The Buffett Buffet
January 20, 1999
by Dale Wettlaufer ([email protected])
It's pretty obvious that I like Berkshire Hathaway and the value it represents right now. The Boring Portfolio, which Alex Schay and I began to co-manage on October 1 of last year, acquired six class "B" shares of the company on New Year's Eve and increased that stake by one-third two weeks later. That much is an objective fact. Rather than defend myself against what Bill can come up with, I'm going to address pervasive misperceptions that are held about this company. I hear Bill's taking a very unique tack on the company, so I don't expect him to give me the first argument against which I will defend, but let's just get into that one anyway.
First, to head off the notion that this company is a closed-end mutual fund, one has to realize first and foremost that all large insurance companies have substantial financial reserves invested in liquid securities. It's just that most insurance companies invest their reserves in debt instruments. Berkshire Hathaway has chosen to invest a substantial amount of its insurance float (premiums that have been taken in but not yet paid out for insured losses) in excellent companies such as Coca-Cola (NYSE: KO), Gillette (NYSE: G), and Freddie Mac (NYSE: FRE). This maximizes investment returns the company can achieve, since equities have handily outperformed bonds over the course of the century.
The proper way to look at these investments, though, is not just as stocks the company happens to own. Had Berkshire Hathaway been able to acquire Coca-Cola outright a decade ago, I think it's highly likely it would have. If Coke were a wholly owned subsidiary of Berkshire Hathaway, people wouldn't look at it so readily as a mutual fund. Just because Berkshire has an approximately 8% stake in the company rather than a 100% stake doesn't mean it won't benefit from the continued reinvestment of cash flow that Coke can generate. The point, then, is that whether Coke were a wholly owned subsidiary or just a significant investment for Berkshire, the reinvestment of cash the company can generate probably would be no different than it is today.
One important thing about Coke's being valued by a public equity market, though, is the effect it has on the surplus of Berkshire Hathaway's insurance businesses. The more public equity value Coke can build, the larger the underwriting capacity at Berkshire's insurance units. The more surplus Berkshire can show, the more cash flow the company can generate around the world as the third-largest global reinsurance underwriter. In addition to its being the third largest in terms of reinsurance written, it's the largest reinsurer in terms of its surplus. The balance sheet is a fortress, allowing the company to grow opportunistically, and failing that, to generate increases in shareholder value through sending capital back to shareholders when good opportunities do not present themselves.
When you look at Berkshire, consider a balance sheet with tangible assets of about $100 billion and tangible shareholders' equity of about $38 billion. Furthermore, when you add back goodwill to invested capital (goodwill represents the value of equity that has been deployed and is thus invested capital), the value of invested capital in the company is approximately $107 billion. The current market value of the company plus its net debt is roughly equal to this number, give or take a half-billion dollars. And I'm not adding back the value of goodwill that has been charged off over the years. What this is saying is that the market believes Berkshire's management will never be able to add any economic value to this capital. What do you think about that?
One is certainly entitled to one's opinions on this one, but I think that's a pretty bad bet. Here's what you have working for you when you invest in Berkshire:
11% of American Express Co. (NYSE: AXP)
8.1% of Coca-Cola Co.
3.2% of Walt Disney Co. (NYSE: DIS) -- this holding has been reduced somewhat
8.6% of Freddie Mac
8.6% of Gillette Co.
16.5% of Washington Post Co. (NYSE: WPO)
3.9% of Wells-Fargo (NYSE: WFC)
(All equity holdings approximate; source 1997 Chairman's letter to shareholders and interim reports.)
The largest source of earnings for Berkshire is its insurance operations, though. Last year, General Re earned $968 million and generated net cash flow from operations of $1.468 billion. Its GEICO Direct Auto Insurance subsidiary is a gorilla, as well. Along with Progressive (NYSE: PGR), it's one the fastest-growing large and profitable property & casualty insurers in the country. Think of GEICO as the Dell (Nasdaq: DELL) of the auto insurance industry in that it will be taking share from other insurance underwriters with its low-cost model of direct distribution and lean production methods.
With over 3% market share at present, there are another 12 percentage points of market share of the U.S. auto insurance market left for GEICO to capture, giving the company a good deal of headroom for growth. In addition, as one of the most active television advertisers in the country (and I suspect radio advertiser, as well), GEICO is branding its product with simple, recurring product propositions: It's the low-cost provider and it's not a hassle to deal with them. This attracts new customers and reinforces product satisfaction messages.
Last year, GEICO showed pre-tax underwriting profits of $281 million on earned premiums of $3.48 billion. That's a highly profitable insurance company that has the problem of being too profitable. GEICO instituted further rate reductions this year to increase market share. Furthermore, the cash flow of this business is excellent. Because it is such a highly profitable underwriter, net income usually understates net cash flow from operations and free cash flow. This is due to the float the company generates, which you can look at as either an increase to net cash flow from operations or as an offset to capital expenditures.
Either way you look at it, it increases free cash flow. In 1999, GEICO should be able to generate over $700 million in cash flow from increases in loss reserves and deferred premiums, and that's even before you start the profit meter ticking on the business. Underwriting profitability will probably not grow that much because the company is gaining market share, but the $700 million in float gets invested wherever the company sees fit.
As for the other parts of Berkshire, you've got some very big value drivers. FlightSafety International has a franchise in the training of airline pilots and other transportation personnel. Last year, the company generated $84.4 million in net income for Berkshire. Super-catastrophe insurance generated underwriting profits of $283 million and other reinsurance underwriting showed a loss of $155.2 million. Net, that's another $128 million in underwriting profitability on businesses that bring in billions of dollars of float for Berkshire to invest.
What's most interesting is Berkshire's growth opportunities. Last year, Berkshire and GenRe generated almost $3.5 billion in free cash flow, not including value added from increases in equity values of investments. That's quite a bit of free cash flow. This year, free cash flow at Berkshire (not including GenRe) will be down, not because things are going poorly, but because the company's growth prospects have really blossomed with its purchase of Executive Jet International. EJI is the largest fractional jet ownership company in the world and had at last count nearly 160 aircraft on order and an operating fleet of over 100 aircraft.
In my rebuttal, I'll talk briefly about the company's smaller cash cow businesses that feed growth opportunities. When you feel bearish about the company, stop to think about the unleveraged balance sheet, the global growth opportunities, the sheer cash this company generates, its track record of increasing shareholder value over the last thirty years at twice the historical rate of return of the S&P 500 (as evidence of management's abilities, not as evidence of exactly what it will do in the future), and the overall rationality of the way this company is run. To really find out about this company, head over to the company's website at www.berkshirehathaway.com. You'll find out much more than I could ever summarize for you.