Saturday, June 24, 2017

Lessons from Omaha - Part 3

This is a continuation of Part 1 and Part 2.

In the last post, we discussed that ETFs should be part of every astute investor's portfolio and since tech is becoming so important, maybe tech ETFs might also make sense. Also, if 90% or more of all investors never ever beat the index, then wouldn't be buying the index i.e. buying ETFs (equity index funds) be the best option? So that's coming from the Oracle of Omaha, Warren Buffett himself.

In this post, we go back to the centuries old business of insurance.

As most students of value investing would know, Berkshire Hathaway grew tremendously after it acquired an insurance business. Insurance is very good for investing because it provides very long term patient capital. One of the greatest obstacles facing asset management is always capital withdrawal or drawdown - one of the most dreadful word in fund management. The thing is, capital or funds (both from retail or institutions) can only be as long term as markets (which is now six months!) Alas, the markets are getting more and more short term. It is now estimated that global exchanges trade all their own outstanding shares every six months. 

By evolution, humans can only think short term. Our primitive minds cannot comprehend long term (like anything longer than a few days in prehistoric times, to a few months a hundred years ago and maybe a few years in modern times). We simply cannot make good decisions when it's too far out even though we know logically it's good. For instance, quit smoking or stop eating junk food. In investing, we just cannot grasp the concept of compound interest. 

Just an example, if you were given a choice of having (A) one cent today which will double every day for the next 30 days or (B) 1 million dollars today, which one would you choose?

A or B?

1 cent today or 1 million dollars today?

Think hard!

Ok, the answer is...


As you can see, a single cent doubling every day gets to $5,368,709 in 30 days but we would choose a million dollars right? We simply cannot comprehend compounding. For those still lost, the answer is (A)!

That is why despite 100 years of investing in markets, we are still so short term, constantly looking at quarterly numbers, unable to think three to five years ahead. Let alone 10 to 20 years, which is the real operating span for most successful companies and their business strategies and the real power of compounding (sorry it doesn't happen in 30 days, it's more like doubling on every 7-8 years which is 8-10x over 20-25 years). Hence for fund management, we need long term capital, which insurance can provide.

Berkshire Hathaway stumbled upon this when it bought Geico. Insurance provide that long term capital that allows for compounding to happen. Without which it's just meagre returns which is what most hedge funds do today. Essentially, hedge fund managers just suck management fees without adding real value to investors.

This long term capital is called "float". Not the kind below, but close metaphorically.


"Float" arising because insurance companies collect premium upfront to insure for some adverse events that people want to avoid, for instance death, illness, flood, or earthquake, or fire, whatever. The insurance companies take the money today but only pay out years later. Meanwhile, they get to invest this money to make more money. This is the beauty of insurance. The ability to hold the "float" is so precious that competitors will charge less and less upfront premium to get "float". In most insurance markets, the amount collected today actually cannot cover the expenses that needed to be paid out because of competition. That's the cost of getting the "float".

But in some cases, it is possible to make a profit as Berkshire found out. Buffett likes to point out that it's because of under-writing discipline, or being able to assess risk properly and hence charge the right premium. If competition becomes irrational, then Berkshire get out and move on. So Berkshire had managed to get the "float" at a profit! When this happens, then the insurer is being paid twice! First of making a profit by under-writing insurance, then again by making money by investing the "float". Buffett says that it's better than free. Something like enjoy a good ONS and then being paid for it? Haha! Okay, that's R21, young investors please just ignore the last sentence.

So, here's my postulation. 

When Berkshire Hathaway started out in 1965, some types of insurance were not well understood, especially auto insurance, which surprisingly only became nationwide in US around the 1960s. Also some types of property and casualty insurance, re-insurance and other specialty insurance only came about later. That is why Berkshire was able to get under-writing profits as a first mover in some of these markets. (Of course, underwriting discipline and good management helped.) Note that it never got into life insurance which is just cut-throat competition, since that's been around for ages. As Berkshire got bigger via M&A, it's easier then to maintain under-writing profits, which helped Berkshire grew its float from $39 million in the 1970s to $91 billion today!

