giofranchi

I hesitate to suggest an opportune time for purchase of their stock. They have done so well that delay has not often been rewarded. However, there are times when Mr. Market becomes disenchanted with LRE, usually when they have a loss that's out of sequence with most of the industry. Early this year, LRE had a bigger piece of Costa Concordia than their peers. No big deal other than to remind the market that they don't walk on water. However, that was reason enough for Mr Market to waltz with some other pretty faces for a while until LRE regained favor. They are a little idiosyncratic. Their stock rose during the financial meltdown. Last year, they made a decent profit and paid another special dividend when few cat exposed companies had much if any profit. This year they are a little behind their own curve, but catching up. I wouldn't buy their stock unless I had a long term perspective. For what it's worth, they often advance a few weeks before a special dividen, then pull back a little before the dividend goes ex. Then drop as expected on the ex dividend date. Then regain that drop within a few weeks. That's past. Does the future recap the past? Well, as Niels Bohr said, "Prediction is very difficult, especially about the future." :) My last comment brings up an interesting epistimological point that I may illustrate by an anecdote about a scientific paper that I wrote a few years ago. The heart of the study was analysis by my co author of thousands of data points published by US government agencies for the separate US states over several decades. The correlations and confidence levels were very high for some of the time series, but the data was entirely retrospective, prediction looking back in time. Then, seven more years of data became available for the key variable to correlate with another time series that was current. Suddenly, this was now from my point of view a prospective study. I was looking back to the future to see what was going to happen! My palms literally began to sweat as I updated the two time series on the run chart. The more complete time series had reversed its direction. Would the newly available data for the key variable also reverse and follow that lead? My palms began to sweat more. Yes, it did! Suggesting conditional causality. This is why I have rational and emotional confidence at a high level for Lancashire. I got into share ownership in a big way in 2006, on the speculation that Brindle's Lloyd's record would continue to be best of class at Lancashire. This has now been supported by the ongoing prospective point of view since then. I have had a huge and quite unfair advantage over Mr. Market as tempus fugit. It's as if I have been able to roll the the camera into the future and see the weak hands that Mr. Market will be dealt and the strong cards that Lancashire will hold. Never the less, this is still probabalistic. It remains to be seen what the future will hold, although it's nice to be allowed a peak at the hole cards. :) That’s exactly why I think you have developed a “feeling” for Lancashire that goes well beyond all your knowledge about the company. It is a true competitive advantage and a wonderful thing to have! And it is just great that you share it with us! I could read all the documents on Lancashire’s website and still “understand” a fraction of what you understand about the business. As a consequence, my predictions could never, never, never be as accurate as yours. We are not talking about recognizing an undervalued stock here. We are talking about recognizing a wonderful business that could go on delivering great results for many years into the future. The help of a person who followed the entire history of Lancashire so closely is very much appreciated! giofranchi You are very kind. But there is a warning in your compliment. Emotional attachment may become a ball and chain around the neck of an investor if the facts change. However, people with neurological deficits that render them incapable of feeling emotions have a great handicap when reasoning and making practical decisions. With Lancashire, I agree that the emotional satisfaction of seeing my prediction confirmed to date has been a big plus. It's entirely possible that Lancashire's outstanding record in business results could continue for as long as Brindle is at the helm and for many years afterward. Think about Walter Schloss' amazing record for 50 years after Ben Graham retired or Warren's even longer record. Time will tell. ??? I do believe that, as soon as a change happens in Lancashire, you will be among the very first ones to recognize it. Either it might be a change for the better or a change for the worse! Of course, I cannot say how you will take advantage of that early realization. Personally, I have discovered that I do not get emotionally attached to businesses. I do get emotionally attached to the people I live with, but never to the businesses I possess. And even with people I always try to keep in mind that they might be gone tomorrow (such is life, right?). giofranchi

