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OK, bash Buffett -- but buy his stock
Insurance companies are amazing cash-flow machines. With a couple of flat years behind it, Berkshire Hathaway has cleared the decks for solid profits.
By Jim Jubak
I come not to bury Warren Buffett but to praise him.
In the last week or so, two other financial pundits, Jon Markman on this site and James B. Stewart in the Wall Street Journal, have argued that Buffett has lost it.
Once Buffett was a CEO worth investing beside, Markman wrote, but now he should be stripped of his title as Oracle of Omaha and called the Natterer of Nebraska. Stewart called Buffett's annual letter to Berkshire Hathaway (BRK.B, news, msgs) autumnal and added he couldn't help wondering if Buffett had lost some of his legendary touch.
I'm sure Buffett's has been called things far worse than "natterer" in his long career. And he really doesn't need any defense from me. The columns, however, do deserve a rejoinder, because I think both articles are so profoundly beside the point that they might cost investors a few bucks or more.
Buffett schmuffett
Warren Buffett
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Deciding whether Buffett is the greatest living investor may be an interesting parlor game, but it has nothing to do with whether or not you should own Berkshire Hathaway stock right now.
As always with a stock, it's not how the stock has done in the past that counts but how it's likely to perform in the future. Yes, Berkshire Hathaway's performance in 2004 (a 4.3% return) and 2005 (flat for the year) was pretty lame. But I think you want to own Berkshire Hathaway now precisely because 2004 and 2005 have positioned the shares very nicely for solid profits in 2006.
Related news and commentary on MSN Money
One of the first things you learn in financial-pundit correspondence courses is that the stock market will do everything it can to embarrass and humiliate you. So I wasn't surprised to see Wall Street upgrade shares of Anheuser-Busch (BUD, news, msgs) just as Stewart's piece citing Buffett's purchase of the shares as an example of his fading prowess as a stock-picker came out. Deutsche Bank (DB, news, msgs) even called the stock a buy and put a $49 price target on the shares -- a potential 13% gain.
And, for the record, I touted Buffett's bet against the U.S. dollar as one of the reasons to own the stock, calling it a hedge fund for the masses. Berkshire Hathaway has lost enough money on that bet for me to wish that Buffett either hadn't made it or that he'd gotten the timing right.
Berkshire as cash machine
But one of the advantages of holding a stock for a while -- and I've owned Berkshire Hathaway in my online Jubak's Picks portfolio and in my personal portfolio since June 2003 -- is that you come to appreciate qualities that escaped you on first acquaintance. In this case, owning Berkshire Hathaway has given me a deep appreciation for exactly what an amazing cash-flow machine an insurance company can be.
Insurance companies take in money in premiums from customers long before they have to pay it out in claims. They invest this float in stocks, bonds, real estate, pieces of other companies or whole companies and reap the returns until this money has to be paid out to customers who file claims. Thus an insurance company has two ways to make money:
- First, there's underwriting profit if the company succeeds in writing policies at a high enough premium that, when claims on those policies are paid out, there's something left over. (The industry uses something called the combined ratio as a measure of this underwriting profit. A combined ratio of 90%, for example, means that the company has paid out in claims just 90% of what it collected in premiums. It has earned 10 cents in profit on every dollar of premium collected.)
- Second, there's investment income. The company invests the float in some mixture of assets looking for the highest return commensurate with the need to avoid losses that would endanger the company's ability to pay out claims. The insurance company also wants to build up its financial strength, as assessed by agencies, such as A.M. Best, that rate insurance companies. Many customers buy insurance based on a company's financial strength.
The best of all worlds is when a company is so experienced at pricing that it can earn a profit on the premiums it collects on the policies it writes, and so deft at investing that it earns a high rate of return on the float. Oh, and so financially strong that even if it gets something really wrong or if chance goes against it, the company will be able to pay out claims without destroying its profitability.
Stormy weather for reinsurers
From that point of view, 2005 was something of a test for Berkshire Hathaway. The company's General Re and National Indemnity reinsurance units took a huge hit from the combination of hurricanes Katrina, Rita and Wilma, losing $3.4 billion from the storms. Reinsurers buy risk by, in effect, insuring the ability of other insurance companies to pay claims in case of a catastrophic event.
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