<THE BORING PORTFOLIO>
Reinsurance Weirdness
"Systems"? No Thanks
By Dale Wettlaufer ([email protected])
Alexandria, VA (Jan. 13, 1999) -- Before we get into anything else, I'll update the transactions announced on Monday. On Tuesday afternoon, we acquired two more shares of Berkshire Hathaway (NYSE: BRK.A, BRK.B) "B" class shares at $2,095 apiece and sold 200 shares of FelCor Lodging Trust (NYSE: FCH) at $22.73 per share, both including commissions.
I have to call your attention to a reinsurance story that I saw on Bloomberg this morning. It seems there's a Bermuda reinsurer that proposes to sell $400 million in common stock in an IPO, for which the prospectus was preliminarily registered with the SEC last week. Brought to you by the fine folks at Merrill Lynch and Chase, the company believes it can realize significant competitive advantages by building a business with a key feature being: "A business strategy that matches profitable long-tailed liability underwriting with long-term investments to produce superior shareholder returns." It goes on to tell us that:
"At least % of our investment portfolio initially will be invested in fixed income securities with a minimum average credit quality rating of AA2/AA. The remainder of our portfolio initially will be invested in managed funds. Union Spring initially expects that substantially all of the managed funds managed directly by it will be traded using three Willowbridge trading programs "XLIM," "VAT" and "Primary." These programs individually have yielded compound annual returns (net of all fees and subject to certain assumptions discussed on page 32) of approximately 32%, 31% and 25% since 1987, 1990 and 1993, respectively."
OK, so at this point the company doesn't really know what percentage of the portfolio will be invested in bonds, but it's left it blank to be filled in later. Great, we like decisive managements like this. Now, what sort of money management outfit might this Union Spring be? They must be good. 32% compounded annual returns since 1987 is an awfully good number.
According to Bloomberg and the wording of the company's prospectus, it appears as though these returns are theoretical results, the product of back-testing trading strategies. Bloomberg words it this way: "Yang's trading programs have generated annual compound returns of at least 25 and one system has yielded an annual return of 32 percent." Waaaaaait a second. These systems? That could mean anything. Putting back-tested systems into practice can reveal lots of problems in these systems, not the least of which are the friction of trading, scaling them up to a portfolio made up of hundreds of millions of dollars rather than the digital money on which a trading system is based, and the fact that patterns that have existed in the past do not always persist in the future.
In addition, one doesn't know a darn thing about the leverage assumptions in these "systems." For all we know, they could assume 10-1 asset/equity leverage that show a 3.2% return on assets into a 32% return on equity. That would be before fees a hedge fund normally claims. If you run a bank, leveraging up a bunch of car loans, mortgages, and commercial & industrial loans with your liabilities consisting of certificates of deposit, savings accounts, and checking accounts, sure, you can leverage up.
But when your liabilities consist of interest-only strips, commodities contracts, and equity options and your assets consist of Russian GKOs, call options on Internet stocks, and Fed funds futures, your asset values can drop pretty quickly while your liabilities are shooting through the roof. A 10% move down in your asset values can wipe you out without your liabilities even increasing. A 3% move down in the value of your assets and a 5% move up in the value of your liabilities can kill 75% of your equity. For more on this point, take a look at the story of Long Term Capital Management. I wrote a piece for which I especially liked the title: Good Times on Borrowed Money.
There are a few points to the above story that I can make. The first is that National Indemnity and GenRe are up against an environment in which total yahoos can come into the market and throw naive money at the reinsurance industry. Would you want to buy these guys' reinsurance? I wouldn't. The discounting that will happen here will make it very tempting for price-conscious buyers, however, whose own margins are being squeezed.
Certainly, any financial investor that puts together such an embarrassing prospectus must believe in these investment results, so of course they'll write as much insurance as their capacity will allow. I mean, you can operate at a combined ratio of 115% and still make up 17 percentage points on the float if you believe in this stuff. Unleveraged long-term expected returns on futures and options trading is very low. Sorry, you don't make 32% in these markets without tons of risk and leverage.
The second point is this: In all parts of Berkshire Hathaway's insurance divisions, we have rational people that aren't playing games with your money or policyholders' money. Just as you can't win an argument with an irrational person and just as there's no arguing with someone who has you at gunpoint, Berkshire is just not going to compete with this naive capacity. In the short term, that's going to hold back reportable earnings. But over longer periods of time, the people that believe in leveraging their business to the hilt on bad pricing and then putting the float into backtested systems are going to sink themselves.
On to other stuff. Cisco Systems (Nasdaq: CSCO) fell $2 1/4 to $95 7/8 today after telecom equipment company Lucent Technologies (NYSE: LU) agreed to acquire remote access concentrator and broadband switch company Ascend Communications (Nasdaq: ASND). This was bad news for Cisco, but was expected. While this does pose a threat to Cisco in the ATM and frame relay switching markets, the core of the Cisco franchise in heavy duty routers is not threatened immediately by this merger. Longer-term, that will be a consideration for us to deal with.
On the Boring Radar, you'll notice Hershey Foods (NYSE: HSY). I just started to read a book titled The Emperors of Chocolate: Inside the Secret World of Hershey and Mars. I knocked off a chunk of it last night and think it should be an excellent read for anyone interested in the confections industry. This will help me understand both Hershey better and a company we already own in See's Candies. I was pretty surprised that See's was not in the index, as Russell Stover was in there. No big deal. I'm looking forward to more this evening. Speaking of books and potential investment ideas, I also received an executive guide on SAP functionality and implementations. We think the enterprise resource planning software industry is still in the first couple innings and we want to know more about it. Notice, by the way, that we've added PeopleSoft (Nasdaq: PSFT) to the Boring radar to join Germany's SAP (NYSE: SAP).
Also of interest on the Boring radar, credit reporting agency and data powerhouse Equifax dropped near its 52-week low again on Brazil worries. We like that very much. We didn't like Borders Group (NYSE: BGP) dropping once again, but we don't find its poor performance surprising. I'm still looking at the numbers Alex did on Friday, and Alex is still awaiting a call from Borders so we can figure out what this company is really worth. As much as we don't believe in selling something beneath its intrinsic value, I am finding it hard to assess that value without a discussion with the company. The company probably hates us now, anyway, because we've never had anything nice to say about the economics of the bookselling business.
Oops, I've run long here. So that's it for today. See you on Friday, or before, on the message boards.
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