Intelligent Investor Club

Berkshire Annual Letter 1996 (Part 4)

GEICO is an extremely valuable asset to Berkshire and is headed by Tony Nicely, a superb business manager.

The strength of GEICO lies in its position as a low-cost operator. With low costs come low prices and good long-term policy holders.

GEICO also gets more than one million referrals (due to their low prices) annually which produces more than half of their business. This lowers than acquisition expensese, which makes their cost even lower.

In 1996, their voluntary auto policy grew 10%, which was an record growth. This is the area that Buffett focuses on and not involutary growth (from assigned risk pools and the like). That kind of growth is unprofitable.

On top of the growth, the underwriting was also profitable. The goal of GEICO is not to increase the profit margin, but to increase the price advantage given to customers. With that, the customer base would be expected to grow even further. …Continue reading » GEICO

Berkshire Annual Letter 1996 (Part 3)

In Berkshire’s super-cat business, they sell policies to insurance and reinsurance companies to protect them from the effects of mega-catastrophes.

As such events occur rarely, Berkshire’s super-cat business will thus show large profits in most years with the occasion huge loss in certain years.

That huge loss year will come – it is only a matter of when. When that happens, shareholders need not panic and sell Berkshire shares. Their after-tax “worst-case” loss from a true mege-catastrophe is probably no more than 3% of their book value (and 1.5% of their market value).

To take things into perspective, the swings in the market price of Berkshire would have been even greater.

Volatility in Berkshire’s earnings isn’t too important either. Warren Buffett would rather earn a lumpy 15% over time than a smooth 12%.

Berkshire has three major competitive advantages in the super-cat business.

1) The parties buying reinsurance from them know that Berkshire has the financial strength to pay under the most adverse of situations.

2) After a mega-catastrophe, insurers might find it difficult to obtain reinsurance even though their needs would be very great at that time. Berkshire will have the capacity to underwrite it when the time comes.

3) They can provide a coverage size that cannot be matched in the industry.

With regards to the pricing, they are made at a level so that eventually 90% of total premiums will end up being paid out in losses and expenses.

It will take a long time to find out whether those prices were correct.

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Two Acquisitions of 1996

There were two acquisitions by Berkshire in 1996, both with qualities they seek – excellent business economics and an outstanding manager.

Kansas Bankers Surety (KBS)

This was an insurance company with an extraordinary underwriting record and an outstanding manager, Don Towle. Don has first-hand relationships with hundreds of bankers, and knows every details of the company.

It took Warren Buffett less than one day to look at the financial statements of the company before deciding to buy it.

FlightSafety International

FlightSafety International is a world leader in the training of pilots. The CEO of the company is Al Ueltschi, 79 years old at the time of acquistion.

It took Warren Buffett 60 seconds upon meeting Al to know that he was exactly the kind of manager that Berkshire needed.

If you can recall, I had previously uploaded an interview that Robert Miles had with Al Ueltschi.

Insurance Operations

The results for both primary insurance and super-cat reinsurance business were outstanding in 1996.

What counts in the insurance business is the amount of float generated and the cost of the float.

This is important to understand as float is a major component of Berkshire’s intrinsic value that is not reflected in book value.

In an insurance operation, float is the money held by the company (but they don’t own). It arises because premiums are always collected before losses are paid out.

Typically, the premiums collected by insurers do not cover the losses and expenses they have to pay. This “underwriting loss” is the cost of float.

An insurance business has value if its cost of float over time is less than the cost the company would incur to obtain the funds.

In Berkshire, the insurance businses has been a big winner as their cost of float has been less than nothing for many years. This access to “free” money has boosted their performance in a major way.

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Over the past 32 years, the per-share book value of Berkshire has grown from $19 to $19,011, at a rate of 23.8% compounded annually.

Due to the purchase of GEICO (becoming a wholly-owned subsidiary), there was a need to restate Berkshire’s 1995 financial statements.

From an economic point of view, the value of the 51% of GEICO owned at year-end 1995 increased significantly when the remaining 49% was bought.

This is because of major tax efficiencies and other benefits.

From an accounting point of view however, it was required for the value of the 51% to be written down at the time Berkshire went to 100%.

