The question I wanted to ask at the Berkshire meeting

I never got to ask a question at the Berkshire meeting. I was a little awed and did not even ask until about 2pm (which was silly). There was a lottery ticket system to determine who got to ask a question anyway.

So here goes (and for the most part I genuinely do not know the answer).

Insurance companies sell promises to make good real goods and services some time in the future for cash now. For example they promise to pay someone's medical expenses or a nursing home bill say 10 years after a premium has been collected. 

They mostly hold the cash receipts in cash and bonds. Berkshire also use some real assets (eg railways) and many banking stocks. 

Because insurance companies are short real goods and services and long cash and other nominal assets they negatively affected by inflation. Long tail insurance companies are obviously worse hit with inflation than short tail companies. 

Can you run through the major Berkshire insurance businesses (GEICO, Gen Re, Ajit Jain's business and others) and tell us what damage inflation will do and why?

Answers are gratefully accepted - especially from Uncles Charlie and Warren (who I somehow doubt read this blog).




John

PS. I should disclose because people are doubting it - that Bronte Capital is LONG Berkshire stock.

J

Thoughts on the Berkshire meeting and a comment on long term care reinsurnace

I am in Omaha and have just been to the Warren and Charlie show. It has been on my "to do" list for my whole adult life and I am strangely disappointed.

It is of course blasphemous to be disappointed in Charlie and Warren. These octogenarians could teach me plenty - they just did not. It was annoying to be in the presence of people so smart and to learn so little.

I have read various notes from the meeting for almost twenty years so I had a fair idea what to expect. I could expect - questions on politics and economics, questions from young people wondering what to do with their life and questions from hedge-fund managers using 25 thousand rich people in a room as an opportunity for self promotion.

I got all this - and for the most part I got the usual homily answers. (The same questions were asked last year and the year before and the year before that. Answers can be got from meeting notes.)

This year we got multiple questions from hedge fund managers who were concerned about the stock price. Charlie Munger in frustration tartly observed that if one (nameless but well known) hedge fund manager was that concerned about short term matters he wasn't really welcome in this room. This got general applause but could (like many of Charlie's answers) be a little more diplomatic.

But with the above exceptions the questions were better than I expected. Much better. We had serious questions from competent Wall Street analysts who mostly asked about insurance, underwriting and regulatory issues - issues that cut to core of what Berkshire is and Berkshire's ability to route money to the parent company (where it can be used unencumbered) and to pay insurance claims. The detailed answers to these questions were largely squibbed.

One analyst for instance made the obvious observation that the organizational structure is "challenging" and wondered why the railway (BNSF) was owned by a regulated insurance subsidiary. Charlie and Warren squibbed it - arguing that BNSF provided more resources for paying claims - noting roughly $5 billion in pre-tax profits. But throughout the meeting Warren argued that one advantage of BNSF was that it was going to be allowed to invest vast sums (far in excess of depreciation) at acceptable regulated returns. In other words BNSF is going to absorb cash. How does this mean the insurance sub is going to have more cash to pay claims? Can claims be paid in steel rails or railway bridges?


This wasn't an atypical squibbed answer. Warren (correctly) argued that General Re was a good asset now but that previously it lost its way. Charlie wasn't going to let Warren get away with this - it was thoroughly lost when Berkshire purchased it (and paid a huge price). However the details of how General Re was brought back into order were simply glossed over. Warren observed that Gen Re had a very nice life reinsurance business. That surprised me. Swiss Re has a sort-of-OK life reinsurance business but life reinsurance is a business that has produced a few disasters one of which I followed closely*. I was struggling to understand what made the life reinsurance business a good business.

Warren also noted - as a throwaway - that they had a long term care reinsurance business that he wished they had less of. Again there was no explanation as to why. But this time it is inside my field of competence so I am going to explain myself.

The disaster of long term care insurance

Long term care insurance has bankrupted almost everyone that ever touched it. It is the insurance against the need to go into a nursing home and it has mostly been sold by insurance agents on commission.

Here is what a commissioned agent does.

They make friends with people who run nursing homes.

When the kids (now middle aged) visit a nursing home they might put their (elderly) parents into the insurance broker is notified. The insurance broker then sells them a policy for their parents.

Of course the policy is going to be used. The people who buy long term care insurance are precisely the people who are going to claim. It is a disaster.

Eventually the policies become so expensive (to cover the losses) that people who won't claim never buy a policy. Adverse selection becomes total.

Long term care insurance is the worst business I have ever seen.

Warren of course never told us that - but somehow he wound up re-insuring it.

I guess he did not want to explain his stupidity.

But then long term care doesn't need to be that awful. Indeed there is (at least) one company that does it well.

That doesn't make long term care a good business - but it might make it an acceptable business.

