Boring Portfolio

<THE BORING PORTFOLIO>
Research Alert: Day Two
The Benefits of "Float"

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Dec. 4, 1998) -- We're jumping straight back into our look at Berkshire Hathaway (NYSE: BRK.A and BRK.B).

A friend mentioned the other day that we started with our look at Berkshire on Wednesday by focusing on GEICO Direct because that's the largest value driver of the wholly owned Berkshire businesses. I didn't consciously make that decision, though the observation is correct. GEICO is the largest single contributor to underwriting results for the company among its short tail lines of insurance (by the way, this link takes you to Rupp's Insurance Glossary. Also, see below for insurance industry links). Super-cat (insurance and reinsurance covering primary insurers and reinsurers' losses in the event of major catastrophic losses) underwriting results beat GEICO by $2.7 million in fiscal 1997 while GEICO's underwriting gain in fiscal 1996 bested super cat underwriting results by $4.4 million.

Both of these categories of insurance grew year-over-year in 1997, but super cat underwriting results are definitely more lumpy than GEICO. The beauty of GECIO is that it provides a fairly predictable (that's relative in the insurance business) and growing stream of cash in the form of the underwriting earnings and in the form of float.

We had better deal with this issue before we go on to anything else, since in the 1997 annual report Chairman Warren Buffett says that "Unless you understand this subject, it will be impossible for you to make an informed judgment about Berkshire's intrinsic value."

Float: Insurance premiums that have been collected, but not yet distributed as payments for insured losses.

The reason why insurance companies are often under-appreciated is this feature of the industry called float. It's capital that a company can use to invest that otherwise would have to come from the issuance of bonds, commercial paper, or equity, all of which have their costs. Looking at how a company is financed, the balance sheet tautology is the place to start. A = L + OE. The left side of the balance sheet -- assets -- is financed by the right side of the balance sheet -- liabilities and owners' equity. From this tautology, we can also re-arrange the terms to show that Owners' equity = Assets minus liabilities.

In the way we look at things, insurance float is an equity equivalent. Maybe that's a misnomer, but that's a term we use to describe something other than debt and other than owners' equity on the right side of the balance sheet that funds the company's assets. In last year's annual letter to shareholders, Chairman Buffett explained: "Since 1967, when we entered the insurance business, our float has grown at an annual compounded rate of 21.7%. Better yet, it has cost us nothing, and in fact has made us money. Therein lies an accounting irony: Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had."

The impact very well-run insurance companies have had on the value added for shareholders is enormous. Every year, this sum of capital on the right side of the balance sheet has grown at an average of 21.7%, creating similar yearly growth in new assets attributable to the additional float. If this were debt and you assumed an average interest rate over this time period, then interest expenses attributable to this capital would have increased at a compound annual growth rate of 21.7%.

If that capital showed up on the balance sheet in the form of new equity every year, then Berkshire would not have been able to maintain the glacial rate of growth in outstanding shares that it has over the last few decades. In fact, shares outstanding have only grown at an approximate rate of 1.012 percent per year over the last twenty years (through the end of 1997). In addition, when you bring perpetual equity capital onto the balance sheet, you've brought perpetual cost of equity to the corporation until the day that equity is re-acquired by the company.

While Mr. Buffett may go about thinking about this in a different way than I, float is more valuable than equity capital not just because there is typically no cost to the float but because there is an implicit cost to the equity capital. If you issue new equity, then the new shareholders are going to demand some return on that equity. Historically, that has been around 11% pre-tax over the course of this century. Berkshire's average float last year was $7,093.1 million. If that were equity capital, the after-tax cost of that capital would be about $780 million. Financed by short-term debt, the after-tax cost of that capital would be at least $230 million.

This matters because float is almost like perpetual capital. The discounted present value of this avoided cost is anywhere from $2.1 billion in the case of short-term debt to $7.1 billion in the case of equity. Thus, the comment that the float has "a value to Berkshire greater than an equal amount of net worth would have had," in the opinion of the company's Chairman. The opinion on value is Mr. Buffett's. I have no idea about the logic that I just laid out. I really try to stay away from assuming a special insight into his thinking, since he agrees with Vice Chairman Charlie Munger pretty often and since I disagree with Mr. Munger on some things. That includes the cost of capital, though I don't use beta in the way I look at the cost of capital and beta is a big hang-up for Mr. Munger.

Anyway, the company's float is a huge value driver for the company and it's a significant component in the way we look at Berkshire's intrinsic value.

More next week on Berkshire. In the meantime, we hope to see you on the Boring portfolio message board. Have a great weekend.


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12/04/98 Close
Stock  Change    Bid
ANDW  +  3/8   16.88
BGP   +  3/16  22.06
CSL   +  1/4   46.19
CSCO  +2 1/16  78.25
FCH   +  1/8   24.06
PNR   +  1/16  37.13
TBY   -  1/16  7.19

                   Day   Month    Year  History
        BORING   +1.10%   0.17%  -1.90%  23.43%
        S&P:     +2.30%   1.11%  21.24%  89.27%
        NASDAQ:  +2.50%   2.75%  27.56%  92.43%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     78.25   226.65%
  2/28/96  400 Borders Gr    11.26     22.06    96.00%
  8/13/96  200 Carlisle C    26.32     46.19    75.45%
  4/14/98  100 Pentair       43.74     37.13   -15.13%
  5/20/98  400 TCBY Enter    10.05      7.19   -28.45%
  1/21/98  200 Andrew Cor    26.09     16.88   -35.32%
  11/6/97  200 FelCor Sui    37.59     24.06   -35.99%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  17606.25 $12216.26
  2/28/96  400 Borders Gr  4502.49   8825.00  $4322.51
  8/13/96  200 Carlisle C  5264.99   9237.50  $3972.51
  4/14/98  100 Pentair     4374.25   3712.50  -$661.75
  5/20/98  400 TCBY Enter  4018.00   2875.00 -$1143.00
  1/21/98  200 Andrew Cor  5218.00   3375.00 -$1843.00
  11/6/97  200 FelCor Sui  7518.00   4812.50 -$2705.50

                             CASH  $11273.22
                            TOTAL  $61716.97

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