Warren Buffett's much anticipated annual letter was released last night, and I finally got around to reading it at 7am this morning. I haven't bothered reading anyone else's comments on it yet, but here are mine.
As always, Buffett reinforced many of his main tenants: good businesses have sustainable competitive advantages, generate attractive returns on capital, and are run by extraordinary managers, even if they don't have to be:
"if a business requires a superstar to produce great results, the business itself cannot be deemed great." - WEB
While I agree with this, I think one might therefore consider Berkshire's insurance businesses "not great", but still very good. Whether it's GEICO, National Indemnity or General Re, each is a disaster waiting to happen without an excellent manager. The same can be said for any financial business really. Look at Citigroup which has arguably been rudderless for years. Compare this to Wells Fargo, which largely avoided the recent subprime mess even though it is a huge mortgage lender in one of the hardest hit areas of the country. Buffett spent some time praising Wells' managment team.
A comment that will surely be reported ad nauseum by the financial media is that "the party is over" for insurance companies. Buffett is simply predicting that the frequency of catastrophes will revert to the mean. They've had it easy since Katrina, but that will not continue forever. Pricing has been soft, and risk exposure across the industry has grown. Cycles are a fact of life in the insurance business. Again this is why you want able managers at the helm. If underwriting standards are allowed to slip, disaster will ensue when the cycle turns down.
Another important point Buffett makes near the end of the 21-page letter is that the insurance businesses produce a large balance sheet item that is compete fantasy. By that, I mean entirely made up by the managers of the business: the estimated loss reserves. The mangers must guestimate how much they will lose on their insurance policies in the future. If they are wrong, and Buffett says that it is a certainty that they are (even he doesn't have a crystal ball), it can lead to big changes in book value and earnings. Again, you want honest intelligent managers who are able and willing to guestimate these reserves as realistically as possible.
Along these lines, Buffet spends some time criticizing corporate accounting practices. He wrote:
"Former Senator Alan Simpson famously said: "Those who travel the high road in Washington need not fear heavy traffic. - If he had sought truly deserted streets, however, the Senator should have looked to Corporate America's accounting."
Specifically, he thinks the return assumptions for corporate pension plans are extremely optimistic. Without spending any time on the arcane subject of pension accounting, all one needs to know here is that increasing the expected return for a company's pension plan assets can boost earnings, and vice-versa. So simply by lifting expected return, management can create accounting earning from thin air. Eventually this will come home to roost in an ugly way when the plan assets are unable to cover liabilities. However, there is currently no incentive for CEO's to be honest as it will be long after they are gone when this implodes, likely leaving taxpayers on the hook. This is certainly an item to pay attention too when analyzing companies with large pension liabilities.
One very interesting item was Buffet's description of some derivative contracts written by Berkshire. He wrote (sold) long-term puts on the S&P 500 and three other worldwide equity indices. They expire in 15-20 years, and are only exercisable at expiration. The strike prices are at the level of the indices on the day written. In return for selling these puts, Berkshire received $4.5 Billion in cash. Berkshire will only lose cash on these contracts if the indexes in question are at lower levels than they were when the contracts were written. And that won't be for 15-20 years. This is vintage Buffett: He gets $4.5B today that he can play around with for 15-20 years, while the chance of any cash loss is very small, and the chance of net loss after investment gains on the $4.5B is almost nil. The downside is that he will have to mark these contracts to market for accounting purposes, so that he will have to report non-cash losses if the markets tank, causing the puts to increase in value (which causes his liability and hence book loss to grow). Of course he could care less about that - cash is king, accounting is fantasy. I have to wonder who the suckers are who bought the puts. Why anybody would pay $4.5B to hold these puts for 15-20 years whereupon they will almost surely expire worthless is beyond me.
There is more to come in part 2, including my current estimate of Berkshire's intrinsic value.
______________
By Todd Kenyon PhD CFA: http://www.vestopia.com/IDs/Profile.aspx?piid=48
As always, Buffett reinforced many of his main tenants: good businesses have sustainable competitive advantages, generate attractive returns on capital, and are run by extraordinary managers, even if they don't have to be:
"if a business requires a superstar to produce great results, the business itself cannot be deemed great." - WEB
While I agree with this, I think one might therefore consider Berkshire's insurance businesses "not great", but still very good. Whether it's GEICO, National Indemnity or General Re, each is a disaster waiting to happen without an excellent manager. The same can be said for any financial business really. Look at Citigroup which has arguably been rudderless for years. Compare this to Wells Fargo, which largely avoided the recent subprime mess even though it is a huge mortgage lender in one of the hardest hit areas of the country. Buffett spent some time praising Wells' managment team.
A comment that will surely be reported ad nauseum by the financial media is that "the party is over" for insurance companies. Buffett is simply predicting that the frequency of catastrophes will revert to the mean. They've had it easy since Katrina, but that will not continue forever. Pricing has been soft, and risk exposure across the industry has grown. Cycles are a fact of life in the insurance business. Again this is why you want able managers at the helm. If underwriting standards are allowed to slip, disaster will ensue when the cycle turns down.
Another important point Buffett makes near the end of the 21-page letter is that the insurance businesses produce a large balance sheet item that is compete fantasy. By that, I mean entirely made up by the managers of the business: the estimated loss reserves. The mangers must guestimate how much they will lose on their insurance policies in the future. If they are wrong, and Buffett says that it is a certainty that they are (even he doesn't have a crystal ball), it can lead to big changes in book value and earnings. Again, you want honest intelligent managers who are able and willing to guestimate these reserves as realistically as possible.
Along these lines, Buffet spends some time criticizing corporate accounting practices. He wrote:
"Former Senator Alan Simpson famously said: "Those who travel the high road in Washington need not fear heavy traffic. - If he had sought truly deserted streets, however, the Senator should have looked to Corporate America's accounting."
Specifically, he thinks the return assumptions for corporate pension plans are extremely optimistic. Without spending any time on the arcane subject of pension accounting, all one needs to know here is that increasing the expected return for a company's pension plan assets can boost earnings, and vice-versa. So simply by lifting expected return, management can create accounting earning from thin air. Eventually this will come home to roost in an ugly way when the plan assets are unable to cover liabilities. However, there is currently no incentive for CEO's to be honest as it will be long after they are gone when this implodes, likely leaving taxpayers on the hook. This is certainly an item to pay attention too when analyzing companies with large pension liabilities.
One very interesting item was Buffet's description of some derivative contracts written by Berkshire. He wrote (sold) long-term puts on the S&P 500 and three other worldwide equity indices. They expire in 15-20 years, and are only exercisable at expiration. The strike prices are at the level of the indices on the day written. In return for selling these puts, Berkshire received $4.5 Billion in cash. Berkshire will only lose cash on these contracts if the indexes in question are at lower levels than they were when the contracts were written. And that won't be for 15-20 years. This is vintage Buffett: He gets $4.5B today that he can play around with for 15-20 years, while the chance of any cash loss is very small, and the chance of net loss after investment gains on the $4.5B is almost nil. The downside is that he will have to mark these contracts to market for accounting purposes, so that he will have to report non-cash losses if the markets tank, causing the puts to increase in value (which causes his liability and hence book loss to grow). Of course he could care less about that - cash is king, accounting is fantasy. I have to wonder who the suckers are who bought the puts. Why anybody would pay $4.5B to hold these puts for 15-20 years whereupon they will almost surely expire worthless is beyond me.
There is more to come in part 2, including my current estimate of Berkshire's intrinsic value.
______________
By Todd Kenyon PhD CFA: http://www.vestopia.com/IDs/Profile.aspx?piid=48