Enjoy! giofranchi

Wonderful letter! Thank you very much, giofranchi

I hesitate to suggest an opportune time for purchase of their stock. They have done so well that delay has not often been rewarded. However, there are times when Mr. Market becomes disenchanted with LRE, usually when they have a loss that's out of sequence with most of the industry. Early this year, LRE had a bigger piece of Costa Concordia than their peers. No big deal other than to remind the market that they don't walk on water. However, that was reason enough for Mr Market to waltz with some other pretty faces for a while until LRE regained favor. They are a little idiosyncratic. Their stock rose during the financial meltdown. Last year, they made a decent profit and paid another special dividend when few cat exposed companies had much if any profit. This year they are a little behind their own curve, but catching up. I wouldn't buy their stock unless I had a long term perspective. For what it's worth, they often advance a few weeks before a special dividen, then pull back a little before the dividend goes ex. Then drop as expected on the ex dividend date. Then regain that drop within a few weeks. That's past. Does the future recap the past? Well, as Niels Bohr said, "Prediction is very difficult, especially about the future." :) My last comment brings up an interesting epistimological point that I may illustrate by an anecdote about a scientific paper that I wrote a few years ago. The heart of the study was analysis by my co author of thousands of data points published by US government agencies for the separate US states over several decades. The correlations and confidence levels were very high for some of the time series, but the data was entirely retrospective, prediction looking back in time. Then, seven more years of data became available for the key variable to correlate with another time series that was current. Suddenly, this was now from my point of view a prospective study. I was looking back to the future to see what was going to happen! My palms literally began to sweat as I updated the two time series on the run chart. The more complete time series had reversed its direction. Would the newly available data for the key variable also reverse and follow that lead? My palms began to sweat more. Yes, it did! Suggesting conditional causality. This is why I have rational and emotional confidence at a high level for Lancashire. I got into share ownership in a big way in 2006, on the speculation that Brindle's Lloyd's record would continue to be best of class at Lancashire. This has now been supported by the ongoing prospective point of view since then. I have had a huge and quite unfair advantage over Mr. Market as tempus fugit. It's as if I have been able to roll the the camera into the future and see the weak hands that Mr. Market will be dealt and the strong cards that Lancashire will hold. Never the less, this is still probabalistic. It remains to be seen what the future will hold, although it's nice to be allowed a peak at the hole cards. :) That’s exactly why I think you have developed a “feeling” for Lancashire that goes well beyond all your knowledge about the company. It is a true competitive advantage and a wonderful thing to have! And it is just great that you share it with us! I could read all the documents on Lancashire’s website and still “understand” a fraction of what you understand about the business. As a consequence, my predictions could never, never, never be as accurate as yours. We are not talking about recognizing an undervalued stock here. We are talking about recognizing a wonderful business that could go on delivering great results for many years into the future. The help of a person who followed the entire history of Lancashire so closely is very much appreciated! giofranchi

I completely agree. And, even if you do have a long term perspective, I would leave ample room to average down. You never know when the next Costa Concordia is going to happen!! ;) giofranchi

Always a good read. giofranchi Q3_2012_Commentary.pdf

I admit I have not read yet the collateral agreement of the loan that BH contracted with Fifth Third Bank. So, mea culpa! Anyway, I don’t understand where the problem is. As long as restaurant operations stay cash flow positive, how Mr. Biglari decides to use the funds he borrowed shouldn’t matter: Cracker Barrel stock price shouldn’t matter. During the 40 weeks ended July 4, 2012, net revenue from restaurant operations was $561,127,000. Total costs and expenses were $531,098,000. Interest on obligations under leases was $7,748,000 and interest expense was $6,200,000. Principal payment on long term debt was $8,379,000 and principal payment on direct financing lease obligations was $4,356,000. So, after paying all BH debt obligations, restaurant operations were still $3,346,000 cash flow positive. I will read the collateral agreement, but I doubt Mr. Biglari is so naïve to be margin called, if he knows he can cover all BH debt obligations solely through the cash provided by restaurant operations. giofranchi

