A letter a day!

A letter a day!

Letter #50 1996

Key learnings:

1. Acquisition of Kanas Bankers Surety:

If you are also anti-social like Buffett, you can consider attending some social events post reading this story.

You might be interested in the carefully-crafted and sophisticated acquisition strategy that allowed Berkshire to nab this deal. Early in 1996 I was invited to the 40th birthday party of my nephew’s wife, Jane Rogers. My taste for social events being low, I immediately, and in my standard, gracious way, began to invent reasons for skipping the event. The party planners then countered brilliantly by offering me a seat next to a man I always enjoy, Jane’s dad, Roy Dinsdale – so I went.

The party took place on January 26. Though the music was loud – Why must bands play as if they will be paid by the decibel? – I just managed to hear Roy say he’d come from a directors meeting at Kansas Bankers Surety, a company I’d always admired. I shouted back that he should let me know if it ever became available for purchase.

On February 12, I got the following letter from Roy: “Dear Warren: Enclosed is the annual financial information on Kansas Bankers Surety. This is the company that we talked about at Janie’s party. If I can be of any further help, please let me know.” On February 13, I told Roy we would pay $75 million for the company – and before long we had a deal. I’m now scheming to get invited to Jane’s next party.

2. Selling fine businesses on “scary” news is usually a bad decision.

“Robert Woodruff, the business genius who built Coca-Cola over many decades and who owned a huge position in the company, was once asked when it might be a good time to sell Coke stock. Woodruff had a simple answer: “I don’t know. I’ve never sold any.”

3. Competitive advantages of Berkshire’s super cat ( high amount) insurance business:

1. The parties buying reinsurance know that they can and will pay under the most adverse of circumstances.
2. After a mega-catastrophe, insurers might well find it difficult to obtain reinsurance even though their need for coverage would then be particularly great. At such a time, Berkshire would without question have very substantial capacity available – but it will naturally be its long-standing clients that have first call on it.
3. Our final competitive advantage is that we can provide dollar coverages of a size neither matched nor approached elsewhere in the industry. Insurers looking for huge covers know that a single call to Berkshire will produce a firm and immediate offering.

“In insurance, it is essential to remember that virtually all surprises are unpleasant, and with that, in mind, we try to price our super-cat exposures so that about 90% of total premiums end up being eventually paid out in losses and expenses. Over time, we will find out how smart our pricing has been, but that will not be quick. The super-cat business is just like the investment business in that it often takes a long time to find out whether you knew what you were doing”.

4. Inactivity is also a type of intelligent behavior. When carried out capably, an investment strategy of this type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio.

“This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team.”

5. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses.

Note that word “selected”: You don’t have to be an expert on every company or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.

6. To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing, or emerging markets. You may, in fact, be better off knowing nothing of these.

7. Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now. Over time, you will find only a few companies that meet these standards – so when you see one that qualifies, you should buy a meaningful amount of stock.

8. 8. USAir

Buffett purchased preferred stocks of USAir and in this letter, he regrets the same,

“I liked and admired Ed Colodny, the company’s then-CEO, and I still do. But my analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations, and by the protection that ownership of senior security seemingly offered me, that I overlooked the crucial point: USAir’s revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be. (If history supplied all of the answers, the Forbes 400 would consist of librarians.)”