Tag Archives: Insurance

Buffett’s Berkshire Letter for 1987

warren_buffett_ku_visit1987 was the year the stock market jumped off the cliff. We use the cliché rather flippantly, but perhaps no metaphor better captures a 20.4% single day drop in the S&P 500. Despite the theatrics, the S&P 500 essentially closed the year where it had started, at 247.

Over at Berkshire, net worth gained $464 million in 1987, or 19.5%. Since taking over, Buffett and Munger’s creation has grown book value per share from $19.46 to $2,477.47, or at a rate of 23.1% compounded annually. Unlike past letters, Buffett doesn’t manage down expectations of future returns; perhaps now he’s proven to himself his consistency.

One of the first items on this year’s agenda are the margins and return on equity (ROE) of Berkshire’s seven non-financial subsidiaries–Buffalo News, Fechheimer, Kirby, Nebraska Furniture Mart, Scott Fetzer Manufacturing Group, See’s Candies, and World Book. In 1987, these seven combined to produce $180 million in EBIT while only employing $178 million in equity capital and virtually no debt. Thinking about it another way “if these seven business units had operated as a single company, their 1987 after-tax earnings would have been approximately $100 million – a return of about 57% on equity capital.” Indeed, quite impressive numbers, even for someone with Buffett’s standards.

How is it that Berkshire’s businesses require such meager portions of capital? As Buffett observes, “the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.” Stated simply, almost every business change requires capital. In a business or industry always in metamorphosis, substantial portions will be consistently consumed. Think here of the ravenous adolescent.

Since the mid-1970s, Buffett has clearly preferred businesses with small appetites, but is his preference generalizable? A Fortune study from 1987 thinks so, for they found “only 25 of the 1,000 companies met two tests of economic excellence – an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: during the decade, 24 of the 25 outperformed the S&P 500.” Where the pace of business and industry change is slow, capital can accumulate and moats develop.

After giving his annual briefing of Berkshire’s non-financial operations, Buffett gives his mind to analyzing their insurance businesses. Insurance, by and large, offers a commodity product, and the industry offers few barriers to entry. By penning a promise, virtually anyone can collect premiums. Like other commodity businesses, price will often be the primary determinant in the purchase decision.

Yet Buffett reminds his owners that “at Berkshire, we work to escape the industry’s commodity economics in two ways. First, we differentiate our product by our financial strength, which exceeds that of all others in the
industry. This strength, however, is limited in its usefulness. It means nothing in the personal insurance field: The buyer of an auto or homeowners policy is going to get his claim paid even if his insurer fails (as many have)… Periodically, however, buyers remember Ben Franklin’s observation that it is hard for an empty sack to stand upright and recognize their need to buy promises only from insurers that have enduring financial strength. It is then that we have a major competitive advantage.”

The second competitive advantage for Berkshire’s insurance business is their “total indifference to volume that we maintain. In 1989, we will be perfectly willing to write five times as much business as we write in 1988 – or only one-fifth as much. We hope, of course, that conditions will allow us large volume. But we cannot control market prices. If they are unsatisfactory, we will simply do very little business. No other major insurer acts with equal restraint.”

Lastly, Buffett’s 1987 assessment of CEOs’ capital allocation was particularly interesting, especially in light of our recent posts on assessing management [see here]. His basic observation is that “the heads of many companies are not skilled in capital allocation.” Yet, shareholders shouldn’t be surprised, for “most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics.” The required new skill set “is not easily mastered,” but absolutely and overridingly critical for business success, for “after ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”

Of course, today’s technocratic mindset would encourage the CEO who lacks capital-allocation skills to run and hire some pristinely-dressed and well-connected management consultants or investment bankers. Unfortunately, “Charlie and I have frequently observed the consequences of such “help.” On balance, we feel it is more likely to accentuate the capital-allocation problem than to solve it.”

There is much more of interest here—comments on Mr. Market’s mania and depression, Buffett’s buy and hold philosophy, and inflation. But for the aspiring capitalist, the above themes are most important—buy simple businesses, in industries with little change, those with economic moats—if possible, and managed by skilled capital allocators. Oh, and be sure to pay the right price.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.

