After reviewing what I wrote Saturday night on Buffett’s Annual Letter to shareholders, I said to myself, “That wasn’t very critical.” Now perhaps I have less to criticize him over — he isn’t boasting about risk free retroactive profits, or being a significant player in life settlements, two things I find morally dubious at best.
But today I reviewed the Annual Report and the 10-K. The two are very similar; I will only mention one thing from the 10-K, but that one thing is big.
But let’s start with basic blocking and tackling. Start with the income statement, balance sheet, and cash flow statements of Berky. The balance sheet and income statements split out by division, but the cash flow statement does not. The cash flow statement has the fine distinctions for the company in aggregate, but the income statements and balance sheet do not.
I want the best of both worlds. I want the cash flow statement segmented, and I want enterprise-wide income statements and balance sheets for Berky, with fine levels of detail. I want those without eliminating what is being done now. That would not be a lot of extra work, and it would only add a few pages to the 10-K — the work is probably done already; all that needs to be done is the formatting.
1) Berky trades at 1.9x tangible book. Not saying that it is fair or unfair. It is what it is. (When one of my kids says that, I reply, “Except when it’s not.”)
2) From page 44, Buffett made some tremendous deals during the crisis, but the lesson here is to have dry powder. Buffett made great decisions with respect to Goldman Sachs, GE, Dow Chemical, Swiss Re, and Wrigley.
3) On page 50 there is positive prior year reserve development for the last three years. I don’t know how far that goes back; I will have to research that. But as I reviewed their reserving policies, I thought they were more than reasonable. They seemed to be a good mix of methods and judgment.
4) I don’t fault Buffett on derivatives. One can use them wisely while decrying their stupid use.
Where I have more difficulty is trying to justify the amounts on the balance sheet. My view of level 3 assets is that those holding them should spill the calculations in detail. We don’t have that here with Berky, though it is better than many companies.
That Berky does not have to post collateral for the most part is significant, and lends to their creditworthiness.
5) Statutory surplus had to increase at the main P&C insurance subsidiaries, because of the acquisition of Burlington Northern. Why? I’m not sure. Ideas?
6) On page 60, the expected return assumption should not have risen 2009 to 2010. 7.1% is too high as a long-term assumption — something in the 5-6% range is reasonable.
7) Berky is half an insurance company, and half and industrial/utility company. It is neither fish nor fowl, and that is what helps make analysis difficult.
8 ) If I were made President/COO of Berky, would I centralize hiring and procurement? No, but I would hesitate before answering. Berky is so unstructured, that there have to be some gains from centralizing, but that said, you don’t want to negatively affect the culture of Berky, which allows acquisitions to continue as if they had not been acquired. That might be changed cfter the death of Buffett, but who can tell? There is a competitive strength in Berky for leaving operations alone — many sellers who love their employees like that.
9) “We view insurance businesses as possessing two distinct operations – underwriting and investing.” So it says on page 68. And how beautiful, underwriting gains every year in every segment. I have not traced the history here, though I know that Berky has been better than most companies. I would only note that the value of float depends on how long the float exists.
10) On page 70, Buffett admits that Workers Comp and other casualty have not done well, which is rare among the lines that have done well.
11) On page 71, he admits that terms are not generally attractive for life business. Also oddly, there are no life premiums earned in 2008 and 2009, but losses in both years. I don’t get this.
12) On page 74, the allocations to junk debt seems too high, though I might make that bet as well. Where else do you go in this environment? The high allocations to foreign debt I suspect are there to immunize Berky on foreign liabilities it has written.
13) Page 76 contains what I think is the core strategy for Berky — Inflation-protected investments in regulated industries funded by the short-term float generated from writing P&C insurance.
14) Page 78 shows how economically sensitive “other manufacturing” can be for Berky, in that profits doubled over 2009.
15) Page 79 — The change in NetJets was the decisive factor as far as changes in the profitability of Berky’s service businesses. Score a big one for David Sokol.
16) Page 81 — the discussion on impairment of equity stakes is fascinating, but I think it would all be easier if Buffett just valued everything at market. Who cares at what level you bought it? The important question is for what can you sell it?
17) The Contractual Obligations exhibit on page 84 made me edgy, because total obligations are large relative to assets. Then I took a step back and said, “But that’s the nature of liabilities, and the difference between that and the value of liabilities is not large.” All that said, review my second risk factor at the end of this article.
18) On page 94, it reveals that Berky is mismatched short, assets versus liabilities. That is a bet that I would take as well, but it is a bet. In a depressionary scenario, it would get pinched.
19) On page 97, he lists his “owner related business principles.” I am an admirer here — the ethics are excellent, relative to the rest of our financial markets. If I wee summarizing much of it I would say:
- Ignore the accounting if it doesn’t represent the economic reality.
- Act like an owner.
- Lumpiness is normal for good investments. Don’t look for smooth results.
20) I appreciate the humility that Buffett displays on point 9 of his principles. He didn’t phrase it right, and now he has corrected it.
But now for what should be at the top of what Warren writes:
The Two Real Risks for Berky
From the 10-K on page 19:
Insurance subsidiaries’ investments are unusually concentrated and fair values are subject to loss in value.
Compared to other insurers, our insurance subsidiaries invest an unusually high percentage of their assets in common stocks and diversify their portfolios far less than is conventional. A significant decline in the general stock market or in the price of major investments may produce a large decrease in our consolidated shareholders’ equity and under certain circumstances may require the recognition of losses in the statement of earnings. Decreases in values of equity investments can have a material adverse effect on our consolidated book value per share.
If I were Buffett, I would put this on page one of his shareholder letter, because this is the biggest risk. No other insurance company in the US takes as much equity risk as Berky. Buffett is a great investor, but in a Great Depression scenario, Berky could be a zonk.
The second risk is more quiet and insidious. Debt has grown where the Berky parent company is on the hook, whether directly, or by guarantee, as at the finance subsidiary. This was AIG ten to fifteen years ago. The initial increase in debt was innocuous, but it led to more increases in debt. After 20 years, AIG was overindebted both in cash terms and synthetically.
What I am saying is that once the discipline against debt is breached, it becomes easy to justify more debt. I think we are seeing that now, and Buffett is compromising his principles.
Hey, Greenberg eschewed debt for two decades, and then piled it on for two decades. Is Buffett doing the same thing? Personally, I think he is, though I don’t think he has thought it through. Warren, if you are reading me, pull back on the debt. It killed Hank.