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"The secrets to Buffett's success" in The Economist


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Anyone else LOL at the very notion that low beta is the reason for Buffett's success? 

 

 

In the Economist article, they say that he bought high quality businesses that were down on their luck and amplified the returns on those investments with leverage from float -- what's incorrect about that?

 

If you really sit down and study Buffett, you will see that is exactly what he did for the most part. Every 10 years or so when the market goes haywire, he's able to deploy capital into situations like the preferred deals he did during the financial crisis (he did similar in the late 80s) and generate extra returns, but for the most part it's all come down to levering up high quality businesses.

 

Now these businesses do indeed tend to exhibit low beta traits, that's true -- but I think that's just caused by the fact that they're high quality businesses with stable cash flows (ideal for levering).

 

 

 

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Now these businesses do indeed tend to exhibit low beta traits, that's true -- but I think that's just caused by the fact that they're high quality businesses with stable cash flows (ideal for levering).

 

Right.  He needs to put a value on them (prediction is necessary) so they must first be predictable.  Therefore... not very volatile as shareholders sleep well sitting on something predictable.

 

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Now these businesses do indeed tend to exhibit low beta traits, that's true -- but I think that's just caused by the fact that they're high quality businesses with stable cash flows (ideal for levering).

 

Right.  He needs to put a value on them (prediction is necessary) so they must first be predictable.  Therefore... not very volatile as shareholders sleep well sitting on something predictable.

 

 

Yeah. The simplist model for BRK would be leverage from float and DTA and a modest amount of debt used to buy high quality businesses with predictable cash flows. 

 

It used to puzzle me how WEB is attracted to the purchase of a great business that had been around 100 years with modest growth prospects at a not so wonderful price that might have an earnings yield of 7% or so.  However, with BRK's internal leverage, that modest earnings yield then increases to 10% or so.  Then, BRK earns a compound rate of maybe 4% per annum above what the great businesses in its stable earn.  Then, the large cash holdings and regular generation of float enable BRK to occasionally pick up unusual bargains like BAC pref + warrants.  Result: now the compounding machine's normalized earnings are perhaps compounding at 11% to 12%  per annum, much more than the earnings of the other great businesses it owns.

 

Think about it.  Here is this mega cap company, selling for less than 1.2 times Q3 BV that is still a machine that compounds earnings and BV at a much higher rate than some of the very best S&P 500 companies that sell at perhaps more than 4 times BV.  We're talking about a company that has compounded BV/SH at the highest rate of all for the last 47 years!

 

Plus, BRK does another neat thing.  A few years ago I puzzled over BRK's SEC filings that Warren himself had apparently personally signed.  These listed at the time $8B or so "best of best" holdings like AmEx, Wells Fargo, Coke etc.  I think these were the majority of BRK's pension plan holdings, things that appropriately would have a growing earnings yield of 7 % or so with enormous compounding potential by the time the pensions had to be paid out.  Contrast that to the bond heavy assets of the typical pension plan that will probably earn about half that rate.  :)

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Yeah. The simplist model for BRK would be leverage from float and DTA and a modest amount of debt used to buy high quality businesses with predictable cash flows. 

 

It used to puzzle me how WEB is attracted to the purchase of a great business that had been around 100 years with modest growth prospects at a not so wonderful price that might have an earnings yield of 7% or so.  However, with BRK's internal leverage, that modest earnings yield then increases to 10% or so.  Then, BRK earns a compound rate of maybe 4% per annum above what the great businesses in its stable earn.  Then, the large cash holdings and regular generation of float enable BRK to occasionally pick up unusual bargains like BAC pref + warrants.  Result: now the compounding machine's normalized earnings are perhaps compounding at 11% to 12%  per annum, much more than the earnings of the other great businesses it owns.

 

Think about it.  Here is this mega cap company, selling for less than 1.2 times Q3 BV that is still a machine that compounds earnings and BV at a much higher rate than some of the very best S&P 500 companies that sell at perhaps more than 4 times BV.  We're talking about a company that has compounded BV/SH at the highest rate of all for the last 47 years!

