Until 1982 Buffett took on personal responsibility for Berkshire's insurance business strategy, senior appointments, and monitoring. As the business grew he realised the need to take more of a back seat, freeing time to concentrate on investments. He looked around for a talented manager to take over as head of all Berkshire’s insurance operations, and found such a talent in Mike Goldberg, a former McKinsey consultant.
Self-deprecatingly Buffett said in his 1982 letter that “planning, recruitment, and monitoring all have shown significant improvement since Mike replaced me in this role.”
The following year Buffett was very hard on himself “in aggregate, the companies we operate and whose underwriting results reflect the consequences of decisions that were my responsibility a few years ago, had absolutely terrible results. Fortunately, GEICO, whose policies I do not influence, simply shot the lights out. The inference you draw from this summary is the correct one. I made some serious mistakes a few years ago.”
Perhaps it wasn’t self-deprecation. The chickens of the late 1970s and early 1980s were coming home to roost in the mid-1980s. Those chickens were some poor underwriting decisions which went unrecognised for some time but had to be acknowledged eventually.
In 1983 for every $100 taken in premiums Berkshire recorded an expense of $121 for claims and operating costs. In other words, the “combined ratio” was 121 (combined ratio is total cost of underwriting (including operating costs) divided by total earning premiums).
Buffett said that it would “be nice” if the underwriting shortcomings could be placed at the doorstep of Mike Goldberg. But that insurance has a long lead time before the effects of decisions are seen, “so the roots of the 1983 results are operating and personnel decisions made two or more years back when I had direct managerial responsibility for the insurance group.” (1983 letter)
Insurers often have great difficulty estimating claims for a 12-month period. The lack of clarity and the dependence on judgement opens the door to over-optimism. The extent of many insurance claims, or even their existence, is not known for many years because there are four parts to insurance loss expenses in any one year:
1. Losses that occurred and were paid during the year;
2. Estimates for losses that occurred and were reported to the insurer during the year, but which have yet to be settled;
3. Estimates of ultimate dollar costs for losses that occurred during the year but of which the insurer is unaware; and
4. The net effect of revisions this year of similar estimates for (2) and (3) made in past years.
Revisions under 2 and 3 may occur many years down the line which adds to the cost line of that later year, distorting the profitability of underwriting then. Take an injury from a car accident. The true extent of the medical costs or time off work costs may not be known for some time. If say an unexpected additional $100,000 is paid out five years later then the amount is charged to underwriting profits in the year it is settled.
Even well-intentioned CEOs and their accountants, who are conscientiously aiming at conservative estimates, often make mistakes. In the mid-1980s Buffett had to admit to such, “At Berkshire, we have added what we thought were appropriate supplemental reserves but in recent years they have not been adequate.” (1983 letter)
In 1984, for example, of the overall $45.4m underwriting loss, $27.6m was a loss on 1984’s business, but $17.8m was a correction for the loss amount recorded for 1983.
Errors in this period were largely caused by under-estimating the tendency of juries and courts, influenced by publicity on high-profile cases, to continuously push up pay-outs for injuries in accidents and other events regardless “of the factual situation and the past precedents for establishment of liability” according to an annoyed Buffett.
Berkshire also erred in the reinsurance area. Much of this being down to client primary insurance firms making errors, “their mistakes have become our mistakes” wrote Buffett.
Buffett ruefully likened the painful experience of having to make surprisingly large payments on business he thought was finished years before to that of the man when travelling abroad received a phone call from his sister infor………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Insurance is at the heart of Berkshire Hathaway. The first significant act after Warren Buffett took control of Berkshire was the 1967 purchase of National Indemnity for £8.6m. There are two main attractions to holding a well-run insurance company within the Berkshire fold. First, it might – although most insurance firms don’t – make a profit on underwriting. That is, what is pays out on claims together with its operating costs (wages etc) is less than it takes in premiums.
Second, the delay between policyholders handing over premiums and insurance claims being paid leads to a “float” of money being held in the company. When Buffett took control of National Indemnity it had a float of $17.3m. That was a considerable sum of money for Buffett to invest; after all Berkshire Hathaway then had less than $30m net assets. His skill would lead to large returns on money under his command.