Today, Berkshire makes an underwriting profit of $2 billion, which we can think of it has essentially Berkshire getting paid 2 billion dollars to borrow 91 billion to invest! That means Buffett had been enjoying almost 50 years of negative interest rates! Now, finally the world caught up. 

This is the power of insurance. 

We talked about Markel in the previous posts. This is often touted as the next Berkshire because the firm is essentially operating the same model. But since auto insurance and the other fields that Berkshire dominated are now pretty competitive, Markel ventured into other types of insurance. I had the time to read part of its annual report and was surprised to find all the types of niche insurance. It started as an insurance firm covering bus and truck fleets but had since branched out to shipping, industrial equipment, re-insurance to even insurance for board directors to cover the risk that the companies which they sit on are involved in fraud. 

Markel Insurance

You see, independent board directors are personally liable to be sued if their companies are involved in fraud. But since they are independent directors, they would have no knowledge of the hanky panky that their companies had been doing day-to-day. So why not create insurance for that? Board directors are paid five or six figures and they would be happy to portion out a sum to cover such risks! That's what Markel did. 

So with that model, Markel grew the way Berkshire did. But this is probably it's 17th year or so. If it follows Berkshire's trajectory, we should see Markel go like 20x in 35 years. It's not too late to buy now! Markel is led by a strong team comprising of strong operating people as well as members of its founding family. There is no succession issues since the main guy, Mr Tom Gayner is only in his early 50s. Having said that, Markel is not cheap, is used to trade at teens but had since re-rated to 20x and recently been trading at 30-40x! It just shows how difficult it is to beat the markets! Find a good idea and it gets traded up in no time!

Anyhow, insurance has been one of the most difficult sectors to understand but having gained this perspective, hopefully we can find some ideas closer to home as well!

Here's wishing a very Happy Hari Raya Puasa to all Muslims!

Sunday, June 04, 2017

Lessons from Omaha - Part 2

This is a continuation of the previous post.

Okay, as promised, here's the investing lessons that we can learn from this year's Berkshire Hathaway's AGM (Annual General Meeting for Shareholders). The first lesson came as a big surprise for many. It came about when Warren Buffett was asked why did he advise his heiress (second wife) to buy S&P500 rather than continuing to put her money in Berkshire Hathaway after he is no longer around. He was dumbfounded for about a second which afterwards he recovered and gave a succinct answer:

The S&P500 represents the best of the best 500 companies of corporate America. These company will continue to thrive and it makes perfect sense to buy them. Berkshire will continue to do well. But 30 years from now, or 50 years from now, it will depend on who is running Berkshire at that time. I just thought it would be wise for her to put her money with America's best 500 companies rather than worry and worst listen to unqualified advisors about what to do. (I am para-phrasing him, these are not his exact words)

Meanwhile, Charlie, in his usual style, munching See's Candies, would bet on Berkshire and ask his heir to do the same. I guess both of them are right. Warren is right because the S&P had a century of track record of generating 10% return per annum over time. Berkshire would be dependent on the manager. In some sense, Warren believed that the managers after him would not be able to beat him. Not the current handpicked ones, but the next one and the next one. Who dare says Berkshire would continue to do well indefinitely without Warren and Charlie. 

They are just so unique! Look at them! 

Warren Buffett and Charlie Munger

Charlie is also right because it's the right thing to say. The next line of managers are in the same stadium and to say that it would be best to investing S&P after both of them are gone is akin to slapping their faces. Or admitting that they would not be as good as their predecessors. Also, Berkshire has built this portfolio of strong solid businesses over these years, surely they would continue to do well for at least a decade or two. No matter who's running the show.

Berkshire Hathaway was founded in 1965, the same year that our beloved country gained independence. The first generation of leaders worked their asses off to make sure that they worked. They have built such strong foundations that we now take for granted. Singapore today enjoys the first world infrastructure, standard of living and status and it is inconceivable that this would crumble in a decade or two. But in 50 years, who knows? No small country ever survived more than 200 years. Even the mighty Sparta. Sparta fell into a long period of slow death decline shortly after they made the legendary last stand against the Persians, depicted in the movie 300 and its sequel.