 

Plus, BRK does another neat thing.  A few years ago I puzzled over BRK's SEC filings that Warren himself had apparently personally signed.  These listed at the time $8B or so "best of best" holdings like AmEx, Wells Fargo, Coke etc.  I think these were the majority of BRK's pension plan holdings, things that appropriately would have a growing earnings yield of 7 % or so with enormous compounding potential by the time the pensions had to be paid out.  Contrast that to the bond heavy assets of the typical pension plan that will probably earn about half that rate.  :)

 

twacowfca,

great analysis of BRK! AmEx, Wells Fargo, Coke… a 7% earnings yield, add the benefit of float and you get a 10% earnings yield, pick up occasionally some unusual bargain and you compound at 11% to 12%… It looks easy!

So why isn’t it copied more often? You know that I am thinking hard about LRE: why an outstanding (unique, I daresay!) underwriter like LRE keeps the large part of its investments in short-term bonds, instead of just copying what Mr. Buffett has shown works so well? I don’t understand: Mr. Brindle could very well go on concentrating exclusively on the underwriting business - as he should do, because that is clearly what he does best -… but why don’t hire YOU??!!  ;) If only with the goal to replicate what you have written about BRK’s way of investing! It doesn’t take Mr. Buffett to do that! If the reason is: it works for BRK, because of Mr. Buffett’s skills; well, then I don’t agree. I just don’t see how Mr. Buffett’s unique investing skills should be required, to achieve good results the way you have so clearly described.

 

giofranchi

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Hey! Mr. Buffett is a genius! No doubt about it! But let’s take another example: Mr. Gayner of Markel Corp.. MKL has compounded book value per share at 17% annualised for the last 20 years. They clearly are good underwriters (although not as good as LRE!) and Mr. Gayner is a good value investor. But a genius?! I have been looking at what Mr. Gayner buys and sells for years now, and it doesn’t even seems to me that he strives to “pick up occasionally” those “unusual bargains” twacowfca has written about.

I think that my question is legitimate, also because I heard Mr. Munger ask it many times before: why are so few those who try to emulate Berkshire business model?

 

giofranchi

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He was successful even without float in the partnership days

 

So what?

 

He didn't make the bulk of his money in his partnership days - he made the bulk of it through Berkshire. Buffett's a pretty smart guy and he must have realized that the easiest path for him to accumulate large amounts of wealth over the long term was not through running his partnership, but taking advantage of the inherent leverage of the insurance business.

 

If you want to generate good returns for your personal account (or really small fund) you are much better off studying what Buffett did in his partnership days.

 

If you want to become a multi-billionaire, you're better off studying what Buffett did with Berkshire and the Economist spells that out for you:

 

He took advantage of the insurance structure's non-callable, low/0 cost leverage and bought underpriced high quality businesses.

Leverage + high quality business = Good returns. That's it. You can't dispute it.

 

 

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What I think truly makes Buffett unique (and this is a view that many others have expressed here on this board already on numerous occasions) are:

1. The robustness of his approach. He has been able to adapt his style/strategy each particular environment during his career. I think this is truly difficult because people in general are ignorant about how the environments effect when making decisions (Kahneman & Tversky, the basketball and gorilla test, etc. etc.).

2. His business acumen. Yeah sure, to do what he did you would "just" have to lever up for free and voilà. Is there any case ever of an insurance company that has been able to increase its business at that rate and to such a size without sacrificing profitability of its underwriting. Take Berkshire Re for example, Buffett actually had to spot the genius of Ajit Jain. Mr. Jain was someone who excelled at school, he didn't have his uniqueness written on his forehead.

 

Gísli

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He was successful even without float in the partnership days

 

So what?

 

He didn't make the bulk of his money in his partnership days - he made the bulk of it through Berkshire. Buffett's a pretty smart guy and he must have realized that the easiest path for him to accumulate large amounts of wealth over the long term was not through running his partnership, but taking advantage of the inherent leverage of the insurance business.