Technically, accountants treat float as a liability for Berkshire because it is set to one day be paid out in claims. In truth, float is a tremendous asset in the right hands.
Experiencing the excitement of making money from float while achieving profitable underwriting (in most years) in the 1970s Buffett was determined to build up the insurance side of the business. To National Indemnity, he added an array of other companies, the most significant of which was GEICO. By 1998 the insurance side had a float of over $7bn and was generating annual premiums totalling nearly $5bn.
Then Buffett went for a giant leap by trebling the size of Berkshire’s float from $7bn to $22.8bn by buying market-leading General Re. It was paid for, not with cash, but by the issue of A and B shares amounting to approximately 272,200 Class A equivalent shares in Berkshire. This raised its issued share capital by 22% and doubled the number of shareholders in Berkshire to about 250,000.
In other words, after the deal former General Re shareholders owned over one-fifth of the economic worth of See’s Candies, FlightSafety, NFM and the other wholly-owned business as well as over one-fifth of Berkshire’s marketable securities such as its 8.1% holding of Coca Cola (worth $13.4bn) and its 11.3% holding in American Express (worth $8.4bn).
Also by issuing new shares in Berkshire Hathaway Warren Buffett’s share of the economic benefit from the enterprises owned by the group went down from 43% to 34% (he and his wife Susan between them held 38.4% of the voting rights through their holdings of A shares).
But what did Berkshire receive in return?
Buffett thought he was getting a conservatively run insurance company that either made underwriting profits or small losses here and there. And he was getting a $15bn float, greatly increasing his firepower. On acquisition he almost immediately reduced General Re’s investment office from 150 to one person, himself, to direct that float.
But the company came with a whole heap of trouble. It took Buffett and Munger years to sort out the problems, which ranged from under-pricing of insurance and poor provisioning for likely insurance claims to a massive number of derivative deals (over 23,000 contracts involving 884 counterparties). General Re bled money after Berkshire purchased it. In the first four years it lost $7.5bn on underwriting.
By the end of 2001, after the terrorist attack on the Twin Towers in New York, things got so bad that Buffett said General Re would have gone bust had it not been for the deep pockets of Berkshire to bail it out. At that point many, including Buffett, thought the purchase a mistake.
But later it was to become what Buffett called a “treasure”. The story of its fall and rise is instructive to anybody interested in investing in insurance companies, not least the importance of having managers with the right cautious mindset for creating float at low cost through taking on underwriting business with a rational profit-focused determination.
To understand the significance of the General Re acquisition we need to go right back to basics both in terms of where Berkshire’s insurance business came from and in how the insurance industry works.
Building on National Indemnity
Following the purchase of National Indemnity and its sister company National Fire and Marine Insurance Buffett too………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Wynnstay (LSE:WYN) has shown average conventional earnings of 29.3p per share over twelve years. With the 19.9m shares it has in issue today if it earned 29.3p per share then that would be a total of £5.83m.
If I was to assume that this will be the earnings attributable to shareholders and, importantly, available to shareholders to remove from the company in each of the future years then I might value the equity at £72.1m:
£5.83m/0.08 = £72.9m
(The market capitalisation of WYN was 19.9m x £3.405 = £67.8m when I bought)
But conventional earnings does not usually adequately allow for the fact that with some companies earnings cannot be taken out of the company if it is to maintain its unit volume of output, spend enough to maintain its economic franchise (e.g. on working capital, new machinery, marketing, service quality, employee training, etc.) and invest in all value enhancing projects.
Some firms have to invest so heavily in these items that little of the conventional earnings can be taken out by shareholders.
Owner earnings is more useful than conventional earnings for getting at the amount shareholders can take after allowing for necessary investment to maintain the quality of the business.
"Owner earnings" in the past
£000s YEAR 2013 2014 2015 2016
Profit after interest and tax deduction 6,171 6,697 6,670 5,829
Add back non-cash items such as depreciation, goodwill and other amortisation 2,523 2,519 2,675 2,783
Totals to: Amount available for distribution to shareholders before considering the need to spend on fixed capital items to maintain the comp………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
Wynnstay (LSE:WYN) has stuck to the same areas of business for decades. This is its strategy, as set out in the 2004 AIM Admission Document:
“The Group intends to continue to develop its three trading divisions [Arable, Feeds, Stores (it had 24 stores then, 54 now)]. As part of its five year corporate plan, it intends to expand these three key areas both organically and by suitable acquisition. The Directors believe they have the depth of expertise within the Company to continue to expand the business as they have in the past.”
