I come not to bury Warren Buffett but to praise him.
In the last week or so, two other financial pundits, Jon Markman on
this site and James B. Stewart in
The Wall Street Journal
, have argued that Buffett has lost it.
Once Buffett was a CEO worth investing beside, Markman wrote, but now he should be stripped of his title as Oracle of Omaha and called the Natterer of Nebraska. Stewart called Buffett's annual letter to
autumnal and added that he couldn't help wondering if Buffett had lost some of his legendary touch.
I'm sure Buffett has been called things far worse than "natterer" in his long career. And he really doesn't need any defense from me. The columns, however, do deserve a rejoinder, because I think both articles are so profoundly beside the point that they might cost investors a few bucks or more.
Deciding whether Buffett is the greatest living investor may be an interesting parlor game, but it has nothing to do with whether or not you should own Berkshire Hathaway stock right now.
As always with a stock, it's not how the stock has done in the past that counts, but how it's likely to perform in the future. Yes, Berkshire Hathaway's performance in 2004 (a 4.3% return) and 2005 (flat for the year) was pretty lame. But I think you want to own Berkshire Hathaway now, precisely because 2004 and 2005 have positioned the shares very nicely for solid profits in 2006.
One of the first things you learn in financial pundit correspondence courses is that the stock market will do everything it can to embarrass and humiliate you. So I wasn't surprised to see Wall Street upgrade shares of
just as Stewart's piece citing Buffett's purchase of the shares as an example of his fading prowess as a stock-picker came out.
even called the stock a buy and put a $49 price target on the shares -- a potential 13% gain.
And for the record, I touted Buffett's bet against the U.S. dollar as one of the reasons to own the stock, calling it a hedge fund for the masses. Berkshire Hathaway has lost enough money on that bet for me to wish that Buffett either hadn't made it or that he'd gotten the timing right.
Berkshire as Cash Machine
But one of the advantages of holding a stock for a while -- and I've owned Berkshire Hathaway in my personal portfolio since June 2003 -- is that you come to appreciate qualities that escaped you on first acquaintance. In this case, owning Berkshire Hathaway has given me a deep appreciation for exactly what an amazing cash-flow machine an insurance company can be.
Insurance companies take in money in premiums from customers long before they have to pay it out in claims. They invest this float in stocks, bonds, real estate, pieces of other companies or whole companies and reap the returns until this money has to be paid out to customers who file claims. Thus an insurance company has two ways to make money:
First, there's underwriting profit if the company succeeds in writing policies at a high enough premium that, when claims on those policies are paid out, there's something left over. (The industry uses something called the combined ratio as a measure of this underwriting profit. A combined ratio of 90%, for example, means that the company has paid out in claims just 90% of what it collected in premiums. It has earned 10 cents in profit on every dollar of premium collected.)
Second, there's investment income. The company invests the float in some mixture of assets, looking for the highest return commensurate with the need to avoid losses that would endanger the company's ability to pay out claims. The insurance company also wants to build up its financial strength, as assessed by agencies, such as A.M. Best, that rate insurance companies. Many customers buy insurance on the basis of a company's financial strength.
The best of all worlds is when a company is so experienced at pricing that it can earn a profit on the premiums it collects on the policies it writes, and so deft at investing that it earns a high rate of return on the float. Oh, and so financially strong that even if it gets something really wrong or if chance goes against it the company will be able to pay out claims without destroying its profitability.
Stormy Weather for Reinsurers
From that point of view, 2005 was something of a test for Berkshire Hathaway. The company's General Re and National Indemnity reinsurance units took a huge hit from the combination of hurricanes Katrina, Rita and Wilma, losing $3.4 billion from the storms. Reinsurers buy risk by, in effect, insuring the ability of other insurance companies to pay claims in case of a catastrophic event.
But thanks to Berkshire Hathaway's low-cost auto-insurance business, Geico, the company's insurance business as a whole showed a slim underwriting profit for the year of $53 million.
That underwriting profit meant that in 2005, again, Berkshire Hathaway didn't pay a cent to use the capital that makes up its float. And since Berkshire Hathaway's float amounts to some $49 billion, that's a huge cost advantage in the investment business. While banks have to pay interest to depositors, and hedge funds have to share profits with their investors, Berkshire Hathaway can invest a no-cost $49 billion.
