In Pursuit Of The Next Berkshire Hathaway

| About: Berkshire Hathaway (BRK.A)


Warren Buffett consistently describes in his annual letters to shareholders of Berkshire Hathaway how carefully calculated operations in the field of insurance can lead to outsized returns.

A well- managed insurance company can enjoy two sources of significant profit - one is its basic insurance activity, and the other is the rational investment of its growing float.

It seems that the major factor hindering investors/analysts from recognizing the major financial potential of the insurance field is their concentrating on “traditional” parameters.

Many investors may be tempted to invest in the manner depicted in the entertaining show "Billions" or in the movie "The Big Short". On the screen, it looks very alluring when a hedge fund manager succeeds in making a few great trades, thereby raking a huge payday for himself and his investors. Although these stories make for great entertainment, for the most part this sort of glamorous methods is more successful in Hollywood's productions than in real life.

The average (as well as the professional) investor should not be lured by these false hopes to make huge profits in the stock market via its short term volatility. This kind of trades will quickly prove to be a double edged sword. Fluctuating equity prices due to events such as terror acts by ISIS, the slowing Chinese economy, the unstable Russian economy, Brexit, Trump's victory, and other factors, all of which cause short term volatility in the stock market, will most likely deny from most investors the fulfillment of their "Billions" dream.

Instead, investors should utilize the long term benefits of the stock market, and realize that investing in carefully selected stocks in specific industries will guarantee high returns.

One of the most promising industries to gain such long term profits is the insurance industry. Warren Buffett, the investment guru, was the first to draw our attention to this path and to demonstrate to us how carefully calculated operations in the field of insurance can generate very significant profits.

What is the advantage inherent in the insurance industry? First and foremost, it is the "float" that every insurance company possesses. The term "float" represents the moneys included in the premiums that insurance policy owners pay to insurance companies to cover a potential insurable event occurring in the future. The unique characteristic of the float is the time lag (typically many years) between the payment of the premium and the occurrence of the event that mandates payment by the insurance company to the insured person. During this time period, the insurance company may invest this money at its choice (similar to the operation of banks with deposits that they receive from the public). This float is listed on a firm's balance sheet as a liability, but in contrast to a regular liability it is a revolving debt that carries with it no interest (for more details see Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) Letter from 2015 - page 10, 1st paragraph).

The float can be maintained undepleted (or even increased) because the incoming money from the new policy payers is used to pay the claims of the older claimants. Furthermore, a successful insurance company enjoys a steadily growing income from steadily rising number of new insurance policies that exceeds its expenses on the coverage of claims. This process further increases the revenues of the company.

Hence, the float represents a source of permanent, steady and even rising source of money which an insurance company can use for long-term investments including investments in the stock market. The float money can be invested in selected, publicly listed stocks or in whole companies, which, in turn, could provide an additional stream of profits to the insurance company.

Thus, a well- managed insurance company can enjoy two sources of significant profit - one is its basic insurance activity, and the other is the rational investment of its growing float money in appropriate stocks. It should be noted that the revenues of most insurance companies are limited to those from their basic insurance operations. Concurrently, the float of these companies are invested in more "solid" instruments (such as cash, short term bonds and real estate) which (particularly at the present time of low interest rates) greatly diminishes their revenues.

One additional advantage of investment in insurance companies is the "safety" element inherent in the existence and nature of this field. The insurance field is one of the oldest financial fields in the world that will most likely continue to grow and thrive due to the natural concern of the average human being about unexpected occurrences with major financial consequences in the future.

Collectively, this data explains why investing in stocks of insurance companies is a very attractive and promising investment path in the long run. The short-term volatility of some of these stocks has essentially no effect on their very favorable long-term performance.

As aforementioned, Warren Buffett was one of the first investors to identify the great potential of the insurance field and to systematically utilize the float for investment purposes. In 1967, he gradually diverted the struggling textile company he had just purchased, Berkshire Hathaway, into the insurance industry. Over the years, Buffett paved his way into the insurance industry, purchasing additional insurance companies. As a result, Berkshire has become one of largest insurers in the world with over 100 billion dollars of float on its balance sheet. This huge amount of money (which is still growing) is utilized by Buffett for further investments in companies he deems worthy of long term investment.

Hence, it is no surprise that Berkshire Hathaway, which traded in 1967 at around $18 per share, has become one of the largest companies in the world, trading today at over $220,000 per share.