As a result, the original 51% of GEICO is now carried on the books at a value that is both lower than its market value at the time the remaining 49% was bought and also lower than the value at which that 49% is carried.

The Relationship of Intrinsic Value to Market Price

Over time, the total gains made by Berkshire shareholders should match the business gains of the company. When the market price temporarily overperforms or underperforms the business, some shareholders (buyers or sellers) will receive outsized benefits at the expense of those they trade with.

While the primary goal of Berkshire is to maximize the amount that their shareholders make, another goal is to minimize the benefits going to some shareholders at the expense of others.

In a public company, fairness prevails when market price and intrinsic value are in sync. This will never happen but a manager can do much to make them close.

The longer a shareholder holds his shares, the more his returns will match Berkshire’s business results; and the less it will depend on what his premium or discount to instrinsic value was when he bought it.

That is one reason Berkshire hopes to attract owners with long-term horizons.

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Berkshire Annual Letter 1995 (Part 9)

In 1996, Warren Buffett proposed having two classes of stock for Berkshire. A class “B” share will be created that has 1/30th of the rights of the existing (or “A”) shares but 1/200th of the voting rights.

In addition, class “B” shares will not be entitled to participate in Berkshire’s shareholder-designated charitable contributions program.

Everyone holding on to the class A share can convert it them into class B shares. This makes it easier for them to use Berkshire shares as gifts.

The motivation behind this exercise is the emergence of many (expense laden) unit trusts aggressively marketed as low priced clones of Berkshire.

Warren Buffett has the view that these Berkshire funds will be mass marketed with huge promises. The not so sophisticated buyers might be mislead by the potential of the funds.

It is likely that commissions and other expenses will eat into the performance, and these investors will be disappointed.

Through the creation of the class B shares, investors can invest directly into Berkshire.

The tradeoffs for Berkshire is that there will be additional costs associated with handling a greater number of shareholders.

A thing to take note for both current and prospective Berkshire shareholders is that the market price of Berkshire and the intrinsic value will not be the same all the time.

Ideally, they should be the same but in reality, there are times when the market value is higher than the intrinsic value and vice versa.

The more informed investors are, the smaller the gap between market value and intrinsic value. By creating class B shares, the merchandising efforts of the Berkshire unit trusts will be blunted and the market value of Berkshire will be closer to the intrinsic value.

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Convertible Stocks

Berkshire made five private purchases of convertible preferred stocks from 1987-1991.

                         Dividend  Year of            Market
 Company                   Rate    Purchase   Cost    Value
 -------                 --------  --------  ------  --------

						(dollars in millions)

Champion International Corp	9 1/4%	1989	$300	$388(1)
First Empire State Corp		9%	1991	40 	110
The Gillette Company 		8 3/4%	1989	600	2,502(2)
Salomon Inc 			9%	1987	700	728(3)
USAir Group, Inc. 		9 1/4%	1989	358	215

When the purchases were made, Warren expected

(a) the returns from them to moderately exceed those from medium term fixed income securities.

(b) they would not beat the returns from a business with wonderful economic prospects.

(c) they would give back at least their capital plus dividends under almost any circumstances.

As it turned out, (a) was met (but only because of the performance of Gillette), (b) was correct and (c) could be wrong (because of USAir Group).

Leaving aside Gillette, the returns of the convertibles would be no more than equal to those earned from medium term fixed income issues.

Furthermore, the returns for Gillette would have been even greater had Warren purchased the shares directly at that time instead of the convertible.

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Berkshire Annual Letter 1995 (Part 7)

In 1995, there were three businesses in the Berkshire staple that underperformed.

The shoe business had depressed earnings but the problem was likely to be a cyclical one.

On the other hand, the industry trends for Berkshire’s newspaper business, The Buffalo News, are not good (This was also previously mentioned in the 1991 Annual Report). Newspapers are less economical attractive now compared to the days when they have a bullet-proof franchise.

Over time, Warren expects their competitive strength to gradually erode, but with many remaining years of being a fine business.

The most difficult problem was in World Book, which had increasingly difficult competition from CD-ROM and other online offerings.

As a result, it had to make major changes in the way it operates, with more electronic products and reduced overheads. Whether these efforts are sufficient remains to be seen.

