Wednesday, July 17, 2013

Charlie Munger: Gresham's Law (In Its New Form)

Gresham's Law - A monetary principle stating that "bad money drives out good." - Investopedia

If someone wants to better understand how Charlie Munger and Warren Buffett think about the insurance business, this turns out to be a useful principle to understand.

Gresham's Law in its original form, according to Charlie Munger, is a "non-starter" for today's world. It just isn't terribly relevant these days.

Yet it is extremely relevant in the newer form that Munger describes below:

"Nobody cares what the melt-down value of the quarter is in relationship to the dime, so Gresham's Law is a non-starter in the modern world. Bad money drives out good. But the new form of Gresham's Law is ungodly important. The new form of Gresham's Law is brought into play - in economic thought, anyway - in the savings and loans crisis, when it was perfectly obvious that bad lending drives out good. Think of how powerful that model is. Think of the disaster that it creates for everybody. You sit there in your little institution. All of the builders [are not good credits anymore], and you are in the business of lending money to builders. Unless you do the same idiotic thing [as] Joe Blow is doing down the street. Pete Johnson up the street wants to do something a little dumber and the thing just goes to a mighty tide. You've got to shrink the business that you love and maybe lay off the employees who have trusted you their careers and so forth or [make] a lot of dumb loans. At Berkshire Hathaway we try and let the place shrink. We never fire anybody, we tell them to go out and play golf. We sure as hell don't want to make any dumb loans. But that is very hard to do if you sit in a leadership position in society with people you helped recruit, you meet their wives and children and so forth. The bad loans drive out the good. 

It isn't just bad loans. Bad morals drive out the good." - Charlie Munger at Harvard-Westlake School in 2010

This doesn't just apply to making loans.

It just as comfortably applies to the insurance business.

To understand Berkshire's willingness to shrink a business with Gresham's Law (in its new form) in mind, consider the example of National Indemnity (NICO) -- a property and casualty insurance company.

Here's how Buffett explained it in the 2004 Berkshire Hathaway (BRKashareholder letter:

"Insurers have generally earned poor returns for a simple reason: They sell a commodity-like product."

NICO is fundamentally a commodity business.

"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?"

How does this relate to Munger's version of Gresham's Law? Well, for starters Buffett asserts:

"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."

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.

So Munger wasn't kidding when he says they are willing to let the business shrink to combat Gresham's Law in its new form.

How did this challenging business contribute so much value to Berkshire when the industry overall, excluding Berkshire, mostly operates at an underwriting loss?

How does so much value get created when a business is allowed to shrink that much for such a long period of time?

Again, as Buffett pointed out, this has contributed roughly half of Berkshire's total.

I'd say this all qualifies as just a bit counterintuitive.

It comes from a kind of discipline that many find difficult to emulate considering real world pressures and other behavioral tendencies. More from the letter:

"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)."

As I said in this previous post:

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.

Finding a business leadership team who not only understands but acts in accordance with this isn't easy.

Self-interest, and other powerful psychological factors (subconscious and conscious) can lead to cognitive errors that adversely affect even the very brightest (this includes those who might be quite admirable in other ways). There just are aspects of human nature that can lead to less than optimal outcomes.

It has little to do with how smart those involved happen to be.

I happen to think this aspect of Berkshire's overall success frequently goes underappreciated. I also happen to think, if internalized, this way of thinking can be both useful to long-term investors and corporate executives alike.


Long position in BRKb established at much lower than recent market prices

Related posts:
Grantham & Buffett: "Career Risk" & "The Institutional Imperative"
Buffett on "The Institutional Imperative"
Buffett: A Portrait of Business Discipline
Buffett on Bold & Imaginative Accounting
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Charlie Munger at Harvard-Westlake 2010