 

That depends how you look at it.  I'm pretty sure his net worth compounded at the highest annualized pace before he wound up his partnership.  He had the "float" of other people's money.  Those gains were necessary in order for him to buy his Berkshire shares in the first place -- in that respect this was the most crucial part of his formula.

 

If not Berkshire then what other path?

He could have continued to draw other people's money and earned excessive fees as today's hedge fund managers do.  Maybe that would have earned him even more money than Berkshire has.  Maybe he could be making $2billion a year in hedge fund fees if he were to go that route today.  Over the past 10 years he might have raked in $20billion, and if he had been doing this going back 40 years, then I'd say he would have been able to make more than his Berkshire shares have grown.

 

So to answer the question of why more people haven't followed the Berkshire formula, it might be that compensation for talented investors is higher in the hedge fund world.  Buffett has been compounding his own money and not making money off of others during the Berkshire days.  Hedge fund managers not only compound their own money, but they also make money off of others.  And if they aren't that rich to begin with, they soon become so if their own assets are a fraction of the fund size and if the fund size is large then it's just rediculous leverage and scaling.

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Yeah. The simplist model for BRK would be leverage from float and DTA and a modest amount of debt used to buy high quality businesses with predictable cash flows. 

 

It used to puzzle me how WEB is attracted to the purchase of a great business that had been around 100 years with modest growth prospects at a not so wonderful price that might have an earnings yield of 7% or so.  However, with BRK's internal leverage, that modest earnings yield then increases to 10% or so.  Then, BRK earns a compound rate of maybe 4% per annum above what the great businesses in its stable earn.  Then, the large cash holdings and regular generation of float enable BRK to occasionally pick up unusual bargains like BAC pref + warrants.  Result: now the compounding machine's normalized earnings are perhaps compounding at 11% to 12%  per annum, much more than the earnings of the other great businesses it owns.

 

Think about it.  Here is this mega cap company, selling for less than 1.2 times Q3 BV that is still a machine that compounds earnings and BV at a much higher rate than some of the very best S&P 500 companies that sell at perhaps more than 4 times BV.  We're talking about a company that has compounded BV/SH at the highest rate of all for the last 47 years!

 

Plus, BRK does another neat thing.  A few years ago I puzzled over BRK's SEC filings that Warren himself had apparently personally signed.  These listed at the time $8B or so "best of best" holdings like AmEx, Wells Fargo, Coke etc.  I think these were the majority of BRK's pension plan holdings, things that appropriately would have a growing earnings yield of 7 % or so with enormous compounding potential by the time the pensions had to be paid out.  Contrast that to the bond heavy assets of the typical pension plan that will probably earn about half that rate.  :)

 

twacowfca,

great analysis of BRK! AmEx, Wells Fargo, Coke… a 7% earnings yield, add the benefit of float and you get a 10% earnings yield, pick up occasionally some unusual bargain and you compound at 11% to 12%… It looks easy!

So why isn’t it copied more often? You know that I am thinking hard about LRE: why an outstanding (unique, I daresay!) underwriter like LRE keeps the large part of its investments in short-term bonds, instead of just copying what Mr. Buffett has shown works so well? I don’t understand: Mr. Brindle could very well go on concentrating exclusively on the underwriting business - as he should do, because that is clearly what he does best -… but why don’t hire YOU??!!  ;) If only with the goal to replicate what you have written about BRK’s way of investing! It doesn’t take Mr. Buffett to do that! If the reason is: it works for BRK, because of Mr. Buffett’s skills; well, then I don’t agree. I just don’t see how Mr. Buffett’s unique investing skills should be required, to achieve good results the way you have so clearly described.

 

giofranchi

 

Giofranchi, you ask a great question: Why doesn't Brindle, who is arguably the best property underwriter in the Bermuda / Lloyds markets invest his float in great businesses the way Buffett does? The short answer is that he has had a top tier record investing in equities in the past, but what he does now is much better for LRE's business.

