giofranchi

March 2014 Commentary Gio Mar_2014_Commentary_FINAL.pdf

Not easy, if you are not an insider… Though, the simple fact of pushing profitability at Cathedral towards the levels achieved at Lancashire might add as much as $40 million after-tax… Not bad! And this has nothing to do with the advantages the Lloyd’s market might bring to Lancashire. ;) Gio

Hi MM, 1) Take a look at Cathedral website: http://www.cathedralcapital.com/ They run Syndicate 2010 and Syndicate 3010 at Lloyd’s. 2) Kinesis is their new vehicle for managing third party capital. Essentially, they write insurance contracts backed by third party capital, and share the profits with their clients. 3) They mostly write short tails and don’t need to accumulate much float, because the great majority of their earnings come from underwriting. On the other hand, like twacowfca has often explained, they must always keep great liquidity to avoid regulation restrictions and to be able to write business quickly and opportunistically when the right opportunities come. Gio

I think we already have plenty of data that confirm this business is superbly run. I never wait for catalyst. I buy a business I like if the price is right. I buy more if the price goes down. Gio

+1 :) Gio

I think 2 were the major catalysts: 1) The acquisition of Cathedral. Mr. Market thesis: Mr. Brindle is an outstanding underwriter, but has no track record in acquiring companies. He has paid 2xBV for Cathedral in a transaction worth $425 million, almost a third of LRE market cap: he has overpaid and diluted shareholders. My thesis: Mr. Brindle has stayed very much inside his circle of competence. Probably few people know Cathedral as well as he does. He has paid $425 million for a company that had earnings last year of approximately $50 million, and which could earn as much as $90 million, if its underwriting reaches the profitability levels of Lancashire. Mr. Brindle has bought external growth cheaply. 2) Lancashire disappointed the market declaring a lower special dividend than was expected. Mr. Market thesis: I want a special dividend in line with last year! My thesis: nonsense! Overall, Mr. Market is thinking LRE is embarking in a new and unproven business strategy. Vice versa, I believe LRE is going to be as good and reliable a capital allocator as it has been in the past, and its business strategy has not really changed: if anything, the acquisition of Cathedral only serves to make that business strategy safer and more predictable for a long time to come. Basically what Gary has just said. :) Gio

Actually, in my comparison with BRK’s operating businesses I have made a mistake: LRE in 2013 paid out 88% of its comprehensive income to shareholders, and since inception it has paid out as much as 93% of its earnings. Therefore, it reinvested for growth only 7% - 12%. And let’s suppose in an hard market it could reinvest as much as 15%. Over a long period of time, through different insurance markets, I guess LRE should be able to reinvest 10% - 12% of its earnings for growth. That’s to say: LRE: - 13% owner earnings yield (9.5% if bought at 2xBV); - 88% - 90% free cash distributed in a very tax efficient way, that can be redeployed for growth somewhere else, 10% - 12% retained earnings to make LRE grow. BRK’s operating businesses: - 8.8% owner earnings yield; - 60% free cash that can be redeployed for growth somewhere else, 20% retained earnings to make them grow. I might be wrong, but it still seems to me LRE compares favorably with a collection of businesses put together by the smartest investor in the world. :) Gio

Gary, here are a few lines from the Seeking Alpha article I posted some days ago: Though Mr. Brindle doesn’t own a large part of LRE, what matters most imo is that a lot of Mr. Brindle’s personal wealth is at stake in the company. :) Gio

I think this is a bit too simplistic. Please, read how I compared LRE to BRK’s operating business taken as a whole entity. If I am right, bought at 2xBV LRE still compares favorably. :) Gio

I need to see what I call “an entrepreneurial force” before investing. And I don’t see such a thing at the head of any mega bank around the world. Therefore, I missed the bank stocks rally. I don’t mind. Just like Mr. Buffett doesn’t mind having missed Apple or Google. Instead, I focused on improving the performance of my operating businesses, and juicing their results a bit with some stock market returns. It has worked quite well until now. And I think it is a strategy that will lead to further gains in my firm’s BV, at least until stock market prices become reasonable again. :) Gio