Let’s make a comparison: KFC + TACO BELL + PIZZA HUT vs. STEAK N SHAKE + WESTERN SIZZLIN + CRACKER BARREL. First of all, I like the franchising of fast-food brands business very much: YUM returned 445% since 2001. YUM operates on a global scale and increased EPS 13%-17% each year since 2001. BH won’t be able to achieve such outstanding results. But I like the business anyway. Second: at the end of 2011 YUM had Total Debt of $3.317 billion, Cash of $1.198 billion, and Total Shareholders Equity of $1.823 billion. Net Debt / Total Shareholders Equity = 116%. On July 4, 2012, BH had Total Debt of $104.179 million, Cash of $46.471 million, and Total Shareholders Equity of $332.186 million. Net Debt / Total Shareholders Equity = 17.37%. Also, total debt of BH is decreasing: from $112.558 million on September 28, 2011, to $104.179 on July 4, 2012. Third: of course, we must dig a little bit deeper, to understand if what Mr. Biglari is doing might be judged a sensible thing to do, or if it must be judged a foolish thing to do. During the 40 weeks ended July 4, 2012, BH generated $34.656 million in Cash from operating activities. If we subtract $4.516 million of Capital Expenditures, we get to $30.14 million. Mr. Biglari sold $38.108 million of investments, paid $7.013 million in Changes in due to/from broker, and bought $102.8 million of investment (the entirety of which probably in Cracker Barrel). So, BH generated $30.14 million in free cash, while Mr. Biglari increased investments by $71.705 million: he invested $71.705 - $30.14 = $41.565 million more than BH generated in free cash. But Cash and cash equivalents at the beginning of the 40 weeks period were $98.987 million. So, subtracting other minor changes in Cash (more or less $11 million), BH ended the 40 weeks period with $46.471 million in Cash. So, the question is: is it too little cash? Can this level of Cash be somehow detrimental to Steak n Shake and Western Sizzlin operations? In fact, I myself, before investing, always want to maintain enough Cash to be sure the businesses I control and manage personally will never run into trouble. Once again, let’s make the comparison with YUM: in 2011, YUM had Restaurant Expenses + General & Admistrative Expenses of $10.512 billion with Cash of $1.198 billion. It means that YUM kept enough Cash to cover more or less 1.37 months of cost of operations. Now, during the 40 weeks period BH had Restaurant Expenses + General & Admistrative Expenses of $306.214 million, which, on a 52 weeks basis, become $398.078 million. It means that BH is keeping enough Cash to cover more or less 1.4 months of cost of operations. It looks sensible to me, not reckless. Just a further comparison with MCD: at the end of 2011 Net Debt / Total Shareholders Equity was 70.6%, and it was keeping enough Cash to cover more or less 1.6 months of cost of operations. Fourth: so BH is not “leveraged”, it is just very much “concentrated”. BH right now has just three productive assets: Steak n Shake, Western Sizzlin, and (17% of) Cracker Barrel. Also YUM has just three productive assets, right? I have heard many things about YUM, but never that it is not diversified enough! Many of the businesses we invest in have just one or two significant productive assets (Apple’s iPhone + iPad = 72% of revenue in Q3 2012, and personally I feel I can predict the future of the fast-food industry much better than the future of the iPhone or the iPad!). Fifth: nobody can compel Mr. Biglari to sell shares of Cracker Barrel. On July 4, 2012, BH had $246 million in Investments (the majority of which is Cracker Barrel), and it had $141 million in Paid-in capital + $249 million in Retained earnings + $69 million (at cost) in BH shares held by the consolidated affiliated partnerships. Permanent capital is far greater than Investments and BH can cover interest expenses while staying very well profitable. If you don’t like what BH is becoming, you can sell your shares, and the share price will decline, but you cannot force Mr. Biglari into selling Cracker Barrel shares. To sum up: if you tell me that Mr. Biglari is a crook and cannot be trusted, well then you give me food for thought. If you tell me that BH is a bad business, well then I just don’t agree. giofranchi

biaggio, if I understood you well, you are concerned about future inflation, because inflation can be greatly detrimental to insurance performance. I think the last sentences in the Q3 2012 Hoisington Quarterly Review and Outlook express very well my own view on inflation: “As commodity prices rose initially in all the QE programs, long-term Treasury bond yields also increased. However, those higher yields eventually reversed and generally continued to ratchet downward, reaching near record lows. The current Fed actions may be politically necessary due to numerous demands for them to act to improve the clearly depressed state of economic conditions. However, these policies will prove to be unproductive. Economic fundamentals will not improve until the extreme over-indebtedness of the U.S. economy is addressed, and this is in the realm of fiscal, not monetary policy. It would be more beneficial for the Fed to sit on the sidelines and try to put pressure on the fiscal authorities to take badly needed actions rather than do additional harm. Until the excessive debt issues are addressed, the multi-year trend in inflation, and thus the long Treasury bond yields will remain downward.” I think it is still many years down the road, before we succeed in reducing overall debt to a sustainable level. Furthermore, Mr. Brindle mostly concentrates on the short tail of the insurance and reinsurance markets, so I don’t see how inflation could turn out to be a significant concern. Of course, if he wants to grow Lancashire a little bit faster than he did until now, he might venture into underwriting longer lasting contracts, but he said many times he will consider doing so only if those contracts hold the promise to be solidly profitable. I am sure he will eventually consider the inflation threat very carefully! giofranchi

Cowboy Ethics: I enjoyed it! http://www.viewfromtheblueridge.com/2012/10/19/cowboy-ethics/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+viewfromtheblueridge%2FJkgK+%28The+View+from+the+Blue+Ridge%29 giofranchi

It will take years, before I even approach your knowledge of Lancashire!! ;D I really like it very much! Thank you! "Take care of the downside, and the upside will take care of itself" giofranchi

