Street Capitalist: Event Driven Value Investments

Over the last few weeks, I have spent a lot of time trying to find certain industries that appear undervalued. One area is insurance, where many insurers with good combined ratios and past performance are trading below book. I was happy to see Wilbur Ross agree in this Q&A with Fortune:

Where do you think the biggest opportunities are now?

There are deep value opportunities in insurance stocks, which were beaten down because of their exposure to the subprime crisis, annuities, and commercial real estate. I won’t name names, but some well-managed life insurance and fire and casualty companies will come through this stronger. They used to trade at one or two times book value but now trade at three-quarters book…

Mr. Distress is ready to buy (Fortune)

A quick look at Google shows us how the sector is looking for reinsurance players:

Most appear pretty cheap on the basis of book value. For the moment, it seems as if these companies are trading at discounts mainly due to market conditions. Most insurance companies are reporting that they are still in a soft market. I know that the folks at W.R. Berkley are expecting that things will start to turn. One indicator of that, to me, seems to be with the uptick in M&A activity. We saw Fairfax Financial acquire Zenith, and recently Perry Capital urged Endurance Services to find a merger partner:

PEMBROKE, Bermuda—One of the largest shareholders of Endurance Specialty Holdings Ltd. has urged the Pembroke, Bermuda-based insurer to find a merger partner.

New York-based hedge fund manager Perry Corp.—which owns 12.6% of Endurance and whose president, Richard C. Perry, is a member of its board of directors—said in a regulatory filing Monday that it expects consolidation in the Bermuda reinsurance market to accelerate in the near term.

Endurance “should undertake an evaluation of its strategic alternatives and pursue a possible merger or other strategic transaction in order to create a stronger company with a defined growth strategy,” Perry, which does business as Perry Capital L.L.C., wrote in the filing with the Securities and Exchange Commission.

In addition, Perry said recent executive appointments at Endurance will “not position the insurer to capitalize on consolidation opportunities.”

Endurance Shareholder Urges Merger (Business Insurance)

Richard Perry might also see the reinsurance sector as undervalued, which is why he thinks opportunities are ripe for Endurance Services. If that is not enough, we also saw Warren Buffett purchase stakes in Munich Re and Swiss Re. Smart, value savvy investors appear to be really interested in these companies and I think they are worth a look.

To me, the key will be to find insurance companies that are trading at low multiples with the capacity to increase policy volumes as the market improves.

(Click for full size)

I still like Fairfax given its book value growth, great management team, and current price. However, I see plenty of other opportunities worth analyzing, especially with P&C insurers. I plan on posting some work that I have been doing on insurance companies sometime this week, so be sure to look for that.

Today, CNBC had Warren Buffett of Berkshire Hathaway (NYSE:BRK-A / BRK-B) on for a few hours, answering questions on everything from Coca-Cola to Greece’s financial crisis. There were some interesting exchanges and you can pore over the entire transcript at CNBC, but I would like to highlight a bit of it.

On Coca-Cola

I’ve blogged in the past on Coca-Cola’s (NYSE:KO) decision to purchase its bottling unit Coca-Cola Enterprises (NYSE:CCE). To me the strategic rationale was that Coke wanted to get control over distribution so that they could more agilely deploy new products to the market place. Buffett seems to agree here, and does note that the bottling business is in general worse than the concentrate business. I thought it was interesting that Indra Nooyi was brought onto the call, she provided some good insight on why Pepsi did their deal:

QUICK: Well, we do want to ask you about another one of your companies, Warren. Coca-Cola came out and surprised a lot of people with this news that it’s going to be buying the North American bottling operations. This is different than what they’d been talking about in the past.

BUFFETT: Right.

QUICK: And it follows what Pepsi did about a year ago; in fact, follows very closely what they’d been doing. What do you think about this deal?

BUFFETT: Well, I think on balance I like it. I mean, Muhtar Kent has done a fabulous job with Coke, and there’s a lot of execution problems in doing anything like that. Pepsi will have them and we’ll have them at Coke. But with Muhtar, I feel confident in the fact that it will get carried off right now. The bottling business is very different than what they call the concentrate business, which is making the Cola-Cola concentrate, gets turned into syrup, gets turned into Cola-Cola. The bottling business is very capital intensive and has low margins. The concentrate business is not capital intensive and has very wide margins. Literally, Coca-Cola with 5 billion of capital could make 8 or 9 billion pre-tax just from the concentrate business. But the bottling business is an entirely different business. So long-term, I like being in the concentrate business much more than the bottling business. But the bottling business, Coca-Cola has what they call a fountain division that sells direct. They have the bottlers. Any time they get a new product there’s a question of how it comes under this contract that originally goes back to 1899. It needed rationalization and this move is a big, big step toward rationalizing it, make it so it’s more–it’s more friendly to the big box retailers of Walmart or some–Costco or somebody like that. And it–but it will–there will be some real execution time involved in it and over time, you would hope that Coca-Cola would have less money involved in the bottling business, because it’s a less attractive business.

QUICK: Obviously, you’re a long-term shareholder, but when you say that there are very likely to be come execution steps, some difficulties along the way, maybe some stumbles, how much patience do you have as an investor? You talking about year or two?