 

BRK had a AAA rating until Warren's put derivatives went against him in 2008 and led to a downgrade as the market value of BRK's stocks also declined.  However, this had little downside because BRK was still one of the most solid companies in the world.  LRE liquidated their equity portfolio in mid 2008 before the stock market tanked to avoid such a possible consequence, because the prospect of a downgrade from A - to below investment grade would have been disagreeable to say the least.  LRE was one of the few insurers to have positive investment returns in 2008, and in every quarter of their existence except one.

 

Lancashire is a short tail property insurer.  This necessitates carrying mostly high quality, short duration liquid assets to be able to pay claims quickly if there should be a large claim. This limits investment returns, but it also gives them the huge optionality that goes with carrying a lot of cash and near cash.  For example, they were able to buy back about 25% of their stock a few years ago at a price that averaged less than book value.  That's the gift that keeps on giving.  Recently, their extra cash has enabled them to leverage their sterling reputation to goose returns through sidecars.

 

Here's how the economics of a sidecar works for them:  their long term return on equity at LRE has averaged 19%+.  Brindle's returns for the syndicates that he and Charmin managed at Lloyds also returned 19%+ on average. All of these returns have been without a single down year, quite low volatility considering that their peers had a very rough time at Lloyd's in the 80's and 90's.  Therefore, it's reasonable to assume that the central value of LRE's returns will continue to be about 19%+ per annum or perhaps a little better with the way they get more upside with less downside in the sidecars.

 

LRE puts a relatively small amount of capital into a sidecar and other investors fund the rest. LRE gets a commission and a management fee for managing the sidecar. This attenuates the downside to their investment in the sidecar if there is a loss.  They also cede some of their most catastrophe exposed business to the sidecar.  This also attenuated the downside from a large catastrophe to their regular business.  Then, if the loss experience of the sidecar is low, LRE will be entitled to a percentage of the profit of the entire sidecar above the profit of their investment in it.

 

Lets assume that the long term expectation of LRE's investment in the risk assumed by the sidecar sidecar would be greater than their long term average return of 19%+ because sidecars are are only set up when rates in a particular sector are exceptionally high.  However, Lancashire limits how much catastrophe exposure it is willing to take on even though their expectation is that the return would be great if they took on more risk. 

 

Let's assume that the long term average expectation of the annual profit of the sidecar is about 20% for the outside investors. LRE's expected return on the sidecar may be perhaps 30%+ because of their overrides.  Plus the risk is far less than if they had retained a higher level of catastrophe exposed business.  :)

 

That return on extra cash not needed in their core business is a lot more than what Lancashire would expect to get from an investment in common stocks.  However BRK's business is much more long tail.  There is a long time available to invest the float until claims have to be paid.  That's why having substantial investments in common stocks makes sense for BRK much more than for Lancashire.

 

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The problem is that the article conflates Berkshire's success (BV compounding) with WEB's success as an investor and businessman (investment performance and wealth compounding through OPM biz).

 

Remember, WEB says that given a small amount of capital today (presumably, untied to an insurance operation), he could compound at 50%.  I don't see him getting that performance solely from leverage and high quality companies.  And no insurance company could have an investment portfolio made up the same way as the portfolio of the Buffett Partnership. 

 

But there is something interesting to be learned from WEB's changing approach over time, which is that when you become wealthy, you can actually stay wealthy and create dynastic type wealth by switching from a "let's get into orbit" strategy to a "let's compound our vast amount of wealth at a nice clip" over time.  I don't really understand why very rich families who have some business acumen put their money in hedge funds that focus on all sorts of crazy strategies, when they could take the high quality approach.

 

Ericopoly seems to be taking the smart approach.  Get into orbit, and then put it all into Berkshire.

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Leverage + high quality business = Good returns. That's it. You can't dispute it.

 

Leverage + high quality business == bankruptcy as well  8)

 

On that note, people always talk about float, Buffett's stock picking ability and understanding of the companies  he invests in. But they always frame it such that his ability to do this has resulted in him finding fantastic investments, which is true. But I think whats often overlooked is the inverse of that.

