In 1992, the United States watched its most successful third party candidate since Teddy Roosevelt garner nearly 20 million votes, or 18.9% of those cast. Bloomington, MN became home to an American temple, with its gargantuan coffers poised to receive the tribute of her mallrats. Over in the stock market, the somnolent S&P 500 opened the year near 417, made a few attempts to rise, but ultimately closed the year near 435.
Over at Berkshire, book value per value increased 20.3%, to $7745. Since Warren and Charlie took up textiles, book value has grown from $19 to $7,745, or at a rate of 23.6% compounded annually. Look through earnings came in at $604 million. Despite all of Warren’s warnings, Berkshire’s performance has consistently been able to outpace his stated goal—to grow intrinsic value at 15% per annum.*
In this year’s letter, Buffett bears all, as he discloses his most exhiliarating activity at Berkshire—“the acquisition of a business with excellent economic characteristics and a management that we like, trust and admire.” And Buffett knows he is not alone, for “in the past, [he’s] observed that many acquisition-hungry managers were apparently mesmerized by their childhood reading of the story about the frog-kissing princess. Remembering her success, they pay dearly for the right to kiss corporate toads, expecting wondrous transfigurations. Initially, disappointing results only deepen their desire to round up new toads.”
What sets Buffett apart from other spirited suitors is his patience. And 1992 saw his patience rewarded, purchasing 82% of Central States Indemnity, “an insurer that makes monthly payments for credit-card holders who are unable themselves to pay because they have become disabled or unemployed.” A family owned business, Central States is based in Omaha and has annual premiums are about $90 million and profits about $10 million.
By 1992, the Berkshire shareholder is surely accustomed to hearing the Chairman warn that future returns will lag those of the past, primarily because its swelling capital base demands larger businesses to produce significant investment returns. In order to grow “look-through” earnings by 15%, or $100 million, Berkshire would likely have to lay out at least a billion. Yet, the amount of excellent businesses that could absorb such an investment is relatively small.
One viable candidate though is super-catastrophe insurance. Looking ahead, Buffett can see that Berkshire’s future earnings growth will increasingly depend on its insurance businesses, and as usual, he wants its shareholders to calibrate appropriate expectations beforehand. In short, super-cat insurance—though likely profitable over the long term—may produce abysmal results for any single year. Pricing in particular is difficult to determine, for “catastrophe insurers can’t simply extrapolate past experience. If there is truly “global warming,” for example, the odds [for potential losses] would shift, since tiny changes in atmospheric conditions can produce momentous changes in weather patterns.” Even worse, occasionally, the unthinkable happens. “Who would have guessed, for example, that a major earthquake could occur in Charleston, S.C.? (It struck in 1886, registered an estimated 6.6 on the Richter scale, and caused 60 deaths.) And who could have imagined that our country’s most serious quake would occur at New Madrid, Missouri, which suffered an estimated 8.7 shocker in 1812.”
“Furthermore, in recent years there has been a mushrooming of population and insured values in U.S. coastal areas that are particularly vulnerable to hurricanes, the number one creator of super-cats. A hurricane that caused x dollars of damage 20 years ago could easily cost 10x now.”
Pricing for the unexpected and adjusting for lifestyle changes represent two prongs of Berkshire’s strategy. The last—conservative accounting. “Rather than recording our super-cat premiums on a pro-rata basis over the life of a given policy, we defer recognition of revenue until a loss occurs or until the policy expires… because the likelihood of super-cats causing us losses is particularly great toward the end of the year. It is then that weather tends to kick up: Of the ten largest insured losses in U.S. history, nine occurred in the last half of the year. In addition, policies that are not triggered by a first event are unlikely, by their very terms, to cause us losses until late in the year.”
“The bottom-line effect of our accounting procedure for super-cats is this: Large losses may be reported in any quarter of the year, but significant profits will only be reported in the fourth quarter.”
On Buying General Dynamics
Of course, all the work in writing reinsurance could be for naught if the capital it provides were not profitably deployed. In common stocks, Berkshire acquired a large new position in General Dynamics. Initially Buffett purchased the shares to take advantage of an arbitrage opportunity (General Dynamics was repurchasing 30% of its shares via a Dutch tender), but the more he uncovered about the business and the CEO Bill Anders, the more impressed he was: “Bill had a clearly articulated and rational strategy; he had been focused and imbued with a sense of urgency in carrying it out; and the results were truly remarkable.”