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it. Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well? I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond. They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend. That's a good point about the influence of the buybacks, but there is a nuance to that. LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end. The point is that those repurchases were not accretive to BV per share when they were made. The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings. In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient. Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks. :) Thanks for that input twacowcfa. Could you shed some light on Lancashire's growth prospects? They grow when they can put capital to productive use without raising their risk profile. Recently, they have been doing this through sidecars which have been discussed on this thread. These give increased upside potential with less downside than if they had taken on increased business entirely on their own in certain high risk, high return lines of business. The sidecars also enable them to offload some of their riskiest exposures. This should help them grow the rest of their business as the remainder should have lower PML's that will help them write more premiums for each dollar of capital. They recently floated $130M in 10 year fixed notes. It will be interesting to see what use they may have for this extra capital. :) Thank you twacowfca, I think that shoeless’s worries about future growth are very well understandable and any insight that could help us answer the crucial question “Are they compounders, or are they not?” is so much welcomed! shoeless (by the way, great nickname! ;)), I tend to believe that Mr. Brindle recognized in the last 6 years they could have compounded shareholders capital just buying back a lot of cheap shares. Too rapid a growth wasn’t necessary to achieve that goal, so he behaved conservatively and settled for low growth. I also tend to believe that in the future he will work hard to replicate past performance: if buying back shares will cease to work as a strategy, he will seek opportunities (e.g. sidecars) to grow a little bit faster. I have said to grow a little bit faster, because actually there has been some growth in the past: in December 2005 surplus capital was $0.947 billion, by June 2012 it has grown to $1.422 billion. That equates to a 6.45% compound annual growth rate. So, as far as I can see, excluding some unforeseeable catastrophic event or Mr. Brindle’s premature departure, three scenarios are possible: 1) You are right, there will be no growth in the future, and an investment in LRE is like a bond that at the current price yields 11%. If you reinvest the coupon in LRE, what you get is an 11% compounder. 2) Mr. Brindle succeeds in growing BV per share 9% each year, like he did in the past, but growing the business a little bit more quickly and buying back less shares. Then, if you reinvest the dividends in LRE, what you get is a 13.5% compounder. 3) Somewhere in between 1 and 2: Mr. Brindle grows the business at 6% each year and buys back less share. If you reinvest the dividends in LRE, you get a 12% compounder. This analysis doesn’t change much my thesis on LRE: what’s not to like about the prospect to partner with someone as reliable as Mr. Brindle and get the chance to achieve a 12% compound annual return, in a world where US Large Caps are priced to return nothing for the next 7 years, and US Small Caps are priced for a negative return? giofranchi

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it. Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well? I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond. They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend. That's a good point about the influence of the buybacks, but there is a nuance to that. LRE 's buybacks were made just about at BV on average, although BV continued to grow so that repurchases were made for slightly less than BV as calculated at year end. The point is that those repurchases were not accretive to BV per share when they were made. The reason BV/SH then grew is that they allowed BV to grow afterwards by retaining future earnings. In summary, the funds used for the share repurchases probably would have been used for even larger special dividends had not they chosen to buy back shares because that was very tax efficient. Therefore, the cumulative dividends very likely would have been higher by the amount that they spent on share buybacks. :) Ah! Ok... I had sent my previous post, before reading what twacowfca had to say about it! :) giofranchi

giofranchi, BV (or revenue) has hardly grown at all over last 6 years and the only reason BVPS has grown is because they were able to buy back shares cheaply. This is no longer the case and they will not be buying back shares while they trade at these prices so I wouldn't assume it. Is there any reason you think the business will grow at a higher rate than it has to date? I guess one can assume the market will harden sometime? But won't it soften thereafter as well? I agreed with twacowfca when he said long ago in this thread that one reasonable way to look at this situation is similar to a bond. They now trade at around 8.5 times avg-earnings which corresponds nicely to 8.5 times 20% of book value. So you are buying a 11-12% yield with no growth. Most of this money will be returned to you via dividend. shoeless, how could you grow BV, if you use all your earnings to pay dividends and to buy back shares? It is clearly impossible. And, if you want to maintain a steady and conservative Premiums / Surplus ratio, if you don’t grow equity, you cannot grow premiums written either, right? In insurance revenue growth is not an “ability”, instead it is almost always a “choice”: paraphrasing Mr. Buffett, if you want to make silly promises, people will find you! And I always try to remember what Mr. Henry Singleton has so successfully shown: there is a time when the most profitable thing to do is buying back shares, and there is a time when the most profitable thing to do is growth. If you don’t use all the earnings to distribute dividends and you stop buying back shares (because shares are no longer unbelievably underpriced), equity will grow. If equity grows, revenue will follow. The question is: how large a capital can Mr. Brindle and his team manage, before they are no longer able to find bargains in the insurance market? At June 30, 2012, surplus capital was $1,4 billion. If it grows at 9% for the next 10 years, it will get to $3.3 billion. In 2010 global insurance premiums were $4.3 trillion. I am fully aware of the fact that Mr. Brindle and his team will never participate in many types of insurance, nonetheless I think they are still dealing with a relatively small amount of capital in a huge market. Maybe, the most sensible way to create shareholders wealth, during the first 6 years of LRE’s existence, was to pay big dividends and to buy back shares (because they were so crazily cheap!); instead, is it so far-fetched to assume that, during the next 10 years, the most sensible way to create shareholders wealth will be to pay big dividends and to grow moderately? Of course, twacowfca can answer this question far better than me! giofranchi