 

Buffett has said that Berkshire's mistakes are usually of omission not commission, its true for their wins as well IMO. Some of there biggest wins have been because omission. Things that he chosen not to do. His ability to say no to things that might appear attractive has resulted in him having very few investments go bad and resulting in permanent capital loss. He has had some bad ones for sure, but in general its not the picks that fascinate as much as the avoidances.

 

Focusing on workouts when the markets were high during the partnership days, avoiding the junk bond and LBO debacle, avoiding the .com bubble, not owning any of the companies that went under during the crisis. Getting out of the GSEs long before the crisis.

 

His ability to navigate and avoid folly is truly impressive. 

 

 

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Leverage + high quality business = Good returns. That's it. You can't dispute it.

 

Leverage + high quality business == bankruptcy as well  8)

 

Low or no cost non-callable leverage + High quality businesses purchased at reasonable or bargain prices = Good returns

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The economist article may overstate the points of the study on which it is based. The authors identified explanatory factors by comparing against a model portfolio reweighted on a monthly basis, before transaction fees, with no adjustments for transaction size to market or liquidity. The idealized Buffett portfolio, taken from 13-Fs, is maintained at fixed weights on a monthly basis, and then updated quarterly. So, if a stock outperforms the portfolio between 13-Fs, it's treated as if it were "sold" until the holding reaches the prior quarter weight. If, in the next 13-F, the stock hasn't been sold at all, then it's treated as if it were "bought" again*.

 

*As far as I understand. Someone else might have a different interpretation of "Buffett's Alpha" by Frazzini, Kabiller,  and Pedersen.

 

In any case, some of the comments on the Economist article were upset by the implication that Buffett doesn't have "alpha", but explaining someone's performance isn't the same as saying that they have no skill, at least not in the colloquial sense.

 

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I have seen a presentation by these guys who claim they can find the factors that explain returns but these factors don't work in practice.  Just look at their mutual fund returns in trying to do this analysis.  They fail to do better than the benchmarks.  The low beta strategy is based upon a measure that typically has low r squared.

 

Packer

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I have seen a presentation by these guys who claim they can find the factors that explain returns but these factors don't work in practice.  Just look at their mutual fund returns in trying to do this analysis.  They fail to do better than the benchmarks.  The low beta strategy is based upon a measure that typically has low r squared.

 

Packer

 

 

Yeah, the classic error of confusing correlation with causality.  The R squared may appear to be high when looking at the market,  but the correlation drops prospectively.  The commonsensical explanation is that businesses with stable and moderately growing cash flows often are low beta, but that does not necessarily mean that low beta stocks are mostly great businesses.  In fact, as Bruce Greenwald and others have pointed out, there is a powerful tendency for high ROE businesses to regress to mean returns.  Buffett's genius is in ferreting out the ones that don't. ( At least not for a very long time. ) :)

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Yeah. The simplist model for BRK would be leverage from float and DTA and a modest amount of debt used to buy high quality businesses with predictable cash flows. 

 

It used to puzzle me how WEB is attracted to the purchase of a great business that had been around 100 years with modest growth prospects at a not so wonderful price that might have an earnings yield of 7% or so.  However, with BRK's internal leverage, that modest earnings yield then increases to 10% or so.  Then, BRK earns a compound rate of maybe 4% per annum above what the great businesses in its stable earn.  Then, the large cash holdings and regular generation of float enable BRK to occasionally pick up unusual bargains like BAC pref + warrants.  Result: now the compounding machine's normalized earnings are perhaps compounding at 11% to 12%  per annum, much more than the earnings of the other great businesses it owns.

 

Think about it.  Here is this mega cap company, selling for less than 1.2 times Q3 BV that is still a machine that compounds earnings and BV at a much higher rate than some of the very best S&P 500 companies that sell at perhaps more than 4 times BV.  We're talking about a company that has compounded BV/SH at the highest rate of all for the last 47 years!

