Warren Buffett explains below why, in certain business situations, it sometimes makes sense to embrace a substantial decline in revenue.
This may not exactly be intuitive but, for investors, coming to grips with some of the thinking behind this is very worthwhile.
Shouldn't a business be striving for growth? Since a little growth is good shouldn't a little more growth generally be better?
I mean, who in their right mind would want to deliberately allow their business to shrink?
Buffett explains below precisely why growth at times is your worst enemy and why Berkshire Hathaway will, in fact, deliberately shrink an insurance business, at times even dramatically so, and for extended periods of time.
It's a mindset rarely understood and even more infrequently implemented. Yet, it gets near the heart of one key reason for the phenomenal success of Berkshire.
Now, though the example Buffett uses below is specifically about insurance, in my view it often applies to other types of businesses even if in more subtle ways.
To me, it is an idea that can be of substantial use to any business person or investor.
The concept can seem a bit odd at first but is certainly worth taking some time to understand. Occasionally, good ideas reside near those things that -- at least on the surface -- might seem to make little sense.
From the 2004 Berkshire Hathaway (BRKa) shareholder letter:
"Since Berkshire purchased National Indemnity ('NICO') in 1967, property-casualty insurance has
been our core business and the propellant of our growth. Insurance has provided a fountain of funds with
which we've acquired the securities and businesses that now give us an ever-widening variety of earnings
"Float is wonderful – if it doesn't come at a high price. Its cost is determined by underwriting
results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have
received. When an underwriting profit is achieved...float is better than free. In such years, we are actually
paid for holding other people's money. For most insurers, however, life has been far more difficult: In
aggregate, the property-casualty industry almost invariably operates at an underwriting loss. When that
loss is large, float becomes expensive, sometimes devastatingly so.
Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product. Policy forms are standard, and the product is available from many suppliers, some of whom are mutual companies ('owned' by policyholders rather than stockholders) with profit goals that are limited. Moreover, most insureds don't care from whom they buy. Customers by the millions say 'I need some Gillette blades' or 'I'll have a Coke' but we wait in vain for 'I'd like a National Indemnity policy, please.' Consequently, price competition in insurance is usually fierce. Think airline seats.
So, you may ask, how do Berkshire's insurance operations overcome the dismal economics of the industry and achieve some measure of enduring competitive advantage?"
The answer comes down to a simple if not easy to implement strategy. Buffett goes on to explain it.
"When we purchased the company – a specialist in commercial auto and general liability insurance – it did not appear to have any attributes that would overcome the industry's chronic troubles. It was not well-known, had no informational advantage (the company has never had an actuary), was not a low-cost operator, and sold through general agents, a method many people thought outdated. Nevertheless, for almost all of the past 38 years, NICO has been a star performer. Indeed, had we not made this acquisition, Berkshire would be lucky to be worth half of what it is today.
What we've had going for us is a managerial mindset that most insurers find impossible to
In the letter, there is a table that shows NICO allowed written premiums to drop from $ 366 million in 1986 to $ 54 million in 1999. An 85 percent decline.
It is this kind of discipline that, as Buffett explains next, many in business find so difficult to copy.
The Colossal Slide
"Can you imagine any public company embracing a business model that would lead to the decline in revenue that we experienced from 1986 through 1999? That colossal slide, it should be emphasized, did not occur because business was unobtainable. Many billions of premium dollars were readily available to NICO had we only been willing to cut prices. But we instead consistently priced to make a profit, not to match our most optimistic competitor. We never left customers – but they left us.
Most American businesses harbor an 'institutional imperative' that rejects extended decreases in volume. What CEO wants to report to his shareholders that not only did business contract last year but that it will continue to drop? In insurance, the urge to keep writing business is also intensified because the consequences of foolishly-priced policies may not become apparent for some time. If an insurer is optimistic in its reserving, reported earnings will be overstated, and years may pass before true loss costs are revealed (a form of self-deception that nearly destroyed GEICO in the early 1970s)."
Again, it's not just the insurance business. Shareholders of many commodity-like businesses that are run with the Berkshire mindset have a much better chance of being served well in the long run. For example, the next time a banker is promising consistently high earnings growth it would be wise to remember the above because it generally applies.
That is not a bank I'd want to own.
For some commodity-like businesses, at times the smartest thing to do is intelligently shrink, even if less dramatically than the NICO example above, until the competitive landscape produces a pricing environment supportive of high returns.
A disciplined management and the kind of culture that supports this way of thinking is harder to find than it sounds.
What about the employees? In the letter Buffett explains:
"To combat employees' natural tendency to save their own skins, we have always promised
NICO's workforce that no one will be fired because of declining volume, however severe the contraction."
Now, they'd be unwise to just say they are going to do that and then not follow through. The key is to have the discipline, patience, and integrity in combination with sufficient financial capacity.
Buffett also makes the crucial point that an insurance business can live with some excess overhead but not underpriced business.
It just requires the kind of senior management who will behave consistent with that reality.
Long position in BRKb
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