You know what they say: “a recession doesn’t destroy capital, it merely reveals the extent to which it had already been destroyed during the previous boom years”… or something like that… I think Mr. Watsa in 2000 started to get worried about both the level of indebtedness and the level of the stock market in developed economies. And I think he knew the process to decrease both indebtedness and stock market prices is a slow and tortuous one. A process that would probably take the best part of two decades! And he decided he would heavily expose FFH to the stock market only in those instances when stock market prices were at or below intrinsic value: 2003 and 2009. The rest of the time he decided to stay hedged. Therefore, no, he certainly wasn’t worried about how people were behaving in 2011… He still was worried about how people behaved in the ‘80s and the ‘90s, and how they behaved from 2003 to 2007. I guess he is worried now about how people have behaved in 2012 and 2013… It is really a two decades picture… And I guess you simply cannot judge it referring to any given year. This being said, I also would have liked that his caution about debt levels and the stock market level would have translated into more action in purchasing whole high quality businesses a la Mr. Buffett… Actually, they have been very opportunistic in buying insurance companies around the world, companies that imo will prove to be great platforms for future growth! Yet, there is no point in denying the fact they might have been much more aggressive (like Al has often said!). I think it simply is not in their DNA yet… But they are working on it… And I think they will get there sooner or later (let’s hope sooner rather than later). In the meantime they have worked hard on improving their underwriting performance, something that imo will lead to interesting financial results in the not too distant future. ;) Gio

Actually, if you go back a few pages on this thread, twacowfca mentioned that he proposed such an acquisition to Mr. Watsa. Mr. Watsa, though, didn’t seem interested. Maybe now things would be different. :) Gio

+1 And, Vinod, I am very pleased we are partners in this one! :) Cheers, Gio

Well, I just don’t see how the answer to your question could be anything but a resounding YES! After all, Mr. Buffett praises Mr. Ajit's achievements at least as much as he praises GEICO structural advantages, doesn’t he? “If you see Ajit at our AM, bow to him deeply!” ;) Gio

The point you mentioned above, is really the key difference between bulls and bears at this time. Almost all who are bearish at this time, Klarman, Rodriguez, Watsa, Hussman, Grant, Grantham, etc bring some version of morality/justice into their equation. For all of them it boils down to justice not being done, for the sinners (who participated in the bubble) got bailed out, the profilgate debtors who got their burden reduced by low interest rates, the prudent savers who are getting punished, the unemployed who did not benefit from fed policies while the rich investors who have stock holdings have gained massively. It does not seem fair. Watsa codes it as "7 lean years and 7 fat years", others are more direct but morality is a common ground for all these investors. Hussman in particular seems to have expected some version of great depression to play out and was caught by surprise when the historical script did not play out. I did incline towards moralists for a long time, but I am coming to the conclusion that while Market serves lots of purposes, enforcing morality is not one of them. It is interesting that the most hyper rational investor of all, Buffett, does not ever mention any of these. Vinod Vinod, Among the list of bears you forgot to mention Mr. Soros… If we are talking about market timing, Mr. Soros’ point of view is not one you want to dismiss…!! Besides, even Mr. Buffett has allocated 76% of BRK’s assets in ways that are much insulated from what the stock market will do in the future… I think I have shown this in the LRE thread. Like they say: pay attention to what they are doing, not to what they are saying! ;) Morality/justice have nothing to do with this. Prices are information. When prices get too much distorted and out of whack with values, people get false information. When people get false information, they do dumb things. When people do dumb things, few other people, those who are great judgers of values, get worried. Imo there is nothing wrong about getting worried. It all depends on how you decide to act on your worries: Mr. Buffett, for instance, decides to concentrate on building earning power for BRK, instead of investing in the stock market; Mr. Klarman decides to give back capital to his investors; Mr. Watsa decides to hedge 100% FFH’s exposure to the stock market… Given the results of the last three years, I might agree with you Mr. Buffett and Mr. Klarman chose the wisest courses of action. ;) Gio

--A Memorial of John Pierpont Morgan, Sr. Gio

Yes! I agree… Actually, I was wondering: Mr. Brindle has stated “pay us 2xBV and let us do our job”… Given the above comparison with BRK’s operating businesses, even at 2xBV LRE would compare favorably… And Mr. Buffett would bring into the Berkshire family another insurance wizard at least as capable as Mr. Ajit… What is Mr. Buffett waiting for before making an offer?! ;) Gio

Mr. Brindle is still very young. If he doesn’t suffer from bad health, and let’s hope he never will, he might stay at the helm for 20+ years! :) Gio