That surely is a way to look at future returns. Another way is to look at the history of LRE and project similar returns into the future. The question is: are historical returns achievable for the next 10 years? twacowfca thinks so, and I am inclined to agree with him. So, let’s do the math: BV per share at the end of 2005: $4.84. BV per share at the end of first half 2012: $8.46. Delta BV per share: DBV per share = $8.46 - $4.84 = $3.62. CAGR in BV per share: 9%. Total dividends distributed: $5.05. Total dividends distributed / DBV per share = 139.5%. Assuming CAGR in BV per share for the next 10 years stays at 9%, at the end of year 10 BV per share will be $20.03. Assuming dividends distributed / DBV per share stays at 139,5%, at the end of year 10 total dividends distributed (for the next 10 years) will be: ($20.03 - $8.46) x 1,395 = $16.14. My firm pays 15% in taxes on dividends, so all I get to reinvest is: $16.14 x 0.85 = $13.71. Here I have to make an assumption on “how” those dividends will be distributed: I assumed that they will grow at the same rate BV per share is supposed to grow, 9% each year. That means in year 1 I will receive $0.9 in dividend after taxes, funds that I can reinvest and compound for the next 9 years. In year 2 I will receive $0.98 in dividend after taxes, funds that I can reinvest and compound for the next 8 years. Finally, in year 10 I will receive $1.95 in dividend after taxes. Let’s assume I can compound the dividends I receive at 10% annually. Let’s assume that at year 10 LRE price will be 1.3 x BV per share. Then, at the end of year 10 my investment will be worth: 1.3 x $20.03 = $26.04 + $13.71 + $6.70 (wealth created reinvesting dividends at 10% annually) = $46.45. Investing today at $14.00, that equates to a compound annual return of 12.75%. Moreover, if I get to compound dividends at 13.5% annually, my investment at the end of year 10 will be worth $49.69: a compound annual return of exactly 13.5%. That is the case in which I reinvest the dividends in LRE. Now, if you think that the September 2012 GMO 7-Year Asset Class Forecasts show a 0% annual return for US large caps and a negative –0,5% annual return for US small caps, then I think the opportunity to get a 13.5% compound annual return (and a relatively safe one! Because you partner with Mr. Brindle) is something not bad at all! If you leave some room to average down, in case the market hits an “air pocket” (paraphrasing Mr. Dalio), better still! giofranchi

I really don't think this is true. Lancashire wants to stay focussed on their underwriting, and that's how they make money. Everything else is a return of capital, and while it's true they think about this like owners (as they are!) that is far from the Berkshire model. Not to say it's bad at all--I think it's wonderful and have owned in the past. Ultimately, I see Lancashire as unlikely being a compounding machine in the same way, though you can emulate some of it by reinvesting dividends. rmitz, I did not mean to say that the BRK model and the LRE model are the same. Everyone can see they are actually quite different: BRK concentrates on long tail insurance contracts, which enable Mr. Buffett to invest an ever increasing amount of float (plus, of course, shareholder equity) for the long term, taking advantage of the stock market short term inefficiencies. While LRE concentrates on short tail insurance contracts (“the stuff we do is very immediate” says Mr. Brindle), taking advantage of the insurance market inefficiencies (“One of the things we try and do after an event is come in and take advantage of the pricing. In our industry you want to try and move in the reverse direction from the herd if you can - and it is a very herd-like industry. People tend to just increase levels of risk, more and more and more - then something really big happens, and they go "Oh, better get out of that particular line of business". And out they all go - and then smarter people (hopefully including ourselves) will then go into that niche, or pocket of opportunity as Jonny would say, and take advantage of that.” says Mr. Brindle). So, they clearly are two different kinds of business model. Instead, what I really wanted to point out is that in both cases I do understand where their competitive advantage come from (very unique men taking advantage of market inefficiencies) and why it should be durable for a long time in the future (I just don’t see market inefficiencies disappear anytime soon). And that understanding gives me confidence that twacowfca’s assumptions of future ROEs, which at least for the next 16 years are in line with the ROEs achieved in the past, are possible. And, if so, LRE is still a very good bargain. As far as dividends are concerned, with a company like LRE I surely prefer stock buybacks, but I am also fine reinvesting the dividends received. One more thing: LRE doesn’t really have to replicate BRK’s success, to prove itself a rewarding investment and a satisfying asset to hold for the very long term. giofranchi

