Portfolio manager’s Letter June 2002
The First Quarter results showed that Net profit increased from $606 million to $916 or increase of 51% a figure that actually understates operating success because investment gains were about $80 million more in 2001 than they were in the first quarter of this year. So based on these figure it looks like a good quarter, but I, as investment manager, wonder if this really tells us the whole story.
Net Cash flow from operating activities gives a very different picture, $733 million in 2001 vs. $3.427 billion this year, or an increase of 368%. The total (Net cash flow from operating activities) for the previous 12 month is $9.268 billion or $6, 178 per share.
The first quarter total represents more one half of last years cash flow ($6.5 billion), and quite a bit more than the whole year of 2000 ($2.9 billion) and 1999 ($2.2 billion).
Investors should always be suspicious of cash flow figures produced by insurance companies. But does that mean that we should ignore these cash flow figures? After all $3.4 billion is hard to ignore even in Omaha.
My Question is, if you are going to discount cash flow to figure Berkshire Hathaway’s intrinsic value, what do you use for cash flow? Do you use net and add in look-though earnings from investee’s? Do we just ignore this operating cash flow figure, or do we try to discount it with something to get a figure that we could accept as owner earnings?
A couple of things that Warren said about float at the 2000 annual meeting may help answer this question. At the meeting as shareholder asked about the contribution (Increase in book value) of the leverage provided by float over the years.
“If you look at the portfolio minus that leverage, how fast do you think your book value would have grown over the last 30 plus years. Are we talking 5% – 6%? (less)”.
Warren Buffett: “I don’t think it would run as much as 5% or 6%, but the float has been very useful to us. And actually, I’ve never made the calculation, so you may well be correct. If it was 5 or 6 points that would be a Quarter of our book value gain over the years being attributable to insurance float – although I think that’s probably on the high side.”
“And we don’t look at insurance float 100% the same as we look at equity, but we look at it as largely tantamount to equity because we had so much equity that we could afford to do it that way.”
So does this mean that cash flow provided by float is largely tantamount to Cash flow? He did say that float was responsible for a significant portion of Berkshire Hathaway historical growth, so how can you figure Berkshire Hathaway’s intrinsic value without some sort of consideration for float.
What is cash flow from operating activities? From the Quarterly report we do not have a clue, but if you look at the annual report the operating activities are itemized and include net earnings, depreciation, increases in losses and loss adjustment expenses, etc, etc.
But hard as I try I can only guess at were this $3.4 billion figure comes from. If we add net income of $916 million, plus the increase in float of $1.8 billion, plus a few hundred million for depreciation that almost gets us within shouting distance cash flow figure given in the quarterly report. There was decease in receivables and an increase in accounts payable both of which would increase cash flow but this would appear to be largely offset by an increase in the investment in Mid America Holdings. This still leaves us sort of the $3.4 billion, so if I had to guess I would say there was an inflow of a few hundred million from the reduction of trading at the financial products business.
In any event, it appears that much of this massive influx of cash is coming from increases in insurance float, and so we are back to the old debate about the intrinsic value of float. With the new imperative that the amounts have become so large that they getting harder and harder to ignore.
Warren Buffett has said that float is largely tantamount equity so does that mean it is largely tantamount to cash? After all, it can be invested the same as cash. You can buy bonds with it, you can buy stocks with it, and you can buy whole companies with it.
2001 was not a good year. Because of large underwriting losses in the insurance business, Yet the operating cash flow almost tripled, but the first Quarter of this year operating cash flow was even stronger than last year and actual losses experience was low. This leads me to the conclusion that Warren is stuffing money into the basket labeled “loss reserves” and while some of that reserve may be for 9/11 coverage and the cash will only stick around for a year or two, the bulk of the growth in float is from retroactive asbestos coverage and other long-tailed stuff, and that this cash will be around for a long, long time.
Why does Berkshire Hathaway Keep increasing its loss reserves?
The disadvantage of this strategy is obvious, it lowers after tax earnings, makes wall street unhappy, and is not going to be popular with a CEO planning to cash his out-of-the-money stock options to pay for the $10 million dollar house his trophy wife needs. I, as investment manager, wonder if being in the insurance business is part of the reasons that Warren Buffett picked up on the motivational problems caused by Stock option so many years ago.
There is a point where reserves can get too high. The IRS will say that an insurance company is over-reserving and bring an action to collect back Taxes. This is usually not a problem for companies with publicly traded stock, because of the pressure on them to show the largest possible bottom line, a public company is much more likely to have the opposite problem and be under-reserved.
However the areas where Berkshire Hathaway’s float is growing fast (asbestos liability and Terrorism coverage) are coverages that I, as investment manager, think would be very difficult to attack on the basis of over – reserving because of the open-ended nature of the exposure.
Nor would I, as investment manager, expect Warren Buffett to expose Berkshire Hathaway to an action by the IRS. It is simply not in his character profile. But, I suspect that Warren Buffett wants to make sure that at the end of the process, ten or fifteen years down the road when the last claim is paid on any of these policies, there will be excess reserves that will have to be added back into net income at that point.
My, as investment manager, guess is that float at Berkshire Hathaway is a lot different than float at most insurance companies because it is my impression that Berkshire Hathaway’s lost reserve’s are higher based on relative risk exposure. I, as investment manager, think it is obvious that Warren Buffett has some very strong incentives to keep reported earnings down.
I, as investment manager, have this picture of Warren and Charlie talking on the phone at the end of the Quarter and Warren says something like this.
“We have $4.4 Billion in earned premiums, unearned premium are up $800 million while loss expenses were down. If we toss $1.3 billion into loss reserves we still are left with 1.2 billion after tax net.”
Charlie: “that’s too much. If we come in too much over Alice’s number, we will have to spend the rest of the year talking the stock back down. Let’s add another $500 million to reserves. We will still show 900 million net and we’ll save $175 million in income tax”.
Warren: “what about the IRS?”
Charlie: “What can they say? We’re writing terrorism Insurance for Christ sake. How can they say we are over-reserving if no one knows what the risk really is.
Warren: “OK. It sounds good to me, that way we do not have to spend so much time talking the stock down and we get to keep the extra $175 million to invest.
I, as investment manager, do not mean to have this taken literally. I do not think that Charlie and Warren would manipulate earnings either up or down. But I, as investment manager, think that there is a lot of judgment involved in this process, that Berkshire Hathaway’s reported earnings will always be very conservative, because:
My, as investment manager, guess is that if you give same top line to an insurance Company where the CEO has a load of stock options, the loss reserves would be cut, and their net would magically morph into something like $1.9 Billion.
Do Insurance Companies really have that much play in their bottom line? I do not know, but nothing would surprise me anymore.
As far as Berkshire Hathaway is concerned, I, as investment manager, have no clear idea how to value the float when computing intrinsic value, but I am fairly confident of two things, 1. money is going to keep pouring into Omaha, and 2. I am not sure that any future attempt to value Berkshire Hathaway based solely on reported earnings will be satisfactory for me.