Thank you, twacowfca! :) In 2013 return on tangible equity for BRK was very much aided by investment results: Net earnings were $19.5 billion, while Comprehensive income attributable to BRK shareholders was $36 billion. My idea, of course, was not to compare LRE with BRK, but to compare LRE with BRK’s operating businesses, taken as a whole entity. For all Mr. Buffett’s talk about “how wonderful a place to be” the stock market is right now, it seems to me BRK is investing less and less in the stock market… My dissection of its total assets wasn’t exactly right, because I haven’t considered the component of cash + bonds. In fact, BRK’s total assets at 2013 year end were allocated this way: Operating business: $294 billion Cash: $48 billion Bonds: $28 billion Stock market investments: $115 billion Therefore, it seems to me that only $115 / $485 = 24% of BRK’s total assets are directly linked to the vicissitudes of the stock market. If I can put 30% of my firm’s equity in something as insulated from the stock market as LRE, I would gladly do so. Thinking that BRK has as much as 76% of its assets allocated that way! Of course, I probably won’t invest more than 30% of my firm’s equity in LRE, because of concentration risk. I have referred to BRK’s operating businesses as “taken as a whole entity”, but obviously a whole entity they are not! Instead, BRK is very much diversified. For reference only, its two largest operating businesses are BNSF and MidAmerican: at the end of 2013 BNSF had $60 billion of identifiable assets plus $15 billion of goodwill, or total assets worth $75 billion; MidAmerican had $62 billion of identifiable assets plus $8 billion of goodwill, or total assets worth $70 billion. BNSF was 15.5% of BRK’s total assets and 33.8% of BRK’s equity; MidAmerican was 14.4% of BRK’s total assets and 31.5% of BRK’s equity. Gio

That is an excellent read - thanks for posting. I agree: a good read. Though, I would say the author focused very much on what went wrong in the last 3 years, and not nearly as much on what went right... Of course, what went right has yet to produce gains and significant financial results, which imo will materialize in the future. Therefore what went wrong I think is much easier to see than what went right. Gio

;D ;D My pleasure! Gio

-Nobel laureate, and behavioral investing pioneer, Daniel Kahneman 50 REASONS WE’RE LIVING THROUGH THE GREATEST PERIOD IN WORLD HISTORY Gio EVA+3.21..2014_NA.pdf

On the other hand, is being 'relatively cheap' compared to the market a reason to buy a stock? Not at all. If you can find another great company with past and prospective 19% ROE and current owner's earnings yield of about 10% and prospective, normalized owner's earnings yield at the current price of about 13%, let me know. Perhaps that should be at the head of the value list. Lancashire looks like a good value to me regardless of relative valuation. But other stocks may do better in the current market. Here is my perspective on LRE: Berkshire capital structure is probably the best in the world. I guess we all agree on this, don’t we? Well, at the end of 2013, BRK had Total Assets worth $485 billion. And, if we split them into Investments and Operating Businesses, we get what follows: Investments: $170 billion Operating Businesses (Insurance Group, BNSF, Finance and financial products, Marmon, McLane Company, MidAmerican, Other businesses, see page 66 2013AR): $315 billion 65% of BRK Total Assets were Operating Businesses. Now, let’s compare what those Operating Businesses do for BRK, and what LRE might do for you: In 2013 Cash From Operations at BRK was $27.7 billion, while Capital Expenditures were $11.1 billion. Depreciation was $5.4 billion. Therefore, we might say the Maintenance Capex were $5.4 billion, while Growth Capex were $11.1 – $5.4 = $5.7 billion. Operating Businesses yielded $27.7 / $315 = 8.8%, of which $5.4 / $27.7 = 19.5% were necessarily reinvested in those Operating Businesses (Maintenance Capex), $5.7 / $27.7 = 20.5% were reinvested in those Operating Businesses for growth (Growth Capex), and $16.6 / $27.7 = 60% were free cash to be invested elsewhere. What we have in LRE, instead, is something that yields 13%, of which roughly 20%-25% is reinvested in the business for growth, and the remaining 75%-80% is free cash distributed to shareholders, being Maintenance Capex almost non-existent. Given the fact BRK assets are 65% invested in Operating Businesses which, taken as a whole entity, exhibit that kind of performance and return profile, why shouldn’t anyone seriously consider the idea of devoting a large portion of his/her portfolio to something with LRE’s return profile? This being said, we must also be aware of the fact that BRK has leverage to work in its favor: $485 billion in Total Assets are backed by $222 billion of Equity, pushing return on equity much higher than return on assets. Gio

No, this is not right. 19 / 1.5 = 12.5%. This is what you will get, unless there is some growth. The other way returns might increase is reinvesting dividends while the stock price is declining. If you reinvest dividends at 1.3 x BVPS, your annual return will be higher than 12.5%. That’s why I leave room to average down. :) Gio Thank you Gio for that explanation. That is helpful :) But imo it is not the thing that truly matters… What truly matters, instead, is that chances, you will receive on average 12% annual in cash for many years to come, are very high. And that will go a long way to always keep your cash reserve meaningful through thick and thin. And that in the long run is a big advantage and a wonderful thing to have. :) Gio

No, this is not right. 19 / 1.5 = 12.5%. This is what you will get, unless there is some growth. The other way returns might increase is reinvesting dividends while the stock price is declining. If you reinvest dividends at 1.3 x BVPS, your annual return will be higher than 12.5%. That’s why I leave room to average down. :) Gio