portfolio. The CPI linked derivatives have been covered extensively in several places and is a key component to the bullish thesis on Fairfax. However, these are not the securities that have caused the under performance. It is the equity picks of Fairfax.

As we will see later, the under performance on the equity picks meant that the equity hedges kept Fairfax in a net short position in a bull market over the last several years.

Book Value per Share:

The book value per share compounded 2.6% CAGR between 2011 and 2015 for Fairfax. This can be separated into two different components. The shareholder’s equity has been compounding at 4.8% CAGR and the shares outstanding has been diluting at 2.1% CAGR over the last five years resulting in a net compounding of 2.6% over the five year horizon.

book-value-per-share

As with most insurance companies, Fairfax’s economic engine is driven by

  1. A profitable insurance underwriting company that generates benefit of float and a great capital structure,
  2. An investment portfolio consisting of bonds and stocks to generate leveraged returns for shareholders

Insurance operations at Fairfax:

Fairfax has a decent record of underwriting over the last five years. The company’s insurance operations have generated $954M of underwriting profit over the last five years. The insurance operations provides a capital structure that enables Fairfax to borrow cheaper than the government of Canada and get paid to hold the premiums in advance. As the tailwinds in the insurance markets continue, Fairfax will continue to benefit out of this. The capital structure is a great source of competitive advantage for insurance companies. I would like to cast the readers attention to our article on capital structure some time ago here.

Fairfax Insurance Returns.png

Investment Returns at Fairfax:

When one looks at the net result of realized and unrealized gains at Fairfax from 2011 to 2015, one would notice that the equity investments have lost Fairfax $378M over the last five years. This mediocre performance has been driven by the under performance of the equity that Fairfax has invested in as compared to the strength of the bull market in general over the last five years. In addition to this, the CPI linked derivatives have cost another $436M to shareholders. However, given the extreme pay off ratio if some of these bets do realize probably makes them a speculative risk worth considering given Fairfax’s long term macro record.

fairfax-equity-returns

At the end of 2015, the value of market investments for Fairfax was about $650M below the cost of the investments. This is before any equity hedges or derivatives causing further deterioration. The common stock exposure (below table excludes funds that are common stock investment funds that primarily has fixed income bonds) shows that close about 40% of the common stocks are held in the US and Canada. There is a significant exposure to stock markets in Greece, Egypt, Ireland, India, China and Kuwait. This is not something for the fainthearted. There are two ways to look at this, the brighter side is that these markets could be a source of alpha, and on the less brighter side, these could result in a host of political, volatility and currency risks.

frfhf-equity-investments

We looked through the most recent 13-f filings for Fairfax’s performance of its long positions in the US.

Fairfax US Positions.png

The four positions in the US make up around 83% of the reported US equity portfolio. Their performance has not been inspiring. We looked up the buying period when Fairfax added these positions and their relative performance against the S&P 500.

bbryfrfhfibmfrfhfkwfrfhfrfpfrfhf

In addition, we reproduce the below extract from the annual report for one of the biggest Greece investments for Fairfax.

frfh-greece-investments

The under performance of the equity picks from Fairfax as against the Russell and the S&P index has caused erosion in the value of the investments for Fairfax. Instead of hedging against equities, the poor long picks of Fairfax has landed them in a net short position that caused them to lose money ($377M) against the general market.

These risks continue to exist in Fairfax stocks today. After the recent election results, the equity hedging has been reduced to 50% from the 112% at the end of Sep, 2016. Unless the underlying picks start performing better, the returns from the equity side will continue to be anemic. The foreign markets risk is something a prudent investor must think carefully over before investing in Fairfax.

The bond portfolio:

With the great disconnect in mind, Fairfax piled on bonds in the anticipation of lower interest rates. With the recent interest rise hikes and the anticipation in the future, one needs to closely look at the duration of the bonds at Fairfax.

frfhf-bond-maturity

Close to half the bonds held at Fairfax have a maturity greater than 10 years which is result in interest rate sensitivity being high on the bond portfolio.

frfhf-interest-rate-sensitivity

Contrast this with Berkshire Hathaway where less than 10% of the bonds was have duration greater than 10 years.

brk-fixed-income-portfolio

Source: Berkshire Hathaway 10-K 2015

Correction: Subsequent to Q3, Fairfax sold 90% of long dated US treasuries which is about $5.6-$5.7B of Bonds. It will be interesting to see the use of cash subsequently as another source of profits in the last few years has dried up.

treasury-bonds

Allied World Acquisition:

Fairfax announced the acquisition of Allied World for $4.9B or $54 per Allied Share. $10 of dividend from the cash between Fairfax and Allied World and the rest in the form of Fairfax shares. Essentially, $0.9B of cash between Fairfax and Allied and then $4.0B of Fairfax stock with an option to replace $2.7B of stock with cash within 75 days of the announcement. It was very interesting to see the conference call where it was announced that Allied would be decentralized and there are no cost synergies. So essentially Fairfax is paying between $435 and $485, a share implying a book value of 1.07 to 1.19 (9/30 2016 BVPS) to buy a company at 1.35 times book value.

