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OK, bash Buffett -- but buy his stock
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But thanks to Berkshire Hathaway's low-cost auto-insurance business, Geico, the company's insurance business as a whole showed a slim underwriting profit for the year of $53 million.
That underwriting profit meant that in 2005, again, Berkshire Hathaway didn't pay a cent to use the capital that makes up its float. And since Berkshire Hathaway's float amounts to some $49 billion dollars, that's a huge cost advantage in the investment business. While banks have to pay interest to depositors, and hedge funds have to share profits with their investors, Berkshire Hathaway can invest a no-cost $49 billion.
Battening down and raising premiums
Neither Warren Buffett nor anyone else can predict how the 2006 hurricane season will shape up, although some readers have written me noting that water temperatures in the Gulf of Mexico are already higher than normal for this time of year, which is often a sign of a strong hurricane season to come.
But after a disaster, a prudent insurance company always raises premiums and may indeed cut back on the risks it takes. And that, Buffett says, is exactly how General Re is approaching 2006.
Here's what Buffett had to say in his annual letter to Berkshire Hathaway shareholders:
"Its an open question whether atmospheric, oceanic or other causal factors have dramatically changed the frequency or intensity of hurricanes. Recent experience is worrisome. We know, for instance, that in the 100 years before 2004, about 59 hurricanes of Category 3 strength, or greater, hit the Southeastern and Gulf Coast states, and that only three of these were Category 5s. We further know that in 2004 there were three Category 3 storms that hammered those areas and that these were followed by four more in 2005, one of them, Katrina, the most destructive hurricane in industry history. Moreover, there were three Category 5s near the coast last year that fortunately weakened before landfall.
"Was this onslaught of more frequent and more intense storms merely an anomaly? Or was it caused by changes in climate, water temperature or other variables we dont fully understand? And could these factors be developing in a manner that will soon produce disasters dwarfing Katrina?" Buffett doesn't claim to have the answers. But he does know what the prudent insurance company should do about the possibility of increased losses: raise premiums. "Weve concluded, Buffett reports, "that we should now write policies only at prices far higher than prevailed last year."
So even if the 2006 hurricane season is as bad as that of 2005, General Re will have gone into it writing insurance with higher premiums and, probably as a consequence, writing fewer policies. Higher prices and less risk. That's a solid improvement for 2006.
Dogged by derivatives
But the big storm losses in reinsurance weren't the only problems that General Re caused for Berkshire Hathaway in 2005. Quite frankly, it looks like someone slipped up when Berkshire Hathaway bought General Re in 1998. Not only did the company drag Buffett into the investigation about accounting fraud at American International Group (AIG, news, msgs), but General Re brought along a huge book of derivative contracts that Buffett has belatedly moved to sell and shut down.
When Berkshire Hathaway bought General Re, the company had a book of 23,218 derivative contracts. A derivative in this case is a contract between two parties in which one sells risk and the other buys it for a price. The terms of how and when that risk will be transferred are extremely specific and highly variable, ranging from moves in interest rates and currencies to changes in the value or yield of specific securities. Time periods can also vary: One in the General Re book, Buffett notes, was set to run for 100 years.
The problem with derivatives of such widely varying terms and durations is that there isn't a liquid market for many derivatives. That makes them hard to trade and hard to price. Exactly how hard to trade Berkshire Hathaway discovered when it began to shut down General Res derivatives book. Selling the first 20,000 contracts produced a $300 million loss. Selling the next 2,150 cost the company a loss of $104 million. At the beginning of 2006, only 741 contracts remained for disposal.
Count it up: Over the last two years, shutting down the derivatives book cost Berkshire Hathaway and its shareholders $404 million in charges that went straight to the bottom line. It's not possible at this point to know what disposing of the last 741 contracts will cost the company. Investors, however, should be glad that they are within sight of the end of these charges.
Major utility acquisition
But there's one more development that may turn out to be even more important. In 2005, Berkshire Hathaway made the kind of big acquisition that investors have been clamoring for since, well, since the General Re deal in 1998. Berkshire Hathaway, through its 81% ownership of MidAmerican Energy Holdings, moved to acquire PacifiCorp, a utility with 1.6 million customers in six Western states. (You can still own preferred stock in the company; it trades as Pacificorp (PCPWP, news, msgs).) The deal, which closed on March 21, puts Berkshire Hathaway in the forefront of a consolidation of the electric-utility grid at a time when the national grid is looking for a huge inflow of capital to increase capacity and reliability. (The repeal of the Public Utility Holding Company Act on Aug. 8, 2005, marked the end of a major barrier to this consolidation.)
In the utility sector, Berkshire Hathaway has found the kind of large-scale investment opportunity that a company with a $49 billion float requires.
So, add it up for 2006:
- Higher premiums and lower risk.
- The coming end of charges from shutting down the derivatives book at General Re.
- And a major investment opportunity in the utility sector.
Those are all important positive changes for Berkshire Hathaway as the stock heads deeper into 2006.
And these three changes -- not the state of Buffett's prowess as a stock-picker -- are why I continue to hold the stock and just increased my target price on the B shares to $3,440 by September 2006.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For suggestions to help navigate the treacherous interest-rate environment see Jim's new portfolio Dividend stocks for income investors. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: AIG-American International Group and Berkshire Hathaway. He does not own short positions in any stock mentioned in this column.
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