Hi Everybody,I think a very instructive situation is being discussed over on the BRK board, starting around post 55711 related to BRK and serious risk.As strange as it may seem, BRK itself is not immune to the spectrum of emotions from fear to greed that drives markets. I don't really want to get into whether BRK does or does not have any additional significant risk but I do think the board situation brings up a good chance to discuss the emphasis that Graham places on Fact.While Graham is most often thought in strictly quant terms, I believe his biggest gift to investing theory was the distinction between estimation of fact based probability vs estimation based on speculation of future events.Graham's emphasis on fact creates an environment where probabilities can be calculated or estimated. Without prior fact while one would think that though probability is deeply effected, possibility might still remain. My take is that though this might be correct in the literal sense, in the practical sense without a factual connection, possibility is not even assured.For example, taking the example of a comet significantly hitting earth, since there is some evidence that this has happened before, the possibility is assured but the probability may be very low. On the other hand, I guess literally it's possible the earth could stop rotating, but since there are no facts to substantiate that it has happened, on a practical level it might as well be deemed impossible.I think that Graham's emphasis on demonstrable fact is an extremely important concept that in itself helps the investor take advantage of hysteria's both fearful and optimistic.ZB
Excellent point, Zen!I happen to think that a number of folks on the Berk Board have reacted with fear and panic based on the lack of precident for experiences such as Berkshire is currently negotiating. Indeed I was quite surprised by WHO was panicking, which is itself testimony to the persuasive power of Mr. Market. I can think of how your point applies to the Tech bubble. Folks were investing based on pure speculation of the future performance of unproven products, companies, and industries. Those who have stuck to the facts have generally performed better. Why, then, speculate on the potential impact of future events on stable and predictable companies such a Berkshire? Why not panic about the threat a mass vegitarian movement poses to McDonalds? In a way this kind of thinking about the insurance industry (the entire economy, really) is the negation of the optimism of the speculative tech bubble. It is a speculative pessimism. Only the conclusion is different: sell, sell, sell instead of buy, buy, buy.If one were to engage in panicky pessimism I think there are more factual bases for such pessimism than the threat of nuclear terrorism. Take, for example, the much more explosive potential of the debt bomb. A country that has been expanding consumer debt at four to five times the growth rate of income for decades now has far more probable worries to address than nukes. Especially since so many seem to be looking to the consumer to pull us out of this recession. What if the interest rates don't do the job? What if the debt load of the average American is already so heavy that renegotiating their first and second mortgages just isn't enough to stimulate demand? What then?At least in this scenario one can start to look at companies and industries, and try to make some educated decisions about who is least threatened and who is likely to survive. Buying debt strapped companies right now would be pretty stupid. Buying an auto company looks just as dumb (even despite the valuation contractions). Buying sub-prime lenders is beyond the pale (and yet many bought Providian--just check out the L'Union board).Your point, Zen, is an excellent one. We need to stay focused on the facts and take advantage of the irrationality of Mr. Market when he (or she) panics.PhoolishPhilip
Hi Zenvestor, Philip, Everyone,My goodness! I've been away for the weekend, but before going had time to print out Berkshire's Q3 report, and was enjoyably reading thru it and doing calculations in spare moments the past couple of days. Then to return and find that anxiety has blown up, way way out of proportion!I've got some reading to do, to catch up. I'll tell what my impression of Berkshire's situation is, though. The company is in excellent shape. I was really pleased with how well it has responded to circumstances in the economy (slowdown) and insurance business (mega catastrophe). All that should be done is being done, new information is being studied and incorporated into the business plans. Berkshire Hathaway employees are responding superbly. No shareholder could ask for more or deserve more.Ok, a loss estimated at about $2.3 billion has occurred. The company generates about $5B/year free cash flow, so can cover that. Some policy coverage implications have been recognized. I'm glad they're recognized not being denied, and steps are being taken to deal with the exposures.Does anyone in the insurance business seriously believe there will not be losses? In the supercat business, there will be occasional huge loss events. Stabilizing the financial impact of loss events is Berkshire's primary purpose; the company is a giant shock absorber, and is designed to take hits.What is the impact of the WTC loss on Berkshire's value? About 2 pct. It is rounding error given inherent sloppiness of value estimation methods. Berkshire is roughly 1/1000-th of the American economy, and it is a part which is better than average in terms of management clarity and conduct, prudent financing, and commitment to staying the course.I think the case might be made that, although Berkshire's present value has diminished a bit it's potential for future growth has not decreased. The value of having a steady partner is increased if others are faint hearted. Berkshire is one of the best if you are looking for a reinsurer or a purchaser for your family business who will honour its commitments.It's late, but next weekend I'll try to share my thoughts on valuation using the new data from the Q3 report. Best to everyone,Woodstove
