Warren Buffett has discussed on one position of Berkshire’s insurance arms into the bonds of 03 projects: 1,2 and 3 of Washington Public Power Supply System (WPPSS) in 1984. That same entity had before defaulted in $2.2 billion of bonds issued to finance the abandoned projects 4 and 5. That sound dangerous when anyone looking at the history of that entity to determine the soundness of purchasing its newly issue bonds. And those 03 projects has its own problems that might weaken or even destroy the credit from guarantees by Bonneville Power Administration.
However, Warren Buffett and Charlie Munger still decided to come in. They judged that the risks at the time they purchased the bonds and at the prices Berkshire paid to be considerably more than compensated for by prospects of profit.
Buffett has mentioned that the criteria for buying stocks for insurance arms are exactly like buying the entire business. “this business valuation approach is not widespread among professional money managers and is scorned by many academics. Nevertheless, it has served its followers well (to which the academics seem to say, “well, it may be all right in practice, but it will never work in theory”. Simply put, we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen to us – particularly if we own a group of such securities”
So Buffett has extended this valuation approach to WPPSS. He bought it for $139 million. And let’s compare this $139 million bonds cost of investment with the same amount in an operating business. For WPPSS, the “business” contractually earned $22.7 million after tax (via the interest paid on the bonds), and the earnings available to the investors in cash. That presents the return of 16.3% on unleveraged capital. It’s hard to find the operating businesses with economics close to those. Only a few that does but then it would be sold at large premiums to that capital. “In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) might command a price of $250 - $300 million (or sometimes far more). So the price Buffett paid was only 50% off the regular conventional price.
So what are the risks involved in this position. Of course on WPSS, there are definitely some risks. It is also the risk that is difficult to evaluate. Even though the long-term results may turn out fine, in any given year Buffett and Munger run the risks that they might look extraordinarily foolish. There would slight risk that the “business” could be worth nothing within a year or two. And another risk is the interest payments might be interrupted for a considerable period of time. Besides, it has the upside ceiling, the cap on the upside potential of $205 million face value of the bond, only 48% higher than the price paid. Buffett considered the upside limit is the important minus. Nevertheless, the great majority of operating business have a limited upside potential also unless more capital is continuously invested in them.
Buffett discussed further: “If you elect to retain the annual earning of 12% bond by using the proceeds from coupons to buy more bonds, earnings of that bond “business” will grow at a rate comparable to that of the most operating businesses that similarly reinvest all earnings. In the first instance, a 30-year, zero-coupon, 12% purchased today for $10 million will be worth $300 million in 2015. In the second, a $10 million business that regularly earns 12% on equity and retains all earnings to grow will also end up with $300 million of capital in 2015. Both the business and the bond will earn over $32 million in the final year.
Warren Buffett believed that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. The example of 1946 bonds explain it well, 20-year AAA tax-exempt bonds traded at around 1% yield. So effectively it was like buying a business that earned 1% on book value.
“If an investors had been business-minded enough to think in those terms - and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For at the same time, business with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, 15% after tax on book. “
Other discussions of Warren Buffett can be found in following link:
Valuing Insurance Companies
Warren Buffett: Accounting And Bond Investment Of Insurers
Loss Reserving Errors In Insurance Reporting
However, Warren Buffett and Charlie Munger still decided to come in. They judged that the risks at the time they purchased the bonds and at the prices Berkshire paid to be considerably more than compensated for by prospects of profit.
Buffett has mentioned that the criteria for buying stocks for insurance arms are exactly like buying the entire business. “this business valuation approach is not widespread among professional money managers and is scorned by many academics. Nevertheless, it has served its followers well (to which the academics seem to say, “well, it may be all right in practice, but it will never work in theory”. Simply put, we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen to us – particularly if we own a group of such securities”
So Buffett has extended this valuation approach to WPPSS. He bought it for $139 million. And let’s compare this $139 million bonds cost of investment with the same amount in an operating business. For WPPSS, the “business” contractually earned $22.7 million after tax (via the interest paid on the bonds), and the earnings available to the investors in cash. That presents the return of 16.3% on unleveraged capital. It’s hard to find the operating businesses with economics close to those. Only a few that does but then it would be sold at large premiums to that capital. “In the average negotiated business transaction, unleveraged corporate earnings of $22.7 million after-tax (equivalent to about $45 million pre-tax) might command a price of $250 - $300 million (or sometimes far more). So the price Buffett paid was only 50% off the regular conventional price.
So what are the risks involved in this position. Of course on WPSS, there are definitely some risks. It is also the risk that is difficult to evaluate. Even though the long-term results may turn out fine, in any given year Buffett and Munger run the risks that they might look extraordinarily foolish. There would slight risk that the “business” could be worth nothing within a year or two. And another risk is the interest payments might be interrupted for a considerable period of time. Besides, it has the upside ceiling, the cap on the upside potential of $205 million face value of the bond, only 48% higher than the price paid. Buffett considered the upside limit is the important minus. Nevertheless, the great majority of operating business have a limited upside potential also unless more capital is continuously invested in them.
Buffett discussed further: “If you elect to retain the annual earning of 12% bond by using the proceeds from coupons to buy more bonds, earnings of that bond “business” will grow at a rate comparable to that of the most operating businesses that similarly reinvest all earnings. In the first instance, a 30-year, zero-coupon, 12% purchased today for $10 million will be worth $300 million in 2015. In the second, a $10 million business that regularly earns 12% on equity and retains all earnings to grow will also end up with $300 million of capital in 2015. Both the business and the bond will earn over $32 million in the final year.
Warren Buffett believed that many staggering errors by investors could have been avoided if they had viewed bond investment with a businessman’s perspective. The example of 1946 bonds explain it well, 20-year AAA tax-exempt bonds traded at around 1% yield. So effectively it was like buying a business that earned 1% on book value.
“If an investors had been business-minded enough to think in those terms - and that was the precise reality of the bargain struck – he would have laughed at the proposition and walked away. For at the same time, business with excellent future prospects could have been bought at, or close to, book value while earning 10%, 12%, 15% after tax on book. “
Other discussions of Warren Buffett can be found in following link:
Valuing Insurance Companies
Warren Buffett: Accounting And Bond Investment Of Insurers
Loss Reserving Errors In Insurance Reporting
