I am reading through the latest letter from Warren Buffet. There are several valuable lessons to learn from the master of value investment. Berkshire Hathaway has four major operations, which Buffet touched on in this letter. The key point here is that each operation works well in different stages of the financial cycle. Together, they make a good portfolio for all time.
On insurance sector of Berkshire
One reason we were attracted to the property-casualty business was its financial characteristics: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as those arising from certain workers’ compensation accidents, payments can stretch over many decades. This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their benefit.
Word of warning: for P/C model to work, it requires strong discipline and careful risk management. In his words:
Berkshire’s attractive insurance economics exist only because we have some terrific managers running disciplined operations that possess hard-to-replicate business models.
Indeed, we are far more conservative in avoiding risk than most large insurers.
In particular, he outlines 4 basic principles for a sound insurance operation. It must
- understand all exposures that might cause a policy to incur losses;
- conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does;
- set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and
- be willing to walk away if the appropriate premium can’t be obtained.
Personally, I think that the fourth principle is crucial. There is no good reason for engaging in a business transaction, if it does not satisfy your terms.
On regulated, capital-intensive businesses
Berkshire has two major operations in this business: BNSF and Berkshire Hathaway Energy (“BHE”)
A key characteristic of both companies is their huge investment in very long-lived, regulated assets, with these partially funded by large amounts of long-term debt that is not guaranteed by Berkshire. Our credit is in fact not needed because each company has earning power that even under terrible economic conditions will far exceed its interest requirements.
This is akin to investing in long-term inflation-indexed bonds. They don’t do anything fancy, but generate a steady income.
On manufacturing, service and retailing operations
It is interesting to read that even Buffet still makes mistakes in asset allocations. One of his most striking quality is his humility in owning his mistakes.
I simply was wrong in my evaluation of the economic dynamics of the company or the industry in which it operates.
The key in making mistakes is to make them small.
Fortunately, my blunders normally involved relatively small acquisitions. Our large buys have generally worked out well and, in a few cases, more than well. I have not, nonetheless, made my last mistake in purchasing either businesses or stocks. Not everything works out as planned.
The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities – Treasuries, for example – whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars.
He noted that many investors mistake volatility for risk.
Volatility is far from synonymous with risk.
It depends strongly on the timeframe. In the short term (up to a year), returns from equities may be more varied than ones from owning cash-equivalents. However, as I have alluded in a previous post, short-term volatility can stabilise over a long period of time. So, don’t be fooled by price fluctuation.