BUFFETT: I–well, no, I just say that–whenever you’re doing anything this big you better–you have to have a lot of confidence in the management and I have confidence in Muhtar to carry this off…

KERNEN: All right. I kind of understand a lot of that, how, you know, you don’t want the two companies competing. But there was a rationale at one point to do it that way, and Mr. Buffett had pointed out the different–you know, it’s a low margin bottling business vs. a high margin syrup business. What exactly changed? Why–you are going to deploy more capital–or you have deployed more to own the bottlers. Why not leave them owned by someone else with a lower margin business? What’s changed? You say something’s changed to make it make more sense.

NOOYI: Yeah, that’s a great question, Joe. So 10, 20 years ago, the market–the beverage market in North America was essentially carbonated soft drinks, and there were a few megabrands that controlled the business, and the market was growing 6, 7 percent in terms of volume. Fast-forward to today. Carbonated soft drinks are now less than 50 percent of the total market, and that’s a very highly profitable part of the whole market. And the overall liquid refreshment beverage business is growing in volume about minus 2 percent and in value about 1 percent positive. So this is not a huge growth business. It’s a big market, it’s about $100 billion category. But it’s not growing in leaps and bounds like it used to a couple of decades ago. When you have one or two publicly listed companies positioned as growth companies trying to fight over a profit pool, that’s not a very good situation, especially if the profit pool is not growing enough to feed the appetites of two or three publicly listed companies. So the only way to compete and stay ahead of competition in this environment is to bring the profit pools back together and figure out how to operate more efficiently.

KERNEN: Warren, you were going to talk about the Coke strategy abroad, right, with their–I guess they’re not buying in those assets, right?

BUFFETT: Well, the–no. The franchise operation works extremely well around the–around the world. And, I mean, you take somebody like Coca-Cola FEMSA in Mexico, I mean, the per capitas there are incredible. I think they’re up close to 500 or thereabouts. And so the franchise system in just country after country, 200 countries around the world, has developed the market in a way that’s been very good for the bottlers and very good for Coca-Cola. And actually, in many countries the bottling operation has been considerably more profitable than it has been in the United States, partly because of the growth aspect that Indra mentioned. So it’s not a system that needs fixing at all around the world. There can be an occasional spot where the bottler isn’t doing the job and the Coca-Cola company will buy it and then–and put it back on its feet and then resell it to somebody in that country. But having local bottlers really works pretty darn well around the globe.

QUINTANILLA: Warren, some people…

QUICK: Warren, there–right.

QUINTANILLA: Some people have been saying that you–people historically bought Coke as an international growth play. Now all the sudden North America’s an awfully bigger piece of the pie. Does it dilute some of the reasons that people got into the stock in the first place?

BUFFETT: No. In terms of where the money is being made, you know, Coke makes, I don’t know exact percentage, but 80 percent of its money around the globe, and it’s growing and just in country after country. Coke has been gaining share really quarter after quarter around the world. And add–none of that volume’s going away, or none of that growth is going away because they’re integrating the bottling system in the United States. It does–it means a concentration more of assets in the United States, but it does not take away from the profit growth that is occurring around the–around the world. I think Coke earned like 9 billion pretax last year, and I think well over 7 billion of that was from outside of North America. And that 7 billion is going to have the same kind of growth rate, which has been substantial, whether or not–you know, wherever the bottling system in the United States is owned.

On Currencies
This is a pretty interesting question because in the past, Berkshire has done some currency trading, particularly with the Brazilian Real.

QUICK: You said, though, that a bet either for or against a currency is a bet for or against that government. If you were worried, and let’s say you’re worry level and let’s just measure a couple of things against each other, euro vs. the dollar, which worries you more?

BUFFETT: That’s a tough–that’s a tough call. I mean, both the euro, European Union countries and the United States are running very large deficits. I mean, they–both of those currencies in terms of purchasing power will decline in value over time in my judgment.

QUICK: British pound vs. the dollar. Is that the same story?

BUFFETT: Same way. I–there are all–they are all following policies that will cause their currencies to lose value. Which one will lose more value than the other, it’s so hard to tell.

QUICK: Yen vs. the dollar? Same story?

BUFFETT: The yen is–Japan is the great mystery of all time. I mean, in terms of the policies they follow, what happens, you know, low interest rates, huge deficits and all of that sort of thing. That one is a mystery I don’t even try to think about solving.

Private Equity:

Private equity gets a lot of criticism for acquiring companies and then piling them up with debt to juice their returns. Usually, the companies that can survive that kind of treatment end up performing quite well when IPOed, but many fail in the process. I am expecting that if we see a big bankruptcy wave, these companies will do pretty well. A lot are great businesses that are just overburdened with debt. I would imagine distressed debt guys like Baupost, Third Avenue, and others will make a killing on these plays. After all, Buffett himself said that he would love to buy TXU at bargain prices if it went into bankruptcy.

KERNEN: One of the reasons I brought up that TXU situation was because in the piece it said there’s a lot of really great companies that–in the private equity universe that have really lousy balance sheets based on the bubble that was around in 2007. So there’s going to be some problems. But is that somewhere where you can look to try to help work out some of the situations? There must be some real gems in there that just, for whatever reason, I look at the fees that the PE firms take, and I look at the dividends that they pay out, and it used to work, but now they actually got to manage some of these things. I mean, couldn’t you find some nuggets in there?

BUFFETT: It’s possible, Joe, but on balance, if you notice, the private equity firms are very reluctant, it seems to me, to come forth with anything that involves big losses. I mean, they–what they usually try and do is get bond holders to make concessions or something. But I’ve not seen them wanting to sell the businesses at large losses. Now, you know, if they go into bankruptcy, then you buy them for the bankruptcy process. I mean, if the old TXU gets to 2,014 and they can’t meet the maturities that they have at that time or they haven’t done it earlier, you know, we may buy–we might think about buying the whole place, you know. But we’ll–we might buy it cheaper after a bond default than we would buy it from a private equity place.