Yes and no. Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers. However, book value is very important as a limit on their potential earnings because they write business exposed to large losses. Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss. LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital. Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%. Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base. twacowfca, please go on writing about Lancashire, because I always learn something new! racemize, actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website: What would you say then frustrates you in the marketplace? Would you say that the inefficiency in the market is a challenge for you? Mr. Brindle: Well, in a way the inefficiency of the market is wonderful for us; the fact that almost everybody else just goes home at 17:00 on a Friday means that we've found some lovely opportunities. So, do we want a totally efficient, wonderful friction-free market? Probably not actually; we quite like the inefficiencies of the market. So the question is: how big a bargain would you have made, investing in BRK during the late ‘70s at 1,5 x book value? I guess a very big one! I think of my firm’s portfolio as if I were putting togheter the “Avengers Team”! ;D ;D ;D No, really: I extract as much cash as I can from the businesses I control, and I use it to partner with: Mr. Buffett, Mr. Watsa, Mr. Marks, Mr. Malone, Mr. Steinberg, Mr. Einhorn, and now Mr. Brindle. If I can do it at book value, very well! Otherwise, I am willing to pay a little bit more, because I think I am getting a good bargain anyway. Leaving room to average down in the future, if I get lucky! giofranchi Giofranchi, You are a man after my own heart. Our capital management is the same as yours. Our company is old media, book publishing. About Y2K, seeing the writing on the wall by the finger of the angel of the Internet, I began to pay a lot of attention to something that formerly had been merely a hobby, passive investing in public companies. This proved to be very successful. Using savings plus the cash flows of our business, passive investing became the tail that wags the dog. Our securities are about twenty times the value of the old media business that has barely held its own. Many of the posters on the board are good analysts, but few really think like businessmen. Most concentrate on factors that can move the needle in the market, but few take the time necessary to dig deeply to ferret out the strength and depth and enduring value of a business within an industry that they attempt to understand. As a former teacher, Dr. Deming, was in the habit of saying in a voice like the voice of God: "You must seek to have profound knowledge." It's refreshing to have your perspective as a businessman. Too kind of you, twacowfca! And Dr. Deming’s advice is really one to treasure. This board is full of very knowledgeable money managers, and money managers tend to think of businessmen (CEOs / managers) as illiterate, rude, and overbearing… and most of the time they are perfectly right! I myself find the behavior and the perspective of many colleagues of mine to be utterly superficial and boring! Anyway, I like to think that not all businessmen are created equal. And maybe I presume too much, but I like to put myself in the same league as twacowfca: those businessmen who seek to live by Dr. Deming’s advice everyday. giofranchi

Yes and no. Book value as a margin of safety floor is less important because of the quality of their business, compared to other insurers. However, book value is very important as a limit on their potential earnings because they write business exposed to large losses. Rating agencies look at capital levels in relation to exposures as estimated by, for example projected maximum losses for different types of business. If a company like LRE greatly increased the amount of premiums written without increasing capital or reducing the PML profile, that company would be at risk of a downgrade, especially after a large loss. LRE keeps doing astute things to lower their PML's and permit them to write more business without increasing the risk of a big hit to their capital. Even so, it would be hard for me to imagine that their normalized ROE will go much higher than 22% or so, compared to their long term average of 19.5%. Therefore the amount of their earnings available for a DCF analysis will always be relative to their capital base. twacowfca, please go on writing about Lancashire, because I always learn something new! racemize, actually, I think about LRE as I would have thought about BRK in the late ‘70s. And Mr. Buffett always said that increase in book value is a good estimate of the increase in value of BRK, though BRK’s value far exceeds its book value. Both Mr. Buffett and Mr. Brindle deal with market inefficiencies, and those inefficiencies are their competitive advantage. As long as market inefficiencies last, their competitive advantage will be durable. From an interview on Lancashire’s website: What would you say then frustrates you in the marketplace? Would you say that the inefficiency in the market is a challenge for you? Mr. Brindle: Well, in a way the inefficiency of the market is wonderful for us; the fact that almost everybody else just goes home at 17:00 on a Friday means that we've found some lovely opportunities. So, do we want a totally efficient, wonderful friction-free market? Probably not actually; we quite like the inefficiencies of the market. So the question is: how big a bargain would you have made, investing in BRK during the late ‘70s at 1,5 x book value? I guess a very big one! I think of my firm’s portfolio as if I were putting togheter the “Avengers Team”! ;D ;D ;D No, really: I extract as much cash as I can from the businesses I control, and I use it to partner with: Mr. Buffett, Mr. Watsa, Mr. Marks, Mr. Malone, Mr. Steinberg, Mr. Einhorn, and now Mr. Brindle. If I can do it at book value, very well! Otherwise, I am willing to pay a little bit more, because I think I am getting a good bargain anyway. Leaving room to average down in the future, if I get lucky! giofranchi

twacowfca, I agree with you. The fact is that I don’t know how much a private buyer could count on Mr. Brindle’s skills to go on compounding capital, after the acquisition is completed. I just don’t see people like Mr. Buffett, Mr. Watsa, or Mr. Brindle to work for someone else… And insurance, as far as I know, is all about management. Also in your assumptions, after Mr. Brindle’s departure, the years of outperformance shrink to just 4, right? A private buyer, of course, must take this into proper account. What I mean is that, if I were a private buyer interested in purchasing the whole company, I wouldn’t want to pay for a “Brindle’s premium”. So, which is more valuable: an insurance company that you own the entirety of and is managed by an average CEO, or an insurance company that you are only partial owner of but is managed by Mr. Brindle? For any business in which management isn’t so important, I agree that entire ownership is a plus. But what about insurance? I wouldn’t be so sure. That’s why I preferred a PV analysis, using assumptions given by a person like yourself, who is clearly very knowledgeable about Lancashire. Anyway, I have proceeded cautiously: I bought just 1/3 of the amount I intend to invest in LRE. And I hope I will be able to average down aggressively in the future. giofranchi