Parody of a scene from 300, movie about Sparta

Similarly Berkshire had benefitted from Charlie's and Warren's continuously learning for 50 years and become the portfolio of first class companies. It took them a lifetime to amalgamate the these businesses to make Berkshire Hathaway today. In fact, the top few companies, according to Warren, makes up 9.5 Fortune 500 companies. These great firms - Burlington North, Coca Cola, American Express, Geico insurance, Wells Fargo, See's Candies will continue to do well for the next decade or two. But in 50 years, who knows? Very few companies last for such long time span. There are some family owned businesses that lasted centuries, but most companies don't. The only company surviving today in the original 30 Dow Jones started in 1896 is General Electric. 

Original Dow Jones

Hence to think that Berkshire will do even better than the S&P500 over the very long term is wishful thinking. Which brings me to the investing lessons today - maybe astute investors like all the readers here should always consider some ETFs in our portfolios. Long time readers of this site would be familiar with some thoughts on ETFs, which are labelled under ETF. In short, initially I thought that we should have some ETFs, but then realized not all ETFs are created equal so maybe not and now I am gravitating towards having at least 2 or 3 ETFs to be a substantial portion of the portfolio. Needless to say, the basket should include the S&P500. Having said that, I haven't bought any. I have ETFs but mostly legacy ones from the early days which are not doing well.

Anyhow, we should definitely reconsider ETFs!

For the world's greatest investor (and stock picker) to come out to say that he wants his heiress to buy ETFs and to thank John Bogle, the father of ETFs at his AGM, to me, means something. Hence my change of heart with respect to ETFs. Well, I don't think it's good to buy the S&P500 now at all time high, but someday, we should put some money and dollar cost average that over time. However I don't think our own STI falls in the basket of right ETFs to own and I would prefer to pick the few winners in Singapore - Singtel, SIA Engineering, Jardine Cycle and Carriage etc.

The next big lesson was the technological disruption that had dawned upon us. Warren Buffett and Charlie Munger never touched technology because it was too far from their circle of competence. They preferred brick and mortar businesses. They like old economy, solid, tangible businesses. In 2000, they completely missed the tech bubble and they were right then. They were ridiculed then revered bcos as the bubble collapsed, their wealth compounded! Fast forward 17 years, we are seeing the same story. Old economy dying but tech thriving. Today the top 10 largest companies in the world are dominated by tech firms.

World's largest companies

Heck! There only 3 non-tech firms: Berkshire Hathaway, Johnson and Johnson and Exxon Mobil. Talk about deja vu! But there are some differences. Today, unlike the 2000 techies, these firms have earnings. Apple makes US$50-60 bn net profit! Together these companies are generating hundreds of billions in profits. This is bigger than the GDP of some countries. Besides making tonnes of money, these firms have also created huge moats around their businesses. It's their eco-systems. They managed use their eco-system and arm-twist their ways to cannibalize the real economies. Google is eating the old media and advertising companies' lunch, Amazon is eating Walmart's lunch and Uber (still unlisted) is eating Comfort Delgro's lunch. 

In fact, we are so tied to some of these system it's hard to unplugged. Just imagine if we are not allowed to use Google today for some reason, how inconvenient would our lives become? We can't even drive properly since we rely on Google Map so much these days. Or if we can't Grab or Uber. Or if Apple disappears today. A huge part of the world would be dis-advantaged as they find an alternative for their iPhones. That's why Buffett bought Apple!

So I guess the message is that we better have some exposure to these tech names. Again a good way to do that would be to buy some tech ETFs that would have all these names. Preferably it should also be global in nature so as to capture all the non-US names as well. After doing like 15 min of Google search, I believe the few candidates would be:

1. QQQ - Nasdaq ETF
2. EMQQ - Global tech ETF
3. HACK - Cybersecurity ETF

Again, I haven't done the deep dive research on these and I don't own any of these at the moment. The history for EMQQ and HACK is also quite short (only 2 years or so). Hence it would also be homework for me to study further and look at better entry if any. Although given that all of them are near all time high, it would be at the backburner in terms of research priority. In fact, these days, there's more selling than buying.

Ok, so that's the lesson for today. Next post we talk about insurance!