Louis Simpson interview

Published on The New York Times, Sunday, April 29, 2007
GEICO Exec Thinks A Lot Like Buffett
Hathaway CEO is a fan of little-known investment manager Louis Simpson

BY GERALDINE FABRIKANT

CHICAGO – Warren E. Buffett is hardly a man of mystery.

But when investors gather in Omaha May 5 for the Berkshire Hathaway annual meeting, there will be a nagging question mark over the hear of the 76-year-old chairman: who might someday replace him in each of the two roles he plays – chief executive of Berkshire Hathaway, and its chief investment officer?

A bit more is known about the choice of a future chief executive. Buffett has said there are three candidates from various Berkshire-owned companies. Buffett watchers speculate that the list includes David L. Sokol of MidAmerican Energy Holdings; Ajit Jain, head of the reinsurance division of Berkshire’s National Indemnity Company; Tony Nicely, chief executive of GEICO; Joseph P. Brandon, chairman of General Re; and Richard T. Santulli, founder of NetJets.

The bigger mystery is who will become the chief investment officer. Buffett says he does not know himself. On this point of succession, “frankly, we are not as well prepared,” he wrote in his 2006 shareholder letter last month.

Here is a clue, though. He or she will probably be a lot like Louis Simpson.

Louis who?

Simpson, 70, has long overseen the investment portfolio of GEICO, the insurance company Berkshire owns, which is not valued at more than $4 billion. He is also the only man other than Buffett who has managed stock investments in Berkshire’s portfolio.

Buffett is a big fan. “He is the kind of person we are looking for: smart, classy, loyal,” he said of Simpson in a recent telephone interview. But Simpson is just six years younger than Buffett, who has written that “for the long term, though, we need a different answer.”

Applicants would do well to learn from Simpson, which is easier now that he has agreed to his first interview since Berkshire Hathaway gained total control of GEICO in 1995.

In many ways, Simpson, whose title at GEICO is chief executive for capital operations, is a lot like his boss. The two have the same general distaste for technology stocks. They both favor intensive research to find attractive companies to invest in, and they share a willingness to bet on returns from just a handful of stocks.

In terms of style, though, there are some major differences. Simpson, a deliberate, slow-talking executive, has maintained much lower visibility. “I have always felt I could do a better job in adding value by being somewhat removed from the circus and pari-mutuel atmosphere of the market,” he said.

Simpson works in Chicago, where he moved from the La Jolla district of San Diego two years ago because his second wife, Kimberly, a chemical engineer, missed the energy of urban life.

Though he is already well-connected among Chicago’s power brokers, he tends to describe people in terms like “fancy” if they are not the plain-spoken types that populate Berkshire’s host of companies.

Simpson’s work life is similarly low-key. On a recent spring day, he sat in his three-room office suite on North Michigan Avenue here, where he works with a small staff, explaining that it had been a particularly busy time.

Busy, though, is relative. There were no researchers running around, no Bloomberg terminals, and no interruptions. “We are sort of the polar opposites of a lot of investors,” Simpson said. “We do a lot of thinking and not a lot of acting. A lot of investors do a lot of acting, and not a lot of thinking.”

He does not crow about GEICO’s performance except to say that “it has been very, very good,” and he is disarmingly honest about investments that have not worked out.

“Pier 1 was a horrible mistake,” he acknowledged. “It was our own doing. They were totally out of touch fashion-wise, and it was a disaster.”

Such mistakes notwithstanding, his track record has even led Buffett to brag about him periodically. In 2004, the only time that Berkshire ever stated GEICO’s performance separately, Simpson over 24 years had posted a 20 percent average annual gain, surpassing the Standard & Poor’s 500-stock index by 6.8 percentage points.

Since 2004, GEICO’s results have been somewhat better than the S & P index, he said, declining to be specific. In 2005, the S & P was up 4.9 percent, compounded. In 2006, it rose 15.8 percent.

“He has an amazing record,” Buffett said in the interview. “He does not make a lot of noise about it. He is a very sensible, sound, decent guy.”

To find stocks, Simpson does not read analysts’ reports. “They have their own agenda,” he said.

Nor does he search data on the Bloomberg terminal for ideas. “If I have the Bloomberg on, I find I am looking at what the market is doing,” he said. “I am looking at every news story. I really like to be the one who is parsing the information, rather than having a lot of irrelevant information thrown at me.”

Sometimes he speaks with Buffett several times a week and sometimes not for a month or two. Simpson makes his own decisions and essentially works alone.

“The more people you have, the more difficult it is to do well,” he said. “You have to satisfy everybody. If you have a limited number of decision makers, they are more likely to agree.”

It is hard to know which stocks are GEICO’s and which are Buffett’s picks. Simpson holds about 10 major positions: According to filings with the Maryland Insurance Administration, they are in American Standard, Nike, Comcast, Costco Wholesale, First Data, Home Depot, ServiceMaster and UnitedHealth Group (he bought it after the stock-option scandal). GEICO’s biggest position is TESCO of Britain, a stock also owned by Berkshire Hathaway.

Simpson found Nike, one of GEICO’s most successful holdings, through a stake in the rival Reebok. He had hired a journalist-turned researcher, and the researcher thought that Reebok was the “cat’s meow,” Simpson recalled, adding: “Paul Fireman ran the company, but not particularly well. The more we got into it, the more I saw the really quality company with the franchise and sports brand was Nike. It was truly a worldwide brand that did not have a lot of penetration in growing parts of the world such as Asia.”

Thomas Russo, a partner in Gardner Russo & Gardner, also studied that industry for investors. GEICO “did an enormous amount of research,” he said. “They wanted to understand the management questions,” adding, “We were researching companies in that same sector, and we had a pretty good idea of what was going on.”

Simpson, who grew up in Chicago and has three sons, began his investing career at Stein Roe & Farnham. During a heady investment period in the late 1960s, he learned the perils of market timing when he worked for Shareholders Management, then a hot fund company run by Fred Carr. But when the market turned, Shareholders’ Enterprise Fund took a nose dive, and there were substantial redemptions. Simpson resigned. “I viewed myself an investor, and they were trading-oriented,” he said.

From there, he joined Western Asset Management where he rose to chief executive. Still, that firm basically followed analysts’ recommendations.

It was not until GEICO’s chairman, John J. Byrne, called him in 1979 to become its chief investment officer that Simpson found a niche where he could put his own ideas to work. Berkshire Hathaway was already a shareholder in GEICO, and Byrne sent several candidates to see Buffett about the management job. After a four-hour interview with Simpson, Buffett called Byrne. “Stop the search,” Byrne recalled him saying. “That’s the fellow.”

Simpson’s compensation has not been disclosed since Berkshire took over GEICO in 1995. At that time, he received a moderate salary and a bonus based on how much the portfolio outperformed the S & P 500. He said that structure had not changed.

Buffett has noted that Simpson could probably make more money elsewhere. Simpson says he is not tempted.

Does the fact that Buffett seeks a younger heir for the long term upset him?
“If he would have asked me to take over the investments for Berkshire, I certainly would have done it,” Simpson said, “but I certainly did not seek it out or wait for it to happen.”

That kind of patience has proved to be its own reward. “Lou can keep running money as long as he wants, “ Buffett said.

Understanding how an insurer makes money

In the earlier article, we discussed understanding an insurer’s balance sheet. Using Progressive (NYSE:PGR) as an example, we simplified her balance sheet. On the asset side, we basically had investments, and on the liability side we had three main sources of funding of those investments: 1) float (policyholders’ money), 2) debt (creditors’ money) and 3) shareholder’s equity.

Now let’s take a look at how the balance sheet links to the income and cash flow statement.

Just like any manufacturing operations have a limited capacity, insurance operations do likewise. For example, Daimler Chrysler’s capacity is the number of car manufacturing plants it has and how many cars those plants can produce.

An insurer’s capacity is its shareholder’s equity, which is simply total assets minus total liabilities. The more policies an insurer writes, the greater its risk of losses if those policies result in claims. Because losses eat into equity, an insurer can’t write too much insurance or it’ll lose serious impairment. For example, if an insurer writes premium equal to 10 times its equity and ends up taking a 10% underwriting loss, then those losses would nearly wipe out its entire equity and render the insurer insolvent.

To prevent this from happening, insurance regulators generally don’t allow insurers to write premiums more than three times their equity, although most insurers stay well below this limit. Thus, the equity on the balance sheet determines how much capacity it has to write insurance and collect premiums.

