In September 2000, a fairly remarkable transaction took place. A small Vermont-based insurance holding company, White Mountains Insurance (NYSE: WTM) announced its acquisition of property and casualty businesses from CGNU, one of the U.K.'s largest insurers, for $2.6 billion. (CGNU put up its CGU Insurance Group subsidiary for sale when it agreed to merge with another big U.K. company.) White Mountains, at a fraction of CGU's size, essentially bet the farm on its acquisition, taking on more than $1 billion in debt financing to get the deal done.
At the time, CGU was the 16th largest property and casualty insurer in the U.S., and had been pursued by big players, including Citigroup (NYSE: C). In the end, White Mountains won out. How big of a deal was this? In 2000, before the merger was completed, White Mountains's existing lines of business made $334 million in revenues. Afterwards, it leapt up to $2.6 billion, the majority of it coming from the CGU (now called OneBeacon) acquisition. The deal was financed partially by a debt offering by Lehman Brothers (NYSE: LEH), and partly by a $300 million convertible preferred stock purchase by Berkshire Hathaway (NYSE: BRK.A).
Under most scenarios, when a small company gobbles up one several times its size, I would recommend running away from the stock as fast as possible. Rarely does a massive acquisition add much in the way of tangible gains to outside shareholders. Empire building tends to work out well for the emperor, not so much for the subjects.
Insurance is a strange business. Underwriting is generally unprofitable, but insurers make up for this by investing premium money before it is paid out in claims. Many types of insurance are long-tailed in nature; it can be years from when a policy is written before a claim is made -- policies can remain valid for decades. It can take years for a poor decision to come back to wreak havoc on an insurer's balance sheet.
In this regard, a quarterly earnings statement from an insurance company is the next best thing to useless. If the company wanted to, it could show no discipline in writing policies in a quarter, show spectacular earnings, and not have to pay for its bad decisions for several years. That payment, however, will be severe when it comes due.
Unfortunately, it seems most businesses are slaves to the quarterly earnings, meeting analyst expectations, whatever it takes to keep the stock price up -- even if it means playing to investor ignorance, rather than to their long-term best interest. For example, a court-ordered report into the rise and fall of WorldCom shows a corporate culture focused on meeting analysts' expectations at all costs. This monomania did nothing to help shareholders.
How refreshing, then, to find a company whose operating guidelines align with the notion that shareholders are best served when decisions are based not on appearances, but on adding the most value to shareowner capital. Here are White Mountains Insurance's operating guidelines, printed in full, with permission. While several items are specific to insurance, feel free to make the parallel to any industry.
We care most about...
Underwriting Comes First
An insurance enterprise must respect the fundamentals of insurance. There must be a realistic expectation of underwriting profit on all business written, and demonstrated fulfillment of that expectation over time, with focused attention to the loss ratio and to all the professional insurance disciplines of pricing, underwriting, and claims management.
Maintain a Disciplined Balance Sheet
The first concern here is that insurance liabilities must always be fully recognized. Loss reserves and expense reserves must be solid before any other aspect of the business can be solid. Pricing, marketing, and underwriting all depend on informed judgment of ultimate loss costs and that can be managed effectively only with a disciplined balance sheet.
Invest for Total Return
Historical insurance accounting has tended to hide unrealized gains and losses in the investment portfolio and over reward reported investment income (interest and dividends). Regardless of the accounting, the group must invest for the best growth in value over time. In addition to investing our bond portfolios for total after tax return, that will mean prudent investment in equities consistent with leverage and insurance risk considerations.
Think Like Owners
Thinking like owners has a value all its own. There are other stakeholders in a business enterprise and doing good work requires more than this quarter's profit. But thinking like an owner embraces all that without losing the touchstone of a capitalist enterprise.
We do not care much about...
Reported Operating Earnings According to Generally Accepted Accounting Principles
Trying to produce a regular stream of quarterly operating earnings often produces disaster. Trying to manage your company according to generally accepted accounting principles can often be silly. As our friend says, we would rather produce a lumpy 99 than a regular 103. We prefer to measure ourselves as we would hope owners measure us by growth in intrinsic business value per share.
Growth In Revenues
We applaud owners who reward executives on premium growth. This often provides fine opportunities for us later.
Often introduced by business consultants. In our personal experience chasing market share has produced the biggest disasters in our business. Often we have profited later from that excitement.
We have never made a strategic purchase... maybe we will someday. We often sell to strategic buyers. Our problem is we really don't have much of a strategy other than to increase intrinsic business value per share.
Putting our capital to work
Intellectually we really don't care much about leaving our capital lying fallow for years at a time. Better to leave it fallow and to wait for the occasional high return opportunity. Frankly, sometimes shareholders would be better off if we just all went to play golf.
Overall, we should be students of capital and business. Adam Smith had it right: "Capital will flow according to its own nature; the invisible hand." If we do not earn and deserve our owners' capital, we will not long have it.
We also admire Benjamin Graham who said: "In the short run the market is a voting machine; in the long run it is a weighing machine."
Obviously, companies that lose money for long periods of time will not be viable. White Mountains's operating principles state is that if they see a course of action -- be it to make a big acquisition, cut back on certain types of business, or even aggressively go after a certain line of business -- they will pursue it, regardless of how it affects their earnings for the next quarter.
The Wall Street game tends to reward businesses for doing everything they can do to show consistent top- and bottom-line growth. It is a rare company that recognizes that business just doesn't work that way, and that it wouldn't necessarily be a good thing if it did.
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann has no reason to suspect that we're removing the bolts from his office chair. Bill owns shares in White Mountains Insurance and Berkshire Hathaway. Bill has written about White Mountains Insurance in The Motley Fool Select. The Fool is investors writing for investors.
The Rule Maker Portfolio has had a cumulative investment of $43,500. As of Nov. 5, 2002, its current value of all cash and equities is $29,411.20. This equals an internal rate of return of ï¿½12.6% since the launch of the portfolio in February 1998.