allied-world-acquisition

Source: Allied Acquisition Slides

Okay. Here is an excerpt of the intrinsic value of Fairfax from the 2015 annual letter.

frfhf-intrinsic-value

So, essentially, Fairfax took undervalued shares to buy Allied World at 1.35x book without any cost synergies. I do hope that Fairfax understand what they are getting in return. Given the long duration bond portfolio and the lackluster performance of the equity book, the additional float for investment cannot be solution to the problem. The current shareholders are going to be diluted anywhere between 12% and 41% through this acquisition.

Dilution.png

All the recent events and their performance raises more questions than answers. As a long term holder of Fairfax, I have to re-think a lot of the assumptions about Fairfax and this post is part of the evaluation. Any new buyers, caveat emptor.

Buffett on Reinsurance

Just a post to keep some notes on reinsurance to self.

The Berkshire Shareholders meeting had little in terms on new content though it was good to see that both Charlie and Warren razor sharp as ever.

Probably one of the most interesting insights came in the initial parts of the Q&A. Reinsurance. Berkshire Hathaway had sold down its position in Munich Re and Swiss Re in 2015. When asked a pointed question about it, Buffett was very articulate and gave two key reasons for it: a. Low to negative yields in Europe b. Surplus capacity in reinsurance industry.

In a way, Buffett was alluding to the fact that with hedge funds like Greenlight Re and Thirdpoint Re entering the reinsurance business and being hungry for float, it is likely that too much competition will make (or has made) pricing softer in the market. Supply up, demand is the same. This should raise two questions: a. Buffett is reducing exposure to the reinsurance business by reducing his stake, Greenlight Re and Thirdpoint Re are going long at the same time. One must thoroughly consider the consequences of betting against the man who built the most profitable reinsurance business in the world and has constantly reminded us that the insurance industry is survived the longest by those who walk away when pricing is not adequate to the risks taken. b. If there is going to be softer pricing in the market, investors in companies like Greenlight Re and Third Point re, not only have to tide over the cost of float but also the rich fees that the hedge funds rake in.  The two net cost adders might make the economics very difficult for investors to make meaningful returns unless the reinsurance companies have many home runs on the investment side.

With the low to negative yields, float becomes less valuable as the capital structure of many of the reinsurance business like Swiss Re and Munich Re allows them to invest float in only certain types of securities. Buffett is essentially betting that it will be tough for reinsurance companies to invest float in positive returns instruments for quite sometime to come. Unless of course, you are Prem Watsa and assume that deflation is going to take over in which case the bonds become very useful. Time will tell. Time to increase watch on the insurance holdings.

Liberty Media — Q4 2015 Shareholding

As I continued to dig into Libery Media (LMCA/K) ownership, I came across a few interesting names that are invested along with John Malone. While it is true that LMCA/K have declined quite a bit since 12/31, we will  only know who else added in Q1 only by April 15th. I knew that Berkshire Hathaway was invested with LMCA/K but I was frankly amazed that it was close to $900M as of 12/31. Looks like one of Warren’s deputies Todd or Ted or both are dabbling with Malone’s entities. You can find our previous thoughts on Liberty Media Corporation here

Datasource: Dataroma.com

LMCA Portfolio Manager % of portfolio Shares Value as on 12/31/2015
Markel Corp 0.5 426,000 $                         16,720,500.00
Berkshire Hathaway 0.23 7,800,000 $                       306,150,000.00
 
% of portfolio Shares Value as on 12/31/2015
LMCK Weitz Value 5.75 1,150,000 $                         43,792,000.00
Century Management Advisors 2.35 39,650 $                           1,509,872.00
Markel Corp 0.54 522,000 $                         19,877,760.00
Berkshire Hathaway 0.44 15,386,257 $                       585,908,666.56

What are we reading?

  • Pershing Sqaure Quarterly Call (Valuewalk)
  • Ackman defends Pershing’s loss in Valeant (NYTimes)
  • My indirect experiences with Valeant (GuruFocus)
  • Why Whitney Tilson is loading up on BRK.A/B? (GuruFocus)
  • Jim Chanos on Wall Streek Week (YouTube)

Been reading a book called ‘Extreme Ownership — How Navy Seals Lead and Win’ — Terrific book on leadership. Found a lot of lessons practical and useful as a leader (Amazon)

What are we reading? — Berkshire

Mondelez International — a possible target for Kraft Heinz (Brooklyn investor)

Berkshire Hathaway profit drops 37% (WSJ)

Berkshire Hathaway nears deal to buy Precision Castparts (WSJ)

Stock owners of Precision Castparts (Dataroma)

Warren Buffett might bet on Aerospace boom to lift precision castparts deal (WSJ)

Why a takeover of precision castparts would be typical Buffett (WSJ)

Disclosure: Own BRK

Greenlight Re and Third Point Re

We had written about the structural advantages of re-insurers before here. We ran through some numbers and here is what we found.