An insurer’s balance sheet is also where it carries its investments. As mentioned earlier, an insurer uses float, debt, and equity to invest in stocks and bonds to earn investment income. Meanwhile, it must also pay interest on its debt. Putting it all together, here’s how an insurer uses its balance sheet assets and liabilities to generate revenue:

Balance Sheet Translates into
1) Investment Portfolio 1) Investment Income
2) Debt 2) Interest Payment
3) Equity 3) Underwriting Profit/ Loss
4) TOTAL 4) Pre-Tax Income

FROM BALANCE SHEET TO INCOME

Let’s use a different example this time, Markel (NYSE:MKL), a property and casualty insurer. In fiscal 2005, Markel’s balance sheet showed about $1.7 billion in equity, $4.4 billion in float, and $850 million in debt, totaling roughly $6.95 billion in financing. These sources of cash were reinvested into $6.2 billion worth of investments (the difference resulting in cash of $0.334 billion and goodwill of $0.34 billion). The simplified balance sheet looks like this:

Markel Balance Sheet in 2005 (Million of Dollars)
ASSETS
1) Investment = $6,200
2) Cash + Goodwill = $750
3) TOTAL ASSETS= $6,950
LIABILITIES & SHAREHOLDER’S EQUITY
1) Float = $4,400
2) Debt = $850
3) Shareholder’s equity = $1,700
4) TOTAL LIABILITIES & SHAREHOLDER’S EQUITY = $6,950

Now let’s link this to the income statement. Markel used its $1.7 billion in equity as capacity to write about $2 billion in premiums, of which it earned $1.94 billion in 2005. Of that $1.94 in premiums earned, Markel incurred about $1.95 in losses (for claims and claims expenses) and operational expenses. Thus, for every $1 in premiums, Markel estimates it will ultimately pay out about $1.01 in losses and expenses – resulting in a 1$ loss per dollar of premium written, in other words, Markel is running at an underwriting loss. Markel paid interest of $64 million on its $850 million in debt, but earned an investment income of $260 million on its $6.2 billion investment portfolio.

To demonstrates how it works:

Numbers in Millions

To summarize, Markel pays 7.5% on its $850 million in debt, resulting in $64 million in interest payments. It also used its $1.7 billion in shareholder’s equity capacity and earns $1.94 billion in premiums, on which it loses about 0.5%, or $10 million, because it wrote insurance at a slight underwriting loss – if you had read my earlier post with diligence, you would notice that as long as an insurance business is securing its fund at less than the market interest rate, it is still good, after all, insurer earns by reinvesting the funds obtained. Using that $1.7 billion in shareholder’s equity, $850 million in debt, and $4.4 billion float, Markel invests $6.2 billion in investments and earns 4.2% or $260 million in investment income and realized gains. Summing all these up equals about $186 million in pre-tax income, which is what Markel earned in 2005. After taxes, Markel earned about $150 million in net income for 2005 – and that’s a very simplified version of how balance sheet accounts flow into the income statement.

FROM INCOME STATEMENT TO CASH FLOW

To link the income statement to the cash flow statement is quite simple. Markel’s $148 million in net income flows directly to operating cash flow (CFO). CFO includes this $148 million, working capital adjustments, and increases or decreases in float. Because most insurers grow their float on an annual basis, CFO is often much greater than net income.

CASH FLOW IN 2005 (IN MILLIONS OF DOLLARS)
1) Cash from operations (CFO) = $551
2) Cash from investing (CFI) = ($567)
3) Cash from financing (CFF) = ($29)

As we can see, via net income, float, and working capital adjustments, Markel had $551 million of operating cash flow to work with. The insurer then puts this cash into investments, as well as some minor outlays for capital expenditures and other activities. This resulted in a $567 million outflow of cash from investment activities (the bulk of which was used to increase Markel’s investments). In CFF, insurers pay out dividends, repurchase or issue of stocks, and issue or redeem debt. In this case, Markel made some minor adjustments to its financing sources by buying back a small amount of stock and debt, resulting in a decrease of $29 million in total. Thus, CFO is usually where net income and float come in from the income statement. This CFO is put back to work in investments, which shows up on the balance sheet, and increases or decreases in debt and stock – as well as dividend payments – flows through CFF, which are subtracted or added to their respective balance sheet accounts.

Hopefully, this summary provides a better understanding of how an insurer’s financial statements link to each other. As you can see, insurers that have strong balance sheets and underwrite profitably can quickly reinvest that cash into more invested assets – and thus use its increased capacity (shareholder’s equity) to write more premiums. And that’s how disciplined insurers can easily attain double digit returns on equity.

What will save us when everything fails?

In the June of 1996, Warren Buffett issued a booklet entitled “An Owner’s Manual” to Berkshire Hathaway’s shareholders. In this manual, he set down 13 business principles, which are the foundation upon which he built Berkshire Hathaway.

These principles are an amazing free gift to all of us, who try to emulate Mr. Buffett. My of my personal favorite is the eleventh principle, which states:

“You should be fully aware of one attitude Charlie [Munger] and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub-par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.

We continue to avoid gin rummy behavior. True, we closed our textile business in the mid 1980’s after 20 years of struggling with it, but only because we felt it was doomed to run never-ending operating losses. We have not, however, given thought to selling operations that would command very fancy prices nor have we dumped our laggards, though we focus hard on curing the problems that cause them to lag.”

This principle essentially refers and is applicable to businesses which Berkshire owns outright, not in public listed equities.

Now, what’s so great about this statement?

To answer this question we must remember how Warren Buffett invests. As we all know, he doesn’t buy a stock based on its price. He buys a stock so he can own a share of a great business. GEICO is a case in point.

Then, when we look at Berkshire’s investments, we see companies like Coca Cola, American Express, and The Washington Post Company, all of which Mr. Buffett has held for over 20 years.

In principle one of the owner’s manual, he says the following in regard to the stock he buys:

“In fact, we would not care in the least if several years went by in which there was no trading, or quotation of prices, in the stocks of those companies. If we have good long-term expectations, short-term price changes are meaningless for us except to the extent they offer us an opportunity to increase our ownership at an attractive price."

This is all great for Berkshire Hathaway, but the question we, small-time investors, need to ask is: How can we use Warren Buffett’s insights to become better investors?

First, we must buy stocks of solid businesses with longevity. Meaning, if you are 30 years old, make sure you buy a stock that will be around for the next 50 years, in case you live up to 90.

Second, we must learn to wait. Oh no, I better explain, when I say wait, I mean “forget about waiting.” Warren Buffett will die before he sells his stocks. Can we do this? It’s better to.

Third, we must stock buying stocks based on their price – not to be confused with value. This is such a difficult concept that 99 out of 100 investors can’t do it. Very few people can buy a stock at $50 and still hold it when the price drops to $20. But then, very few of us are billionaires.

Lastly, when we find a company we really like, we must buy its stock in large amount. Imagine if we, or our parents, bought Wal-Mart in August 1972, ok, better be more realistic, in 1982, we would be sitting on a 173-bagger. Meaning for every $1000 invested in 1982, it is worth $173,000 today. If we add the dividends in, we don’t even need to count the capital gain because in dividend alone, we’d be getting 88cents for every original 28cents (after accounting for stock splits) the share was worth in 1982.

So when the charts and the ratios, and the EPS estimates fail us, which they will eventually, these four steps will save us, and more. Amen!

Understanding an insurer's balance sheet

Insurance companies are magical creature that, in the hands of a skilled operator, perform alchemistic feats and literally mint money. But, reading and understanding their financial statements are a little difficult, so let’s try to break this task down into bite-sized chunks. First we’ll get familiar with the terms and calculations; later on, we’ll see how the statements are linked and flow into each other.

Balance Sheet

Insurance companies are balance-sheet-driven businesses, so we’ll start here with the assets, followed by the liabilities. Let’s look at the 2005 balance sheet of the auto insurer, Progressive (NYSE: PGR).

2005 Assets (Million of Dollars)
1) Fixed Maturity Securities = $10,222
2) Preferred Stock = $1,220
3) Common Equities = 2,059
4) Short-Term Investments = $774
5) Cash =$6
6) Accrued Investment Income = $133
7) Premiums Receivable = $2,501
8) Reinsurance Recoverable = $406
9) Prepaid Reinsurance Premium = $104
10) Deferred Acquisition Cost = $445
11) Income Taxes = $138
12) Property & Equipment = $759
13) Other Assets = $133
TOTAL ASSETS = $18,899

This is way too convoluted, so let’s make some simplifications. We’ll group all investments (bonds, stocks) into “Investments” and throw cash in there as well. Then we’ll create a category called “Policyholders’ money we don’t have yet.” This will consists of:

1) Premiums receivable – future premiums to be received.
2) Reinsurance recoverable – money that the reinsurers owe.
3) Prepaid reinsurance premium – money already paid to reinsurers for future reinsurance policies
4) Deferred acquisition cost – money already paid but not yet expensed, such as agent commissions and premium taxes, to acquire policies.

Everything else we’ll group it under “Other assets.” *Important note: PLEASE – when investing in an insurer, just like in banks, always read the footnotes, here I’m simplifying for clarification purposes.

Thus, our simplified assets portion of the balance sheet shall read:

1) Investments = $14,280
2) Policyholders’ money we don’t have yet = $3,455
3) Other assets = $1,163
TOTAL ASSETS = $18,899

Now that you’ve got the hang of how I’m simplifying things, we’ll go into the liabilities and shareholder’s equity. The 2005 numbers for these two items read:

2005 Liabilities and Shareholder’s Equity (Million of Dollars)
1) Unearned premiums = 4,335
2) Loss & loss adjustment expense reserve = $5,660
3) Accounts payable, accrued expenses & other liabilities = $1,511
4) Debt = $1,285
5) SHAREHOLDER’S EQUITY = $6,108
TOTAL LIABILITIES & SHAREHOLDER’S EQUITY = $18,899

We shall simplify the liabilities portion like how we did for assets. First, we shall group it into 4 categories; 1) Policyholders’ money that we have, 2) Debt, 3) Other liabilities, and 4) Shareholder’s equity.