KERNEN: Well, you know how to run utilities, and you might get the chance with, I forget how much is coming due.

BUFFETT: We might get the chance.

KERNEN: Yeah, 20 billion or something.

BUFFETT: Yeah, we might get the chance.

Health Insurance:

Unfortunately, I don’t see his ideas here happening. Although it is interesting to hear about how much Buffett and Munger admire Gawande, whose works are popular among value investors.

KERNEN: But you’re saying start over and do it on a bar–bipartisan basis is what you just said.

BUFFETT: I would–I would call in the smartest people in the health care field. I mean, you know, people like the fellow out of Kaiser Permanente or Mayos or this fellow the…

KERNEN: Mayo, Cleveland Clinic, Safeway…

BUFFETT: Or Gawande, the doctor–yeah, yeah. Cosgrove at…

KERNEN: Whole Foods.

BUFFETT: …Cleveland Clinic and…

KERNEN: There’s a bunch of smart–there’s a bunch of people that have some great private market–or free market ideas. And to do it…

BUFFETT: I’d lock them–I’d lock them in a room, Joe, and I’d tell them, you know, come out when you figure out how–some way to get this going in the other direction toward 13 or 14 percent. And it can be done. It can be done…

QUICK: Right. Warren, very quickly, so a viewer wrote in, Greg Robinson from Portland, Oregon, on this subject, said, “Wouldn’t a better fix for health care be a system similar to auto insurance? Could you give a specific–a simple scenario of how Geico would insure a large portion–population of people, perhaps having them pay a portion of the bill themselves so they will police the doctors? I’m a big believer in catastrophic care, but paying for your own maintenance.” Does that sound like a feasible idea?

BUFFETT: Yeah, it probably does. But the truth is, I would get people that know a lot more about it than I do. And, I mean, it–if you get the fellow that’s written on health care recently in the New Yorker, Gawande. I mean, he had–he had an article last summer that was absolutely magnificent (THE COST CONUNDRUM – Atul Gawande). My partner Charlie Munger sat down and wrote out a check for $20,000 to him and he’s never met him, never had any correspondence with it, he just mailed it to the New Yorker and he said, `This article is so useful socially.’ He says, `Just give this as a gift to the–to Dr. Gawande.’ It compared medical costs in McAllen, Texas, to El Paso, and it just showed how, with no better results, that in McAllen they were, you know, they were spending close to twice as much per person. And you have these enormous variances around the country. And, you know, if you had some really smart people running it that knew a lot about medicine, they’re going to–they could do a lot about it.

Using Stock as Currency:

I think this is a case where over simplification causes people to get the wrong idea. I believe that while Buffett was pretty opposed to issuing stock for deals, he can act rationally and do it when the terms make sense. In Kraft’s case, making sure you are not using stock that is greatly undervalued to purchase something that is less than a bargain– especially when you have to sell off key pieces of your business at ultra low prices, like the pizza business.

KERNEN: Welcome back to SQUAWK BOX. Still to come in the next hour, PepsiCo CEO Indra Nooyi, that’s coming up at 8:10. Let’s get back to Omaha, that’s where we find our very own Becky Quick with Warren Buffett. Beck, I was thinking about Matt Rose and Burlington and using stock and Warren with Kraft and Cadbury and I love to get him talking about that, to try to figure out why stock was a good idea for Burlington, that it wasn’t a good idea for Kraft and I love it when you say you don’t like that deal, even though you love management. Go into that again. What was the difference between Kraft using stock and you using stock, other than maybe valuation on the company being acquired?

BUFFETT: Yeah, well, we hate using stock. No question about it, Joe. And because we already owned some Burlington beforehand, it turned it we had to use about 30 percent stock and as I put in the annual report, even though the Burlington holders were getting $100 a share, we felt it cost us more than that because we thought our stock at the time we made the deal was somewhat underpriced. We’d have done all cash if I’d felt comfortable in terms of our balance sheet, using all cash. But I never want to put us in a position where we’ve–we’re stretched in the least. So to make the deal, I had to do it. And I came to the conclusion that using 30 percent stock, which was about 6 percent of all the shares we had outstanding, still left us with a deal that made sense. But if it had to have been all stock or 50 percent stock, we couldn’t have done it and if I’d had enough cash around to do it, so I could’ve done it all cash, I would’ve liked it better.

KERNEN: How about Kraft? You warming up to that finally? Or are you still–you still don’t like it. You don’t get to vote, I guess, do you?

BUFFETT: No, we didn’t get to vote. And it wasn’t just–it wasn’t just the stock that was being used, although that was a terrible currency to use, just as our own stock is a terrible currency to use. But it wasn’t just the stock, it was the price being paid and it was the fact that the pizza business was sold in a very tax inefficient manner to partly fund the purchase. And it just–in the end, I felt poor after the deal was made. But I, you know, I wish Irene the best on executing well on it and I hope it works out. We’ll be a lot better off financially if it does, but I wouldn’t have done it.

QUICK: Warren, that question that Joe raised is one that we got from a lot of viewers, too. In fact, Todd in Parker, Colorado, wrote in and said, “In your annual report, you say that you’ll consider issuing stock when we receive as much in intrinsic business value as we give up. When exchanging Berkshire shares for Burlington Northern, did Berkshire shareholders receive less, equal or more in intrinsic value?”

