Monday, May 21, 2007

Berkshire Hathaway Assesses LT Insurance Risk

While much ink is spilled about Warren Buffett and his current investment choices, very little energy is spent on assessing much more important decisions (or absence thereof). The buy/sell of KO one of his largest equity holdings comes to mind. (To whom would he sell said James Grant in 1998. ) Many of these, though virtually absent from public discussion have far greater import to the long-term profitability of his enterprise. Another such decision involves the virtual absence of growth (overall) in the insurance business. As per annual reports; 2006 premiums earned were $24.0 billion compared with 1999 premiums earned were of $19.3 bill. That corrsponds to less than 3% annual top line growth for 7 years. Absent the $7 billion (one time) premium gain in the first quarter, new risk would not have changed long-term growth rates materially. Compare this figure with your average Bermuda company (ACE) that showed a 5 year cumulative growth in premiums in the 13%/14% range. The master himself has suggested that returns will be down in 2007, perhaps sharply. What does his gimlet eye see that myopic investors fail to discern from the inflation/interest rate trends. While I admit to talking my position (short p/c stocks), one would have to give credit to the institutions (buyside, hedge funds) piling into the insurance stocks (life and p/c alike) with the hope that being long US US bonds (through holding US insurance assets) and a winning trade for years will continue to work, absent the foggiest notion about what is coming down the pike in this notorious cyclical industry. The industry is due for a long period of seriously declining margins and ROEs, and investors are likely to be as surprised of the outcome as they are of the impact on their portfolio of insurance stocks.

REITs and Financials

A very decisive pullback in the REIT sector ought to give caution to the bulls stampeding through the financial sector. While we've seen this rotation before, the size of the REIT sector
curently is much more significant than five or ten years back. In addition, the wave of property mergers, and the financial calculus (i.r. cash returns) of real estate now makes it clear that the margin of safety in real estate investments in general (and lending in general) that much thinner. Far be it for one observer like myself to call the top in financials (or at least encouraging investors to sell on strength ). But even loooking at the major banks suggests that the ROE's discounted by the current valuations need to continue to be in the high teens (and above range through 2010). What has changed to make the risk/reward so much more problematic as we approach mid year earnings season? For one, notwithstanding the multi-weeek strength in the dollar, it is still dangerously hovering at multiyear lows at a time when it is clear the European Central Bank is popping its own property bubble. The aggressiveness of the ECB and the changing complexity of international capital flows suggests favoring long term asset reallocation to non-dollar assets (albeit cautiously at these levels). Can one explain the feverish multiyear depreciation of the $ any other way? and why are $ equity markets so complacent? I for one would suggest that the burden of proof is on the guardians of $ stability, and that attempting to buy $ assets with the hope that they will appreciate faster than the $ is depreciating is a risky proposition. As the repository of most dollar denominated assets with substantial exposure to rising long-term interest rates (currency imposed), the banking system is de-facto losing its credit worthiness and the security of its long term profit stream. Mid-single digit intermediate term returns (five years) can be obtained much easier in the bond market, with less potential loss of capital