First, “Policyholders’ money that we have” is made up of:

1) Unearned premiums – policyholder money paid for future coverage.
2) Loss and loss adjustment expense reserve – policyholder money set aside for already incurred losses, incurred but not reported losses, and the cost of settling claims.
3) Other policyholder liabilities which in Progressive case, it does not have any.

Our simplified balance sheet will thus looks like this:

ASSETS
1) Investments = $14,280
2) Policyholders’ money we don’t have yet = $3,455
3) Other assets = $1,163
TOTAL ASSETS = $18,899

LIABILITIES & SHAREHOLDER’S EQUITY
1) Policyholders’ money we have = $9,9995
2) Debt = $1,285
3) Other liabilities = $1,511
4) Shareholder’s equity = $6,108
TOTAL LIABILITIES & SHAREHOLDER'S EQUITIES = $18,899

The first thing to note here is float. In a nutshell, float refers to the money that policyholders give to insurer in return for insurance. With our simplified balance sheet, calculating float is simple:

FLOAT = POLICYHOLDERS’ MONEY WE HAVE – POLICYHOLDERS’ MONEY WE DON’T HAVE YET

In this case, we can see Progressive has about $6.54 billion in float. We can also see “Other assets” and “Other liabilities” are about the same, so we’ll net them off and ignore these. Finally, we’ve debt and shareholder’s equity value.

Thus, we’ve three main pieces that comprise the balance sheet (ignoring other assets and liabilities, which we’ve netted out): 1) Float, 2) Debt, and 3) Shareholder’s equity.

The reason I simplified to these three points is because each of these represents the different pieces of financing: 1) Float is money provided by policyholders, 2) Debt is provided by creditors, and 3) Shareholder’s equity (estimated liquidation value) is provided by equity holders.

Now back to the basics. An insurer takes money from these three sources of funding (policyholders, creditors, and stock holders) and invests it. If we take Progressive’s float of $6.5 billion, debt of $1.3 billion, and shareholder’s equity of $6.1 billion, we get a total of funding of $13.9 billion – notice this is about equal to Progressive’s $14.3 billion in investments. In other words, an insurer takes money from policyholders (float) and creditors (debt), and pays out operating expenses, claims and claims expenses, and interest payments. The remainder is left over for the stockholders and taxes – this money is reinvested into investments and increases shareholder’s equity, which increases the value of the insurance company to stockholders. However, if the insurer is taking bad risks, it’ll end up owing a lot of claims (if the losses fall to the bottom line, this eats into shareholder’s equity).

In an insurance business, the three determinants to evaluate are 1) the amount of float the business generates, 2) its cost of the float, and the most important 3) the long term outlook for both these factors. The cost of float is determined by the underwriting result of the insurer. Usually, there’ll be a cost attached to it which leaves it running at an underwriting loss. But the business only has value if its cost of float over time is less than the cost the company would incur otherwise to obtain fund. But the business is a lemon if the cost of float is higher than the market rate. The beauty of an insurance business is if it is able to run at an underwriting profit, it means they’re getting paid for holding other people’s money.

By now it should be clear what drives an insurer’s balance sheet value: the more shareholder’s equity and float, the better. However, as in all things, a caution here is appropriate – in the short run, if an insurer under-prices its policies so that it can grow premiums and float very quickly, in the long run, losses will eat up the float and shareholder’s equity, so just like in investing, watch out for fools who rush in. Progressive’s $6.5 billion in float (at end of 2005) and $6.1 billion in estimated liquidation value (shareholder’s equity) were valued at $21 billion.

An interesting answer from Warren

For most of us, the true value investors, at certain intersection, we are faced with the dilemma of which is the better value investing method – the classic Graham method, or the Fisher method. Fortunately, a former value investing blogger turned private capital manager, Shai Dardashti, asked Warren Buffett a very interesting question in a hand delivered letter this past January. Amazingly, Shai received a hand-written answer to his great question this week.

In his letter, Shai asks just a single question:

“At the Q&A I arranged you told me that today (May 23, 2005) you were ‘85% Graham and 15% Fisher.’ If you were today 20-something years old, again looking to allocate less than $10 million, and free to allocate capital into well over 8,000 opportunities (before even considering anything overseas), would your Latticework of Mental Models primarily be searching for:

a) Situations reminiscent of 1957 – akin to Daehan Flour Mills, or
b) Situations reminiscent of 1987 – akin to Moody’s Corporation?”

In response to Shai’s 1091-words letter that accompanied the question above, Warren got straight to the point with an 8-words hand written reply. Mr. Buffett wrote:

“Either is fine.”
“[a] Better for small sums.”
“[b] Better for large sums.”

If we probe further, if one has only a small sum, the classic Graham method is superior to the other methods. Those situations reminiscent of 1957 follow the Graham approach to value investing that focuses on very low P/E and/or net assets per share greater than the current trading price. I must say I was a little taken back from Warren’s choice because of some of the other ideas which I read from him – for example “buying a great business at a fair price is better than buying a fair business at a great price.” Now after rethinking, I think it depends on the situation, for example, the amount of funds you have on hand to invest. So now with this, it puts certain thoughts I had originally back into perspective – Is finding a company with a durable competitive advantage selling at a price with a margin of safety not quite as important as I thought? Should I be also looking for deep value opportunities in the class Graham method? I’ll be probably thinking about all these questions for quite some time.

These are some excerpts from past interviews or quotes which either Buffett or Munger have remarked in the past. And perhaps it can shed some light on this important question.

Mr. Buffett, on June 23, 1999 shared with Business Week:

“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

If you noticed, what stands out for me here is the time when he made the comment. It was right at the peak before the dot-com crash. It kinds of debunk the notion that when a market is overly valued, there’s not a single opportunity. But what Warren seems to indirectly suggest is there’s an opportunity in all kinds of market, be it a bull or a bear.

More recently, Morningstar reported:

Munger also recalled a comment made by Buffett at the Berkshire annual meeting concerning how cheap Korea stocks had become during that country’s financial meltdown in 2002: “There were flour mills trading at two times earnings. Warren thought he was young again.”

Here’s one of the two mental models used by Warren in his investment patterns over the years. The first is the classic Graham approach.

At a talk to Colombia students in 1993, he shared:

“When I got out of Colombia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody’s industrial manual, banks and finance manual and public utilities manual. I went through all those page by page.

I found a little company called Genesee Valley Gas near Rochester. It has 22,000 shares out(standing). It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.

I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual was $12 - $20. Earnings were $16 per share. I ran an ad in the Fort Scott paper to buy that stock.

I found Union Street Railway, in New Bedford, a bus company. At that time, it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.”

In late 2005, he explained to a group of Harvard students:

“Citicorp sent a manual on Korean stocks. Within 5 or 6 hours, twenty stocks selling at 2 or 3x earnings with strong balance sheets were identified. Korea rebuilt itself in a big way post 1998. Companies overbuilt their balance sheets – including Daehan Flour Mill with 15,000 won/year earning power and selling at “2 and change” times earnings. The strategy was to buy the securities of twenty companies thereby spreading the risk that some of the companies will be run by crooks. $100 million was quickly put to work.”

The following will reflect the second mental model which Warren adopts – the Fisher method.

The following is from an article written by Carol Loomis published on April 11, 1988 in Fortune provide interesting clarity on the modus-operandi of Berkshire in 1987:

On Unusual profitability (High ROE with Low Debt, i.e., high ROIC)

“But in his 1987 annual report, Buffett the businessman comes out of the closet to point out just how good these enterprises and their managers are. Had the Sainted Seven operated as a single business in 1987, he says, they would have employed $175 million in equity capital, paid only a net $2 million in interest, and earned after taxes, $100 million. That’s a return on equity of 57%, and it is exceptional. As Buffett says, ‘You’ll seldom see such a percentage anywhere, let alone at large, diversified companies with nominal leverage.’”

Paying for Quality

“By 1972, Blue Chip Stamps, a Berkshire affiliate that has since been merged into the parent, was paying three times book value to buy See’s Candies, and the good-business era was launched. ‘I’ve been shaped tremendously by Charlie,’ says Buffett. ‘Boy, if I had listened only to Ben, would I ever be a lot poorer.’”

Value investing lessons from Centaur Capital (Part 3)

This is the third and final part of an interview with Zeke Ashton, Matthew Richey, and Bryan Adkins of Centaur Capital.

EL: How do you find short ideas? Do you limit downside risk? What indicates to you that a company is a scam?

MR: Most good shorts have a common theme – there’s some set of factors that cause investors to get more enamored with a business than they otherwise should be. It could be a really hot product (prone to being a fad), or a highly promotional management team (prone to over-promising and under-delivering), or a once-successful business that’s now being slowly marginalized, but still trading at a sky-high valuation (prone to investor disappointment). We use various screens to uncover likely candidates, and we also just keep our eyes open to businesses that potentially fit one of these policies.