In 2003 turnover was £85m, compared with over £430m today. A number of feed, grain, retail and haulage acquisitions followed. There were some big moves such as the acquisition of Glasson Grain in Lancashire in 2006, Just for Pets in 2007, Wrekin Country Stores in 2007 and Young Animal Feeds in 2009. By 2009 turnover was £215m.
History shows a consistent strategy even to this day, as stated in the 2018 Annual Report:
“Over a period of the last thirty years, a twin stranded growth strategy has been successfully implemented…These two strands are represented by focused acquisitions, and gradual organic expansion through increasing geographical reach and product extension…The fragmented nature of the supply sector into farming and the rural economy has supported the success of this strategy, the Board believes that many opportunities remain, and that the continuation of this approach, with additional financial resource, will continue to produce rewarding results for all stakeholders in the business.”
Alongside the strategy the firm pursued a policy of increasing dividends – the 2004 Admission Document stated:
“The Company has a progressive dividend policy which seeks to reward shareholders. The Directors therefore intend to maintain a balance between retained profit and profit available for distribution to shareholders.”
In 2003 the dividend was 3.8p today it is 14.6p, an average annual growth rate of 8.8%.
Shareholders are not the sole priority
At first it seems shocking that directors do not state that the company is run solely to maximise shareholder wealth. They, in the 2020 Annual Report, state the aim is to achieve a balance “to satisfy the expectations of all stakeholders”. There are five main “stakeholder groupings”:
My last two newsletters discussed the steady profitability of Wynnstay (LSE:WYN) through good times and hard times. When I recently bought at £3.405 I judged there to be a good margin of safety between its intrinsic value and what Mr Market was asking for it. Since then Wynnstay has reported good profits for the year to October 2020 in the face of the Brexit uncertainty, Covid restrictions and the recession. Also Simon Thompson, a writer for Investors Chronicle, has written positive things about the company. So the share has risen to £4.40. You will have to make your own judgement on whether the margin of safety is now sufficient.
(I've recently been approached to run a deep value mutual fund (an OEIC, supervised by the FCA, and open to all investors). A thought occurred to me regarding the gap between me buying Wynnstay and publishing a series of Newsletters about the company and the £1 rise in share price during that time. If I had been running the fund I would have invested other people's money alongside mine at £3.405, or perhaps a little more given the larger sum to invest. Clearly, this is an argument for saying yes to becoming a fund manager. What do you guys think? Would anyone be interested in putting money into a fund where I had sole decision making power on investment selection? Investment management charges, by the way, would be 0.85% of assets under management.)
Wynnstay's Piotroski Analysis
If the firm is profitable and produces positive cash flow it has a capacity to generate funds internally. A positive earnings trend suggests an improvement in the firm’s ability to generate positive future cash flows.
2019: £6.1m/£175m = 3.5%
No Piotroski point scored.
4. Cash flow (before WC investment) greater than profit (so profits are not driven primarily by positive accruals, which may be ‘managed’)? WYN scores a point here.
Leverage, liquidity, and source of funds
Measuring changes in capital structure (debt:equity ratio) and the firm’s ability to meet future debt service obligations.
2019: £3.1m/£170m = 1.8
An improvement therefore another Piotroski point.
2.Has the firm’s current ratio (current assets divided by current liabilities) improved over the past year?
2020: £114m/£58m = 1.97
2019: £121m/£67m = 1.81
Respectable ratios in both years, and an improvement in 2020, therefore one more Piotroski point.
3. Has the firm avoided raising fresh equity capital (e.g. rights issue or placing) in the last year?
It has, so a point is gained here.
2019: £62m/£491m = 12.6%
An improvement, therefore an………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
The Agriculture Division: This collection of businesses manufactures and supplies agricultural inputs including 300,000 tonnes per year of feed for animals. It offers a full range of animal nutritional products, e.g. feed blocks and has two compound feed mills and a blending plant of its own, but also uses third party mills to satisfy additional seasonal requirements or when customers are outside the area normally covered by Wynnstay’s (LSE:WYN) lorries.