I have found the letter in attachment to be interesting. giofranchi Broyhill-Letter-Oct-12.pdf

I have received the suggestion to start a thread in which to post “macro” papers worth reading. Of course, they may not be very useful for investing, but they are great fun! ;D I attach the Hoisington Quarterly Review Third Quarter 2012. giofranchi HIM2012Q3.pdf

Giofranchi, Thank you for the present value analysis for Lancashire. When I said I don't think the market misprices LRE, I meant that as a start up only six years ago, taking only that record into account, the market prices LRE appropriately. My own opinion, of course, is that Lancashire's true value is much greater than that because Brindle has a Buffett like record of similar returns that goes back to the mid 1980's. Your PV analysis doesn't seem to have a terminal value after a defined period of time. If so, this makes it problematical , and a PV of @ six times the current market price is way too high in my opinion for a conservative analysis. 19.5% seems to be a realistic expectation for LRE's RoE, based on Brindle's cumulative record. I think LRE will probably do a little better than that going forward for some of the reasons I've expressed, including their use of sidecars to increase profits while lowering risk, the gradual hardening of markets as investment returns, that add only a small percentage to LRE's earnings, put pressure on other insurers etc. Even so, 19.5 % is an appropriate expectation going forward. By the way, $8.06 is their Q2 FCBV/SH. Their Q3 FCBV/SH is probably 5% to 7% higher as Q3 was likely a low loss quarter with few if any large losses. :) If Mr. market were capable of a PV analysis based only on LRE's short record, It would probably have an appropriate terminal value only a few years out, perhaps six years more, after which LRE's returns would be assumed to regress to the hurdle rate. The cost of capital for LRE may actually be lower than 10%. They recent sold a ten year fixed rate note at 5.70%. 8% or 9% may be an appropriate cost of capital in today's low interest rate environment for LRE instead of ten percent. This would tend to increase the PV in your analysis, as using an appropriate terminal date would lower the calculated PV. The big unknown is the appropriate terminal date after which their returns would cease to be excess. I think that terminal date should be more than six years out because Brindle's record is 20 years plus, including his time at Lloyds. He is still in his forties, and he has built up a great team at LRE that would be expected to carry on well without him. But 20 years may be too long because "there is many a slip, 'twixt cup and lip." Lets assume conservatively that Brindle's tenure as CEO is 12 more years (unless there is a take out before then at a much higher P/E than now) and that his team will continue to have the same high returns for four more years after his departure, after which the returns will drop to the hurdle rate. That would put the terminal date 16 years out if you wanted to do another calculation using a different formula for PV. Thank you for your analysis that is much food for thought. :) twacowfca, I think your assumptions regarding Mr. Brindle’s tenure of just 12 more years are very conservative! He is just 49! And clearly is extremely passionate about his work! Anyway, even taking into account your assumptions, my thesis does not change much. If you explicit Professor Penman’s formula (“Accounting for Value”, page 68, Columbia Business School Publishing) that I used before, what you get is the following: Present value of equity = B0 + [(ROE1 – r) * B0] / (1 + r) + [(ROE2 – r) * B1] / (1 + r)2 +[(ROE3 – r) * B2] / (1 + r)3 + etc. Until you get to the 16th year (12 of Mr. Brindle’s tenure + 4 more years after his departure). According to your assumptions, I used $8.46 as B0, a ROE of 19.5% and a cost of capital of 9%. Then, even assuming terminal value equal to zero, we still get a PV of equity of $36.85. My idea is not really to get to a “number”… what I would like to discuss is the inability of the market to value properly a machine that can compound capital at high rates of return for a very long time. I think the greatest inefficiencies in the market are there. And that’s why I don’t really like to jump from an undervalued security to another: because short term mispricings (and for “short term” I mean 3-5 years) are much less remarkable than long term mispricings (and for “long term” I mean 15-20 years). giofranchi Thank you very much, Giofranchi. I have shied away from PV analyses because assumptions about how long excess returns will continue are usually over optimistic. However, this dialog has helped me get comfortable using 12 + 4 = 16 years as a reasonable and conservative period for returns about equal to Brindle's long term record to continue (unless there is a take out before then at a much higher multiple than their recent multiple has been). This supports my gut feeling that this company is a treasure that shouldn't be sold at the current valuation, merely because it has had a great ride. Well, I didn't even know of Lancashire, until I read your posts... :-[ But now I have read about it a lot and you helped me clarify many doubts: and I agree with you that this company is a treasure! So, you certainly are the one to be thanked! ;) giofranchi