As for limiting risk, we do take a number of precautions, because there’s no doubt the risk/reward of shorting is vastly inferior to the economics on the long side. First and most importantly, we maintain a strict rule which actually comes from the original Motley Fool Investment Guide: Never short an open-ended situation – i.e. a company that has what could potentially be a wide-open, long-term growth opportunity – no matter how overvalued it might look today. Second, we size our shorts much smaller than our longs – typically only half the size, on average. Third and finally, we maintain individual position loss limits on our shorts (1.5% of the fund) in order to protect against the theoretical potential for unlimited loss. At times, we’ll purchase puts instead of shorting the common in order to get built-in loss protection.

EL: Do you have any favorite investment metrics that you particularly like to look for in a company? What do you look for when reading a company’s financial? When calculating FCF, how do you separate maintenance and growth capex (capital expenditures)?

ZA: I would say that it is important to approach each new idea with the goal to best answer the question “what is it worth?” first and foremost, and then based on the type of business it is, to apply the valuation methodologies that are most appropriate for the job. For example, while we love simple businesses at low multiples to earnings and cash flow, there’re other ideas that may be just as good or better where the business isn’t currently generating any free cash flow at all. Or where the recent cash flow produced by the company doesn’t reflect how much value the business is actually creating. We try to answer the question of what a business is worth by using a combination of metrics that make the most sense. Whatever valuation approach we choose to take, it’s always rooted in the fundamental truism that a company’s value is equal to the discounted value of all future free cash flow.

MR: As for the question of growth versus maintenance capex, we do sometimes make that distinction, particularly for fast-growing businesses with heavy capex requirements. The differentiation between growth and maintenance capex is helpful in getting a handle on what free cash flow might look like at a different stages of a business’s life cycle. For instance, a growth retailer typically generates little, if any, free cash flow during its early growth phase, but then it can generate a monsoon of free cash once it stops adding new units. By understanding the different capex requirements at these different stages of growth, it helps us more precisely model the company’s free cash flow over time, and thereby reach a better estimate of intrinsic value. The key, however, is to remember that growth capex is still capex – and it’s only the true free cash flow which should be discounted within a DCF model.

EL: What is the investment book that taught you the most? Who are some of the great investors you admire and why?

BA: Warren Buffett has called Benjamin Graham’s The Intelligent Investor the best book ever written on investing, and I can’t disagree with him. It was the first investing book I ever read and it gave me the proper foundation for sustainable success in the market. I consider myself very fortunate to have read the Mr. Market parable, along with the rest of the book, before being exposed to the Efficient Market Theory and the like in college.

As for great investors that have influenced me, I’ve read as much as I can about Joel Greenblatt, Seth Klarman, and Eddie Lampert (Sears Chairman and one of the few who earned more than a billion last year as fund managers), primarily. They all reiterate the basic tenets of Buffett and Graham, but hearing them from different perspectives really helps crystallize them in your mind. Lampert, in particular, is a great case study since his recent history involves remarkable capital allocation at public companies, enabling you to actually see the effect of massive share buybacks, improving operating cash flow, the emphasis of profitability over same-store sales, etc.

MR: I’ve always had a fascination with why stocks are priced the way they are – and, more significantly, what makes a stock worth a given price. In my quest to understand stock valuation, I probably benefited most from reading Aswath Damodoran’s Valuation, which is basically the bible on discounted cash flow analysis. It helped me think through the mathematics of how a company’s intrinsic value is comprised of all its future free cash flow. That understanding of valuation theory is my single most important tool as a value investor. Even when I don’t run an actual DCF spreadsheet, the principles of DCF provide me with a framework for rationally approaching any given investment opportunity.

As for influential investors, I resonate strongly with Philip Fisher’s philosophy on identifying great businesses that can grow and compound over a long period of time. I give Tom Gardner credit for shaping my Fisher-esque views on how to identify the world’s best businesses – those with enduring competitive advantages, repeat-purchase business models, great balance sheets, high returns on capital, etc.

EL: Are there any investment ideas out there that you currently find attractive and can talk about?

BA: The market gave a 30% haircut to Whole Foods Market (NYSE: WFMI) back in November, likely because of the perception that Whole Foods reported “disappointing” same-store sales. I use that word very loosely, considering that their reported comps were still in the high single digits – numbers most grocers could only dream of. John Mackey, the CEO, is very open with investors, explaining that the company is focused on maximizing economic returns. Instead of building new stores just to please Wall Street, the company tries to spend money only when the return on capital exceeds that of the cost. I know it sounds like common sense, but unfortunately it’s not too prevalent among public companies. With a unique shopping experience and a loyal base of customers, Whole Foods still has plenty of growth ahead.

ZA: We also like the recently announced acquisition of Wild Oats (Nasdaq: OATS), which offers a nice value creation opportunity if it can get Wild Oats’ margins up to Whole Foods level. Finally, coming back to Mackey, this is a man who clearly works for the joy of the game, and now pays himself $1 a year. We’ve had a lot of success investing in companies where the CEOs pay themselves a pittance but have significant ownership stakes in their business.

EL: And just for fun: Do you think the Dallas Mavericks can win the championship within Dirk’s career? What are your opinions on Mark Cuban?

MR: This should be the year that Dirk not only gets a championship, but the MVP as well. I actually think the Mavs have the type of emerging talent, unselfish team play, and bench depth that can fuel a series of championship. Mark me down as believing in a Mavs dynasty over the next three seasons.

As for Cuban, in spite of his embarrassingly bad reality show, I like the guy – particularly in the context of his role as Mavs owner. I truly admire his passion, which has clearly been the driving force in turning the Mavs from worst to first. Cuban says a lot of provocative things, which is part of his charm, but the one topic on which I have to disagree is when he says the stock market is just like gambling. Yes, the stock market has animal spirits of greed and fear, but unlike a casino, the stock market is comprised of real businesses, with real assets, real cash flow, and therefore real and growing value. In the long term, gamblers lose a fortune, while investors make a fortune. But then again, he’s the billionaire.

And finally, this is the end of the interview. Personally, what Bryan Adkins answers to Emil’s question on the investment book to read reflect exactly what I have experienced from the start. The only logical way to sustainable financial success in the stock market is to have a strong and the correct fundamental, and this relates to those preached by Graham.

Coincidently, I like the business model of Whole Foods Market as well. Not only is the CEO a great model for management, the basic concept of chain-store is in itself a scaling business. To add to that, the way Whole Foods treat its employees, customers and suppliers is world-class, almost like how Sam Walton did for Wal-Mart with his grounding principles. Sam, in his biography mentioned, if he were to start a whole new business in 1990s, what would he do? He said he’d still be in the retail business, but he’ll focus on niche retail business and food is one of it. I’m not recommending that the stock is good to buy but what I’m saying that this business will be much bigger than it is from today. Mark this down.

Value investing lessons from Centaur Capital (Part 2)

We shall continue with the interview conducted by Emil Lee with Zeke Ashton, Matthew Richey, and Bryan Adkins of the savvy value investing hedge fund, Centaur Capital.

EL: It seems your investment thesis for both long and short ideas is to find “obvious ideas.” To buy shares in high-quality companies at low prices, investors must often overlook a “stigma” – such as LabCorp’s (NYSE: LH) reputation for being mature and stodgy (I covered this company as an analyst). Can you give us your ideas on what “stigmas” should be overlooked and which ones shouldn’t? How do you avoid “value trap”?

ZA: To the extent that we can find simple, easy-to-analyze businesses that are obviously very cheap, we naturally prefer those. In investing, you don’t get extra points for “degree of difficulty” – this is why Warren Buffett talks about looking around for 1-foot bars to step over rather than trying to learn how to jump over 7-foot bars. Unfortunately, after the run-up we’ve seen in small-cap stocks over the past five or six years, the market hasn’t offered a lot of simple, high-quality businesses trading at less than 10 times free cash flow for a while, so we’ve had to work a little harder to find good ideas.

MR: As for “value traps,” it’s probably helpful to define the term. I’ve seen certain stocks labeled as value traps just because they’ve traded at low multiples for an extended period of time. That’s not necessarily a value trap. For instance, back in 2003 we owned one so-called value trap, Lone Star Steakhouse, which worked out very well for us, rising from $18 to $27 with 2 years and paying large dividends all the way. A true value trap is a stock that trades at a low multiple to earnings, free cash flow, book value, or some other statistical metric – but where that low multiple is not indicative of being undervalued. Typically the low multiple is justified because the company’s current earnings power is at risk of being impaired, or else because the business is prone to becoming obsolete within the next decade.

The best way to avoid value traps is to never buy a stock just because it appears cheap on some statistical multiple. Back in 2002 and 2003, there were a ton of good businesses at low multiples – and most of them were genuine bargains. But today, a low-multiple stock is far more likely to be a subpar business facing some nasty risk factors – i.e., a value trap. Value investing, contrary to how it’s often portrayed by financial academics, does not merely equate to buying low-multiple stocks. Intelligent value investing requires thinking through all forward-looking assumptions, and thereby figuring out what a business is worth. Some businesses justify low multiples; some justify high multiples. It all just depends on the nature of the business – competitive advantages, growth prospects, and the like. It’s by this process of independent thinking and testing our assumptions that we’re able to weed out value traps, while also occasionally finding gems that carry an unjustified stigma.