Dear woodstove,I agree with most of your comments, except for the $5 billion part. It is true that pre-tax earnings at Berkshire were $5.65 billion in 2000, but $3.96 billion were realized capital gains. I'd add back the goodwill amortization, and there are a couple of big purchases (Shaw, Johns Manville) which only kick in this year, but I don't think you'll get FCF being $5 billion.The biggest worry I have is the acknowledgement by Mr. Buffett that writing policies at break-even at General Re is no longer satisfactory. I just don't see that we can count on much better than break-even underwriting at GenRe over a cycle. Can GenRe do much better than break-even when interest rates are low? Maybe, maybe not; Mr. Buffett believes that rates will be good only for about a year or so. This also acknowledges that Mr. Buffett expects to invest float in fixed income instruments primarily.Best,Lleweilun Smith
woodstove (and everyone else),If you read all of my rantings on the Berkshire board you know how I feel about the recent events. Don't worry, I won't make you endure a full recap :-).Maybe I sounded a bit worried, and I'm afraid I didn't make my point very well. My concern was NOT about the one time losses Berkshire suffered from the Sept 11 attack -- we have been warned literally for decades that super catastrophies would occur, and Berkshire would have the occasional "terrible quarter", and now we have. And a single $2.3 billion loss is not a serious problem.What I did not expect, however, was that Buffett and the Gen Re underwriters would make a "huge mistake" with their underwriting, especially during Buffett's presumed oversight (I wonder how much he is really involved with Gen Re, if at all). This one-time loss wasn't "fatal", but it was certainly worse than expected. And it means that they have mis-priced an entire category of insurance business. Nearly every time he talks about insurance, Buffett reiterates the need to take only sensible risks and be fully compensated for them, and here they have failed. And Buffett's comments that Gen Re has broken his three cardinal rules of underwriting --- after the acquisition -- are also very worrisome.At some point, after a number of "unforced errors", you have to start to wonder if they really have a handle on their business. Buffett got a good price for Gen Re, but I don't think he or any of us expected to sit through 10 years of large losses and sloppy underwriting, and that is what it's starting to look like. It is this loss of credibility -- a chink in the Berkshire armor -- that has me most worried. And imagine if this had happened after Buffett gone -- how much faith would you have that the then-current management could get on top of the problems?And Buffett nixed my prmiary source of optimism by saying that any price increases in the industry would not last longer than a year. A longer-term increase would have been a way for Gen Re to make up for its losses and finally deliver some economic value to Berkshire, but unfortunately one good year (even a really really good year) won't do it.I still believe that there is a high chance that over the "very long term" (20+ years), Berkshire will endure. But my projections for its future value are now much diminished, and will be until I'm convinced that Gen Re can actually add substantial economic value to Berkshire.Tiddman
"What I did not expect, however, was that Buffett and the Gen Re underwriters would make a "huge mistake" with their underwriting, especially during Buffett's presumed oversight (I wonder how much he is really involved with Gen Re, if at all). This one-time loss wasn't "fatal", but it was certainly worse than expected. And it means that they have mis-priced an entire category of insurance business. Nearly every time he talks about insurance, Buffett reiterates the need to take only sensible risks and be fully compensated for them, and here they have failed. And Buffett's comments that Gen Re has broken his three cardinal rules of underwriting --- after the acquisition -- are also very worrisome."Hi Tiddman,In my opinion this conclusion is debatable. It is very difficult to judge if there has been an underwriting mistake based on one low probability but significantly expensive event that just happened. It's equivalent to thinking that just because a lottery I was running was hit for $100,000 on the ninth $5 try, that the lottery concept is flawed overall. It's the long term overall payment vs cost that counts.I believe that this has always been Mr. Buffett's view on insurance and is still.So what's with the shareholder letter? There are few businessmen that I respect as much as Mr. Buffett and because of my respect for his business talent, I've found that it's often helpful to look around what he is saying versus looking directly at what he says. I've always been of the opinion that unlike the common perception of Mr. Buffett as a fair to all, easily visible, open book, he is very cunning, very close to the vest, and very competitive when it comes to making and keeping profit. So while I'm sure everything in his letter is sincere, the main message I get, which is for public consumption since anything internal to his insurance businesses does not need reiteration publicly, is that, "theoretically" the stakes around the world have gone up significantly (didn't he mention trillion somewhere), it is absolutely necessary for his industry and his company to be fully compensated for these much more expensive risks. Plus since no compensation is probably enough, there really should be some govt reinsurance for the reinsurers. So I guess my bottom line take on the letter is it was an opportune method to accomplish three things for BRK. 1. Imply to the business community that significantly increased risks and costs will be assigned back to them. 2. Add momentum to the thought that for significant man-made disasters, a govt backstop is needed. 3. Somewhat assure shareholders that the current loss is manageable and the company is secure. In other word's, more revenue with less risk to a company that is absolutely viable.What is interesting to note is that in a shareholder letter, the 3rd point (assuring shareholders) takes a back seat due to the alarmist message that must be delivered to bring out points one and two. Probably some serious cost-benefit was done on that point.So in my opinion, I think that at least for the next few years the BRK insurance business is enhanced by the current environment. Don't forget, the insurance business substantially profits from increased customer fear. So while I won't make any opinion on the general state of BRK's insurance underwriting, I don't think the 9/11 event in itself would change the longer term view of their underwriting ability and more likely will help out over the next few years. Just my own personal take,ZB