That company is (and this will be a surprise to many of my readers) Genworth. The same Genworth that was a spin-out of crappy long-tailed insurance businesses from GE Capital. It includes a mortgage insurance company (with what is probably a toxic Australian exposure) and a long term care business.

Here is what they do to make the long term care business acceptable.

They employ a sales force of 60-65 year old people on salary not commission. Because they are on salary not commission they have no incentive to write bad risks. They do not troll for business in nursing homes.

This sales force visits the home of leads and has a cup of tea or coffee and a social chat. They might spend twenty minutes having a chat.

They will find out what the lead's husband or wife is doing.

They will find out whether the lead is doing the New York Times crossword or reading sophisticated books.

And whether they play golf or do some exercise.

They will look for pictures of the grandchildren and ask questions about them.

They will observe and ask about the pile of toys and children's games in the corner.

And only then will they ask anything that looks like an underwriting question but they will have already decided whether to underwrite the business.

Here is what is going on.

People who have stable relationships into old age tend not to wind up in nursing homes. They look after each other. Singles are the biggest risk and asking about a spouse is the critical question.

Doing the New York Times crossword or reading sophisticated books indicates no Alzheimer's disease. That removes another major insurance risk.

Golf suggests some physical fitness - and removes more risk.

The children's toys however are - after a solid marriage - the next largest risk mitigating factor. If the grandparents look after the grandchildren that creates a reciprocal obligation. The children are far less likely to put granny in a nursing home if granny is a part of their own kid's lives.

Warren knows all this. He knows why some insurance businesses are better than others. He knows why their life reinsurance business is good (I have no idea). He knows why their long-term care reinsurance business is bad (and after this post so do you).

But Warren told us surprisingly little. And for that I am disappointed.




John


*I was once obsessed by the collapse of Annuity and Life Re.

Post script: in all except a very bad year or a very high cap-ex year the depreciation plus profits of BNSF will probably be less than cap-ex so there are likely to be distributable funds. One exception may be if a catastrophe removes many of the bridges or damages the rails or closes the line for an extended period. That however may well be a big claims year for the insurance company so the situation can still be problematic.

Huabao Suspends Trading After Falling on Short-Seller Report

Huabao - a Chinese flavours and fragrances company in Hong Kong - has suspended trading after falling on a short-seller report. To quote a Business Week article:

Huabao International Holdings Ltd. (336), a maker of flavors and fragrances used in cigarettes, suspended trading in Hong Kong after the stock plunged on a short-seller report that questioned its finances. 

Huabao fell 8.1 percent to HK$3.98 at the close in Hong Kong yesterday after short seller Anonymous Analytics said the company “reports absurdly high margins, which industry sources say should not be possible.” 

The company didn’t give a reason for the suspension. In a Hong Kong stock exchange filing late on April 24, Huabao said it wasn’t aware of any reasons for the changes in its share price and trading volume.

Readers of this blog should be familiar with the stock as I blogged about it here. I also blogged about the (now in excess of a) billion US dollars the CEO had cashed out and the derivative transactions that she had used to do so.

The suggestions in my blog post - and a few other things - were covered in the short-seller report.




John Hempton


Disclosure: We remain short this company - albeit in modest quantity.

Do I have any blog readers in Istanbul?

Just asking. I am visiting.

Send me an email through the blog.

Daddy you are more evil than I thought

It is the holiday part of the trip and I was strolling through the back-lot footpaths of Venice with my twelve year old son. We were doing out best to get lost (surprisingly easy) and I had given up worrying that my wife had (dangerously) gone shopping.

It was four hours chatting to the boy about business and history and life without the interruptions of computers, phones or video games.

We talked about the trading history of Venice, the closure of the Venetian constitutional system (La Serrata of 1286 to 1297) and the subsequent relative decline. We talked about the expenses of the nearly endless series of wars against the Ottoman empire.

We even mentioned the rise of double-entry accounting. We got as far as the collapse of the Venetian State at the hands of Napoleon.

We also talked at length for the first time about our business. We run a hedge fund. Our job is simple: make rich people richer through investing, trading in financial markets.

Half of that is relatively easy to explain: we buy shares in good companies. My son wanted to know why I was not interested in buying Facebook (he thought the shares are going up). I told him that it had 4 billion in revenue, 1 billion in profits and a market cap that was likely to edge 100 billion. The numbers are from memory (I am on holidays). That seemed expensive. However it was only about $200 per regular user which does not seem so expensive. I did not think I could analyse it well. This was the beginning of a discussion about price.

But then the area our fund is best known for came up. I am a short seller.

I went through the mechanics of short-selling. I borrow a share from a broker. I sell it in the market. If the stock goes down I get to buy it back for less than I sold it. I repay the loan by returning the share and I keep the profit. I explained it does not work so well when the stock goes up.