ZA: LabCorp is actually a very simple business and was one that we felt was very predictable. From a valuation standpoint, we were able to use free cash flow and basic free cash flow multiples as a starting point on the valuation. At the time of our original purchase of LabCorp back in 2003, I don’t think it was cheap because of any stigma so much, but rather it was simply not fully appreciated for the outstanding qualities it possessed. It was an excellent business but an “in between” stock. It was a growing business, but not growing fast enough for the growth-type investors. It was very reasonably priced, but not cheap enough for the hardcore value investor. The company’s financials were somewhat distorted by a history of acquisitions that inflated the P/E ratio, turning off investors attracted by that metric. It wasn’t in the S&P 500 at the time we purchased it, either.

In any event, over the past couple of years, Labcorp has been such a stellar business, and the company has delivered excellent earnings and cash flow and bought back a ton of stock. Also, the company was added to the S&P 500, and I think people just woke up to the fact that LabCorp was a very good business trading at a big discount to the S&P 500. Even now the company isn’t overpriced by any means. In short, any good company that becomes undervalued gets there either because investors don’t recognize it as a good business, or because a number of investors don’t want to own it right then because of some recent negative news.

It’s part of our job to try to figure out what the negative argument on any idea might be, and try to determine if the negative thesis has merit. Sometimes, we simply can’t figure out why a stock is cheap, and in those cases, we simply try to cover all the bases in our research. We’ve learned over time to trust our own judgment when we can’t find any valid reason or identify a stigma that might explain why a given stock might be cheap.

EL: Please provide a “cradle to grave” description of one of your successful investments.

MR: Alliance Bernstein (NYSE: AB – formerly Alliance Capital) has been a longtime resident in our portfolio, off and on, for much of the past four years. We found the stock back in 2003, when it fell sharply amidst the mutual fund scandal and industry-wide investigations by Eliot Spitzer. In late 2003, AB traded for around $30 per share, with a dividend yield of 6% and a multiple of less than 10 (times) structural FCF. One of the reasons AB remained cheap for so long is because it has an unusual corporate structure. The publicly traded entity is a limited partnership which owns roughly one-third of the parent company. This structure requires that investors take a “look-through” approach to the overall parent company (the Alliance Bernstein operating partnership) in order to understand the true worth of the publicly-traded share (Alliance Bernstein Holdings L.P.).

Fortunately, we were inclined to do the work because we love asset managers – an industry we know a thing or two about. The asset-management economic model has no inventory or receivables risk, plus it has the potential for economies of scale as assets under management grow. Particular to AB, we really liked the 2001 acquisition of Sanford Bernstein, which brought a value-investing philosophy to a company that previously has been geared primarily toward growth investing.

The stock was a good performer in 2004 but really took off in late 2005 thanks to rapid asset inflows into its value and international investment products. By early 2006, we had the opportunity to sell at just over $60, which was where we pegged conservatively fair value, based on a DCF (discounted cash flow) model and conservative growth assumptions. After we sold, the stock went as high as $72, but within six months it was back to $60. By that time, we had the benefit of two more quarters of financial results, which showed that AB’s growth in profits and FCF had been much stronger than we’d previously anticipated. As such, we saw fit to increase our fair value estimate to the low $70s.

With AB just over $57, in August 2006, the stock was priced at around 80% of our new fair value estimate, making it a buy once again. As the stock market turned higher in fall 2006, so too did AB and we quickly got our chance to sell when the stock got north of $70. Once again, we were probably overly conservative in our assumptions, as AB has gone to much higher levels (over $92 as at 17 Apr 2007). But we were satisfied with our outcome, and we’ll continue to follow the AB story and look to buy it again if it falls back to undervalued levels.

EL: Please provide a “cradle to grave” description for one of your unsuccessful investments.

ZA: Bandag (NYSE: BDG) is a stock that we had originally purchased back in 2002, when we saw it as a deeply undervalued, cash-flow producing business at very low multiples to cash flow. The company was the market share leader in re-treading equipment for tires and owned patents on the method, in addition to selling the equipment and rubber for the actual re-treading. The company had a long history of cash generation, increasing dividends, and intelligent share buybacks. In addition, at that time it was in the process of divesting a relatively unprofitable chain of retail tire stores that ultimately freed up a lot more cash and highlighted the true profitability of the underlying business. We late sold at a nice profit.

About a year later, in late 2004, the stock fell way back and we purchased Bandag again. Unfortunately, this time around the company was suffering from significant inroads being made by cheaper new tires from Asia, while input costs were also increasing. These two factors were rapidly squeezing Bandag’s margins. Bandag was compensating for this by directing its cash flow to a new chain of truck lubrication and service stations, which at the time we thought might be a good idea. Unfortunately, it became apparent to us after several quarters that this initiative was never going to have the returns once generated by the core business, and that the core business, while likely to survive, was likely to be far less profitable going forward as globalization took its toll. We sold our shares at about a 20% loss from our original purchase price the second time around in order to buy some other things that looked better to us at the time.

In a final ironic twist, Bandag later announced it would be bought by Bridgestone at a price that would have represented a very nice return on our original stock price. There’re a couple of lessons in this: First, in our modern world the competitive moat around a business can deteriorate rapidly. Second, in looking back at our research on the company, we actually believe that selling was the right thing to do, and that there was no way to have seen a buyout coming because Bandag had been a family-controlled company for decades and there was no indication that was going to change. We see their having to sell that business as confirmation of weakness, not strength. That’s not to say we would’ve minded having a good outcome for our troubles instead of a bad one.

In summary, we think our original decision to buy Bandag was good, as was our decision to sell. The second purchase of Bandag, even though it was only two years later, was flawed – Bandag’s fundamentals had deteriorated, and the stock had become a great example of the “value trap” that Matthew described earlier. Of course, had we taken longer to realize our mistake and gotten the benefit of the favorable acquisition price, we might still have enjoyed a good outcome from a poor decision.

Check back later for the third and final part. Again, great insight from Centaur: Sometimes value is right under your nose, as with LabCorp, and sometimes you have to look from a different angle, as with Alliance Bernstein.

Value investing lessons from Centaur Capital (Part 1)

This is an interview conducted between Emil Lee, an analyst and a fellow value investor, with the partners at Centaur Capital. Centaur’s founder, Zeke Ashton, was profiled in James Altucher’s excellent read, “Trade like Warren Buffett.” He is dubbed by James (along with Mohnish Pabrai) a Buffett-style hedge fund manager. The following is the interview, conducted via email by Emil.

EL: Please provide a brief history of Centaur Capital

ZA: Sure. Centaur Capital got its start in early 2002 when I moved to Dallas and started a limited partnership called the Centaur Value Fund, which launched in August of 2002. Matthew Richey and I had worked together at The Motley Fool for a couple of years and shared a similar investment framework, so of course I was delighted when Matthew joined Centaur in late 2003. Matthew acts as co-portfolio manager of each of our funds, and so the investment decisions are always made in a consensus fashion. We had about $3 million under management at that time, as I recall, which seemed like a lot of money to us at the time. Bryan (Adkins) joined us in April of 2006 as a securities analyst, and because he is cursed with having multiple talents, he gets to handle our IT needs and has various other duties in addition to being a full-time analyst. He’s been a great “value investment” for us.

Today, we continue to manage the original partnership, and have added additional funds for U.S. and offshore institutional investors as well. In early 2005, we launched a retail mutual fund in partnership with our friend (and also former Motley Fool writer) Whitney Tilson and his business partner, Glenn Tongue. Whitney and Glenn are great investors and really nice people to work with, so that’s been a fun experience for us. The fund is called the Tilson Dividend Fund (TILDX), and we use a value-based dividend and covered call writing strategy that we developed and which we believe is a fairly unique. Across all of our accounts, Centaur Capital had about $70 million under management at year-end 2006. As far as track record, readers can see the results of the Tilson Dividend Fund by going to the Tilson Mutual Funds website (www.tilsonmutualfunds.com). As for our limited-partnership trck record, I’ll just say that we’ve produced returns over five years that are at the high end of the goals and expectations that we set for ourselves.

EL: According to a shareholder letter, your due diligence process entails printing out a huge stack of annual reports, SEC filings, and whatever other research you can find and then sitting down and reading it all. This is a typical due diligence process. Why do you think Centaur is able to produce a superior track record using the same research methods as everyone else? How granular do your valuation models get?

ZA: First of all, I think you should realize that there is an awful lot of money managed in this world where the decisions are not based on detailed fundamental research or an emphasis on buying assets at prices that are demonstrably less than intrinsic business value.

Matthew Richey: If we have any edge, it’s simply that we try to be highly disciplined – specifically, disciplined to only buy stocks that we determine to be conservatively undervalued, and then disciplined to sell once a stock reaches our estimate of fair value. We’re also highly risk-averse, and we strive to only take action when all our research points to a favorable outcome. We look at a lot of stocks that we mentally toss into the “too tough” category. But for the names where we’ve done our homework and know a price what we’re willing to pay, then it’s simply a matter of waiting for Mr. Market to give us our price – and he often does, if we’re patient.

As to the granularity of our valuation models, we aim to follow Einstein’s advice: “Everything should be made as simple as possible, but not simpler.” The problem with many models, of course, is garbage in, garbage out. It’s of no use to make a model super-granular, but full of inaccurate assumptions. We try to avoid any illusion of false precision by sticking to a handful of key big-picture variables – the durability of competitive advantage, profit margins, capital expenditures requirements, and conservative growth potential – all leading to a forecast of future free cash flow, which we then discount back to present value using an 11% discount rate. We also typically forecast both a base case and a stretch case to arrive at a range of estimated fair value.