Both Greenlight Re and Third Point Re are structured similarly with Greenlight Capital and Third Point LLC running the investment books. Both follow 2% management fee and 20% incentive agreements with high watermark. Currently unearned premium is around 50% of equity (actually close to 40% of equity) for both the insurers. We have assumed cost of float as 2% for both the insurers. We tried to model the returns to the shareholders under various circumstances of underlying returns from the hedge funds. The shareholder equity varying as a function of float net of the cost of float.

Underlying Equity  $100.00
Float Leverage  $ 50.00
Total Assets  $150.00 102%
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $105.00 $102.90 $102.90 -31.4% 1.0% -48.1%
-20% $120.00 $117.60 $117.60 -21.6% 1.0% -33.4%
-10% $135.00 $132.30 $132.30 -11.8% 1.0% -18.7%
0% $150.00 $147.00 $147.00 -2.0% 1.0% -4.0%
5% $157.50 $154.35 $153.48 2.3% 1.0% 2.5%
10% $165.00 $161.70 $159.36 6.2% 1.0% 8.4%
20% $180.00 $176.40 $171.12 14.1% 1.0% 20.1%
30% $195.00 $191.10 $182.88 21.9% 1.0% 31.9%

Over a period of time, if one assumes that the insurers grow their float to get a structure where they have $100 of float for $100 of equity (which is still conservative as reinsurers typically write 5X of capital) However, given the general risky nature of where the float is invested, 1X is a more proper allocation for this strategy.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 102%
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity
-30% $140.00 $137.20 $137.20 -31.4% 2.0% -64.8%
-20% $160.00 $156.80 $156.80 -21.6% 2.0% -45.2%
-10% $180.00 $176.40 $176.40 -11.8% 2.0% -25.6%
0% $200.00 $196.00 $196.00 -2.0% 2.0% -6.0%
5% $210.00 $205.80 $204.64 2.3% 2.0% 2.6%
10% $220.00 $215.60 $212.48 6.2% 2.0% 10.5%
20% $240.00 $235.20 $228.16 14.1% 2.0% 26.2%
30% $260.00 $254.80 $243.84 21.9% 2.0% 41.8%

One thing is very evident here, if the re-insurers are not prudent and conservative, it will wipe out equity fast as float functions exactly how leverage does. Companies like Berkshire own whole companies where earnings are less volatile compared to stock market instruments and they also own a lot of fixed income instruments. Third point returned -32.6% in 2008 and Greenilght Capital returned -22.6% in 2008. The above table clearly shows what would happen if another such year were to occur for these two insurers whose investment books are managed by the insurers. As the investments are starkly different from other insurers, it might be worthwhile to consider the volatility of the instruments.

How would Berkshire or Markel look with a similar capital structure? Remember, they do not charge 2% and 20%. However, they have taxes to drag them down and both of them have great historical performance to their back on running a reinsurer and its investment books. Markel lost 16% of their book value in 2008 which is remarkable considering that they were leveraged 2.2:1 on their float largely thanks for their fixed income instruments which was up 0.2% and equities were down 34%. Berkshire was down (9.6)% in 2008 thanks again to the fortress balance sheet and the fixed income securities that Berkshire owns.

If Markel or Berkshire had a similar structure, this is how they would look.

Underlying Equity $100.00
Float Leverage $50.00
Total Assets $150.00 100% 35% Full Tax
Underlying Rates of Return $150 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Before Tax Net Underlying Returns of Shareholder Equity After Tax
-30% $105.00 $105.00 $105.00 -30.0% 0.0% -45% -45%
-20% $120.00 $120.00 $120.00 -20.0% 0.0% -30% -30%
-10% $135.00 $135.00 $135.00 -10.0% 0.0% -15% -15%
0% $150.00 $150.00 $150.00 0.0% 0.0% 0% 0%
5% $157.50 $157.50 $157.50 5.0% 0.0% 8% 5%
10% $165.00 $165.00 $165.00 10.0% 0.0% 15% 10%
20% $180.00 $180.00 $180.00 20.0% 0.0% 30% 20%
30% $195.00 $195.00 $195.00 30.0% 0.0% 45% 29%