Then I got to the nub of the issue: I am a short-seller of frauds and stock promotes. I look for people in the stock market who have fake accounts and who are stealing from gullible shareholders (also known as marks, dupes, fools, day traders or mutual fund managers). There is a torrent of money being ripped off (many billions of dollars for instance in the case of the Chinese frauds a surprising amount of which came from Fidelity). Through short-selling I stick up my sail on my little boat in the hurricane of theft and some of that loot drops into the cabin.

He asked me how I find all these fake accounts and fake companies and I told him a few of our methods (we have many).

He asked if I ever dobbed the scammers in to regulators and I said I did sometimes but it was mostly not a satisfactory experience. To be a good short-seller I only need to be right about 90 percent of the time. If most the companies I short-sell have fake accounts I will do fine. However if I dob them into regulators I need to be absolutely right in that it does not bode well to dob an honest person into the authorities. So mostly I keep my gob shut and express my opinion (and it is an opinion) in a bet in the financial market.

Moreover talking about which stocks you think are frauds is a dangerous thing. Regulators sometimes (even foolishly) have been known to investigate short-sellers for telling the truth. (Being  short Lehman Brothers and vocal about it was a good way of getting an SEC investigation for talking truth to power.) Also crooks sue short-sellers giving you nasty and expensive legal bills.

Silence is altogether a better strategy.

But then he came to the nub of the issue. The easiest scammer to find is a repeat offender. We actively seek out people who promote dodgy stocks and who who are repeatedly involved in dodgy companies. The slogan is “once a scumbag, always a scumbag”. That slogan is probably not strictly accurate -  but we only need to be right 90 percent of the time to be fantastic at this business – and the recidivism amongst scammers is surprisingly high.

In that sense long sentences for people like Bernie Ebbers are not in my interest. I would prefer slime-bags to be back-in-business rather than in prison. More opportunities for me.

So, perceptively my son asked whether it was in my interest to dob scammers into regulators – he asked whether the reason we did not do it much was because of the reasons stated above or because we liked the scammers to be free and profitable. Alas – and I had to confess it – at least part of it was that being a successful short-seller required that regulators were inadequate to the task of policing fraud.

I did not talk about this with him – but it is becoming harder under Mary Schapiro. The SEC is getting better at their job – and that is not good for me. It would be better if regulators stayed hopeless. Alas they are getting better.

So, says my son asks you like nasty people to steal from poor investors, mutual funds (and he did not say pension funds for school teachers) so that you can join them in taking the loot by being a short-seller – and you don't want the regulators to do anything about it because there are more opportunities for you?

Sheepishly I confess yes.

And he says with a mixture of admiration and horror: “daddy you are more evil than I thought”.





John

PS. A long time ago I promised Felix Salmon an economic defence of short-selling. I did not deliver – but it is sort of written in my head. I think I owe it to my son too.

Lessons in my laundry: Italian edition

On my travels I found myself in a fine hotel in Central Milan. I came in about Midnight the previous night from London (courtesy the atrocious service of Easy-Jet*).

At 6.15AM I was up for my morning meeting - via a fast-train to Bologna. My shirt was clean courtesy the expensive London laundry. I just wanted an ironing board to press out the wrinkles.

There was not one in the room - so I rang reception. I asked them to bring one up. They said "impossible" which I found peculiar. An ironing board is a pretty standard service in a 4 star business hotel.

Then they explained that they could not get one before 7.30 (which was just before my train left). I said this was a bad fail for a business hotel.

Then they said something that was so stereotypical Italian it left me breathless. They told me it would be against the law to bring an ironing board to my room before 7.30 am.

I told this to my Bologna business contact and he scoffed. Of course somewhere in the 10 million lines of Italian code there is - of course - something that talks about ironing boards. Dysfunctional government (at least by the standards of OECD countries) is an iconic feature of Italy - but this was not government as a problem - it was government as an excuse.

At least Easy-Jet don't blame the government for their bad - even rude - service.



John


*If anyone knows why European discount carriers are so horrible but Southwest (surely a similar model) is so pleasant (at least in a relative sense) let me know. In the USA I will fly Southwest in preference to any other airline. In Europe I am learning to avoid the discount airlines.

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A post script is warranted: Part of my dislike of Easy-Jet had to do with a ridiculous overcharge of GBP12. Trivial really. However when I complained at the counter the discussion had the tone of "I can see you are right but our computer won't let me refund the money so sorry". Silly stuff that indicated process over service. And I had 90 minutes at an airport and was frazzled. Not a good combination. I did not raise my voice - just walked away frustrated.

In frustration I wrote a (nasty) letter to them. I do not think they linked me to this blog - but they refunded the 12 pounds. I think that marks them as several steps better than Ryan Air. I have not quite forgiven but I think I am prepared to give them another go.

