Why Warren Buffett Invested in Verisk Analytics

| About: Verisk Analytics (VRSK)
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Berkshire Hathaway's latest 13F-HR quarterly filing for institutional holders reveals a new position in Verisk Analytics (NASDAQ:VRSK). Verisk provides proprietary data, analytics methods, and embedded decision support solutions to property and casualty insurance, mortgage, and healthcare industries in the U.S. The company's shares do not look cheap at first glance, with a recent stock price of $32 per share and analyst estimates for EPS of $1.64 and $1.88 in 2011 and 2012, respectively.

So why did Buffett's holding company decide to establish a new position in Verisk during the second quarter? Obviously, we can only speculate, but since Verisk serves the insurance industry, Berkshire Hathaway is probably in an excellent position to judge the company's business fundamentals.

Perhaps the most intriguing aspect about Verisk is its pricing power in an inflationary environment. In the February issue of The Manual of Ideas, up-and-coming value investor Josh Tarasoff of Greenlea Lane Capital wrote an essay on pricing power, describing the factors investors should consider when assessing a company's ability to raise prices above the rate of inflation.

In the essay, Tarasoff highlighted two companies with exceptional pricing power. One of those two companies was Verisk. Here is a portion of Tarasoff's thesis on the company:

Verisk is an American company that was founded in the 1970s by the major US property and casualty insurance companies. These companies collectively provided Verisk with their claims data in order to create a centralized database that would allow the industry to analyze risk better.

Verisk came to provide data, analytics, and other services that were absolutely critical for its customers to conduct business. However, because it was owned by and existed to serve its customers, Verisk didn’t charge high prices. This seems to have persisted over the decades, even though Verisk converted to a for-profit corporation in 1997 and went public in 2009.

Today, Verisk’s revenues are only about 2 basis points of its customers’ collective revenues and only 1-2% of their operating expenses. This despite the fact that its products are unique, indispensible, and have enormous value-add. I think Verisk could raise prices above inflation.

A key thing I look at in relation to the ability to raise prices above inflation is the operating margin. If prices go up X% in excess of inflation, the resultant operating income growth is equal to X multiplied by the reciprocal of the operating margin. So, in this context it is good to have low operating margins because it makes above-inflation price increases more meaningful.

Verisk’s operating margin in the most recent quarter was about 40%. While this is impressive, it means that each 1% price increase above its cost inflation results in only 2.5% operating income growth.

While it seems unlikely Buffett will ever explain his reason for adding Verisk to Berkshire's portfolio, we wouldn't be surprised if his thinking had much to do with the thesis Tarasoff outlined several months ago. After all, great minds do sometimes think alike.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.