In 2013, Frazzini, Kabiller, and Pederson from Yale University published a paper entitled "Buffett's Alpha"ׂ, which provided the empirical proof that the investment of float in equities was one of the main contributors to the impressive long term record of Warren Buffett. They found that in addition to Buffett's phenomenal ability to purchase safe and predictable (low beta , cheap and quality) stocks, his alpha was enhanced by investing the float of the insurance companies he purchased. This float allowed Buffett to lever his investment portfolio by a factor that averaged 1.6 in relation to the equity of Berkshire. In other words, if Buffett's investments yielded 12%, then Buffett's investment portfolio actually yielded about 20%. His ability to maintain this stable ratio over time (without paying interest on the loan and without exposing the company to the usual hazards of investing with margin), together with his ability to invest in the stocks of safe and profitable companies, underlay Buffett's outstanding alpha, according to the researchers.

Considering the major financial benefits and outsized returns associated with the proper/rational investment of the float discussed above, it is surprising that so few insurance companies/investors operate along these lines in the insurance industry.

The Table below lists a number of selected insurance companies, other than Berkshire Hathaway, (Markel Corporation (NYSE:MKL), Fairfax Financial Holdings Ltd. (OTCPK:FRFHF), White Mountains Insurance Group, Ltd. (NYSE:WTM), W.R. Berkley Corporation (NYSE:WRB), Arch Capital Group Ltd. (NASDAQ:ACGL), Alleghany Corporation (NYSE:Y)) the financial activities of which are characterized by both a conservative and profitable underwriting insurance activity (measured by the Combined Ratio which represents the ratio of incurred losses and operating expenses as a percentage of earned premiums), and an investment portfolio which has a relatively high exposure to equities and alternative investments (rather than solely cash and fixed maturity securities).

Table 1: Financial Long-term Performance of Selected Insurance Companies 1

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[1] All figures (calculated from each company's annual report/10-K) are for December 31, 2015, with the exception of Price to Book ratio which is updated for November 9, 2016.

[2] Excluding cash, short term investments and fixed maturity investments.

[3] Excluding derivative exposure/hedges.

[4] Calculated in in Canadian Dollars.

[5] Adjusted for dividends.

[6] Data for ACGL is for a 10 year period ending on December 31, 2015 with the exception of Price to Book ratio which is updated for November 9, 2016.

CAGR - Compound annual growth rate.

Analysis of the data in the Table reveals the following main findings: 1. A relatively low Combined Ratio for all insurance companies listed, demonstrating their strong and profitable basic insurance activity. 2. The investment portfolio of each of the companies is significantly larger than their shareholder equity due to the investment of their float. 3. Markedly higher total returns of all companies (represented by the 15 year compound annual growth rate (CAGR) of share price) when compared with the 5.2% return of the S&P 500 index in the same 15 year period. 4. A high correlation for each company listed between the CAGR of share price and CAGR per share book value (which approximates the economic value of a company by accounting rules). The similar dynamics/pattern of these two parameters makes a long term investment in the equities of these "Compounding Machines" very attractive despite the typical short term volatility of their share price.

It seems that the major factor hindering investors/analysts from recognizing the major financial potential of the insurance field is their concentrating on "traditional" parameters such as quarterly earnings, price to earnings ratios, return on equity/assets and dividend ratios rather than focusing on the ultimate measure of shareholder value, namely - CAGR per share book value over time.

It should be noted that even the CAGR per share book value calculation may underestimate the intrinsic value of highly profitable insurance companies, since their balance sheets report the worth of many subsidiaries (primarily privately held companies) at cost and not at their true value. For example, Berkshire lists See's Candies at its cost price of around 20 million dollars (minus amortization costs over the years) whereas the yearly profits alone of See's Candies as of today exceed this amount by 4 times. Moreover, the earnings of publicly held securities by insurance companies are not included in their income statement, thus leading to further underestimation by Wall Street of their true earnings. For example, Berkshire's ownership of almost 10% of Coca Cola Corp., is not incorporated in Berkshire's earnings reports (with the exception of dividends received).

In conclusion, every portfolio manager/individual stock picker should appreciate the great potential and value of investing in solid and stable insurance companies that invest the premiums that they obtain in a rational and selective fashion with a long-term view. As far as the public is concerned, even those who display major suspicion towards the stock market cannot ignore the solid data discussed above. The average insured person should reach the conclusion that in parallel to paying high premiums to insurance companies, he should participate in the huge profits resulting from his and others' premiums. Rationally investing in the insurance industry has the potential to gradually and safely deliver outsized returns over time.

Disclosure: I am/we are long ACGL, BRK.B, MKL, WRB, WTM, FRFHF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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