EL: According to a Value Investor Insight interview, you often get ideas by running quantitative screens. As a result, your firm is “sector agnostic.” How do you go about getting to know an industry in a relatively short period of time? Do you subscribe to any information sources/trade magazines that you find particularly useful for industry research?

Bryan Adkins: If our screens bring up a handful of names that seem interesting, we’re more inclined to go with the business models that we best understand. Our perspective is the simple an investment thesis, the better. We try to stick with what we know and avoid mistakes. For example, since I’m familiar with the retail model, it’s much easier for me to analyze Home Depot competitive advantages and determine how its makes money than to analyze Bank of America.

We don’t read any particular trade magazines. When I’m researching a company or industry, Google is usually the only resource I need – from Fortune and BusinessWeek write-ups to recent articles in The Wall Street Journal, blogs, and more, the internet pretty much covers all informational bases.

MR: We’re big believers in sticking to our circle of competence. But we also see no reason why our circle of competence shouldn’t be gradually expanding over time. That’s why once or twice a year we’ll look at an entirely new industry. In 2004 and 2005, I began exploring precious metals, while Zeke began looking into oil and gas. Our learning process involved reading annual reports, conference call transcripts, industry-related research reports, and the occasional book on the industry’s history. It was a slow process, but we now have reasonable expertise in both of those areas.

There have been other sectors, however, where after a long, hard look, we decided the industry is too tough for our analysis to pay off, so we simply abandoned it. Such was the case last year after I spent three weeks scrutinizing the debt collection industry. I found that the two main players, Portfolio Recovery Associates (Nasdaq: PRAA) and Asset Acceptance (Nasdaq: AACC), are both great companies run by shareholder-friendly management – but the business model involves too many moving parts for me to identify a clear range of intrinsic value.

Check back later for part 2. That Einstein quote about simplicity, in my opinion, is one every value investor should cast on their forehead. I’ve noticed that great value investors like those at Centaur know what they know and what they don’t know – in other words, they know the boundaries of their circle of competence, but they constantly work on expanding that circle. Interestingly, they talked like Warren Buffett in a lot of ways too.

Insurance Business Part 2

How to calculate loss ratio?

Loss ratio = loss and loss reserves expenses divided by net premiums earned

How to calculate expense ratio?

Expense ratio = underwriting expenses or anything that is related to selling the insurance divided by net premiums earned.

These two formulas will determine to underwriting performance of an insurance business. The ratios will reflect the disciplinary level and effectiveness of an underwriter. Since most insurance policies are commodity-like, insurers generally lack pricing power. In fact, any business which is commodity-like lacks pricing power and what distinguish the best from the rest lies in cost for most commodity-like business. The low-cost producer will hold the advantage. But in insurance, it lies in both cost and also the ability to make use of the float which ultimately determines the cost of capital. As a result, with the intense competition in pricing, most people don’t care who writes their policy as long as the price is cheap. Thus, insurance prices function in the manner of supply and demand. When times are good, insurers make underwriting profits, and loss ratios decrease. Because of the smaller losses, some insurers driven by short-term greed, increase capacity by writing more policies, without consideration for future risk. The increase in supply results in decrease in prices. Eventually, the cycle turns and losses increases. The turkey came home to roast for those insurers who wrote a lot of policies at low prices and left holding the baggage. It is almost akin to the stock market working during the boom-bust cycle.

Investors should thus look for insurers who stay discipline, boom or bust. When loss ratios are low and insurance prices are soft, the disciplined insurers cut back on premium growth, even if it means foregoing short-term profits – again similar to the workings of value investors. So when the underwriting cycle turns, the undisciplined insurers will be saddled with large losses. Some even go bust. The resulting decrease in capacity means tantalizing profits for disciplines insurers who patiently wait for better pricing. You could see that after 9/11, the disciplined insurers reap the rewards justly because they could write better policy priced at a higher price when the other undisciplined insurers are left with little room to write policy after a catastrophe.

Loss and underwriting expense ratios are used to interpret the underwriting experience of property & casualty insurance companies. Loss and loss adjustment expenses (LAE), on a statutory basis, are stated as a percentage of premiums earned because losses occur over the life of a policy. Underwriting expenses, on a statutory basis, are stated as a percentage of premiums written rather than earned because most underwriting expenses are incurred when policies are written and not spread over the policy period. The statutory underwriting profit margin is the extent to which the combined loss and underwriting expense ratio are less than 100%.

Unlike many other forms of contractual obligations, LAE often do not have definitive due dates and the ultimate payment dates are subject to a number of variables and uncertainties. As a result, the total LAE payments to be made by periods, as shown below for example, are estimates.

Total Within 1 year 1-3 years 4-5 years More than 5 years

LAE US$1,022,603 $622,305 $319,277 $33,691 $7,330

LAE are for the payment for both reported and unreported claims. Loss reserves are estimation based upon case to case evaluation of the type of claim involved and the expected development of such claims. The amount of loss reserves and LAE reserves for unreported claims can be determined on the basis of historical information by line of insurance. Inflation is reflected in the reserving process through analysis of cost trends and reviews of historical reserving results.

The company’s ultimate liability may be greater or less than the stated loss reserves. Reserves are closed monitored and are analyzed quarterly by the company’s acturial consultants. The company may or may not discount to a present value that portion of its loss reserves expected to be paid in future periods. However, the tax reform Act of 1996 does require the company to discount loss reserves for federal income tax purposes.

LAE reserves are typically comprised of 1) claims reported or known as case reserves (CR) in the industry, and 2) reserves for losses that have occurred but for which claims have not yet been reported, referred to as incurred but not reported reserves (IBNR), which includes a provision for expected future development on case reserves. CR are estimation based on the experience and knowledge of claims staff regarding the nature and potential cost of each claim and are adjusted as additional information becomes known or payments are made. IBNR is derived by subtracting paid loss and LAE and CR from the ultimate loss and LAE.

Ultimate loss and LAE are generally determined by extrapolation of claim emergence and settlement patterns observed in the past that can be reasonably be expected to persist in the future. In forecasting ultimate loss and LAE with respect to any line of insurance, past experience with respect to that line of insurance is the primary source, but cannot be relied upon in isolation.

Uncertainties in estimating ultimate loss and LAE are magnified by the time lag between when a claim actually occurs and when it’s reported and settled. This time lag is referred to as the “claim-tail.” The claim-tail for most property coverage are typically fairly short, in the absence of litigation, and settled no more than a few years after occurrence. In contrast, claim-tails for casualty are usually very long, occasionally extending for decades. Casualty claims are susceptible to litigation and can be significantly affected by changing contract interpretations and the legal environment which contributes to the extended claim-tails. Claim-tails for reinsurers could be further extended due to delayed reporting by ceding insurers or reinsurers due to contractual provisions or reporting practices. During the long claims reporting and settlement period, additional facts regarding to the coverage written in the prior accident years, as well as about actual claims and trends may become known, and as a result, the insurer may adjust its reserve. If management determines that an adjustment is appropriate, the adjustment is booked in the accounting period in which such determination is made accounting with GAAP. Accordingly, should reserves need to be increased or decreased in the future from accounts currently established, future results of operations would be negatively or positively impacted, respectively.

Last but not least, the last factor to consider is the premiums to surplus ration. Statutory requirement indicates that this ratio should be no greater than 3 to 1. This is calculated by dividing the net premiums written by the policyholders’ surplus. In effect, this is a measure to curb overwriting of insurance.

Hopefully, all these discussion would have shed some light for those who are intrigued on how to evaluate an insurance business.

Insurance Business Part 1

What is insurance?

Insurance is a contract which transfers risk from the customer (the insured) to the insurance company (the insurer). If, for example, an insured customer gets into a car accident, his insurance company ends up paying the bill. In return for undertaking this risk, the customer must pay the insurance company a premium upfront.

What are premiums?

Premiums for insurance companies are essentially equivalent to sales for retail companies. Insurance companies take in premiums from customers, from which they pay out losses and cover expenses. Written premiums refer to the amount of new business an insurance company writes or “sells” to customers each year. If an automobile insurance company acquires 100 new customers in a year, with each contract requiring customers to pay $1000 in premiums, then that insurance company’s written premiums is $1 million for that year.

So far, it is pretty straightforward, isn’t it? The total amount of premiums an insurer is entitled to receive from its customers over the life of their insurance contracts is the gross written premiums.

What are net premiums?

Risks come in all kinds of shapes and sizes, and at times, an insurance company does not want to take on certain risks, or it wants to transfer some of its risk to another insurer (known as reinsurer). The insurance company must pay reinsurance premiums to the reinsurer. This reinsurance cost must be subtracted from the gross premiums, and the result is the net premiums. Just as net sales are a better measure of a retail business, it is the same for an insurance business.

What are net premiums earned?