BUFFETT: Well, we felt, Charlie and I, felt that we received as much or a tiny bit more in intrinsic value as we gave up. But we factored into that some other things I mentioned in the annual report. Namely, that putting $22 billion of cash to work made good sense for us in this business and that the opportunities over the next 40 or 50 years to keep putting more and more cash at reasonable returns in, just like we do in our utility business, also was an attractive opportunity. We’re going to generate lots of cash over the years and we don’t always have great places to put that. This offers one vehicle where we can put it at decent rates of return. Not great rates of return, but decent rates of return.

Animal Spirits and Acquisitions:

QUINTANILLA: Warren, you go–we know this is–you’re passionate about this from the letter, you go into a long hypothetical about company A buying company B whose stock is undervalued. You say that CEOs long on confidence and short on smarts, wants to buy company B for the prestige and maybe the compensation. Is that a–is that a veiled slight at Rosenfeld?

BUFFETT: No, it’s 50 years of being in board rooms and just seeing what happens. And you know, Keynes talked about–probably the best–the best chapters written on investing were chapters eight and 20 in “The Intelligent Investor” for individual investing. The best chapter ever written in sort of describing how the world works in markets is chapter 12 of “The General Theory” written by Keynes and in it he talks about animal spirits and what causes people to do the deals and all of that. It’s a marvelous chapter. And I’m not sure that he had Kraft in mind, but he had a lot of the companies that I’ve experienced over the years in mind. It’s a very normal thing. I mean, you know, everything looks–everything looks rosy, you know, when you first are looking at a deal. You don’t see the downsides. You don’t see the execution problems, you don’t see the people who are going to leave. You don’t see–you don’t see all kinds of things. And I’m guilty of that, too, incidentally. I’ve made some dumb deals in my life and I’ll make some more dumb deals and animal spirits will enter into those dumb deals. I guarantee you that. I just try to keep them under control and if I don’t, I count on Charlie to keep me under control.

Debt Problems in the US

QUICK: All right. Let’s get to some more questions that came in from shareholders. There’s one guy’s–number 184 for the control room. This came from Scott Deller in New York. He says, “How much debt would sink the United States? If the answer’s unknown, isn’t it risky to race at top speed toward that line?” There were a lot of questions like this that came in.

BUFFETT: Yeah. Well, we are doing things that are causing the debt to rise at a very rapid rate, I mean, when you’re running, you know, a fiscal deficit like we are. As long as you issue debt in your own currency, debt doesn’t sink you. Now it–what it does is it destroys the value of money over time. So you can make–you can make it so that the person who lent you money, 10 years from now or 20 years from now gets back dollars that aren’t worth very much. But you can–as long as you’ve got a printing press, you can–you can issue any amount of debt in your own currency. It’s when the world says to you, `We don’t want debt in your currency any more, issue it in something that’s more solid,’ and that’s what they do–they’ve done to various developing countries. That’s what they used to do to South American countries and so on. And then the music stops. The IMF comes in and whatever they take. We have this great reputation for 200 years, and people will accept dollars for a long time. But if the printing presses would run at a sufficient rate, people after a while would say, `Wait a second. We’re going to get stuck.’ You know, it’s interesting, when we talk about what’s happened in the last year or two how the taxpayers paid for this or the taxpayers paid for that, taxpayer hasn’t paid for any of it. We haven’t raised taxes on anybody. What we’ve done is the lenders have paid for it. So it’s…

QUICK: Well don’t those–don’t those costs eventually get passed onto the consumer too, though?

BUFFETT: Not–the costs really get passed on–generally speaking, they get passed onto the saver. They just–inflation steals from savers, and inflation is the logical consequences of printing too much money.

QUICK: And seniors who are living on fixed incomes.

BUFFETT: Anybody that’s living on any kind of fixed income. I mean, you know…

QUICK: And small businesses that are maybe hoping to get a loan from a bank that can’t give it at this point.

BUFFETT: …anybody that has their money–anybody that has their money in a money market fund or anything like that, you know, if we issue enough–if we keep printing enough–if we keep a large enough fiscal deficits we will eventually print a lot of money and money will be worthless. And incidentally, if the United States runs up trillions and trillions and trillions of debt to the rest of the world, you know, I will guarantee you that the politicians of 10 or 20 years ago will not want to pay that back in hard money. It just doesn’t–it doesn’t make any sense.

The Financial Crisis in Greece
Buffett’s advocates swift action in dealing with the problem in Greece. I think that this is pretty appropriate. What we saw in the financial crisis here was that companies which did not deal with their problems fast enough wound up dead. When you are in a situation where you depend on borrowed money, you don’t have the luxury to sit and twiddle your thumbs. You’ve got to act before your credit lines dry up.

QUICK: When you look at the situation in Greece right now and what’s happening with the trouble they’ve gotten into, do you believe that contagion spreads to not only other EU nations, but potentially other states here in the United States? Is that a huge worry for you?

BUFFETT: There’s a huge incentive for the EU to handle something like Greece and, of course, that’s what you’re seeing now. I mean, it isn’t–it isn’t because the rest of–the other 15 countries in the EU have suddenly developed this great affinity for Greeks. They just–they know the consequences of, you know, if A is going to lead to B and you can’t stand B, solve A. And that is essentially the situation. That’s what we went through a year and a half ago, you know, after–when we stepped in and guaranteed money market funds and commercial paper and all of those things. We saw a run on the country developing, and, believe me, it was developing. And no one has to lend money to country A or country B or country C. And if they lose money with country A they’re going to get more worried about country B and country C just like the same experience we had with financial institutions in the fall of 2008. The time to stop runs is early on.

