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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

Market volatility and circle of competence

The markets have been roiled these last few days to put it mildly. Dow Jones has been down 8.5% in the last four days. Indian Sensex is down 7.8%. Lots of individual stocks are down a lot more. There are a lot of investors wondering what’s in store next. Will the market fall another 10%? 20%? We have a very profound answer. We don’t know. And we don’t try to act or predict on something we don’t know.

However, whenever there is a sale, we are usually in the background looking around trying to see if something catches our eyes. When market goes down, assets get cheaper. It is akin to a shopping sale for us. If the market goes really, really down, it is a garage sale.

We believe what we do have is what Buffett calls a circle of competence. Limited number of companies where we think we have a good understanding of the fundamentals and what the companies might be worth 10 years from now. The intrinsic value of some of these companies is getting very interesting. We do not know what Mr Market will value these companies one year from now and even two years from now. However, we will still be okay if these companies go down 10-20-30% down after we buy it as we think the probabilities are high that the companies that we are investing in will be bigger, better, stronger ten years from now and that knowledge is our competitive advantage that enables us to deploy capital now when there is uncertainty and volatility around in the market. Once the capital is deployed, the key is to be patient and wait for the market to move from a voting machine to a weighing machine.

We are deploying some capital and watching to see if further bargains open up. Our war chest is ready. If none do, we just go back to whatever we were doing before and wait for more shopping festival seasons. If some bargains do further open up, we will be there buying things we understand.

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

Buffett’s Capital Structure and Alpha; Greenlight Re

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:

  • Float generated by insurance offers good amount of leverage for the portfolio that Buffett manages
  • Cost of float has been less than zero; Buffett gets paid to manage the float; (see below table) Buffett can borrow cheaper than the U.S. government.
  • Float is not directly connected to the markets but to events; the debt will not disappear overnight or cannot be called overnight and hence almost non-recourse
  • As long as the insurance companies continues operations, a significant piece of this float will be available for long time (almost permanent capital)
  • Insurance operations are exempt from the investment act of 1940 which place restrictions on operations; Berkshire could not have intervened in Geico, Salmon, special situations or own whole public companies; Berkshire would have been regulated as a mutual fund
  • Insurance operations can buy whole public companies

.Table from: Paper on Buffett’s Alpha (here)

Cost of Float

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.

Allan Mecham — Links of interest

Came across a few articles of Allan Mecham from Arlington Capital who has been beating the pants out of S&P 500 since 1999. He does not use spreadsheets or any models, he just sits, reads and thinks. While we have not seen the audited performance, it does seem like that certain audits were carried out and it was kosher. Sharing a few links to read more about this guy. It makes an interesting read.

MECHAM

Is this the next Warren Buffett? (Forbes & Forbes)

The 400% man (MarketWatch)

The 400% man – A lesson for aspiring investors (BaseHitInvesting)

Musings on the 400% man (Alephblog)

Interview with Allan Mecham (ManualOfIdeas)

Allan Mecham — The Early Years (ValueWalk)

Allan Mecham 2014 Letter (Valuewalk)

Allan Mecham on the Bull Case for Sony and Alleghany (Valuewalk)

Allan Mecham Unloads Berkshire and Loads Up Outerwall (Valuewalk)

Allan Mecham a Businesslike approach to Investing like Ben Graham (Valuewalk)

What are we reading?

Email Communication between Muthu and Prof. Bakshi (WiseWealthAdvisors)

Hedge Fund Due Diligence Uncovers Serious Questions (ValueWalk)

How Warren Buffett Calculated ROE (ValueResearchOnLine)

Deutsche Bank: An inside look at Former CEO’s role in LiborGate (ZeroHedge)

Why Microsoft’s Windows 10 Upgrade is bad news for Intel (BusinessInsider)