Investment Manager’s Letter April 2006
Japanese Real Estate
The March 27 issue of The Nikkei Weekly contains a page one story about of the aftermath of the great Japanese real estate bubble. The good news is that real estate is finally bottoming out, not only in central Tokyo, but also in several other major urban areas in Japan. Commercial land prices in 2005 in the greater Tokyo, Osaka, and Nagoya areas increased for the first time in 15 years, according to statistics released by the government last week.
The bad news is that elsewhere in the country land prices fell an average 2.8%, and this was the 15th straight year of decline. Land prices in depopulated regional areas, including Aomori and Yamagata prefectures continued to decline. Commercial land prices over all of Japan dipped 2.7%, and residential land prices slid by the same percentage. Since their peak in 1991, residential land prices have fallen about 47% and are currently at the pre-bubble level of 1986. Commercial land prices have plummeted about 70% in the same time span and are now at the same level they were in 1974.
If this is not scary enough, this deflation has occurred during a period of very easy money. Since 2000, long-term interest rates in Japan have been at or near zero. Then in March 2001 the Bank of Japan began a process of “Quantitative Easing,” a process that appears to be the Japanese equivalent of helicopter money, and it still took five years for real estate to lift its head up out of the toilet.
On the question of, can this happen here, I, as investment manager, would like to think not. Our central bank has consistently shown more fiscal restraint than the Bank of Japan, and that could save us from a Japanese style fifteen year real estate bear market. But lately I, as investment manager, have become less sanguine in this view. As it becomes more obvious that our real estate bubble has been lately financed from sources outside the United States, I, as investment manager, am beginning to wonder whether restraint by the FED is still all that relevant.
I, as investment manager, think it likely that first quarter earnings at Berkshire Hathaway will surprise many. I, as investment manager, have tried to estimate Berkshire Hathaway’s quarterly results in the past and have not been particularly successful. But not being one to let past failures hinder my attempts to predict, I thought I’d take a whack at Berkshire Hathaway’s first Quarter.
Hidden in last month’s release of Berkshire Hathaway’s earnings 2005 was the fact that the fourth quarter of 2005 was very strong. Since Berkshire Hathaway does not choose to break out fourth quarter results, I, as investment manager, will start by doing this for them (by subtracting the nine month totals for operating earnings from those for the full year). This yields the following figures.
Underwriting Gain = $780 million.
Investment Income = $1,035 million.
Operating Businesses = $1,064 million (including MidAmerica).
Total 4th Quarter 2005 Operating Earnings = $2,879 million.
This was indeed a pretty good quarter, and if it had not been for Wilma it would have been even better. Wilma caused our hurricane bill to increase by $400 million. Without Wilma, Berkshire Hathaway would have had an underwriting gain of $1.180 billion in fourth quarter. For a comparison, let’s look at the first quarter of last year.
Underwriting Gain = $492 million.
Investment Income = $787 million.
Operating Businesses = $861 million (including MidAmerica).
Total first Quarter 2005 Operating Earnings = $2,140 million.
Most people did not understand that the fourth quarter was that strong. The gain from the first to the fourth quarter was 35%. With an underwriting gain of $780 million, it is not just GEICO that can produce great underwriting results. From the annual report:
“We’ve concluded that we should now write mega-cat policies only at prices far higher than prevailed last year — and then only with an aggregate exposure that would not cause us distress if shifts in some important variable produce far more costly storms in the near future. To a lesser degree, we felt this way after 200 4 — and cut back our writings when prices didn’t move. Now our caution has intensified. If prices seem appropriate, however, we continue to have both the ability and the appetite to be the largest writer of mega-cat coverage in the world.”
Warren Buffett says he wants “much higher prices” than last year. Perhaps the 4th quarter underwriting gain is early testimony to Berkshire Hathaway’s progress in this direction. A recent story in the Orlando Sentinel noted that four more insurance companies filed for rate increases over the weekend. The increases requested ranged from 22% to 81%. As justification for the request one company spokesman said:
“The reinsurance market is in a panic because of the storms of the last couple of years,” said Mel Russell, senior vice president for underwriting, marketing and product development for United Property.
Russell said his company was told to expect to pay at least 40 percent more for reinsurance, once United Property finalizes its contracts in June. And those costs will be passed down to customers.
“The market is very volatile right now”, Russell said. “… ultimately it’s going to hit everybody right in the pocketbook, because it’s starting from the top down.”
For the first quarter of this year we can start were we left off above. The first quarter was Hurricane free, but underwriting results in the first quarter are always a good deal less than the fourth quarter of the previous year. Even so, they could be up as much as 40% from the first quarter of 2005. We will estimate underwriting profit at $700 billion, maybe more as premium increases start to kick in. Since investment income has been steadily increasing about $100 million a quarter because of the upward move in interest rates, we can estimate the first quarter as follows:
Underwriting Gain = $700 million.
Investment income = $1,135 million.
Operating Businesses = $1,100 million.
Estimated Total Operating Earnings first Quarter 2006 = $2,935.
This would be an increase of 38% from last year, but seems to me a reasonable guess. At 35%, taxes would take about $1,027 million and that would leave $1,908 after tax, plus whatever investment gains there are. For this, I, as investment manager, have no guess except that we know that Berkshire Hathaway sold $265 of Ameriprise in March.
March closed with the dollar down about 1% for the quarter against the major currencies, so Berkshire Hathaway likely had a gain (probably $100 million plus) on this FOREX bet versus a $307 million dollar loss in last year’s first quarter. With investment gains added in, net income could conceivably double over last year’s figure of $1.363 billion, which I will classify as a good quarter. And who knows, it might even be enough to keep the stock over $90,000.
As the market moves higher, we have lightened up some of our short positions. We still remained hedged, but the addition of some small long positions works to make the hedge a little more bullish. We still feel the long term trend is bearish, but it looks now that the current cyclical up trend may last a while longer.