Warren Buffett (Trades, Portfolio)ās Berkshire Hathaway BRK.A BRK.B is like the "North Star" of the value investing community. Berkshire released Warren Buffett (Trades, Portfolio)ās much-anticipated letter to shareholders. You can find it right here on Gurufocus.
Berkshire is a conglomerate that runs a major insurance operation, a railroad, utiliities, industrial manufacturers and retailers. Its holdings include recognizable consumer brands like Duracell, Fruit of the Loom, Geico and Seeās Candies.
Buffett usually discusses Berkshire's insurance opearations in the shareholder letter, and this year is no exception:
"For the P/C industry as a whole, the financial value of float is now far less than it was for many years. Thatās because the standard investment strategy for almost all P/C companies is heavily ā and properly ā skewed toward high-grade bonds. Changes in interest rates therefore matter enormously to these companies, and during the last decade the bond market has offered pathetically low rates. Consequently, insurers suffered, as year by year they were forced ā by maturities or issuer-call provisions ā to recycle their āoldā investment portfolios into new holdings providing much lower yields. Where once these insurers could safely earn 5 cents or 6 cents on each dollar of float, they now take in only 2 cents or 3 cents (or even less if their operations are concentrated in countries mired in the never-never land of negative rates)."
The insurance industry has been pretty much left for dead. Few are interested to invest here, and the price-book values are generally very low. Note that by Buffettās measures, the insurance companies have seen their gross earnings on float cut in half or worse. For many insurers, the gross returns have historically exceeded their total gross profit. Ergo, they absorbed a loss on writing policies in order to make it up through investment returns.
"Some insurers may try to mitigate their loss of revenue by buying lower-quality bonds or non-liquid āalternativeā investments promising higher yields. But those are dangerous games and activities that most institutions are ill-equipped to play."
This is a dangerous game because when default rates explode, the investment shortfalls can quickly eat through all of the equity of the insurers. It also requires a much more sophisticated investment organization that would be comparable to those at strong boutique wealth management shops or hedge funds. If a portfolio deteriorates, it can result in downgrades from A.M. Best, a company that rates insurance operations' creditworthiness. A downgrade can result in rising costs of capital, setting off a vicious cycle of degrading profitability.
"Berkshireās situation is more favorable than that of insurers in general. Most importantly, our unrivaled mountain of capital, an abundance of cash and a huge and diverse stream of non-insurance earnings allow us far more investment flexibility than is generally available to other companies in the industry."
Berkshire has always had the advantage of having the unrivaled investment acumen of Buffett and Munger. That not just helped Berkshire directly. For a great team of investors, it is perfectly feasible to identify and mentor other investment talents. A board at a regular insurance organization will struggle enormously to recognize that same talent.
"The many choices open to us are always advantageous ā and sometimes have presented us with major opportunities. Our P/C companies have meanwhile had an excellent underwriting record. Berkshire has now operated at an underwriting profit for 16 of the last 17 years, the exception being 2017, when our pre-tax loss was a whopping $3.2 billion. For the entire 17-year span, our pre-tax gain totaled $27.5 billion, of which $400 million was recorded in 2019. That record is no accident: Disciplined risk evaluation is the daily focus of our insurance managers, who know that the rewards of float can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style."
With insurance operations, there is always a tension between growth and profitability. It is easy enough to grow assets by lowering underwriting standards and writing ever more favorable policies from the customer's perspective, but ultimately that leads to underwriting losses. Those can be offset with investment results, but thatās very tough to do in the current environment, and inevitably, scaling up investment returns proves hard to do as well.
"As I have repeatedly done in the past, I will emphasize now that happy outcomes in insurance are far from a sure thing: We will most certainly not have an underwriting profit in 16 of the next 17 years. Danger always lurks. Mistakes in assessing insurance risks can be huge and can take many years ā even decades ā to surface and ripen. (Think asbestos.) A major catastrophe that will dwarf hurricanes Katrina and Michael will occur ā perhaps tomorrow, perhaps many decades from now. āThe Big Oneā may come from a traditional source, such as wind or earthquake, or it may be a total surprise involving, say, a cyber attack having disastrous consequences beyond anything insurers now contemplate. When such a mega-catastrophe strike, Berkshire will get its share of the losses and they will be big ā very big. Unlike many other insurers, however, handling the loss will not come close to straining our resources, and we will be eager to add to our business the next day."
Iām not sure whether Buffett is preparing shareholders for the inevitable tough year in insurance or if he is just softening up customers of cat insurance that may read the shareholder letter. A big cat risk manifesting itself will no doubt be a real blow. However, insurers nowadays tend to limit total exposure even to cat risks. For example, there are often ceilings in place on policies, meaning the insurers know what their maximum liability is even under grave circumstances.
"Charlie and I do not view the $248 billion detailed above as a collection of stock market wagers ā dalliances to be terminated because of downgrades by āthe Street,ā an earnings āmiss,ā expected Federal Reserve actions, possible political developments, forecasts by economists or whatever else might be the subject du jour. What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning more than 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt. Returns of that order by large, established and understandable businesses are remarkable under any circumstances. They are truly mind-blowing when compared to the returns that many investors have accepted on bonds over the last decade ā 2 1ā2% or even less on 30-year U.S. Treasury bonds, for example."
Buffett is talking about Berkshire's book of public equities here. It is always interesting to see Buffett lay out his investment criteria, and here heās emphasizing his love for businesses with strong balance sheets - right at a time when I donāt hear anyone talking about balance sheets anymore.
"In past reports, weāve discussed both the sense and nonsense of stock repurchases. Our thinking, boiled down: Berkshire will buy back its stock only if a) Charlie and I believe that it is selling for less than it is worth and b) the company, upon completing the repurchase, is left with ample cash. Calculations of intrinsic value are far from precise. Consequently, neither of us feels any urgency to buy an estimated $1 of value for a very real 95 cents. In 2019, the Berkshire price/value equation was modestly favorable at times, and we spent $5 billion in repurchasing about 1% of the company. Over time, we want Berkshireās share count to go down. If the price-to-value discount (as we estimate it) widens, we will likely become more aggressive in purchasing shares. We will not, however, prop the stock at any level."
Berkshire has been most aggressive with repurchases late in 2019. Book value has been between 1.26x and 1.46x. I think Buffett is indicating they are interested in buying back shares in the 1.2-1.4 range. They also issued an offer to buy out shareholders with $20 million worth of stock. Thatās surprising to me, as the current price to book is close to 1.4x. I didnāt think they would go so high. Given the comments above about buying dollars for 95 cents, it indicates they estimate Berkshire's value to be at least 1.47x book.
Berkshireās stock went up 11% in 2019 compared to a 31.5% total return for the S&P 500. Thatās Berkshireās biggest underperformance since 2009. Some analysts believe Buffett should have addressed that as something else than a short term underperformance, since Berkshire has underperformed the market benchmark often in the past. Most notably, pundits were calling out Buffett for having lost its touch in 1999.
My betās with Buffett, though. I think time will reveal that Buffett still has it, and that his critics never learn.
Disclosure: I have written Berkshire puts, which is a form of a long position.
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