QUICK: But do you think that this is something that could happen here in the United States, if you look at California or New York, if you start looking at some of the states that have very large financial problems?

BUFFETT: Yeah, and they can’t print money.

QUICK: They can’t.

BUFFETT: No, no. What they can do is one of three things. They can cut expenses, they can raise income, or they can go to Washington eventually.

QUICK: And you think Washington would cover all of those problems?

BUFFETT: It would be very tough if you’re in Congress and they say, `Well, you bailed out General Motors, and you did this and that. And are you going to say, “People in the largest state in the union or whatever it is, that we’re not going to take care of you? I mean, the political problem would be huge. But there’s no question that states and municipalities the fiscal–the financial situation for them has deteriorated dramatically. We did not write any municipal insurance to speak of in 2009. The risk got higher and the premiums got lower and that just–it made it a dumb sort of thing to do in our view.

QUICK: Tying this back to Europe and if Europe and Germany do step in and provide for Greece, as it looks like they very–may very well do at this point…

BUFFETT: Almost have to, yeah.

QUICK: …does that make you think that all these hedge funds that are betting against the Euro are on the wrong side of this fence?

BUFFETT: Well, I don’t know what happens to the euro exactly, but I mean, there are–I’m sure there are hedge funds that are betting against the euro that are hoping that for one reason the Germans gets mad at the Greeks, or whatever it may be, you know, they are–let’s say there are two banks in town. You own a bank and I own a bank. Now, if I want to put you out of business what do I do? I go out and hire 50 bums on the street and get them to stand in line in front of your bank. You know, that’s all I have to do. You know, and those 50 will become 100. And after a while, I can let the 50 bums and go, and it will create its own dynamic. You do not want that to happen with countries. So you better stop it, you know, right off the bat. And everybody realizes that. The only question is whether it gets it gets bogged down in something or other.

I woke up at 7AM yesterday to have a chance to read Warren Buffett’s Berkshire Hathaway 2009 letter to shareholders (PDF). This year’s letter did not disappoint. I would like to highlight a few key ideas from the letter.

Intrinsic Value

At the beginning of each letter, you will see a table of how Berkshire Hathaway’s growth in book value fared versus the S&P 500’s. Now, as Buffett states below, book value does not precisely peg intrinsic value but it comes close:

The ideal standard for measuring our yearly progress would be the change in Berkshire’s per-share intrinsic value. Alas, that value cannot be calculated with anything close to precision, so we instead use a crude proxy for it: per-share book value. Relying on this yardstick has its shortcomings, which we discuss on pages 92 and 93. Additionally, book value at most companies understates intrinsic value, and that is certainly the case at Berkshire. In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our all-important insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value. By this measurement, as the opening paragraph of this letter states, our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.

Whitney Tilson takes a different approach for figuring out the company’s intrinsic value: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. This is closer to what Warren Buffett has recommended for pegging Berkshire’s intrinsic value, but it is also more difficult to determine. For most people, the book value approach should be sufficient enough.

Float

Most people don’t understand float, but it is probably the key factor in Berkshire Hathaway’s growth over the last 40 years. Let’s say you are a value investor and you manage to take control of a company. In general, your opportunities range from reinvesting in the business you have acquired, to looking at outside opportunities. These can be acquisitions of other businesses or simple investments in securities. Normally, such investments must be paid for using free cash flow or debt. But if you were to acquire an insurance company, you would have one more weapon in your arsenal, float:

Insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over decades. This collect-now, pay-later model leaves us holding large sums – money we call “float” – that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. Though individual policies and claims come and go, the amount of float we hold remains remarkably stable in relation to premium volume. Consequently, as our business grows, so does our float.

If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float. This combination allows us to enjoy the use of free money – and, better yet, get paid for holding it. Alas, the hope of this happy result attracts intense competition, so vigorous in most years as to cause the P/C industry as a whole to operate at a significant underwriting loss. This loss, in effect, is what the industry pays to hold its float. Usually this cost is fairly low, but in some catastrophe-ridden years the cost from underwriting losses more than eats up the income derived from use of float…

Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest.

Let me emphasize again that cost-free float is not a result to be expected for the P/C industry as a whole: In most years, premiums have been inadequate to cover claims plus expenses. Consequently, the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. Outstanding economics exist at Berkshire only because we have some outstanding managers running some unusual businesses. Our insurance CEOs deserve your thanks, having added many billions of dollars to Berkshire’s value. It’s a pleasure for me to tell you about these all-stars.

Bolded for emphasis. The $16M to $62B figure is absolutely amazing and speaks to the power of a disciplined insurance operation. Not to detract from the 2009 letter, but I think the following discussion on National Indemnity from the 2004 is quite insightful here. Indeed, in Buffett’s 2004 letter, he said that without the acquisition of National Indemnity, Berkshire would be nowhere close to its size today:

So, you may ask, how do Berkshire’s insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage? We’ve attacked that problem in several ways. Let’s look first at NICO’s strategy.

When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry’s chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.

What we’ve had going for us is a managerial mindset that most insurers find impossible to replicate. Take a look at the facing page. Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.

Many insurance companies end up chasing premiums without adequate risk management and blow up. They never have the time to really endure and grow, the way that Berkshire has done with National Indemnity and its other operations. Now, back to the 2009 letter.