Buffett’s Berkshire Letter for 1982

1982 saw guns ablaze at the Falkland Islands. Walt Disney World grew its empire by opening its second largest theme park—Epcot. Wayne Gretzky set the reigning record for the most goals scored during an NHL season, netting 92. And the S&P 500 started the year near 120, fell below 105 by mid-August, and rebounded to close the year near 140.

Over at Berkshirebuffett, “operating earnings of $31.5 million in 1982 amounted to only 9.8% of beginning equity capital (valuing securities at cost), down from 15.2% in 1981 and far below our recent high of 19.4% in 1978.” Buffett found three causes for the decline—first, “a significant deterioration in insurance underwriting results,” second, “a considerable expansion of equity capital without a corresponding growth in the businesses we operate directly,” and third, “a continually-enlarging commitment of our resources to investment in partially-owned, nonoperated businesses.”

As Buffett has mentioned in preceding years, return on equity capital should be the most significant metric for evaluating management performance. However, in Berkshire’s case, this metric has become less and less useful, as standard accounting practices fail to fully reflect Berkshire’s share of its equity holdings’ earnings. For example, Berkshire owned a significant stake of GEICO in 1982; however, rather than including Berkshire’s share of GEICO’ earnings ($23 million) with its earnings, accounting standards dictate that only distributed earnings (i.e., cash dividends) be noted (which were $3.5 million after tax). So long as GEICO retains some of its annual earnings for reinvestment, those earnings will not immediately show up on Berkshire’s annual report, even though their share of them is just as real as the assets on GEICO’s balance sheet. Over time, Buffett is confident that these retained earnings will become more fully reflected in the stock prices of their portfolio.

Despite low returns on equity capital, book value at Berkshire grew $208 million, thanks to an increasingly cheerful consensus in the stock market. Starting the year with a book value of $519 million, the levity lifted Berkshire’s net worth nearly 40%.

Looking forward, Buffett foresees insurance underwriting results for 1983 to be no sight for the squeamish. For the industry, 1982 would seem bad enough, with Best estimating a combined industry ratio of 109.5; in short, that means that every dollar of insurance float cost $1.095, or a 9.5% annual rate. However, Buffett cautions that this relatively lousy results are a best case estimate, for in any given year, “it is possible for an insurer to show almost any profit number it wishes, particularly if it (1) writes “long-tail” business (coverage where current costs can be only estimated, because claim payments are long delayed), (2) has been adequately reserved in the past, or (3) is growing very rapidly.”

Looking over his competitors’ results, Buffett’s nose has caught some unpleasant whiffs, noting that “several large insurers opted in 1982 for obscure accounting and reserving maneuvers that masked significant deterioration in their underlying businesses.” Herein lies the wisdom—“In insurance, as elsewhere, the reaction of weak managements to weak operations is often weak accounting. (It’s difficult for an empty sack to stand upright.)”

The root of this temptation lies in the fact that insurance is a commodity business; its service amounts to a promise, and most purchasers take every insurer’s word to be that of the saint. Even worse, in insurance, barriers to entry are few; anyone with sufficient regulatory capital and a John Hancock can make a promise. Insurance then, unlike other commodity businesses, almost always operates “under the competitive sword of substantial overcapacity.” Only in those rare cases where there is a natural or financial megadisaster does capacity retreat; and until such an event, Buffett forecasts that the insurance industry will not be profitable.

Lastly, Buffett concludes with some reflections on issuing equity for acquisitions. Their golden rule is that they will not issue shares unless they receive as much intrinsic business value as they give. Of course, stated so simply, no rational business manager should reject it; but in practice, very many do, using a variety of odd rationalizations and linguistic high jinks.

To help the manager apply the golden rule, Buffett recommends thinking about one’s own stock as a currency. Every time that a business issues shares for an acquisition, it has to honestly ask whether it would be willing to sell its whole business for its implied worth. In other words, if I value my business at X, I should not use its shares as currency for any purchase that values those shares at less than X. As Buffett notes, “A cumulation of small managerial stupidities will produce a major stupidity – not a major triumph. (Las Vegas has been built upon the wealth transfers that occur when people engage in seemingly-small disadvantageous capital transactions.)”

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway at the time of this writing.