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Berkshire Annual Letter 1995 (Part 6)

What counts in the insurance business is the amount of float generated (money held but not owned) and the cost of it. There is float because premiums are always paid upfront and it takes time to resolve claims.

Usually, the premiums that an insurer takes in will not cover the losses and expenses that it must pay. This is called an “unwriting loss” and reflects the cost of float.

If this cost of float is lower than market rates for money, then that insurance company is profitable.

At times when there is no underwriting loss, the cost of float is acutually negative, giving “free money”.

In any business, its profitability is determined by three things:

1) What its assets earn;
2) What its liabilities cost; and
3) its utilization of leverage – the extent by which assets are funded by liabilities rather than by equity.

Berkshire has always done well on the first point. What most people don’t realise is that they have also benefited greatly from the low cost of their liabilities.

Often, they are able to generate plenty of float on very advantageous terms.

At the end of 1994, they had $3.4 billion of float. If they had replaced that with $3.4 billion of equity, it would have meant more shares, equal assets and lower earnings attributed to each share.

The acquisition of GEICO will increase their float by $3 billion, with the probability that the cost of the float will be nothing (due to underwriting profits).

Super-Cat Insurance

Berkshire is able to stand out in the field of super-cat and large risk insurance because of:

1) Their unmatched financial strength;
2) Their ability to supply quotes faster than anyone else.
3) Their ability to issue policies with limits larger than anyone else.

The nature of the super-cat insurance business is such that it can show large profits in many years but there could be occassional years of huge losses. Thus, it will take many years to evaluate the profitability.

Both Warren Buffett and charlie Munger are quite willing to accept relatively volatile results in exchange for better long-term earnings.

However, they will never write business at inadequate rates. A bad insurance contract is like hell; you can get surprises from it even 20 years down the road.

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Berkshire Annual Letter 1995 (Part 5)

Back when Warren Buffett attended Columbia University under the tutorlege of Benjamin Graham, he found out that Ben was the Chairman of Government Employees Insurance Company (GEICO), an unknown company to him.

One weekend, Warren Buffett took a train to the headquarters of GEICO, where he was met by Lorimer Davison, Assistant to the President (and who was later to become CEO).

Even though Warren’s only credentials at that time was a student of Graham, “Davy” spent four hours teaching him about the ins and outs of the insurance business.

Up to this day, Warren Buffett is thankful to Davy’s generousity with his time, as Berkshire would not have gotten to where it is today without that afternoon meeting.

As Warren found out, GEICO’s strength was in using direct marketing as its method of selling, giving it an enormous cost advantage over competitors who sold through agents.

So in 1951, Warren started to buy shares in GEICO on four occassions using money that he earned as a delivery boy for The Washington Post.

This stake of $10,282 was more than 50% of his networth and was sold in 1952 for $15,259. (The stake if kept to 1995, would have growth to $1.3 million.)

From 1976 to 1980, Berkshire spent $45.7 million to accummulate a 33.3% stake in the company. Because of the aggressive share buybacks by the company, this stake actually grew to 50% of the company.

In 1995, Berkshire paid another $2.3 billion for the other half of the company that it didn’t own, gaining full control of the company and taking it private.

Warren Buffett likes businesses with economic castles protected by unbreachable “moats”. GEICO is one such example.

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R.C. Willey Home Furnishings

R.c. Willey Home Furnishings was a business discovered by Irv Blumkin of Nebraska Furniture Mart while he was walking around.

Bill Child, CEO of R.C. Willey took over the company from his father-in-law in 1954 and grew the sales from $250,000 to $257 million in 1995.

The fact of it is that retailing is a tough business. During Warren Buffett’s investment career, he has seen a large number of retailers enjoy terrific growth and high ROE for a while, only to suddenly nosedive into bankruptcy.

This happens more often in retailing than in manufacturing or in the service industry. The reason is because a retailer is easily copied so he has to constantly come up with new ways to attract customers.

And shoppers are always faced with new merchants.

On the other hand, there are kinds of businesses whereby the owner only has to be smart once. By being early in the game, he can coast and still turn out pretty well.

A sidenote.

Just how many managers can Warren Buffett handle reporting to him? His answer:

“If I have one person reporting to me and he is a lemon, that’s one too many, and if I have managers like those we now have, the number can be almost unlimited.”

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