 

Plus, BRK does another neat thing.  A few years ago I puzzled over BRK's SEC filings that Warren himself had apparently personally signed.  These listed at the time $8B or so "best of best" holdings like AmEx, Wells Fargo, Coke etc.  I think these were the majority of BRK's pension plan holdings, things that appropriately would have a growing earnings yield of 7 % or so with enormous compounding potential by the time the pensions had to be paid out.  Contrast that to the bond heavy assets of the typical pension plan that will probably earn about half that rate.  :)

 

twacowfca,

great analysis of BRK! AmEx, Wells Fargo, Coke… a 7% earnings yield, add the benefit of float and you get a 10% earnings yield, pick up occasionally some unusual bargain and you compound at 11% to 12%… It looks easy!

So why isn’t it copied more often? You know that I am thinking hard about LRE: why an outstanding (unique, I daresay!) underwriter like LRE keeps the large part of its investments in short-term bonds, instead of just copying what Mr. Buffett has shown works so well? I don’t understand: Mr. Brindle could very well go on concentrating exclusively on the underwriting business - as he should do, because that is clearly what he does best -… but why don’t hire YOU??!!  ;) If only with the goal to replicate what you have written about BRK’s way of investing! It doesn’t take Mr. Buffett to do that! If the reason is: it works for BRK, because of Mr. Buffett’s skills; well, then I don’t agree. I just don’t see how Mr. Buffett’s unique investing skills should be required, to achieve good results the way you have so clearly described.

 

giofranchi

 

Giofranchi, you ask a great question: Why doesn't Brindle, who is arguably the best property underwriter in the Bermuda / Lloyds markets invest his float in great businesses the way Buffett does? The short answer is that he has had a top tier record investing in equities in the past, but what he does now is much better for LRE's business.

 

BRK had a AAA rating until Warren's put derivatives went against him in 2008 and led to a downgrade as the market value of BRK's stocks also declined.  However, this had little downside because BRK was still one of the most solid companies in the world.  LRE liquidated their equity portfolio in mid 2008 before the stock market tanked to avoid such a possible consequence, because the prospect of a downgrade from A - to below investment grade would have been disagreeable to say the least.  LRE was one of the few insurers to have positive investment returns in 2008, and in every quarter of their existence except one.

 

Lancashire is a short tail property insurer.  This necessitates carrying mostly high quality, short duration liquid assets to be able to pay claims quickly if there should be a large claim. This limits investment returns, but it also gives them the huge optionality that goes with carrying a lot of cash and near cash.  For example, they were able to buy back about 25% of their stock a few years ago at a price that averaged less than book value.  That's the gift that keeps on giving.  Recently, their extra cash has enabled them to leverage their sterling reputation to goose returns through sidecars.

 

Here's how the economics of a sidecar works for them:  their long term return on equity at LRE has averaged 19%+.  Brindle's returns for the syndicates that he and Charmin managed at Lloyds also returned 19%+ on average. All of these returns have been without a single down year, quite low volatility considering that their peers had a very rough time at Lloyd's in the 80's and 90's.  Therefore, it's reasonable to assume that the central value of LRE's returns will continue to be about 19%+ per annum or perhaps a little better with the way they get more upside with less downside in the sidecars.

 

LRE puts a relatively small amount of capital into a sidecar and other investors fund the rest. LRE gets a commission and a management fee for managing the sidecar. This attenuates the downside to their investment in the sidecar if there is a loss.  They also cede some of their most catastrophe exposed business to the sidecar.  This also attenuated the downside from a large catastrophe to their regular business.  Then, if the loss experience of the sidecar is low, LRE will be entitled to a percentage of the profit of the entire sidecar above the profit of their investment in it.

 

Lets assume that the long term expectation of LRE's investment in the risk assumed by the sidecar sidecar would be greater than their long term average return of 19%+ because sidecars are are only set up when rates in a particular sector are exceptionally high.  However, Lancashire limits how much catastrophe exposure it is willing to take on even though their expectation is that the return would be great if they took on more risk. 