So Buffett dropped the thoughts of arbitrage and “decided that Berkshire should become a long-term investor with Bill. We were helped in gaining a large position by the fact that a tender greatly swells the volume of trading in a stock. In a one-month period, we were able to purchase 14% of the General Dynamics shares that remained outstanding after the tender was completed.” [NB–In less than two years, Mr. Market re-appraised Berkshire’s stake at more than four times its 1992 price.]
On Buying Growth or Value
As always, Buffett uses his annual letter as a lectern to dispense his investing lesson for the day. And 1992 saw him distill wisdom from contemporary financial jargon. To both his fellow investment professionals who pursue “value” stocks, and those seeking “growth,” Buffett notes that John Burr Williams, some 50 years ago, set forth the proper equation of value, as “the value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Stated so, it is clear that investing—no matter one’s emphasis—will be most successful insofar as one can determine future cash flows and the remaining life of a given asset.
Growth “is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.” And what is investing except the seeking of value sufficient to justify the price paid? “Value investing” then is redundant.
Yet, “whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.”
The investor then should not settle comfortably in this jargon, for growth projections can soar to the moon, and discounted assets can still be priced too dear. Focus on cash flows, while keeping in mind, that “the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return. Unfortunately, the first type of business is very hard to find: Most high-return businesses need relatively little capital. Shareholders of such a business usually will benefit if it pays out most of its earnings in dividends or makes significant stock repurchases.”
On Health Care Liabilities
Even among smart and hard-working stock analysts, one can find negligent disregard for off-balance sheet liabilities—pensions, health care benefits, SIVs, etc. One only needs to look to today’s Washington to see the difficulties of reserving money for tomorrow’s health care.
Thinking as an insurer, Buffett notes that “no CEO would have dreamed of going to his board with the proposition that his company become an insurer of uncapped post-retirement health benefits that other corporations chose to install. A CEO didn’t need to be a medical expert to know that lengthening life expectancies and soaring health costs would guarantee an insurer a financial battering from such a business.” Given the rate and cost of health care innovations, population demographics, and the United States’ love for perceptions of egalitarianism, it is indubitable that health care costs relative to GDP will be much higher than they are today. To insure against this eventuality would require more chutzpah than any insurer would care to muster.
Yet, “many a manager blithely committed his own company to a self-insurance plan embodying precisely the same promises – and thereby doomed his shareholders to suffer the inevitable consequences. In health-care, open-ended promises have created open-ended liabilities that in a few cases loom so large as to threaten the global competitiveness of major American industries.”
And Buffett is not afraid to place blame, for “the reason for this reckless behavior was that accounting rules did not, for so long, require the booking of post-retirement health costs as they were incurred. Instead, the rules allowed cash-basis accounting, which vastly understated the liabilities that were building up. In effect, the attitude of both managements and their accountants toward these liabilities was “out-of-sight, out-of-mind.”
“Managers thinking about accounting issues should never forget one of Abraham Lincoln’s favorite riddles: “How many legs does a dog have if you call his tail a leg?” The answer: “Four, because calling a tail a leg does not make it a leg.” It behooves managers to remember that Abe’s right even if an auditor is willing to certify that the tail is a leg.”
All told, 1992 was a year with much to say. Beyond these lessons, Buffett highlights the advantages of purchasing securities in the secondary market (rather than initial offerings), the lack of correlation between high corporate overhead and business performance, and the true cost of stock options. And last but not least, learn from Mr. Buffett’s mistake; be not too incautious with your 89 year old employees. Some, like Mrs. B., just may rekindle the fire to compete. At 99, Buffett finally got her signature on a non-compete.
Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.
* Of course, growth in book value and intrinsic value often diverge significantly, and in extreme cases, show no correlation. In assessing Buffett’s performance in 1992, we feel comfortable taking him at his word: that Berkshire’s book value is a useful, albeit conservative, proxy for valuing the business.
[In more recent years, this same assessment would look increasingly foolish, as one of the largest components of Berkshire’s intrinsic value today is the value of its insurance float, which has grown significantly, relative to Berkshire’s book value, since 1992. In 1992, Berkshire had 2.3 billion in float vs. about 7.5 billion in equity; in 2008, it was 58 billion in float vs. 109 billion.]