IN GAAP, accrual-based accounting states that revenues and costs must be matched to the periods for which they are applicable. In other words, if a customer pays you today for a service to be rendered in a year, you cannot recognize that revenue and the associated costs until the service is performed. Similarly, since insurance contracts are often written for multi-year periods, the portion of the premium earned must be recognized on an accrual basis. For instance, if a customer pays an insurer $10 million in premiums in order to insure its risk for 10 years, then every year it is earning a tenth of the total net premium written, so its yearly net premiums earned is $1 million.

In reality, like any other type of company, the more business an insurer does, the better (assuming the business is writing the policy with the associated risks in the correct manner, of course). The companies that are able to generate a lot of premiums are generally more valuable. Some investors like to use price-to-sales ratios (market cap divided by sales) when judging retail business. In a way, it’s to a certain extent worth taking a glance at the price-to-net-premiums-earned ratio in order to ascertain an insurance company’s premium generating ability. Not forgetting that insurers have other sources of revenue besides premiums because premiums by itself is often insufficient to cover all associated losses and expenses if it is not put to work. And such revenue that flows through to the net income of the insurance company varies widely depending on the company.

Some of the top insurance companies are White Mountains, USAA, Mercury General, Progressive, Geico, General Re, W.R. Berkley, and Merkel.

Like great value investors who only load up heavily when the bet is highly mispriced, great insurance companies do business only when risk-adjusted returns are favorable. As such, investors should look for insurance companies that grow net premiums earning when risk premiums are high which usually occurs after a catastrophe or an industry shake-out, and stay disciplined when risk premiums are low. Interestingly, this is the simple formula Warren Buffett has stuck to turn Berkshire Hathaway which owns Geico and General Re, into the insurance juggernaut it is today.

What is float?

In the insurance industry, premiums held or written are other people’s money (OPM) till such time when the liability for the contract is over and done with. OPM is also known as float. And float is the heart of the insurance business that determines the moat of the company. Float has its cost or conversely has a value to it depending on how the float is deployed between the day the insurance receive the premium to the day it has to pay out all costs associated with the written premiums. Float is wonderful if it has no cost or if it doesn’t come at a high price, and over and above this, if it produces a cost associated with the float which is less than the cost the company would otherwise incur to obtain the funds.

Warren Buffett once remarked that float “has cost us nothing, and in fact has made us money.” Therein lay an accounting irony: “Through our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had.”

When you pay the premium on your automobile insurance, those premiums help cover operating expenses and go toward paying automobile claims from customers who get into accidents. The great thing about premiums is that insurer collects the money upfront but doesn’t have to pay out claims until much later down the road. In the meantime, the company “floats” these unpaid premiums by investing in stocks, bonds, and other securities to pocket a profit.

Float is really a valuable form of capital because not only does the insurance company get to keep the investment income, but also the company’s cost of capital is often low or even positive.
Here’s is how float is calculated: Net loss reserves + loss adjustment expense + funds held under reinsurance assumed + unearned premium reserves – insurance related receivables – prepaid acquisition costs – prepaid taxes – deferred charges applicable to assumed reinsurance.

Wow, that is really a handful but fortunately as always, it can be simplified to say that float is simply cash received from the customers that have not been paid out yet for claims and expenses.

The more float a company has, the more investment income it can generate. That’s a wonderful concept which Warren brought to Berkshire and the resulting outcome is Berkshire’s float increased from $20 million to $49 billion in the period from 1967 to 2005.

What is short tail and long tail claims?

The length of time between receiving a premium and eventually paying out claims affect how profitable float can be. The longer it takes to pay out claims, the more value the float can creates because ultimately what value a float can create is dependent on the basic notion of investing – you need time to create value, and many times, patience for a business to realize any value which is undervalued. For instance, Progressive and Mercury General write automobile insurance that is generally paid out quickly. If an insured driver gets in an accident, then the claim for vehicle damage and bodily injury is paid out soon. This is known as short tail insurance. On the other hand, insurance companies that insure liabilities like asbestos claims take a long time between getting the premium on hand to the day it is paid out because of litigation that remains for years and years. In general, such long tail insurance is preferable because the float can be reinvested over longer periods of time and compounding it.

What is the importance of loss reserve in the business of insurance?

As described earlier, accrual accounting states that revenues should be recognized when earned and that expenses should be matched to revenues in the same period. Therefore, insurers have to recognize their losses in the same period as they earn their premiums. The tricky part is insurers often do not pay claims until some future date, and this requires them to estimate their losses and creates a reserve for this estimate for future claims.

Estimating claims losses is sort of like trying to guess how drunk you are after each successive shot of tequila. Since the drunkenness doesn’t come until later, you have to make educated guesses based on statistics such a body weight and historical experiences. Insurers estimate their losses using actuarial estimates and experiences too.

If, in the aforementioned situation, you’re too conservative, you won’t have enough to drink and won’t achieve your desired state of intoxication. Similarly, insurers who are overly conservative may allocate too much of their capital to reserves and be underleveraged which depressed their investment income.

Conversely, if you’re too aggressive and have too much tequila, then you may end up your night prematurely due to excessive drunkenness, and you may end up with a hangover or even alcohol poisoning. Similarly, insurers who are too aggressive with their loss reserves may find that later on, they have to recognize losses and may even become insolvent.

One thing is clear though between the selection from these two approaches – it’s better to err on the side of caution just like all value investors’ approach to investing with caution. Even if an insurer can get away with aggressive loss reserves in the short run, claims must eventually be paid, and overly aggressive insurers end up paying the piper more often than not.

If loss reserves are management estimates, then how do investors get comfortable investing their hard-earned money in an insurance company? Reputation and historical track record are some ways to gauge an insurer’s creditability. If I’m at a golf course with Tiger Woods and my neighbour, Billy, and both of them tell me they have awesome handicaps, I’d tend to put more faith in Tiger Woods. Likewise, insurance managers who have great reputations mostly are due to long track records of conservative approach and also accurately estimating loss reserves.

As time passes and claims get paid, loss estimates become much more accurate. Every year, as new information unfolds, the insurer must re-estimate historical loss reserves, resulting in a loss adjustment expense. Overly aggressive insurers who under-reserve their losses and overstate income, eventually realized their claims are higher than their reserves, and have to make an upward loss adjustment expenses.

Insurers report their historical results in cumulative redundancy tables. If loss reserves were too aggressive, then the results show a large deficiency. If they were too conservative, then the result shows a large redundancy.

Practices of insurance all-stars

Some insurance companies have demonstrated over a stretch of years and underwriting cycles that they have the culture and integrity to adequately measure loss reserves. Investors would be well-served to stick to management teams that have already proven their mettle. As the saying goes, “If you don’t know the horse, know the jockey.” Some insurance companies with rock-solid “jockeys” are Geico, General Re, Berkshire Hathaway, Markel, Cincinnati Financial, and U.S.A.A.

How to evaluate an insurance company?

The key determinants are 1) the amount of float that the business generates, 2) its cost, and 3) the long term outlook for both these factors which is the most critical.

To start, float arises because premiums are received before losses are paid out with an interval that sometimes extends over many years depending on the nature of the risk insured – long tail or short tail. During the interval, the float is invested in securities. This pleasant event typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it must eventually pay out. An underwriting loss would occur in this case, which is the cost of the float.

Thus, an insurance business only has value if its cost of float over time is less than the cost the company would otherwise incur to obtain the funds. But the business is a lemon if its cost of float is higher than market rate of money.

Because loss costs must be estimated, insurers have enormous latitude in figuring their underwriting results – there are two extremes, conservative or aggressive – and that makes it very tough for investors to calculate a company’s true cost of float. Errors of estimation, usually innocent but sometimes not, can be huge. The consequences of these miscalculations will flow directly to earnings. An experienced observer can usually detect large-scale errors in reserves, but the general public could not and at times, even these numbers are implicitly blessed by big names auditors. Thus, both the income statement and balance sheet can be a minefield in insurance business if the loss estimation is horribly overdone.

Hence, it pays to strive to be both consistent and conservative in reserving of loss. Occasionally, mistakes will be made and it is inevitable. And a warning here is there is nothing symmetrical about surprises in the world of insurance – they’re almost invariably unpleasant.

In insurance, an underwriting profit means there is zero cost of float. In other words, you get paid for holding other people’s money. If an underwriting loss occurs, it does not means the business is a lemon, it is a lemon only if the cost of float is more than the cost the company would otherwise obtain through other means.

Why is long tail better than short tail insurance?

Simply, the odds are better and time is on your side. Some years back, a few insurers that were then experiencing large losses offloaded a significant portion of these to Berkshire Hathaway which penalized its then current earnings but it gave them float they can use for many years to come. After the loss that they incur in the first year of the policy, there’re no further costs attached to this business.

If these policies are properly priced, the pain-today, gain-tomorrow effects should be taken. These transactions will materially distort the current earnings but provide great long term favorable results. Many reinsurers have little taste for this insurance. They simply can’t stomach what huge underwriting losses can do to their reported results, even though these losses are produced by policies whose overall economics are certain to be favorable. Therefore, investors should be careful in comparing underwriting results of different insurers.

An even more extreme long tail kind of insurance which you won’t find much of elsewhere besides at Berkshire arises from transactions in which they assume past losses of a company that wants to put its trouble behind it. To illustrate, the ABC insurance company might have last year bought a policy obligating Berkshire to pay the first $1 billion of losses and loss adjustment expenses from events that happened in, say, 1995 and earlier years. These contracts can be very large though a cap must be in placed to limit the exposure.

