In 1983 Warren Buffet set down 15 owner-related principles that he thought new shareholders would find helpful in understanding his managerial approach. Now, nearly 30 years later much has changed. For example, the company issued B shares, then split them 50 to 1, and announced a stock buyback policy. Also let's face it, Berkshire is under close scrutiny as David Sokol was essentially fired this year, a once regarded shoe in for succession, and now new and largely unheard of "players" have been recruited, not to mention the stock price has recently underperformed the S&P 500.
This is the forth in a series of analytical articles which will examine the Berkshire Hathaway of today against the backdrop of the 15 principles outlined in 1983 and see if any valuable insights might be gained from such an exercise. Previously we examined Principles 1-3 in Berkshire Hathaway's Owner's Manual and now we turn our attention to Principle 4.
Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.
Buffett states that the goal of Berkshire is simply to grow the value of its stock at a faster rate than the S&P 500 (Principle 3). In his Owner’s Manual discussion of Principle 4 Buffett explains that he hopes to achieve this goal by purchasing businesses, or purchasing stock. The funds that will be used to make these purchases are generated primarily through the Berkshire’s insurance subsidiaries “float”. For an excellent description of “float” and its role in Berkshire’s business structure I strongly recommend the article Buffett’s Berkshire Hathaway Buoyed By Insurance ‘Float’ published in the Wall Street Journal. From the article:
This float is money Berkshire holds to pay insurance claims in the future, but in the meantime can be put to work in stocks and long-term investments that earn returns for Berkshire's own benefit. Effectively borrowed funds at little or no cost, Berkshire's float enables the company to acquire businesses and assets beyond what its equity capital alone would permit, Mr. Buffett has previously said.
And, in the 2009 Annual Report Buffett describes the concept of float as follows:
If premiums exceed the total of expenses and eventual losses, we register an underwriting profit that adds to the investment income produced from the float…Our float has grown from $16 million in 1967, when we entered the business, to $62 billion at the end of 2009. Moreover, we have now operated at an underwriting profit for seven consecutive years. I believe it likely that we will continue to underwrite profitably in most — though certainly not all — future years. If we do so, our float will be cost-free, much as if someone deposited $62 billion with us that we could invest for our own benefit without the payment of interest. (p.6)
Buffet goes on to explain that the entire Property & Casualty Insurance industry usually does worse with float, that most years premiums have been inadequate to cover claims plus expenses, and that the industry’s overall return on tangible equity has for many decades fallen far short of that achieved by the S&P 500. He credits the unusual success of his company to outstanding managers who lead unusual insurance businesses. Buffett highlights a couple. The first is GEICO which is led by Tony Nicely. Tony joined GIECO at age 18 and is now 66 and is portrayed of course as the typical Berkshire manager brimming with joy, talent, and would rather be doing nothing else.
Then there is Ajit Jain who heads National Indemnity which issues only a very few policies each year but they are huge and unusual whereas GIECO issues millions of small auto insurance policies. Although Ajit writes billion dollar limits Buffett boasts that he does not lay off one dime to other insurers – he carries the full load. Ajit is often mentioned when the notion of Buffett’s successor’s come up and indeed Buffet states openly in the Annual Report of 2009 “If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit.”