Hi Everyone,The topics of facts vs fear/hope, and the insurance risk aspect for Berkshire, have been in my thoughts this past week.It seems to me that starting with current and historical facts, and then applying some adjustments for future scenarios, is a more practicable, less overshoot prone, method of estimation. The current and history are somewhat at hand, though there may be reporting distorions or errors in the model used - eg not recognizing impaired assets or liabilities off the balance sheet. Get a current valuation, as if the business were to stay pretty much as it is today. Then apply a factor to recognize there will be changes, in the business or its environment.The hope (eg of future growth) or fear (eg of future liabilities) aspect can be confined to the 2nd stage evaluation. It divides up the work, and if it is necessary to update quarterly, the two parts can be handled as distinct problems. How much has the current company changed in the past quarter? Have its opportunities or risks changed, or are they about the same multipliers as before?So, with Berkshire and terrorism event exposure, first estimate what is the significance of the WTC losses, then second estimate the outlook for other terrorism losses.For WTC, the total loss to the US economy may be estimated as follows:Stuff: 100K workplaces out of maybe 200M, 0 homesteads out of 200M, and 0 resources (minerals etc). Maybe .0001 fraction of total stuff.Process: 5K deaths, another 15K job-equivalent casualties mostly due to mental stress, out of maybe 200M. Again .0001 fraction of process capacity.Other: Maybe 2 pct loss of productivity due to economic shutdown for a week. Probably to be carried over into future years, as frictional cost of extra security. Mr Greenspan noted the extra cost but did not put a number to it, in some recent testimony.Should the "other" loss of productivity be included in the WTC economic loss? Maybe on a one time basis as a side effect, but not repeated per incident if there are any more.So assume maybe .0001 economic loss from a WTC-size terrorist event.That is significant but it is hardly incapacitating for the US economy. The economic growth from a single year can replace two hundred such losses.More significant is the cost of reorganization of social conduct for additional security, which at 2 pct does equal 2 hundred WTC losses per year.All the above numbers are arguable, but at least are concrete so can be debated fairly unemotionally. Also, the process is two stage, estimating the WTC loss, and the probability and size distribution of other events.About 20 WTC-sized events would exhaust Berkshire's insurance capacity. But two processes would be expected to kick in. First, social or legal changes to limit insurance coverage, to preserve the insurance concept for reasonable losses. This has been seen before, eg limits on injury claims for auto policies. Second, circuit breakers within the Berkshire organization would limit the exposure. Insurance is an after the event settlement, and even the absence of prior legislation would not stand in the way of a rule change if it were essential to preserving commercial activites requiring insurance.My own opinion is that the supposed risk, of an unlimited series of WTC sized losses, or a single loss equal to 10-100 WTCs, is so unlikely to be relevant to Berkshire's situation that it is not an investing risk. It is most certainly a business consideration, to be urgently addressed in policy terms and in requesting legislative action. Which is underway. That is, since the business risk is being handled by competent people, I can be comfortable as an investor.Philip points out that there are other scenarios, eg debt excesses in the economy, that are much more likely to require attention than a multiple-WTC loss. I am in agreement with him about the necessity of addressing those concerns. Though, to be frank, I do not see them as a reason to avoid investing in stocks. Rather, it seems to me that one has to consider various risk possibilities - what could go wrong with my investment choices? - and then avoid some situations and keep others within a reasonable balance with offsetting opportunities. For example, the resolution of a severe debt problem might be a 30-40 pct devaluation of the currency; very drastic but also a suggestion that it might be prudent to own some fractional shares of tangible businesses, not just a bunch of currency equivalents.The question that Tiddman raised, is it prudent to have 90 pct of one's investment money in Berkshire stock, is really one of risk focus. The reward is outsided if Berkshire does well (as it has in the past and appears likely to keep on doing in the future), and the risk is also outsided if Berkshire, or the insurance business overall, does poorly. That is not a question to be answered in isolation, in the abstract, but only in the context of a particular investor's requirements for medium term quotational reassurance, for a guarantee of no single organization failure exposure, etc.My own belief is that one should hold only as much concentration in a stock as allows one to be comfortable, to not have to fret about what the market might do. A business owner might have significant investment money tied up in his business, but feel very comfortable because he is familiar with all the risk factors and "knows", despite the certainty that bumps will occur, that he and his company are capable of dealing with them. The word "knows" belongs in quotes because no one really does know, and the case cannot be proven. But any sensible entrepreneur goes on, because he trusts himself, and realizes he is facing a business risk not a self-investing risk.When investing as a minority shareholder, one must trust the capability and conduct of the directors and managers. Given that, it reduces the selection problem to one of business risk and fair pricing. The question I guess one should be asking, is would I be in such and such a business if I owned it outright, knew the industry, and had the personal time?Woodstove
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