 

Let's assume that the long term average expectation of the annual profit of the sidecar is about 20% for the outside investors. LRE's expected return on the sidecar may be perhaps 30%+ because of their overrides.  Plus the risk is far less than if they had retained a higher level of catastrophe exposed business.  :)

 

That return on extra cash not needed in their core business is a lot more than what Lancashire would expect to get from an investment in common stocks.  However BRK's business is much more long tail.  There is a long time available to invest the float until claims have to be paid.  That's why having substantial investments in common stocks makes sense for BRK much more than for Lancashire.

 

twacowfca,

your knowledge of the insurance/reinsurance business is clearly deep and all-comprehensive. I really hope we all on this board could go on benefiting from it!  :)

 

giofranchi

 

 

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Ericopoly seems to be taking the smart approach.  Get into orbit, and then put it all into Berkshire.

 

txlaw,

you most surely are right!

But consider that for each “astronaut” (the person who really succeed in getting into orbit), there are at least 999 people who stay on earth… Those 999 left behind should be content to manage a business as effectively as possible, extract from it as much free cash as possible, and use it to buy high quality enterprises at good (or, when possible, very good!) prices. They will have a productive life, a rewarding career, and they will create wealth.

 

The quote I liked the best from the book “American Gridlock”, which I have just finished reading, follows:

The late Australian billionaire Kerry Packer put this to me better than any theorist ever has: “Woody, if you meet someone very successful who thinks he deserved his success, you know you have met a real jerk.” Bingo!

 

giofranchi

 

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Yeah. The simplist model for BRK would be leverage from float and DTA and a modest amount of debt used to buy high quality businesses with predictable cash flows. 

 

It used to puzzle me how WEB is attracted to the purchase of a great business that had been around 100 years with modest growth prospects at a not so wonderful price that might have an earnings yield of 7% or so.  However, with BRK's internal leverage, that modest earnings yield then increases to 10% or so.  Then, BRK earns a compound rate of maybe 4% per annum above what the great businesses in its stable earn.  Then, the large cash holdings and regular generation of float enable BRK to occasionally pick up unusual bargains like BAC pref + warrants.  Result: now the compounding machine's normalized earnings are perhaps compounding at 11% to 12%  per annum, much more than the earnings of the other great businesses it owns.

 

Think about it.  Here is this mega cap company, selling for less than 1.2 times Q3 BV that is still a machine that compounds earnings and BV at a much higher rate than some of the very best S&P 500 companies that sell at perhaps more than 4 times BV.  We're talking about a company that has compounded BV/SH at the highest rate of all for the last 47 years!

 

Plus, BRK does another neat thing.  A few years ago I puzzled over BRK's SEC filings that Warren himself had apparently personally signed.  These listed at the time $8B or so "best of best" holdings like AmEx, Wells Fargo, Coke etc.  I think these were the majority of BRK's pension plan holdings, things that appropriately would have a growing earnings yield of 7 % or so with enormous compounding potential by the time the pensions had to be paid out.  Contrast that to the bond heavy assets of the typical pension plan that will probably earn about half that rate.  :)

 

twacowfca,

great analysis of BRK! AmEx, Wells Fargo, Coke… a 7% earnings yield, add the benefit of float and you get a 10% earnings yield, pick up occasionally some unusual bargain and you compound at 11% to 12%… It looks easy!

So why isn’t it copied more often? You know that I am thinking hard about LRE: why an outstanding (unique, I daresay!) underwriter like LRE keeps the large part of its investments in short-term bonds, instead of just copying what Mr. Buffett has shown works so well? I don’t understand: Mr. Brindle could very well go on concentrating exclusively on the underwriting business - as he should do, because that is clearly what he does best -… but why don’t hire YOU??!!  ;) If only with the goal to replicate what you have written about BRK’s way of investing! It doesn’t take Mr. Buffett to do that! If the reason is: it works for BRK, because of Mr. Buffett’s skills; well, then I don’t agree. I just don’t see how Mr. Buffett’s unique investing skills should be required, to achieve good results the way you have so clearly described.

 

giofranchi

 

Giofranchi, you ask a great question: Why doesn't Brindle, who is arguably the best property underwriter in the Bermuda / Lloyds markets invest his float in great businesses the way Buffett does? The short answer is that he has had a top tier record investing in equities in the past, but what he does now is much better for LRE's business.