Lessons in my laundry: Hong Kong edition

I do irregular (but extended) business travel. (It comes from living in Australia – when you travel it is usually more than a week.)

And so I find myself needing to wash and iron business shirts and press a suit. Nothing complicated – but strangely the price and procedure changes by country. In New York I usually stay in Brooklyn and my walk to the subway takes me past a Chinese laundry which is breathtakingly cheap – my bag usually costs under $12. That is about a quarter what I would pay in Sydney (which is an expensive city for almost everything) and a third London. Brooklyn seems cheaper than other US cities.

This low-cost laundry (clearly a benefit to me) is made possible by a near-sweatshop centralised Chinese laundry where (immigrant) workers work hard for what may or may not be minimum wage.

When I wrote a post about that I was criticised for daring to state the obvious about income inequality in the United States. It is a taboo topic. In my defence several readers noted that investment bankers regularly press their own shirts in London. I certainly do in Sydney.

When I stayed in a friend's house in Chicago I discovered much to my surprise they did not have an ironing board. I thought it worth a blog post. And whilst the underlying tone was that income inequality was not the finest attribute of a society I have to say it is not entirely a bad thing. The couple I stay with in Chicago are a monstrously successful husband and wife team with children. Very few married women with children pull that off in Sydney – and the reason was obvious. The wife's work life (high profile but only moderately remunerative) relied more than a little on the two nannies and the implied low-wage workers (such as the staff at the local laundry) who relieved her of the mundane house-work that fills many (mostly female) lives in Australia.

This was feminist achievement made possible by income inequality. But it was achievement at a very high level and the USA is better for it.

This trip I stayed at a friend's apartment in Hong Kong. Nice place – not huge – but half-way up the Mountain on Hong Kong Island with an expansive view of skyline (when you can see through the pollution).

I asked to borrow an ironing board. My friend said he could do better. He knocked at a small door past the closet next to the kitchen and out popped a Filipino house-keeper maybe 20 years his senior. She cheerfully laundered my clothes and left them neatly pressed. She also made me breakfast, cleaned up my dishes and made my bed when I went to work.

I made a point of trying to work out her story. She had been a migrant worker throughout her life – mostly in Hong Kong but also in Dubai (which she found harder). She was thinly educated but thought her children (who she had spent years away from) were better prepared than her. The reason for migrant work was to educate her children (though I know nothing about their prospects – the Philippines are not a highly functional place). Unlike Harry Potter she did not show any unhappiness in living in the “cupboard under the stairs”. Instead it was a step-up for her and (especially) for her family. And it was better than Dubai.

But it made me deeply uncomfortable. Migrant workers are a profoundly anti-democratic institution – they provide a class of very-low income people who don't vote. The ethos of democracy is something burnt into my consciousness. In this ethos we are “created” equal (and thus have an equal vote) and dint of luck and hard work (or coming from the right womb) produce inequalities (some deserved, some otherwise). But the vote (hopefully a secret ballot) is one of the great equalisers – and acts to create a more harmonious society (albeit one that will interfere with income distribution to some extent). The woman who cheerfully lived in the cupboard under the stairs challenged what I thought was right in the world.

But then I was in Hong Kong (that is China) and another low-wage worker who does not vote in China seems – well – somewhat irrelevant. And my world view was out of place. Moreover the woman's children were clearly better off for her migrant work. And the Philippines would be a true basket case without remittances.

And low-income workers are a gift to those who get to employ them. They make the Feminist achievements of my above-mentioned Chicago friends possible. They can free productive people to work on things that were productive.

And that was clearly the case for my friend – consciously trying to pick up additional commercial languages (think India), improve his computer processing skills (python) and read a book per week. His ambition to build himself into as fine a thinker (and with as many diversified mental models) as Charlie Munger. Human capital development made possible by the profoundly undemocratic institution of migrant work.

But that was not the only thing people do with their wealth in Hong Kong. Hong Kong Island has become a pastiche of office towers for financial businesses and shopping malls selling the global standard set of luxury goods. Interspersed amongst that are stylish but ultimately vacuous bars where you can get wasted in the time you would have otherwise spent ironing your clothes and doing the dishes. It is not far (just a subway) from Kowloon where you can experience the smells and sounds of Asia – but they joke on Hong Kong Island that you need your passport to go there.

This is a world very different to mine – with some amazingly productive people – their productivity made possible by the institutions of China. Interspersed amongst that the most dilettante hedonistic lifestyle of an elite who can think of nothing better to spend their loot on than Swiss watches and French Brandy.

Whatever: I am going to make a confession. I liked having someone launder my clothes and the stylish bars are very cool. Freeing up all that time to read an extra book per week – that would be very cool too.




John