Friday, March 4, 2011

2010 Berkshire Shareholder Letter: $ 66 Billion in Cost-free "Deposits"

Actually, even better than cost-free...

From Warren Buffett's latest Berkshire Hathaway (BRKashareholder letter:

At Berkshire, we have now operated at an underwriting profit for eight consecutive years, our total underwriting gain for the period having been $17 billion. I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years. If we accomplish that, our float will be better than cost-free. We will benefit just as we would if some party deposited $66 billion with us, paid us a fee for holding its money and then let us invest its funds for our own benefit.

Buffett, later in the letter, describes the key disciplines required to run an effective insurance business...

At bottom, a sound insurance operation requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can’t be obtained.

Many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by a testosterone-driven CEO to accept shrinking volumes has led too many insurers to write business at inadequate prices. "The other guy is doing it so we must as well" spells trouble in any business, but none more so than insurance.

A similar advantage -- that being low cost deposits -- exists within Wells Fargo (WFC).  Buffett has explained the Wells advantage in the past:

Wells Fargo obtains their money, which is the raw material, they obtain their money cheaper than anybody else. 

He later added...

If you're a copper producer, and copper is selling for two dollars a pound, and you want to measure the stress of copper going to $1.30, for a guy whose production cost is $1.50, you know, he's got problems. If his cost is a dollar, he doesn't have problems. And Wells, in terms of its raw material costs, is better situated than any large bank, by some margin. So, it's built to sustain a lot.

That'd be "cheaper than anyone else" besides Berkshire Hathaway.

Berkshire may not technically be a bank but its $ 66 billion of "float" plays the same role as deposits at a bank. Somehow, over the years, they have figured out a way to consistently get paid for holding other peoples money and investing those funds for the benefit of shareholders.


Long BRKb and WFC
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