Bloomberg on Pabrai-now he won't say returns-normally does, doesn't he?

[Guest kawikaho]

By the way, why are all the re-insurers for P&C down so much in the past few months?  Are they forecasting for a soft market?

[woodstove]

Just a nit, but I think Munger's remark was if one owned three diverse businesses, one would be securely rich.  A bit different from owning three stocks.  Wholely owned businesses do not have same exposures of delayed reporting of business info (stocks only get quarterly info), agency risk of managers/boards/control group, etc.

 

Buffett recently wrote something about merit of Berkshire having dozens of independent streams of cash flow.

 

 

[Vish_ram]

Lot of articles about Pabrai are misleading. I do understand the need to be in news cycle but where is the balance and fairness in those articles.

 

1) You can not cherry pick returns from a single portfolio that Pabrai is managing. One of his portfolio has underperformed market for last several years (as per Jan -09 letter) and no one talks about it. A better approach is to show a composite return.

 

2) Pabrai has used options, he has bought PNCL options etc.

 

3) Why is the Bloomberg article showing returns only till 2006?

 

4) By changing strategy, he talks about reducing risk. Why there's no talk about potential reduction in returns?

 

I do have a lot of respect for Pabrai but his PT Barnum side sometimes gets the better of him. Or it is possible that the folks writing about him are inclined to flatter.

[Carvel46]

Flattery gets a reporter second interviews... and greater access generally.

 

I enjoyed the read, even if it reads like PR. It is what it is...

 

 

[Mungerville]

ORH ..... book is going up almost guaranteed this year

 

Im not saying you are wrong Mungerville, just curious on what area you find gives you cause for the optimism in this particular year? 

 

I also hold ORH.

 

What gives me optimism is really pretty simple.  The underwriting is under control so a combined of 100% is achievable and has been achieved in recent years in an average market for reinsurance which I think is what we have in 2009 - not hard, but not as soft as 2008 at least in reinsurance.  This isn't the reason, I'm just getting that out of the way.  So, with that out of the way, imagine this is a mutual fund you are invested in. 

 

1.  Now imagine this mutual fund having a guaranteed minimum return of 8% after-tax buying at $40 per share just to start off with zero risk using none of the assets; 

 

2.  Then add some of the best investment managers in the business to that mutual fund to take the assets of say $1 dollar which you can buy for 90 cents (i.e. book value is $45 and price of stock is $40) and invest where they see fit - say undervalued stocks, MBS, junk bonds and you get the full return from that in a market that is semi-disfunctional;

 

So that's pretty damn good so far - an 8% head start after-tax, and assets for 90 cents on the dollar on top of that. 

 

3.  Now on top of this, let's say they get a little over-enthusiastic about the economic situation and misread a bit and buy stocks and other risk assets a little early and then the bear market resumes.  So you lose some of your assets, but because the wreaks havoc on the entire industry's already somewhat depleted capital base, a hard market for reinsurance occurs.  So you lost some assets, but now with a combined ratio of 90-95%, buying at $40 per share, you get an extra yield of 3-6% after tax added to that initial guaranteed yield of 8%.  So you are at 11-14% yield in this "dire" scenario.  On top of that you still have the assets invested in now very undervalued securities with the opportunity to buy more.

 

-------------------

 

My first point is the big kicker because that is one hell of a head-start.  ORH's equity capital or book value is $2.7 billion but... it owns $2.3 billion in muni bonds the great majority of which are guaranteed by Berkshire Hathaway which are pretty rare securities as Berkshire only guaranteed $15.6 billion of these in total - see p. 13 of Berkshire's 2008 annual report, 6th paragraph.  So, in my view there is zero credit risk there.  Furthermore, for those who care about mark-to-market volatility, they still owned $1.8B notional in CDS at year-end 2008 at Odysee so that will more than take care of any m-to-m volatility/credit risk or perceived credit risk in those munis as well as the 0.3 billion in convertible bonds ORH held at year end.  On top of that, they have 1.2 billion in US government bonds.  So they have a rock solid bond portfolio of 4 billion on book value of 2.7 billion which you can buy for 90 cents or $2.4 billion.  The $4 billion yields $280M pre-tax or $200M after-tax on your purchase price of $2.4 billion for the whole company.  That is a risk free 8% after-tax head start using float that costs them nothing.  So its like a mutual fund with a guaranteed 8% return, with no risk, tax sheltered because you already paid tax, and where you still have not started investing the net assets of yet.

 

The second point speaks to buying the net assets at 90 cents with great management investing the assets.  The third point is really important because if the markets turn down from here, and ORH loses book value because of its equity investments, we should almost be guaranteed a hard-market and expanding market share going forward as the competition will be on its knees and moreover the equity values will be wound up like springs being so low.  So we have a counterbalancing effect that is very significant.  And part of point #1 and point #3 talk to the two very important advantages of a well run P&C business: i) no cost no maturity investment leverage - who the hell can get that these days other than institutions supported by the government?, and ii) the countercyclical aspect built into the business - when investment returns get crushed, underwriting profit typically increases thereafter and for those that are ready, they can really expand their market share on top of that to get more float.

 

Take all that together and add a talented investment team and your worst-case scenario has to be an annual return of well north of 10% even in the worst economic and/or market environment.  8% is locked and loaded to start after all.  So that's the downside and that's how I like to think and that's pretty damn good for the downside.  So if that's the downside, what is the highly likely return?

 

                                                       

[Smazz]

Good write up Mungerville thanks.

 

I didnt give the Munis the proper consideration when I last looked at it especially with respect to the remaining CDS.

 

again, great write up.

[vinod1]

Thanks for the writeup Mungerville.

 

Hard/Soft insurance markets have always been discussed in terms of the supply side i.e. funds available to the insurance companies. I have never seen a discussion in terms of the demand side. How does the demand for insurance vary with economic cycle? Is it fairly immune to economic cycle or would it be possible to have a sharp drop in demand in a depression type scenario? In this case would we not have a soft market if we assume that the supply remains constant or falls lower than the demand side?

 

Thanks

 

Vinod