Buffett uses the rest of the insurance section of the letter to praise Ajit Jain’s activities at Berkshire Reinsurance and mentions that GEICO has gone from the country’s 6th largest auto insurer to the third largest in just 15 years. One of the best things about Buffett is he always owns up to his mistakes. It seems as if a foray into the credit card business did not work out so well for GEICO:

And now a painful confession: Last year your chairman closed the book on a very expensive business fiasco entirely of his own making.

For many years I had struggled to think of side products that we could offer our millions of loyal GEICO customers. Unfortunately, I finally succeeded, coming up with a brilliant insight that we should market our own credit card. I reasoned that GEICO policyholders were likely to be good credit risks and, assuming we offered an attractive card, would likely favor us with their business. We got business all right – but of the wrong type.

Our pre-tax losses from credit-card operations came to about $6.3 million before I finally woke up. We then sold our $98 million portfolio of troubled receivables for 55¢ on the dollar, losing an additional $44 million.

GEICO’s managers, it should be emphasized, were never enthusiastic about my idea. They warned me that instead of getting the cream of GEICO’s customers we would get the – – – – – well, let’s call it the non-cream. I subtly indicated that I was older and wiser.

I was just older.

That kind of honesty is unparalleled in shareholder letters, which usually read more like corporate propaganda than honest assessments of the business.

Burlington Northern Santa Fe

(Flickr: SP8254)

The regulated utilities section of the letter provides some insights on why the Buffett chose to acquire Burlington Northern. I think that for the most part, guys like Bruce Berkowitz were right in their assessment on Burlington Northern:

CONSUELO MACK: Let me ask you about the Burlington Northern acquisition, the largest acquisition that Berkshire Hathaway has ever made. The Wall Street Journal coverage of it saidWarren Buffett is turning Berkshire Hathaway into a big industrial operator and it’s no longer thenimble investment firm that it was once. What’s your view of what Warren is doing in buying thesebig industrial companies?

BRUCE BERKOWITZ: Berkshire has a tremendous amount of flow from the premiums received from long-term insurance policies. That flow has to be invested in very secure, sound financial instruments such as: electric utilities cost plus or a railroad business which has the stability unlikemany businesses. So here he’s taking money that’s actually got a zero cost to it and then investing itat a reasonable, not at an egregious yield, but at a reasonable investment yield. But when the cost iszero, the returns are phenomenal. He’s brilliant. Warren Buffett is being Warren Buffett in that he’smarried another great big business to Berkshire Hathaway that’s going to make a sizeable difference overtime

Buffett believes that BNSF should be looked at as a utility as well:

Our BNSF operation, it should be noted, has certain important economic characteristics that resemble those of our electric utilities. In both cases we provide fundamental services that are, and will remain, essential to the economic well-being of our customers, the communities we serve, and indeed the nation. Both will require heavy investment that greatly exceeds depreciation allowances for decades to come. Both must also plan far ahead to satisfy demand that is expected to outstrip the needs of the past. Finally, both require wise regulators who will provide certainty about allowable returns so that we can confidently make the huge investments required to maintain, replace and expand the plant…

In the future, BNSF results will be included in this “regulated utility” section. Aside from the two businesses having similar underlying economic characteristics, both are logical users of substantial amounts of debt that is not guaranteed by Berkshire. Both will retain most of their earnings. Both will earn and invest large sums in good times or bad, though the railroad will display the greater cyclicality. Overall, we expect this regulated sector to deliver significantly increased earnings over time, albeit at the cost of our investing many tens – yes, tens – of billions of dollars of incremental equity capital.

Buffett does not say explicitly what he thinks the returns on invested capital will be for the railroad business but that it should increase over time. Burlington Northern should definitely have the kind of pricing power it needs to ward off the frictional forces of inflation, should regulators act properly.

NetJets

(Course Correction: NetJets)

When David Sokol took the reigns at NetJets, I think people looked at the situation in two ways. 1. This would be a test for Sokol, to see if he has what it takes to be the CEO of Berkshire Hathaway. 2. Berkshire’s businesses aren’t infallible and may need guidance from time to time. Here is what Buffett said of the situation:

We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. That means we are sometimes late in spotting management problems and that both operating and capital decisions are occasionally made with which Charlie and I would have disagreed had we been consulted…

The major problem for Berkshire last year was NetJets, an aviation operation that offers fractional ownership of jets. Over the years, it has been enormously successful in establishing itself as the premier company in its industry, with the value of its fleet far exceeding that of its three major competitors combined. Overall, our dominance in the field remains unchallenged.

NetJets’ business operation, however, has been another story. In the eleven years that we have owned the company, it has recorded an aggregate pre-tax loss of $157 million. Moreover, the company’s debt has soared from $102 million at the time of purchase to $1.9 billion in April of last year. Without Berkshire’s guarantee of this debt, NetJets would have been out of business. It’s clear that I failed you in letting NetJets descend into this condition. But, luckily, I have been bailed out.

Dave Sokol, the enormously talented builder and operator of MidAmerican Energy, became CEO of NetJets in August. His leadership has been transforming: Debt has already been reduced to $1.4 billion, and, after suffering a staggering loss of $711 million in 2009, the company is now solidly profitable.

Most important, none of the changes wrought by Dave have in any way undercut the top-of-the-line standards for safety and service that Rich Santulli, NetJets’ previous CEO and the father of the fractional- ownership industry, insisted upon.