Under GAAP accounting, this “retroactive” insurance neither benefits nor penalizes the current earnings. Instead, an asset called “deferred charges applicable to assumed insurance” is set up. This amount reflects the difference between the premium received and the losses that it is expected to be paid (for which reserves are immediately established). This asset is then amortized by making annual charges to earnings that create equivalent underwriting losses. By their nature, the losses will continue for many years, often stretching for decades. As an offset, they have the use of float, lots of it.

Clearly, float carrying an annual cost of this kind is not as desirable as float that is generated from policies that are expected to produce an underwriting profit. Nevertheless, this retroactive insurance is still a decent business though it is not the better of the two.

And the ultimate benefit that is derived from float will depend not only on its cost but fully as important, how effectively it is deployed.

An example of long tail and low probability insurance is best found in transactions done at Berkshire. Ajit Jain is the all-star underwriting insurer manager in the world of insurance. Single-handedly, many deals were consummated due to his brilliance. An example is he negotiated a very interesting deal with Grab.com, an internet company whose goal is to attract millions of people to its site and then to extract information from them that would be useful to marketers. To lure these people, Grab.com held out the possibility of a $1 billion prize (having a present value of $170 million) and Berkshire insured its payment. A message on the site explained that the chance of anyone winning the prize is minute, and indeed no one won. But the possibility of a win is far from zero.

Writing such policy, a modest premium is received, face the possibility of a huge loss and get good odds. Very few insurers like that equation. Because each policy has its unusual and sometimes unique characteristics, insurers can’t lay off the occasional shock loss through their standard reinsurance arrangements. Thus, any insurance CEO doing a business like this must run the small, but real risk of a horrible quarterly earnings number, one that he would not enjoy explaining to his board or shareholders. However, any proposition that makes compelling mathematical sense regardless of its effect on quarterly earnings should be embraced for long term gain.

Getting to know the insurance business

The astute Warren Buffett hasn’t done too badly insurance stocks. Warren used to own a bank that was possibly the best-run bank in the U.S., with a 2.3% return on assets in 1979 (that performance would roughly put it in the top 2.5% of banks today). However, the Bank Holding Company Act of 1969 required that Buffett chose between insurance and banking. He chose insurance. Yes, the stodgy old insurance, perhaps one of the great creators of wealth in the world. Here’s why.

Float is the by-product when policyholders pay insurers upfront and don’t expect their money back until the event that is insured happens. Meanwhile, between this interval, the insurer can deploy the money by investing and pocket the returns. Keep in mind, the insurer gets to use other people’s money (OPM) to invest for itself.

In 2005, Berkshire Hathaway had $49 billion in float. If it invested this in 4.97% one-year Treasury Notes, it could make about $2.4 billion without taking any risk or whatsoever. Another insurance company, Cincinnati Financial used its float to buy shares in Fifth Third Bancorp’s stock and turned a $283 million investment into $2.7 billion as of the end of 2005 – a gain that directly increases the intrinsic value of Cincinnati’s stock.

The ability to make money using OPM money is the hallmark of a great investor. Banks, mutual funds, hedge funds, and private equity funds all use OPM money, but what makes insurance superior to all these other OPM users is the fact that insurers can have a positive cost of capital.

In a nutshell, the combined ratio indicates how much an insurer pays out in premiums or losses. A combined ratio under 100% indicates that the insurer is making an underwriting profit. In this case, not only does the insurer get to use the premium collected to make money for itself, it also doesn’t have to pay back the full amount it “borrowed.” It’s as if someone came up to you and said, “Hey, here’s a billion dollars, you can do whatever you want with it, as long as you give me $990 million back. Pretty sweet deal, isn’t it?

Similarly, banks too use OPM. Customers deposit funds at banks, and the banks loan those funds out and collect interest, which it pockets. The key difference is that depositors, in exchange for allowing the bank to use their money, expect to receive interest payments, so banks have to pay them 2% to 5%. In other words, the bank has a negative cost of capital. On the surface, mutual funds have it a little bit better. Investors give the fund their money, and the mutual fund gets to keep about 1% of assets – a positive cost of funds, right? Wrong. Whereas banks and insurers keep the profits from reinvestment, all the reinvestment profits that mutual funds earn belong to the investor, not the mutual fund manager. Not only that, but investors expect mutual funds to earn a reasonable return of capital. Otherwise, they yank back their money. And thus, this is an implied cost of funds.

So, to a well-run insurer, float is an awesome weapon. It can be used to internally fund the business. It can be reinvested for profit. It often generates its own income. Best of all, the insurer keeps all the profit for itself.

Now, here’s the bad news. If, by now, you’re convinced of the total awesomeness of the insurance industry, it’s time to add some caveats. The downside is that insurance involves taking risks. In 2004, Montpelier Re’s combined ratio was 77.8%, in other words, the company retained $0.22 for each dollar of premium collected. This was incredibly impressive given that 2004 was, at the time, the worst year ever in property and casualty insurance history. In 2005, which was much worse than 2004, Montpelier Re’s combined ratio was 200.7%, meaning it paid out $2.007 for every dollar it took in. Needless to say, this resulted in huge losses and the stock took a nose dive. Although reinsurance tends to have more risk than more predictable types of insurance, such as auto insurance, the point is that year-to-year results for insurers can fluctuate, on account of the inherent volatility of the business. Having said that, what separates a superior insurer from a mediocre one is underwriting discipline.

Before investing in an insurance business, there’re two things: who and when. “Who” refers to picking the right insurers – the ones who have low expense ratios, disciplined underwriters, and a knack for investing float profitably. Personally, the insurers I admire are Berkshire Hathaway (do I have to list this, this is so obvious), Progressive, Markel, White Mountains, USAA (not listed), Zenith, Torchmark, Old Republic, Mercury General, and Cincinnati Financial.

“When” refers to timing. Like in investing, the best time to invest is when blood is on the street. Why? Because I know if a disciplined underwriting is writing policies at a 100% combined ratio (i.e., breaking even on underwriting), then others are probably losing money and will have to cut capacity or go out of business – suggesting more future profits for a disciplined underwriter. This also helps to buy at low valuations (preferably at a low price to tangible book ratio).

When to sell and when to hold

I don’t believe in buy and hold until death do you part. The way I see it, the choices you can make are to buy, hold, or sell. It seems crazy to forgo one of your three options simply to adhere to a motto. Flexibility is one of your biggest advantages as an investor. Why give it away for nothing?

By the same token, if you sell too quickly, you can miss out on huge multi-baggers such as Wal-Mart, and Coke in the early days.

Really, you want the best of both worlds – a strategy that allows you to both harvest profits and achieve huge returns. That means thinking carefully about both your sell criteria and your hold criteria. These criteria are different for every investor and every portfolio, but I’ve found the following works well for me.

Really, you want the best of both worlds -- a strategy that allows you to both harvest profits and achieve huge returns. That means thinking carefully about both your sell criteria and your hold criteria. These criteria are different for every investor and every portfolio, but I've found the following works well for me.

1) Hold when the price changes

Price changes, up or down, don’t change a company’s fundamentals. If you sell simply because the stock has made you 50% in a short time, you’re potentially throwing away a much bigger long-term profit. If the price goes down on no news, the company becomes more attractive, not less. So it doesn’t make sense to sell simply based on price changes.

2) Hold when temporary bad news comes

Adverse news will come to every stock, sooner or later. The company will miss estimates by pennies but fall by dollars. In itself, this isn’t a reason to sell. If the factors are temporary, and, in the long term the business is still strong, it still makes sense to hold, or even buy.

3) Sell when the stock is way overvalued

If a great stock is fairly valued, then it makes no sense to sell it, generally. You’ll likely know that company better than any new company you add to your portfolio, and it’s hard to find great companies at cheap prices, so you should naturally be reluctant to give up the ones you have on hand. But if the company becomes extremely overpriced, then it’s time to jettison it – it will be unlikely to earn spectacular future returns.

A couple years ago, Warren Buffett noted he made a mistake holding on to Coca Cola when it was priced at a high of 60 times earnings or more in the late 1990’s. Though Coke is a great business, it was way too expensive back then, and subsequently, its stock has had terrible returns.

4) Sell when the business fundamentals changes

If you’re buying a great business, and suddenly you notice that the business isn’t actually that great any more, it makes sense to sell. The key decision point is whether the changes are temporary bumps or the business competitive edge has eroded permanently. I suspect like in Berkshire Hathaway case, they sold H&R Block recently for such a reason.

The customer base and the margins of its core tax-return business are slowly being eroded by competition from tax software such as Intuit’s TurboTax. H&R has responded with its own tax software, but it’s clear that technology is changing the tax business and weakening its competitive position.

5) Sell when there’s a better stock to buy

If you’re short on money but see an incredibly compelling stock that you absolutely must own, then by all means sell a less attractive stock to raise the funds. But before you make the move, make sure you take into account the transaction costs and taxes. Often it won’t make sense to sell a company in which you have large returns, pay the taxes, and put the proceeds into a marginally more attractive stock. So if you have to switch, ensure the next pick has a much higher margin of return than what you have on hand.