With $100 of Float to $100 of equity

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $140.00 $140.00 $140.00 -30.0% 0.0% -60% -60%
-20% $160.00 $160.00 $160.00 -20.0% 0.0% -40% -40%
-10% $180.00 $180.00 $180.00 -10.0% 0.0% -20% -20%
0% $200.00 $200.00 $200.00 0.0% 0.0% 0% 0%
5% $210.00 $210.00 $210.00 5.0% 0.0% 10% 7%
10% $220.00 $220.00 $220.00 10.0% 0.0% 20% 13%
20% $240.00 $240.00 $240.00 20.0% 0.0% 40% 26%
30% $260.00 $260.00 $260.00 30.0% 0.0% 60% 39%

Markel at the end of 2014 had $145 of float to $100 of equities. Remember the fixed income securities and why Markel will not be very volatile and probably the returns will not exceed 10% on assets invested.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 100% 35% Full Tax
Underlying Rates of Return $200 Invested After 2% Management Fee After 20% Performance Net Underlying Returns to Investor Cost of Float Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
-30% $171.50 $171.50 $171.50 -30.0% 0.0% -74% -74%
-20% $196.00 $196.00 $196.00 -20.0% 0.0% -49% -49%
-10% $220.50 $220.50 $220.50 -10.0% 0.0% -25% -25%
0% $245.00 $245.00 $245.00 0.0% 0.0% 0% 0%
5% $257.25 $257.25 $257.25 5.0% 0.0% 12% 8%
10% $269.50 $269.50 $269.50 10.0% 0.0% 25% 16%
20% $294.00 $294.00 $294.00 20.0% 0.0% 49% 32%
30% $318.50 $318.50 $318.50 30.0% 0.0% 74% 48%

When one takes a closer look at the economics of the business models, it looks like third point and Greenlight re have managed to replicate a capital structure that replicates similar economics to Berkshire or Markel while getting much much better deals for themselves in the process instead of the taxman.

However,  things get interesting further. Greenlight Re is trading at 0.87 book and Third Point Re at 1.07 times book. Berkshire is trading at 1.46 book and Markel at 1.64 times book.

Underlying Equity  $ 100.00
Float Leverage  $ 50.00
Total Assets  $ 150.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $150 Invested Net Underlying Returns of Shareholder Equity P/B =1 P/B =1
-30% $105.00 -48.1% -41.8% -51.5%
-20% $120.00 -33.4% -29.1% -35.7%
-10% $135.00 -18.7% -16.3% -20.0%
0% $150.00 -4.0% -3.5% -4.3%
5% $157.50 2.5% 2.9% 2.3%
10% $165.00 8.4% 9.6% 7.8%
20% $180.00 20.1% 23.1% 18.8%
30% $195.00 31.9% 36.6% 29.8%

If the re-insurers grow the book to have float to 1X of capital.

Underlying Equity $100.00
Float Leverage $100.00
Total Assets $200.00 GLRE 3Re
0.87 1.07
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity
P/B =1
P/B =1
-30% $140.00 -64.8% -56.4% -69.3%
-20% $160.00 -45.2% -39.3% -48.4%
-10% $180.00 -25.6% -22.3% -27.4%
0% $200.00 -6.0% -5.2% -6.4%
5% $210.00 2.6% 3.0% 2.5%
10% $220.00 10.5% 12.0% 9.8%
20% $240.00 26.2% 30.1% 24.4%
30% $260.00 41.8% 48.1% 39.1%

A good comparison would be Markel today. I have just included what Berkshire would do with a similar capital structure.

Underlying Equity $100.00
Float Leverage $145.00
Total Assets $245.00 35% Full Tax Berkshire MKL
1.46 1.64
Underlying Rates of Return $200 Invested Net Underlying Returns of Shareholder Equity Net Underlying Returns of Shareholder Equity After Tax
P/B =1
P/B =1
-30% $171.50 -74% -74% -81.8% -83.8%
-20% $196.00 -49% -49% -65.1% -68.9%
-10% $220.50 -25% -25% -48.3% -54.0%
0% $245.00 0% 0% 0.0% 0.0%
5% $257.25 12% 8% 5.5% 4.9%
10% $269.50 25% 16% 10.9% 9.7%
20% $294.00 49% 32% 21.8% 19.4%
30% $318.50 74% 48% 32.7% 29.1%

Clearly given the valuation difference between Third Point, Greenlight Re’s with the Markel’s of the world, the risk-reward points clearly towards the former.

However, one must be very mindful on how the volatility is handled within the books. Markel and Berkshire have their fixed securities helping them manage well through a downturn. Will Greenlight and Third Point be able to replicate with their long / short strategies and event driven value investing?

Will the shareholders want the comfort of the Berkshire balance sheet at expensive valuations and a size that kills performance or the risk / reward of the newer re-insurers with seasoned hedge fund managers like David Einhorn and Daniel Loeb who have been lackluster of late and are still new to the re-insurance business. Or is there a place for both categories in one’s portfolio?

Disclosure: Own BRK.B, MKL; Evaluating GLRE and TPRE