Written by Alex Hughes, International Analyst, StocksInValue
Original article first published in StocksInValue
With the stock price down 15% over the last year, the time is right to take a closer look under the hood of Berkshire Hathaway (BRK.N). We think it is an interesting proposition, but don’t take it from us, here’s the investment case for Berkshire in Warren’s words:
- “I believe the chance of any event causing Berkshire to experience financial problems is essentially zero”,
- “I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments”,
- “Our per-share intrinsic business value is almost certain to advance over time”.
After acquiring a controlling interest in a failing textile mill in 1965, Warren Buffett reallocated its capital into insurance, providing float and operating earnings to acquire more businesses and securities. Through his investment brilliance and by retaining all earnings, Berkshire has compounded its book value at 19.4% for 50 years, a feat that is unlikely to be matched. It is now a $285 billion NYSE listed conglomerate that owns hundreds of businesses as well as a $140 billion investment portfolio.
Berkshire operates a highly decentralised structure with just 25 employees at head office overseeing 325,000 employees throughout the subsidiaries. This allows Buffett to focus on capital allocation and succession planning. At the age of 85, future growth rates will depend less on Buffett and more on protégé’s Todd Coombs and Ted Wechsler as well as whoever is appointed CEO.
Berkshire has expanded into capital intensive industries in recent years with the large scale acquisitions of MidAmerican Energy in 1999 and Burlington Northern Santa Fe in 2010. Berkshire’s most recent purchases include the $37 billion Precision Castparts and $23 billion Heinz deals. But insurance remains the largest profit contributor.
Insurance is the most important contributor to Berkshire’s operating earnings. While the auto-insuring Geico is perhaps the best known, the reinsurance divisions of Gen Re and Berkshire Hathaway Reinsurance make the biggest contributions to underwriting profits.
For a handsome fee, Berkshire’s reinsurance group incurs risks that other insurers are unwilling or unable to undertake themselves. For insuring large scale and sometimes obscure risks (like World Cup events and terrorism) Berkshire is “the only number to dial”, enabled by its unmatched balance sheet strength. Reinsurance delivers lumpy profits, with the ever present risk of catastrophic losses: “a truly terrible year in the super-cat business is not a possibility — it’s a certainty. The only question is when it will come”. Thus far, that certain catastrophic loss is yet to raise its head – Buffett does have a habit of under promising to foster realistic expectations amongst his disciples – and returns from reinsurance have been exceptionally good. It’s worth mentioning that reinsurance is somewhat “anti-fragile”, to borrow a phrase from Nassim Taleb, in that a bad year enables a series of good years after reinsurance prices have been raised.
The core philosophy of Berkshire’s insurance operation is its focus on underwriting profitability above all else. Premium volume will be sacrificed if the pricing level is not conducive to underwriting profits.
When we view the insurance unit as a whole, the focus on underwriting profitability becomes clear in the results; only one year in the last 13 has recorded an underwriting loss (2002 following the 9/11 World Trade Centre terrorist attacks). However, when we consider the cumulative loss ($398m) relative to the amount of float created ($38.4 billion), despite being impacted by the worst terrorist attack in US history, which cost the insurance industry $35 billion, Berkshire was able to obtain a significant amount of investable funds at a cost of just 1.14%, dramatically lower than the borrowing costs of the US government. This track record gives us confidence in Berkshire’s underwriting methodology and hence we hold an optimistic view with regard to its future.
Adding weight, Buffett said in 2014: “Indeed, we are far more conservative in avoiding risk than most large insurers. For example, if the insurance industry should experience a $250 billion loss from some mega-catastrophe – a loss about triple anything it has ever experienced – Berkshire as a whole would likely record a significant profit for the year because of its many streams of earnings. We would also remain awash in cash and be looking for large opportunities in a market that might well have gone into shock. Meanwhile, other major insurers and reinsurers would be far in the red, if not facing insolvency.”
The value of Berkshire’s float should not be overlooked. At year end 2014, Berkshire held $84 billion of float, which is policy holder’s money held in anticipation of paying insurance claims. Buffett once said “If Charlie, I and Ajit are in a sinking boat, and you can only save one of us, swim to Ajit” and it’s easy to see why, as the majority comes from Ajit Jain’s reinsurance division.
Under standard accounting policies, float is recorded as a liability and deducted from assets to calculate equity, just like debt. However, to strictly regard float as a liability is arguably incorrect. “Owing $1 that in effect will never leave the premises – because new business is almost certain to deliver a substitute – is worlds different from owing $1 that will go out the door tomorrow and not be replaced.” As Berkshire’s float is both long dated, enduring and costless (or profitable on average), it is arguably more similar to equity than debt. Buffett has said: “Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”
It makes sense for conservative investors seeking international exposure to consider Berkshire, with its once in a lifetime management team, fantastic set of assets all available at a reasonable price today. In some respects, Berkshire is economically similar to investing in an S&P500 index fund with free put protection thrown in. Just consider:
- Falling equity prices are positive for long term investment returns.
- Berkshire remains very liquid, with a very large amount of investable funds: short maturity bonds, insurance float and operational cash flow
- No one can question Buffett’s decisiveness when opportunity arises. During the aftermath of 2008, Buffett rapidly invested $46 billion at attractive rates of return
- Buffett has essentially put a floor under the price at 1.2x book value by announcing he has the intention to purchase large quantities of Berkshire stock should the price retreat to that level.