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
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 |
|
|
|||
| -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 |
|
|
||
| -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
Lots of work has been done trying to reverse engineer how Buffett managed to build his $350B behemoth. Tons of books discuss about value investing as practiced by Buffett, while some of the smarter ones delve deeper into the insurance operations that Berkshire operated. When we look closely at the insurance operations, some of the key advantages of this structure are:
.Table from: Paper on Buffett’s Alpha (here)
So, float provided a cheap source of leverage and (almost) permanent capital. What would Berkshire look like if Buffett had invested in S&P 500 instead of handpicking companies? Joseph Taussig of Taussig capital did do the work and reverse engineered the investments.
S&P grew 9.7% CAGR for 40 years between 1969 and 2009. Warren Buffett’s investments grew at 12.4% CAGR. If one had taken the taken all the money (close to $70M when Warren Buffett assumed Berkshire in 1969) and put it in S&P 500, one would have $2.5B and with Warren Buffett’s stock picks, one would have $4.3B. Around 2009, Berkshire’s market cap was about $150B. Why the difference? The study from Taussig capital does a great job of explaining this difference in simple terms, for every $ of equity capital, Buffett used 2$ of reserves, with 12% return on investments, Buffett earned 12% of equity plus 2 times 12% on reserves = 36% net of 4% cost of float (2% for every 1$ of leverage / reserves) and ended with a ROE of 32%. Since Berkshire is domiciled in the US, it has to pay taxes, and the post tax returns are 20% CAGR which takes us close to $150B. The difference between $4.3B and $150B (in 2010) came from the insurance structure.
So, a huge piece of the returns came for Berkshire because of the capital structure than from the investing alpha that Buffett created. Warren Buffett did pick the right insurance companies to buy which mattered a lot. Buffett’s big alpha were from picking the right insurance vehicles that have created the massive conglomerate. As long as the insurance operations do fine and returns on incremental investments is decent, Berkshire will do fine in the future as well.
How does an investor starting today structure an operations with a capital structure better than Berkshire? Remember that Buffett also defers taxes by not selling securities and compounding the float from the taxman. Also note that the ROE’s came down from 32% to 20% because of taxes.
Enter David Einhorn and Greenlight Re. David Einhorn started a re-insurer based in Bermuda (which is tax free) and re-directs all the cash to Greenlight capital to invest which creates better economics than Berkshire does. Although, as Warren often points, insurance as an industry runs at a net loss through the cycle. Greenlight Re has been struggling to keep the combined ratio low and there are additional headwinds for a shareholder. Einhorn charges 2% management fee and 20% of profits of every year (with watermark). It is a very lucrative deal for David Einhorn. With earned premiums close to 50% of capital, the portfolio is levered at 0.5X. If S&P returns 10% and David Einhorn invests to meet the market returns of 10%. With the leverage, it will be 15% minus the 2% management fee and 20% incentive fee, it will be worth 10%. The effects of leverage are being eaten up by Einhorn and not flowing to the shareholders. However, if the unearned premium does go up, it might present interesting possibilities as he has returned 18.9% CAGR on investments in Greenlight Capital since inception in 1996. Einhorn’s ability to create alpha plus the fact that the stock is trading at a discount to book value offers additional possibilities if the unearned premiums go up.
For now, we are content just monitoring Greenlight Re and Third Point Re (Daniel Loeb’s version of the same structure) and watch it for more time.
Berkshire Discloses Ownership in Kraft Heinz (Valuewalk)
Moody’s corp. Long idea (jInvestor)
Railroads Competitive Advantage are Solid but Challenges Lay AHead (Morningstar)
Do Something Syndrome (Farnam Street)
The initial piece below in italics is adopted from buffettfaq.com
Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.
You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all. A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.
Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.
The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn’t have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.
I know more about business and investing today, but my returns have continued to decline since the 50’s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.
If you are an investor in a market like India today, would this is applicable to you? What would be the things that would work for you and things that would hinder you…
We looked carefully at the Kraft and Heinz merger deal and we were blown away by the numbers. Let us look at it two separate ways to see whether it holds water:
Berkshire and 3G bought Heinz by investing $4.25B of equity each and Buffett topped it with $8B of preferred stock in Heinz. Berkshire has already received $1,440M of dividends from the preferred stock in two years. Chances are by the time the stock gets called, he would have received another $720M of the dividends.
Berkshire and 3G are adding $5B each to pay the $10B dividend @ $16.5/share. At today’s closing price of $88.95/share, ex-dividend, the share is worth $72.45/share. Buffett on CNBC said that post the $5B investment, he would own 320 million shares of the combined company. That is worth $28.3B. $5B of that is yet to be invested, so, $4.25B turned into $23.45B in 2 years. This is a mind-boggling return of 450% in 2 years. What an elephant he has bagged on such a big investment…..
To top it all, Berkshire will also get $8B back next year that he has to deploy elsewhere from the calling of the preferred stock. In addition, 3G has indicated that they will maintain the current 3% dividend, that is $2.2/share dividend on 320 million shares, about $700M/year will flow into Omaha starting this year.
The other way to calculate it is, Kraft’s market cap today is $52B; Kraft’s shareholders will get $10B dividends; 49% of the combined company that Kraft’s current shareholders will own, will be worth $42B; 51% of the rest will be worth $43B; initial equity investment was $8.5B equally by 3G and Berkshire; Implied value for the original $8.5B is $43B; (not taken into account the $10B dividend as it will flow from Berkshire and 3G in the future to Kraft’s shareholders)
Either way, Warren Buffett’s elephant gun has fired a salvo that will bring cheers to his shareholders as a new equity position that will be his largest or second largest position once the transaction is closed depending on the stock price on any given day.
When Charlie Munger speaks, it pays to listen. Hat tip to @valuewalk we can read through the full notes from the $DJCO 2015 meeting. As always, Charlie’s thoughts are profound and candid as always. Here is the link to the annual meeting notes.
We are thinking quietly about the Kraft Heinz deal. What is the hidden margin of safety that Buffett is counting on?
When we look back on Berkshire’s acquisition of BNSF, the deal initially looked crazy. Here is Warren’s justification for it and here is what some of the value investors thought about it. Investors believed that Warren had gone loco. The deal turned out to be very good for Berkshire shareholders. Five years since the deal, BNSF has provided $15B dividends back to Berkshire on the purchase price of $26.5B that he paid to own the rest of the company. (Link) Part of that was luck due to oil being transported more on rails compared to five years ago that even Warren could not have anticipated. Nevertheless, when Warren has capital of tens of billions of dollars that needs to get allocated, he is still finding deals with the required margin of safety and returns proving that he is a continuous and an innovative learner. If one were to value the railroad at where the competitors are trading it, it looks like BNSF will be worth about $66B.
One has to sit back and think about what are the margins of safety is Warren counting on the Kraft-Heinz deal? One, of course is 3G’s focus on cost. But is there something beyond it? What does it mean for the Shareholders? It will be the second biggest security in the Berkshire’s portfolio soon.
Markel Ventures by Brookyln investor here
Markel 2014 Annual Report Analysis by Brooklyn investor here
Kraft Heinz Deal by Brooklyn Investor here
Why the Kraft Heinz Deal is a Rare Kind of Warren Buffett Deal by Forbes here
Wall Street is Feeling Left Out after the Kraft Heinz Deal by Business Insider here
Beowulf Capital 