Buffett Shares Good News, Not Bad

Here are a few thoughts I have on Warren Buffett's 2004 Annual Letter:

1) On page 5, he mentions HomeServices of America, which is the second-largest real estate broker in the U.S., which Berkshire owns through its stake in MidAmerican Energy. What is less known is, this is beginning to involve Berkshire in the mortgage and title insurance businesses as well. Their agents are incented to capture more of the total value of a real estate transaction. Given their aggressive growth, both organically and through acquisition, it will not surprise me to find that they are the biggest when 2005 rolls around.

2) On page 6, Buffett describes how he runs his general insurance businesses. He is one of the industry's rational players who is willing to reduce exposure and even exit lines of business in which he can't make a reasonable profit. This is my philosophy of what makes a good insurance company as well. The last three years have been fat ones in the P&C insurance sector. 2005 will not be as kind, so Berkshire will not make so much there next year, but will avoid the hits that more aggressive companies will take later.

3) Berkshire also doesn't cut employees when business conditions don't warrant the writing of business, as most other insurers do (page 8). (I know of only two others, PartnerRe (PRE - commentary - Cramer's Take) and Montpelier Re (MRH - commentary - Cramer's Take), that work that way.) Aside from engendering loyalty of employees, it keeps talent in place for when conditions get more favorable. It also avoids empire-building by avoiding writing business just to keep receiving a paycheck, which is endemic in insurance.

4) Personal note: I met Ajit Jain (page 10) at the World Insurance Forum last year. Aside from being a very talented underwriter, he was also generous in spending time talking insurance with a relative nobody like me.

5) On page 11, Buffett states that the profitability of a derivative book is never known until it starts to shrink in size. Growing derivative books can always show profitability through mis-marking positions, if only slightly.

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At time of publication, Merkel or his fund had positions in MRH and PRE, though positions may change at any time.

David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

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Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.