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Is Buffett a Hedgie?

April 12, 2007 | About:
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Todd N Kenyon

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There is always massive speculation each time Buffett makes a new investment. In many cases, it is clear that a particular purchase fits his typical criteria: a fairly simple business, a strong moat, attractive and sustainable returns on capital, free cash generation, and long-term business predictability. This is all fine and well, but I can’t help but wonder if there isn’t more than might meet the eye behind Buffett’s investment choices.

Everyone knows that Berkshire is highly leveraged to insurance, and furthermore, that Buffett and Jain love to insure big cat risks. They are happy to do so if they feel they are fairly (probably more than fairly in their minds) compensated for assuming these risks. In many cases, they are the only place to turn to due to their huge capital base and willingness to look at such risks.

Buffett is the first to say that at some point, they will take large losses in this business. Not if, but when. We got a taste of this during 2005’s hurricane season. I say a taste, because it could be far worse. God forbid, if a large Cat 4 or 5 storm hits a major metropolitan area on the east coast, Katrina damages could look minor. Let us not forget about Earthquakes in California, or the potential for a major terrorist act, something else that Buffett has gone on record as saying he believes is inevitable.

In each of these cases, Berkshire would likely face huge (but calculated and survivable) losses. But what about some of Berkshire’s other businesses? I believe that many of them would benefit in such a scenario, potentially hedging out some of Berskshire’s cat exposure. Buffett has purchased many companies in the housing and building materials industries: Clayton Homes, Shaw, Benjamin Moore, Johns Manville, Acme Building Brands, and MiTek, and he has equity exposure to USG. All of these companies would likely see increased demand in a cat scenario.

What about the recent, hotly debated railroad purchases? Even these may fit into this thesis. Railroads are far more energy efficient than other shipping alternatives. Once again, many potential cat scenarios would drive up oil prices – the obvious being a major Gulf storm hitting Houston, or a terrorist situation that strains Middle East relations or even targets oil directly. As oil gets more expensive, the attractiveness of rail freight does too.

Now I know that this is all somewhat morbid, but it’s hard to deny the following:

  • Buffett has probably given more thought to the potential types, magnitudes, and probabilities of catastrophes than just about anyone (other than Jain).
  • He has clearly made many recent purchases of companies that fit this thesis.
  • Having stakes in such businesses would give Berkshire even greater competitive advantages over its pure-insurance competitors in the event of a catastrophe.
  • Buffett ran a hedge fund for many years – you can read his letters to partners here: http://www.ticonline.com/buffett.partner.letters.html

Before someone else does it, I will take the other side of this argument:

  • It is possible that he simply feels comfortable with the aforementioned industries, and was able to pick the businesses up at attractive prices, with no thought as to how they might affect the risk exposure of his entire portfolio.
  • Buffett doesn’t care about temporary fluctuations in Berkshire’s earnings, and certainly doesn’t care about what Wall Street thinks.
  • I am succumbing to the tendency for the human mind to look for patterns where there aren’t any.

All of these are very valid arguments. But Buffett has demonstrated time and time again that he is always a couple of steps ahead of the crowd. So maybe, just maybe, the Oracle has even more up his sleeve than he’s been given credit for.

About the author:

Todd N Kenyon
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 2.0/5 (1 vote)

Comments

vooch
Vooch - 7 years ago
Todd,

Nice article. I like your thought process.

- Vooch

crafool
Crafool - 7 years ago
Todd,

I believe your idea is very valid. Buffett has said many times that insurance is a commodity type of business, and that the only way for Berkshire to differentiate itself from the competition is by their strong balance sheet and underwriting discipline.

As you state they will not underwrite unless they are adequately compensated for the risk. This generally entails underwriting with limited to no competition, and those times are generally in periods when the industry is under duress. I remember think about Berkshire's projected claims after Katrina and thinking how those dollars paid out would be coming back to the company through the building materials subsidiaries. That has a great moderating effect on Berkshire's balance sheet, but more importantly than hedging their risk was the great advantage it gives Berkshire over its competitors in reinsurance. Think about it: Berkshire gets back some of its own dollars paid in claims as well as its competitors' dollars, and is able to write more policies at better terms than its competitors. How much value does that ability bring to the intrinsic value of Berkshire?

Regarding railroads, I believe Buffett understands that America's energy needs are growing, and that America's two main domestic sources for energy are natural gas and coal. Berkshire already controls over 10% of the distribution of natural gas through its pipeline companies and with his railroad purchases he has gained probably exposure to anywhere from 3% to 7% of the distribution of coal. Utilities are building coal plants because their cheaper to run than natural gas, and the "Not in my backyard crowd" as well as "What do we do with the spent fuel rods" prevents nuclear plants.

Obviously, he still thinks about the basics like replacement cost (I don't think you can replace Burlington Northern or just about any of the railroads for the total capitalization values), barrier to entry, pricing power, and price paid.

-CRafool
tnkenyon
Tnkenyon premium member - 7 years ago
Well put, Crafool. Your points are definitley valid, and I like the way you described the benefit of owning these businesses - he gets some of his loss dollars back, and some of his competitors' as well. I don't think there are any competitors that can claim the same advantage. I came up with this "theory" when he first started buying up these building-related companies. I am surprised that I haven't seen anyone else comment on it.

Your railroad/energy comments are true as well, and it doesn't hurt that he may get some more loss dollars back from the rail and energy businesses. Whereas the insurance businesses are built on a big capital base and expertise in pricing risk (and hence are commodity businesses, other than the expertise/discipline factor and size of capital base), the energy and rail assets are essentially irreplacable / impossible to economically duplicate. So net/net they compliment each other very well.

I think alot of folks just think Buffett buys whatever looks cheap enough and fits his well-known parameters. But I think we agree that he does put alot of thought into how the pieces fit within the overall portfolio.

Thanks for the comments.

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