Battening Down, Raising Premiums
Neither Warren Buffett nor anyone else can predict how the 2006 hurricane season will shape up, though some readers have written me noting that water temperatures in the Gulf of Mexico are already higher than normal for this time of year, which is often a sign of a strong hurricane season to come.
But after a disaster, a prudent insurance company always raises premiums and may indeed cut back on the risks it takes. And that, Buffett says, is exactly how General Re is approaching 2006.
Here's what Buffett had to say in his annual letter to Berkshire Hathaway shareholders:
It's an open question whether atmospheric, oceanic or other causal factors have dramatically changed the frequency or intensity of hurricanes. Recent experience is worrisome. We know, for instance, that in the 100 years before 2004, about 59 hurricanes of Category 3 strength, or greater, hit the Southeastern and Gulf Coast states, and that only three of these were Category 5s. We further know that in 2004 there were three Category 3 storms that hammered those areas and that these were followed by four more in 2005, one of them, Katrina, the most destructive hurricane in industry history. Moreover, there were three Category 5s near the coast last year that fortunately weakened before landfall. Was this onslaught of more frequent and more intense storms merely an anomaly? Or was it caused by changes in climate, water temperature or other variables we don't fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina?
Buffett doesn't claim to have the answers. But he does know what the prudent insurance company should do about the possibility of increased losses: raise premiums. "We've concluded," Buffett reports, "that we should now write policies only at prices far higher than prevailed last year."
So even if the 2006 hurricane season is as bad as that of 2005, General Re will have gone into it writing insurance with higher premiums and, probably as a consequence, writing fewer policies. Higher prices and less risk. That's a solid improvement for 2006.
Dogged by Derivatives
But the big storm losses in reinsurance weren't the only problems that General Re caused for Berkshire Hathaway in 2005. Quite frankly, it looks like someone slipped up when Berkshire Hathaway bought General Re in 1998. Not only did the company drag Buffett into the investigation about accounting fraud at
American International Group
, General Re also brought along a huge book of derivative contracts that Buffett has belatedly moved to sell and shut down.
When Berkshire Hathaway bought General Re, the company had a book of 23,218 derivative contracts. A derivative in this case is a contract between two parties in which one sells risk and the other buys it for a price. The terms of how and when that risk will be transferred are extremely specific and highly variable, ranging from moves in interest rates and currencies to changes in the value or yield of specific securities. Time periods can also vary: One in the General Re book, Buffett notes, was set to run for 100 years.
The problem with derivatives of such widely varying terms and durations is that there isn't a liquid market for many derivatives. That makes them hard to trade and hard to price. Exactly how hard to trade is something Berkshire Hathaway discovered when it began to shut down General Re's derivatives book. Selling the first 20,000 contracts produced a $300 million loss. Selling the next 2,150 cost the company a loss of $104 million. At the beginning of 2006, only 741 contracts remained for disposal.
Count it up: Over the last two years, shutting down the derivatives book cost Berkshire Hathaway and its shareholders $404 million in charges that went straight to the bottom line. It's not possible at this point to know what disposing of the last 741 contracts will cost the company. Investors, however, should be glad that they are within sight of the end of these charges.
Major Utility Acquisition
But there's one more development that may turn out to be even more important. In 2005, Berkshire Hathaway made the kind of big acquisition that investors have been clamoring for since, well, since the General Re deal in 1998. Berkshire Hathaway, through its 81% ownership of MidAmerican Energy Holdings, moved to acquire PacifiCorp, a utility with 1.6 million customers in six western states. (You can still own preferred stock in the company; it trades as
The deal, which closed on March 21, puts Berkshire Hathaway in the forefront of a consolidation of the electric utility grid at a time when the national grid is looking for a huge inflow of capital to increase capacity and reliability. (The repeal of the Public Utility Holding Company Act on Aug. 8, 2005, marked the end of a major barrier to this consolidation.)
In the utility sector, Berkshire Hathaway has found the kind of large-scale investment opportunity that a company with a $49 billion float requires.
So, add it up for 2006:
Higher premiums and lower risk.
The coming end of charges from shutting down the derivatives book at General Re.
And a major investment opportunity in the utility sector.
Those are all important positive changes for Berkshire Hathaway as the stock heads deeper into 2006.
And these three changes -- not the state of Buffett's prowess as a stock picker -- are why I continue to hold the stock and just increased my target price on the B shares to $3,440 by September 2006.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: AIG-American International Group and Berkshire Hathaway. He does not own short positions in any stock mentioned in this column.
At the time of publication, Jubak did not own or control any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.