Thoughts on Business and Technology

Notes : Berkshire Annual Letter – 1990

Performance Highlights :

  • Net Worth up by $326 million to $1.841 Billion
  • Book value $4,612.06 ( gain in book value from $19.6 , 23.2% compounded annually   )

Look-Through earnings : 

These are earnings of  “investees” that are not reported ( as per GAAP) in the financial statements of a holding company as they are retained by the investees and returned to the holding company as dividends. However if the company retaining the earnings is investing the funds intelligently and in a owner friendly way, either by repurchase of stocks or to increase the intrinsic value of the franchise. It is advantageous to the holding company then paying dividends. Dividends would incur taxes which then would diminish the capacity of the holding company to invest the earnings.

On Berkshire’s Intrinsic value growth :

We hope to grow our intrinsic value and “look-through earnings” 15%  annually.  – Warren Buffet in 1990 annual letter

Buffet Eroding moat of News Papers & Media Businesses : 

 The reason media businesses have been so outstanding in the past was not physical growth, but rather the unusual pricing power that most participants wielded. Now, however, advertising dollars are growing slowly. In addition, retailers that do little or no media advertising (though they sometimes use the Postal Service) have gradually taken market share in certain merchandise categories. Most important of all, the number of both print and electronic advertising channels has substantially increased. As a consequence, advertising dollars are more widely dispersed and the pricing power of ad vendors has diminished. These circumstances materially reduce the intrinsic value of our major media investments and also the value of our operating unit, Buffalo News – though all remain fine businesses.

To add to the injury this was before the onset of internet… One of the reasons Buffet sites for still owning the news paper business is “Profits may be off but our pride in the product remains” .

On Berkshire Insurance operating principle : 

The picture would change quickly if a major physical or financial catastrophe were to occur. Absent such a shock, one to two years will likely pass before underwriting losses become large enough to raise management fear to a level that would spur major price increases. When that moment arrives, Berkshire will be ready – both financially and psychologically – to write huge amounts of business.

We are ready to accept higher volatility. Hence Berkshire is not spreading risk as insurers typically do; we are concentrating it. Our combined ratio will never fall in the industry range of 100 – 120, but will instead be close to either zero or 300%

Super Cats : 

chico_state_wildcatsWhat are Super Cats ?

The buyers of these policies are reinsurance companies that themselves are in the business of writing catastrophe coverage for primary insurers and that wish to “lay off,” or rid themselves, of part of their exposure to catastrophes of special severity.

Super Cat contracts :

A typical super-cat contract is complicated. But in a plain- vanilla instance we might write a one-year, $10 million policy providing that the buyer, a reinsurer, would be paid that sum only if a catastrophe caused two results: (1) specific losses for the reinsurer above a threshold amount; and (2) aggregate losses for the insurance industry of, say, more than $5 billion. Under virtually all circumstances, loss levels that satisfy the second condition will also have caused the first to be met.

photo credits :

Framework for evaluating insurance results : 

Underwriting loss / Float Developed Ratio : When measured over years gives a rough indication of the “cost of funds generated” by insurance operations. A low cost of funds signifies a good business; a high cost translates into a poor business.

The Float =  ( total of loss reserves, loss adjustment expense reserves and unearned premium reserves )  - ( agents’ balances, prepaid acquisition costs and deferred charges applicable to assumed reinsurance )

“Cost Of Funds”  : is the underwriting loss and other expenses that an insurer incurs to generate the float or funds to be invested by the insurer.  Figuring a cost of funds for an insurance business allows anyone analyzing it to determine whether the operation has a positive or negative value for shareholders. If this cost (including the tax penalty) is higher than that applying to alternative sources of funds, the value is negative. If the cost is lower, the value is positive – and if the cost is significantly lower, the insurance business qualifies as a very valuable asset.

– In some cases, effective cost of funds can be considerably less than zero. Essentially policyholders, in aggregate, pay the company interest on the float rather than the other way around.

BIG DISCLAIMER for cost of funds : we won’t know our true cost of funds for a given period ( 10-20 years) until all losses from this period have been settled many decades from now. Second, the value of the float to shareholders is somewhat undercut by the fact that they must put up their own funds to support the insurance operation and are subject to double taxation on the investment income these funds earn. Direct investments would be more tax-efficient.  tax penalty adds about one percentage point to their cost of float.

Conclusion – In the insurance business, there is no statute of limitations on stupidity.

Wells Fargo : Why Berkshire bought 10% stake in Wells Fargo in 1989/90

  1.  – Great Management with Carl Reichardt and Paul Hazen running the business. Buffet compares Carl & Paul to Tom Murphy and Dan Burke at Capital Cities/ABC. Each pair is stronger than the sum of its parts because each partner understands, trusts and admires the other
  2.  – Management pays able people well, but abhor having a bigger head count than is needed.
  3. - Management attacks costs as vigorously when profits are at record levels as when they are under pressure.
  4. - Management sticks with what they understand and let their abilities, not their egos, determine what they attempt.

Wesco Financial letters to shareholders : 

Buffet recommends the following commentary by Charlie Munger on Banking and the impact of perverse incentives and regulations on the lending practices in 1990’s.

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