 

BRK had a AAA rating until Warren's put derivatives went against him in 2008 and led to a downgrade as the market value of BRK's stocks also declined.  However, this had little downside because BRK was still one of the most solid companies in the world.  LRE liquidated their equity portfolio in mid 2008 before the stock market tanked to avoid such a possible consequence, because the prospect of a downgrade from A - to below investment grade would have been disagreeable to say the least.  LRE was one of the few insurers to have positive investment returns in 2008, and in every quarter of their existence except one.

 

Lancashire is a short tail property insurer.  This necessitates carrying mostly high quality, short duration liquid assets to be able to pay claims quickly if there should be a large claim. This limits investment returns, but it also gives them the huge optionality that goes with carrying a lot of cash and near cash.  For example, they were able to buy back about 25% of their stock a few years ago at a price that averaged less than book value.  That's the gift that keeps on giving.  Recently, their extra cash has enabled them to leverage their sterling reputation to goose returns through sidecars.

 

Here's how the economics of a sidecar works for them:  their long term return on equity at LRE has averaged 19%+.  Brindle's returns for the syndicates that he and Charmin managed at Lloyds also returned 19%+ on average. All of these returns have been without a single down year, quite low volatility considering that their peers had a very rough time at Lloyd's in the 80's and 90's.  Therefore, it's reasonable to assume that the central value of LRE's returns will continue to be about 19%+ per annum or perhaps a little better with the way they get more upside with less downside in the sidecars.

 

LRE puts a relatively small amount of capital into a sidecar and other investors fund the rest. LRE gets a commission and a management fee for managing the sidecar. This attenuates the downside to their investment in the sidecar if there is a loss.  They also cede some of their most catastrophe exposed business to the sidecar.  This also attenuated the downside from a large catastrophe to their regular business.  Then, if the loss experience of the sidecar is low, LRE will be entitled to a percentage of the profit of the entire sidecar above the profit of their investment in it.

 

Lets assume that the long term expectation of LRE's investment in the risk assumed by the sidecar sidecar would be greater than their long term average return of 19%+ because sidecars are are only set up when rates in a particular sector are exceptionally high.  However, Lancashire limits how much catastrophe exposure it is willing to take on even though their expectation is that the return would be great if they took on more risk. 

 

Let's assume that the long term average expectation of the annual profit of the sidecar is about 20% for the outside investors. LRE's expected return on the sidecar may be perhaps 30%+ because of their overrides.  Plus the risk is far less than if they had retained a higher level of catastrophe exposed business.  :)

 

That return on extra cash not needed in their core business is a lot more than what Lancashire would expect to get from an investment in common stocks.  However BRK's business is much more long tail.  There is a long time available to invest the float until claims have to be paid.  That's why having substantial investments in common stocks makes sense for BRK much more than for Lancashire.

 

twacowfca,

your knowledge of the insurance/reinsurance business is clearly deep and all-comprehensive. I really hope we all on this board could go on benefiting from it!  :)

 

giofranchi

 

Thank you for the compliment, but without any false modesty, I can't accept it.  If I have any insight about insurance businesses it is to realize how little I know.  That's why who's in charge is so important.  It's like the saying, "If you don't know diamonds, know your jeweler".

 

For example, a few years ago, I was trying to understand the adequacy of  FFH's asbestos reserves.  Prem had taken initiative to strengthen those reserves which had proven to be inadequate in some of the companies he had bought.  This reflected badly on the strength of the balance sheet, but very highly on Prem and his team as those strengthened reserves were better than most other insurers had reserved based on years of future estimated claims.  The character of Prem and his team was much more important in my mind than the technical issue.  Then, I looked at a letter Warren had sent to the SEC in response to an inquiry about how they approached the same reserving issue.  It turned out that BRK had already reserved about 75% more than anyone else in the P&C universe for asbestos claims. 

 

In truth, I have no expertise in adequacy for such claims, but I do know that BRK and FFH are on my short list of companies I want to be a part owner of.  :)

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