This eagerly anticipated missive was, at least for this reader, a little short of excitement. Given Mr. Buffett’s penchant for very long-term strategies with few surprises, that is probably a good thing from his perspective. Here are a few observations on this year’s shortened letter. I focused more on the insurance operations, which are of the most interest to my usual readership.
Mr. Buffett set up his successor last month when he promoted both Ajit Jain and Greg Abel to Vice Chairman, making clear that one of them would be the next CEO. Mr. Jain is responsible for all insurance operations, and Mr. Abel for the rest of the Berkshire businesses. However, a slightly longer version of this year’s letter resides in the annual report, in which we learn — at the very end — that Mr. Buffet has no plans to retire. “I also want to assure you that I have never felt better. I love running Berkshire, and if enjoying life promotes longevity, Methuselah’s record is in jeopardy.” So, Messrs. Jain and Abel are waiting in the wings, but it looks like business as usual.
Berkshire’s preferred measure of financial performance is change in intrinsic value. He defines intrinsic value as “the discounted value of cash that can be taken out of a business during its remaining life”. Simple to define, but highly subjective to determine. For this reason, Berkshire has, for many decades, used book value per share as a proxy for intrinsic value per share. This may have been a reasonable proxy, especially for measuring the change, but as the business focused increasingly on owning entire businesses and not mainly marketable securities, book value per share began to dramatically understate intrinsic value. For this reason, a couple of years ago, Berkshire added market value per share as an additional measure in the letter and, to keep things honest, kept a comparison with changes in the S&P 500 Index. Berkshire had an excellent year on both book and market value per share — 23.0% and 20.9%, respectively. However, the S&P had an excellent year too, at 21.8%, so Berkshire’s performance was no more than in line with the market.
Buffett candidly explains that of the $65.3 billion increase in book value per share, $29 billion was a result of the tax bill passed by Congress in December, which has the effect of lowering the rate at which Berkshire’s capital gains will be taxed.
Several times, Mr. Buffett laments the paucity of attractive acquisition targets and the consequent significant cash and short-term treasury holdings of Berkshire ($116 billion, up from $86 billion in 2016), on which it earns “only a pittance”. Simply put, prices for “decent” businesses “hit an all-time high” as “price seemed almost irrelevant to an army of optimistic purchasers”. And, in addition, “the ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity”. We have been here before, with Buffett bemoaning the absence of bargains, but recall how the strategy also plays out, with Berkshire going on a spending spree during the financial crises as their cash riches in a buyers’ market enabled them not only to make acquisitions, but also to make extremely profitable investments in the preferred stock of Goldman Sachs, Dow Chemical and others.
One of Mr. Buffett’s favorite subjects is why insurance is such an amazing business because it generates “float”. He never lets an annual letter go by without explaining how Berkshire is built on this phenomenon and boasting about how “extraordinary” Berkshire’s growth in float is — to $114.5 billion at year-end. This is despite relegating much of the usual discussion of the insurance businesses to the disclosures in the annual report and 10-K. Mr. Buffett notes that the generation of float is particularly fertile in long-tail lines of insurance business, such as for losses caused by asbestos exposure, and that by specializing in “jumbo reinsurance policies”, Berkshire has become by far the largest property and casualty insurance company, when measured by float. The biggest recent driver of float was the “huge deal” with AIG in 2017, the largest insurance transaction in history.
Nevertheless, Berkshire’s insurance operations actually made an underwriting loss in 2017, the first in 15 years, an extraordinary accomplishment. The P&C industry as a whole frequently makes underwriting losses, though they generally report an overall profit after taking account of investment earnings. Berkshire has been a major player in underwriting insurance for catastrophic events, such as hurricanes, but after a catastrophe-light period in recent years, three significant hurricanes hit the U.S. last September. Berkshire’s current estimates of its losses from those events is approximately $3 billion, enough to drive an underwriting loss — but still an easy loss to handle in the context of Berkshire’s overall financial position.
Berkshire’s stated goal is to substantially increase the earnings from its non-insurance group. That will require Berkshire to make “one or more huge acquisitions” — and if successful, Mr. Buffett informs us: “Our smiles will broaden”!
I look forward to the publication of National Indemnity’s Statutory Annual Report and will dig into the details of their retroactive reinsurance deals in a future blog.
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Jonathan Terrell is the Founder and President of KCIC. He has more than 30 years of international financial services experience with a multi-disciplinary background in accounting, finance and insurance. Prior to founding KCIC in 2002, he worked at Zurich Financial Services, JP Morgan, and PriceWaterhouseCoopers.Learn More About Jonathan