With the debt reduced to $1.4B and the company profitable, David Sokol looks as if he has passed the test. Sokol has gradually had the opportunity to get more face time with the media. We saw this with his activities at NetJets and the investment in BYD. I think he is poised to be the right operations guy at Berkshire, with Ajit Jain handling the insurance operations and the still unnamed CIO handling investments.

Financial Products and Derivatives

On occasion, Buffett has criticized the government’s lending policies with good reason. Berkshire is unable to get the kinds of lending rates that TARP recipients received in the past, which put the company at a decided disadvantage when it came to bidding on parts of companies such as AIG. But in this year’s letter, Buffett sheds light on another problem:

The residential mortgage market is shaped by government rules that are expressed by FHA, Freddie Mac and Fannie Mae. Their lending standards are all-powerful because the mortgages they insure can typically be securitized and turned into what, in effect, is an obligation of the U.S. government. Currently buyers of conventional site-built homes who qualify for these guarantees can obtain a 30-year loan at about 51⁄4%. In addition, these are mortgages that have recently been purchased in massive amounts by the Federal Reserve, an action that also helped to keep rates at bargain-basement levels.

In contrast, very few factory-built homes qualify for agency-insured mortgages. Therefore, a meritorious buyer of a factory-built home must pay about 9% on his loan. For the all-cash buyer, Clayton’s homes offer terrific value. If the buyer needs mortgage financing, however – and, of course, most buyers do – the difference in financing costs too often negates the attractive price of a factory-built home…

Our product is first-class, inexpensive and constantly being improved. Moreover, we will continue to use Berkshire’s credit to support Clayton’s mortgage program, convinced as we are of its soundness. Even so, Berkshire can’t borrow at a rate approaching that available to government agencies. This handicap will limit sales, hurting both Clayton and a multitude of worthy families who long for a low-cost home.

These kinds of double standards hurt buyers of Clayton’s homes, especially considering that Clayton’s buyers are not speculators. Most are simply people looking to buy a home and live in it. They aren’t the gluttonous home flippers that helped fuel the excess supply in the housing market.

One of the problems with the media and Warren Buffett is that they often try to over simplify what he says, boiling things down into sound bytes that don’t give the full picture. This is definitely the case with derivatives.

A number of commentators have criticized Buffett for investing in derivatives contracts after calling derivatives weapons of mass destruction. The thing is, Buffett was criticizing how most financial institutions were using derivatives. For the most part, companies like AIG were writing billions upon billions of dollars worth of CDS contracts using faulty math behind defaults. They were totally unrealistic. We see now that Greece tried to use contracts to fudge their budgetary accounting and make their deficits appear artificially lower. These kinds of uses of derivatives are pretty stupid and can cause the mass destruction that Buffett described. Actually, if you look at AIG and the state of Greece, you could argue that they have already caused that destruction.

The Berkshire approach to derivatives is different. For the most part, Buffett looks at these like he does insurance. He is trying to find mispricings where the risk is limited and the duration from now till when money must be exchanged is sufficiently long enough to earn enough from the float to limit any kind of damage that would occur if Berkshire is on the losing side of these contracts:

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault. It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.

Most people incorrectly assume that value investing means just investing in well run large cap stocks. It doesn’t. Value investing is buying a dollar for 50 cents. Where that dollar exists should not matter. A good investor should be willing to travel across asset classes in search of these bargains, and that is what great investors like Seth Klarman, Prem Watsa, and Warren Buffett have done in the past.

The entire letter is worth reading, especially for getting a more detailed insight into some of Berkshire Hathaway’s lesser known subsidiaries and overall performance for 2009.

Former Treasury Secretary Hank Paulson has a new book coming out, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, which looks like an interesting account of what happened from his perspective. As Paulson describes:

The pace of events during the financial crisis of 2008 was truly breathtaking. In this book, I have done my best to describe my actions and the thinking behind them during that time, and to convey the breakneck speed at which events were happening all around us.

I believe the most important part of this story is the way Ben Bernanke, Tim Geithner, and I worked as a team through the worst financial crisis since the Great Depression. There can’t be many other examples of economic leaders managing a crisis who had as much trust in one another as we did. Our partnership proved to be an enormous asset during an incredibly difficult period. But at the same time, this is my story, and as hard as I have tried to reflect the contributions made by everyone involved, it is primarily about my work and that of my talented and dedicated team at Treasury.

–Henry M. Paulson

Warren Buffett recently had an opportunity to interview Paulson in Omaha, and didn’t spare any tough questions, choosing to even ask about whether the TARP would be repaid (Paulson said yes).

Below is a video of the interview:

via: Paulson: Acts averted disaster (Omaha World Herald)

Whitney Tilson just put out a great presentation describing why Berkshire Hathaway (NYSE:BRK.B / BRK.A) is undervalued. I wanted to highlight a few points from the presentation:

Tilson notes that Berkshire Hathaway is transitioning away from being primarily an investment company, to being driven by earnings from its operations. A number of analysts have noted that one of the reasons for the Burlington Northern acquisition was to lessen the need for a great investor to manage Berkshire’s huge cash horde. The acquisition is expected to add a steady stream of income from a business that Buffett believes has great long-term prospects.

Tilson goes on to use a methodology for estimating Berkshire’s value that comes straight from Buffett himself: you take the company’s per share investments and add them to pretax earnings per share with a multiple attached. The chart shows that usually, the market ends up exceeding the company’s intrinsic value, although recently this has not been the case. There could be a number of reasons for this, including the recent financial crisis.

