Two investors I admire, Bill Ackman (Trades, Portfolio) and Whitney Tilson (Trades, Portfolio), have recommended that to learn about investing, investors should read Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) annual letters to shareholders. This series focuses on the main points Warren Buffett (Trades, Portfolio) makes in these letters and my analysis of the lessons learned from them. In this discussion, we cover the 2001 letter.
Berkshire's investment strategy
In 1987, Buffett wrote that in addition to Berkshire’s permanent common stock holdings, it holds large quantities of marketable securities in its insurance companies. He bucketed these into five major categories: (1) long-term common stock investments, (2) medium-term fixed-income securities, (3) long-term fixed income securities, (4) short-term cash equivalents and (5) short-term arbitrage commitments.
The guru said Berkshire has “no particular bias” when it comes to choosing from these categories. Buffett just continuously searches among them for the highest after-tax returns as measured by "mathematical expectation," limiting himself always to investment alternatives he thinks Berkshire understands. He said the criteria has nothing to do with maximizing immediately reportable earnings; instead, the goal is to maximize eventual net worth. The 2001 shareholder letter provides a good case study of this.
Distressed investing: The FINOVA Group case
In the letter, Buffett described one of these investment alternatives in detail. In late 2000, Berkshire began purchasing the obligations of FINOVA Group, a troubled finance company. FINOVA then had about $11 billion of debt outstanding, of which Berkshire purchased 13% at about two-thirds of face value. Buffett expected the company to go into bankruptcy and believed that liquidation of its assets would produce a payoff for creditors that would be well above their cost. When default loomed in early 2001, Berkshire joined forces with Leucadia National Corp. - now Jefferies Financial Group Inc. (JEF, Financial) - to present the company with a pre-packaged plan for bankruptcy.
The plan was subsequently modified and involved Berkshire and Leucadia borrowing and immediately lending $5.6 billion to FINOVA, concurrently obtaining a priority claim on its assets. Berkshire and Leucadia were able to earn a spread of about two percentage points, with FINOVA starting to pay down the debt right away.
Bankruptcy plan and 9/11 impact
As part of the bankruptcy plan, which was approved on Aug. 10, 2001, Berkshire also agreed to offer 70% of face value for up to $500 million principal amount of $3.25 billion of new 7.50% bonds that were issued by FINOVA. The offer, which was to run until Sept. 26, 2001, could be withdrawn under a variety of conditions, one of which became operative if the New York Stock Exchange closed during the offering period. Sadly, the NYSE did close in the week of Sept. 11, so Berkshire promptly terminated the offer.
Berkshire decided to reduce its exposure because many of FINOVA's loans involved aircraft assets whose values were significantly diminished by the events of Sept. 11. Other receivables held by the company also were endangered by the economic consequences of the terrorist attacks. Buffett said he felt that overall the transaction would still prove satisfactory for Berkshire. In part, this was because Leucadia had day-to-day operating responsibility for FINOVA, and Berkshire had “long been impressed with the business acumen and managerial talent of its key executives.”
Takeaways from distressed investing
My takeaways from this episode of distressed investing are as follows. One, Berkshire’s long-term approach enabled it to profit from an arbitrage between a liquidity and solvency issues. Buffett assessed that FINOVA was going bankrupt, but that liquidation of its assets would produce a profitable payoff for creditors. Second, Buffett spread its risk by sharing the deal with Leucadia, a respected investor. Third, Berkshire had inserted a material adverse change clause, enabling it to get out at no cost to itself if something happened. Unfortunately, 9/11 happened and Berkshire was not committed to the extra financing. While not all investors are going to be able to get into distressed investing, it is a good example of Buffett’s "mathematical expectation" principle. It is also a good case study of Buffett spreading risk through partnership and having the optionality to withdraw.
Implications and lessons of 9/11
A good deal of the 2001 letter goes toward discussing the implications and lessons of 9/11. Indeed, in the section titled "Principles of Insurance Underwriting," Buffett said, “What counts in this business is underwriting discipline.” Winners, he said, are those that “unfailingly stick” to three key principles:
"They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions."
"They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks."
"They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn't work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so."
The events of Sept. 11 made it clear Berkshire’s implementation of rules one and two at General Re had been dangerously weak. In setting prices and also in evaluating aggregation risk, Buffett noted Berkshire “had either overlooked or dismissed the possibility of large-scale terrorism losses.” That was a relevant underwriting factor, and Berkshire had ignored it.
Overall, the attacks resulted in significant insurance claims related to property damage, business interruption and liability. However, while the 9/11 attacks had far-reaching consequences, Berkshire Hathaway's diversified portfolio and long-term investment strategy might have helped mitigate some of the impact.
Recommended reading
In the 2001 letter, Buffett noted Berkshire had “as fine an array of operating managers as exists at any company.” He highlighted that we can read about many of them in a book by Robert P. Miles: "The Warren Buffett (Trades, Portfolio) CEO: Secrets from the Berkshire Hathaway Managers."
Buffett said the “ability, energy and loyalty” of Berkshire’s portfolio company CEOs was simply extraordinary, which was also demonstrated when he said:
"We now have completed 37 Berkshire years without having a CEO of an operating business elect to leave us to work elsewhere."
The Oracle of Omaha also recommended Jack Welch's “terrific book,” "Jack, Straight from the Gut." Buffett noted that he and Charlie Munger (Trades, Portfolio), in discussing this book, agreed that Joe Brandon (General Re's new CEO at the time) had many of Jack's characteristics: “He is smart, energetic, hands-on and expects much of both himself and his organization.”