Giofranchi, Thank you for the present value analysis for Lancashire. When I said I don't think the market misprices LRE, I meant that as a start up only six years ago, taking only that record into account, the market prices LRE appropriately. My own opinion, of course, is that Lancashire's true value is much greater than that because Brindle has a Buffett like record of similar returns that goes back to the mid 1980's. Your PV analysis doesn't seem to have a terminal value after a defined period of time. If so, this makes it problematical , and a PV of @ six times the current market price is way too high in my opinion for a conservative analysis. 19.5% seems to be a realistic expectation for LRE's RoE, based on Brindle's cumulative record. I think LRE will probably do a little better than that going forward for some of the reasons I've expressed, including their use of sidecars to increase profits while lowering risk, the gradual hardening of markets as investment returns, that add only a small percentage to LRE's earnings, put pressure on other insurers etc. Even so, 19.5 % is an appropriate expectation going forward. By the way, $8.06 is their Q2 FCBV/SH. Their Q3 FCBV/SH is probably 5% to 7% higher as Q3 was likely a low loss quarter with few if any large losses. :) If Mr. market were capable of a PV analysis based only on LRE's short record, It would probably have an appropriate terminal value only a few years out, perhaps six years more, after which LRE's returns would be assumed to regress to the hurdle rate. The cost of capital for LRE may actually be lower than 10%. They recent sold a ten year fixed rate note at 5.70%. 8% or 9% may be an appropriate cost of capital in today's low interest rate environment for LRE instead of ten percent. This would tend to increase the PV in your analysis, as using an appropriate terminal date would lower the calculated PV. The big unknown is the appropriate terminal date after which their returns would cease to be excess. I think that terminal date should be more than six years out because Brindle's record is 20 years plus, including his time at Lloyds. He is still in his forties, and he has built up a great team at LRE that would be expected to carry on well without him. But 20 years may be too long because "there is many a slip, 'twixt cup and lip." Lets assume conservatively that Brindle's tenure as CEO is 12 more years (unless there is a take out before then at a much higher P/E than now) and that his team will continue to have the same high returns for four more years after his departure, after which the returns will drop to the hurdle rate. That would put the terminal date 16 years out if you wanted to do another calculation using a different formula for PV. Thank you for your analysis that is much food for thought. :) twacowfca, I think your assumptions regarding Mr. Brindle’s tenure of just 12 more years are very conservative! He is just 49! And clearly is extremely passionate about his work! Anyway, even taking into account your assumptions, my thesis does not change much. If you explicit Professor Penman’s formula (“Accounting for Value”, page 68, Columbia Business School Publishing) that I used before, what you get is the following: Present value of equity = B0 + [(ROE1 – r) * B0] / (1 + r) + [(ROE2 – r) * B1] / (1 + r)2 +[(ROE3 – r) * B2] / (1 + r)3 + etc. Until you get to the 16th year (12 of Mr. Brindle’s tenure + 4 more years after his departure). According to your assumptions, I used $8.46 as B0, a ROE of 19.5% and a cost of capital of 9%. Then, even assuming terminal value equal to zero, we still get a PV of equity of $36.85. My idea is not really to get to a “number”… what I would like to discuss is the inability of the market to value properly a machine that can compound capital at high rates of return for a very long time. I think the greatest inefficiencies in the market are there. And that’s why I don’t really like to jump from an undervalued security to another: because short term mispricings (and for “short term” I mean 3-5 years) are much less remarkable than long term mispricings (and for “long term” I mean 15-20 years). giofranchi

twacowfca, I experienced difficulties in posting this message, so I attach it as a word file. Could you please download it? Thank you, giofranchi LRE_implied_valuation.doc

I particularly enjoyed shalab’s answer! But I have read all your answers and they have provided a lot of food for thought. Thank you very much! Parsad, please, do not really believe my only goal is to make money! You are all great investors and great people, and I would really loathe to give you an impression of me that is so wrong! Call me naïve, but I believe there is at least some truth in the following well-known quote by Mr. Icahn: "I'm like the gunfighter you hire to save the town. That gunfighter is there to do good...but he'll only do what he does if he knows he'll get paid for it." Carl Icahn Let me explain: paraphrasing Mr. Winston Churchill, private enterprise really is the strong horse that pulls the whole cart. And for private enterprise to do its job, wealth must be created. If a business does not create wealth for too long a time, whether it be Yhaoo! (Loeb), or Canadian Pacifics (Ackman), or Chesapeake (Icahn), or Cracker Barrel (Biglari), as far as I know, two are the paths that could be followed: 1) some changes are implemented, believing that profitability and growth will resume, 2) the business is orderly wind down, and cash is returned to shareholders, who will put it to better productive uses. In the process I am aware that mistakes are going to be made. The Time Warner example, Mr. Munger referred to, might surely have been a mistake. And without any doubt a lot of other mistakes were made by Mr. Icahn! But also useful and praise-worthy goals were achieved! At least, that is what I believe… though, I might be utterly wrong! giofranchi