Using Tilson’s $142,500 estimate, we see that given current prices, Berkshire is undervalued by about 26%.

Lastly, Tilson points out that even though the intrinsic value of Berkshire Hathaway is just $142,500, the company should grow and add to cash within a year. Adjusting for these changes, Berkshire Hathaway may be undervalued by as much as 44%. Be sure to read the full presentation for more details on Tilson’s analysis.

This is great news for any Berkshire Hathaway shareholder. By being added to the index, managers are going to be forced to pick up B shares and in turn help drive the stock’s price up:

Buffett, who is Berkshire’s chairman and CEO, wasn’t immediately available to comment Tuesday afternoon, but he discussed the prospect of Berkshire joining the S&P 500 during last week’s special shareholder meeting on the stock split.

Buffett said he expects Berkshire will benefit from joining the S&P indexes, saying it will suddenly have buyers for about 6 percent of its shares because many investment funds buy stock in the companies in the S&P indexes to mirror the moves of the indexes. And those mutual fund buyers would plan to hold the stock long-term, which is what Buffett wants.

“Over time, if it’s in the S&P, I think it’s a slight plus for shareholders,” Buffett said last week.

Buffett’s Berkshire to be added to S&P indexes

Now about that Dow Jones Industrial Index…

Warren Buffett is pretty active with foreign insurance companies these days. Not to long ago, Berkshire Hathaway (NYSE:BRK-A) did a deal to take on some of Swiss Re’s life insurance portfolio. Now, Munich Re is reporting that he owns 3% of the company:

Release of an announcement according to Section 21 WpHG [German Securities Trading Act]
WKN 843002
ISIN DE0008430026

Warren E. Buffett, USA, informed us in accordance with Section 21, para. 1 of the German Securities Trading Act (WpHG) that his share of the voting rights in our company had exceeded the threshold of 3% on 18 January 2010 and amounted to 3.045% (6,011,029 voting rights) as per this date. Thereof 2.994% (5,911,029 voting rights) are attributable to him in accordance with Section 22, para. 1 sentence 1 item 1 of the WpHG.

Munich, 26 January 2010

The Board of Management

Notifications relating to holding of voting rights 2010 (Munich Re)

I don’t know too much about Munich Re, but for any global value guys, it is probably worth taking a look at.

Howard Marks of Oaktree Capital has a new memo that is great as usual. I particularly liked his point about inflation:

When Paul Volcker left the Fed in 1987, he was asked at his first public appearance, “Will interest rates go up or down?” He answered presciently: “Yes.” Of course, his answer is still the right one. But from today’s levels, I think rates are more likely to go up than down (there’s so little room for the latter).

Reduced faith in the dollar means it would take higher interest rates to attract non-U.S. buyers to dollar investments. And, even domestically, (a) one of these days the government will stop holding rates down and (b) higher inflation would require rates to rise to compensate for the fact that the dollars with which debts are repaid will buy less. For all these reasons, I think investors must consider the prospect of higher inflation, dollar weakness and higher interest rates.

What to do about them? The list of possibilities is long:

· Buy TIPS.
· Buy floating rate debt.
· Buy gold (but only at the “right” price, and what’s that?)
· Buy real assets, such as commodities, oil and real estate (ditto).
· Buy foreign currencies.
· Make investments denominated in foreign currencies.
· Buy the securities of companies that will be able to pass on increased costs.
· Buy the securities of companies that own commodities, or that own assets denominated in foreign currencies.
· Buy the securities of companies that earn their profits outside the U.S.
· Hold cash (to invest once interest rates have risen).
· Sell long-term bonds (and possibly go short).

These are the actions that can profit from – or that provide the flexibility to adjust to – increased inflation, a decline in the dollar and increased interest rates, all of which are interconnected. The most important one is the last one: long-term bonds could suffer worst in an inflationary, higher-rate environment, especially given today’s low starting yields.

One final point: When I provide this answer to the frequent question about inflation, I ask people whether they agree. Usually they do. Then I ask how much of their portfolio they’re willing to devote to protecting against these macro forces. If their answer is 5%, 10% or 15%, I point out that that’s pretty close to doing nothing. The question is whether you’re willing to devote at least 30-40%. Few people are.

But that’s the thing: It’s easy to say, “I’m worried about inflation.” It’s something very different to say, “I’m worried enough about inflation to do something meaningful about it.” Let me know when you decide how much you’re willing to devote.

Howard Marks: Tell Me I’m Wrong (Oaktree Capital)

Marks makes an excellent point about whether managers are taking on superficial hedges — only investing a small, meaningless amount in their hedges. These positions make great talking points in quarterly letters but offer nothing by way of actual protection for their partners.

The best hedging opportunities usually come in the form of missed priced insurance. Nassim Taleb’s option trading seems to fit this description. The most recent example is the CDS trade that worked beautifully during the crisis. Credit default swaps were so mispriced that even a small position offered massive returns.

When things look dangerous, great investors are always ready to significantly protect themselves. Warren Buffett’s hoarding of cash provided Berkshire with great opportunities to invest in companies that were temporarily weakened by the crisis. Investors like Seth Klarman sometimes move 50% into cash if opportunities dry up. That is a meaningful move that protects investors from potential losses versus those who complain about overheated markets while keeping their partners hopelessly fully invested.

I’ve been thinking about hedging a lot these days and plan on having a comprehensive post up soon.