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of shareholder value However, in well-managed oat-generating businesses, the transition is not as severe because the output is almost never sold at a loss As the demand for a product (trading stamps in this case) declines, the company may reduce its size slowly without much pain and suffering The amount of oat does not drop as fast as revenues decline With respect to oat and declining business, Charlie Munger, chairman of the Blue Chip board, wrote in 1981, In our trading stamp business, our oat is large in relation to current issuances (Trading stamp revenues peaked at $124 million in scal 1970, and our 1981 revenues of $156 million therefore represent a decline of 87% from peak volume) 6 Blue Chip s oat has been a good source for Berkshire s growth Using this oat, Berkshire acquired several companies including See s Candies, Mutual Savings, Buffalo Evening News, and Precision Steel Why did Berkshire acquire these businesses that do not seem to have anything in common We get a good insight into Buffett and Munger s principles of investing and running businesses from what Charlie Munger wrote7 :
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Our ve constituent businesses have more in common than might be noted by a casual observer: 1 They are all high-grade operations suffused to a considerable extent with business ideas of Benjamin Franklin, manned by high-grade people operating within a long tradition emphasizing reliable and effective service 2 When functioning properly, each business will usually generate substantial amounts of cash not claimed by compulsory reinvestment in the same business
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Buffett and Munger have emphasized the importance of cash ows beyond the compulsory reinvestment in the same business because these cash ows can help growth of Berkshire as a whole
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Conclusions
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In your investments, you should follow Buffett s lead and stay within your circle of competence, which in Buffett s case is insurance Buffett s
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in-depth understanding of insurance business has served Berkshire well Its insurance business GEICO has done well, in part, because Buffett does not pay attention to short-term earnings volatility Also, instead of borrowing in the open market, Buffett uses low-cost oat, or other people s money, from the insurance business to invest in or acquire other companies
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Reinsurance: More of Other People s Money
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[W]e are a Fort Knox of capital, and that means volatile earnings can t impair our premier credit ratings Thus we have the perfect structure for writing and retaining reinsurance in virtually any amount In fact, we ve used this strength over the past decade to build a powerful super-cat business1
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f a hurricane hits Miami, an insurance company with a large number of policies in the area will be inundated with claims and could go bankrupt Other natural or man-made disasters such as tornadoes, oods, res, oil spills, and earthquakes can also result in huge insurance claims in short order To avoid a nancial disaster, many insurance companies transfer their risks to other insurance companies, called reinsurance companies General Re Corporation is one of the largest reinsurance companies in the world, and it is owned by Berkshire Hathaway
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Size Matters: Berkshire s Acquisition of General Re
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A small insurance company for that matter, any small company cannot take large risks even when the rewards seem attractive For this
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reason, larger insurance companies are likely to be more pro table than smaller ones For Berkshire as a whole, size is advantageous because more of the insurance and reinsurance premiums and oat can be kept in-house Furthermore, Berkshire may accept more reinsurance business from other insurance companies In 1998, Berkshire Hathaway acquired General Re Corporation for $22 billion This remained Berkshire s largest acquisition until November 2009 when Berkshire announced plans to acquire Burlington Northern Santa Fe for $34 billion Berkshire s premerger shareholder equity of $31 billion increased by 70 percent in one fell swoop When the merger was announced, General Re was the largest professional property and casualty reinsurance group domiciled in the United States, and it conducted business in almost 150 countries It was one of only ve nongovernmental US-based nancial institutions with an AAA senior debt rating from Standard & Poor s Was $22 billion a good price to pay At the time of the acquisition, General Re s underwriting (operating) pro ts were about zero and it was not expected to earn any such pro ts These results had been similar in recent years But the rm was growing fast, having expanded its insurance premiums at an annual rate of 107 percent in the 10-year period ending in 1997 Since General Re s underwriting pro ts were about zero, the value of underwriting pro ts per se can be assumed to be zero However, oat, or the amount of premiums collected in advance but claims not yet paid, was $149 billion As discussed in previous chapters, oat can be valued dollar for dollar or even higher owing to potential growth Buffett has made similar arguments: [T]hough our oat is recorded on our balance sheet as a liability, it has had more economic value to us than an equal amount of net worth would have had As long as we can continue to achieve an underwriting pro t, oat will continue to outrank net worth in value 2 If oat can be valued at about $149 billion, General Re s total value would be at least $149 billion So why pay $22 billion There may have been intangible assets such as reputation and synergy with other Berkshire units that I am unable to assess but that Buffett could have Overall, it does not appear to be a cheap acquisition that a pure value investor would endorse In line with our discussion in 6 on Buffett-style investing, Buffett probably saw growth potential and was willing to pay a premium for that reason
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