Wynnstay also supplies fertiliser and seed (cereals, grass, forage, oil seed, pulses, roots, maize, catch crops, game cover, amenity seed).
Its Grainlink business offers farmers a grain marketing service with access to specialist milling, malting and feed markets. To the Shrewsbury office, GrainLink added a Grantham base in 2019.
The company also offers bespoke agronomy advice.
The main areas of operation are in Wales and central England.
The company’s reach has been steadily extended. Glasson Grain a Lancashire importer, shipper and trader of animal feed materials and fertiliser blender was bought in 2006. This business operates fertiliser blending manufacturing facilities at Winmarleigh, Goole and Montrose, and also sources from a facility at Birkenhead.
Wynnstay Woodheads Seeds, bought in 2010, operates a seed processing plant in Yorkshire, and trades grain and supplies fertiliser.
In 2015 it bought Agricentre which operates a network of eight units supplying a wide range of agricultural inputs including animal healthcare, dairy hygiene and animal nutrition products as well as feed related equipment and other hardware. Its units are located from Bristol to the Isle of Wight.
In 2017 a Montrose blending plant was acquired – the company intends to “build on” this presence in Scotland.
In 2018 the outstanding shares in the FertLink joint venture were acquired, helping to make Wynnstay the second largest fertiliser blending manufacturer in the UK.
Stanton Farm Supplies, which mostly delivers to dairy farmers using vans, was bought in April 2019 for £0.53m. It covers Avon, Dorset, Somerset and Wiltshire.
Specialist Agricultural Merchanting
This division has 54 “depots” – big sheds – open to the public as well as farmers, selling a very wide range of farming or rural pursuits products (25,000 different items). The way the company puts it is that the stores are for agriculture and for the rural and urban dweller with an interest in pets, horses, and also for people with a plot of land too large to call it a garden.
Most of these stores are in Wales or central England, as far south as the M4. However, there are now three stores in Devon/Cornwall/Somerset, one in Salisbury and a handful in Lancashire and Yorkshire.
Online sales are increasingly important.
The wholly-owned Youngs Animal Feeds provides equine and small animal feeds for Wynnstay stores and other wholesalers and retailers in the West of the UK.
Joint Ventures and an Associate
It has three joint venture business:
Wynnstay was a mere £12m turnover company in 1988. In 1992 it became a PLC and joined OFEX in 1995. When it moved to AIM in 2004 it was a £16.5m MCap company employing 340 people (it now has about 1,000).
By then its trading area covered Wales, th………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
I first bought Wynnstay Group shares (LSE:WYN – not Wynnstay Properties) a year ago at 317.4p. They have since reported robust results in the face of both Brexit and Covid. The impressive profits history and the strong strategic and financial position they enjoy in the post-Brexit world serving farmers and other rural folk means I have confidence that this business will continue to grow steadily. So, I’ve bought a lot more shares at 340.5p for my Modified price earnings ratio portfolio. (Market capitalisation of Wynnstay at my buying price: £3.405 x 19.95 shares = £67.9m)
Wynnstay was set up 100 years ago as a farmer’s cooperative to supply items such as feeds, fertilisers and seeds. It still has 3,000 farmer shareholders, but is now on AIM with many other shareholders
Its shares have dropped from over £6.60 since early 2017 on fear of Brexit decimating farming. In previous newsletters (see 22nd – 30th July 2019 and 10th – 16th January 2020) I expressed my reasons for thinking that UK politicians – and European politicians for that matter – would not let UK agriculture suffer in the brave new world they were creating and thus the share price decline was overdone, especially in light of the fact that Wynnstay gains more profit from retailing to the general public (as well as farmers) from its 54 country supply stores than it does from delivering bulk items to the farm gate.
A new dawn
Fortunately, there is renewed hope in the land, and Wynnstay’s directors are optimistic that farm investment will recommence. According to Wynnstay’s directors UK food producers now have the ability to seek new markets for agricultural products and the UK Agriculture Bill will result in a more resilient agricultural sector.
It expects to benefit from its role in supporting farmers focusing on environmental investment and efficiencies (it has a lot of experts advising farmers as well as selling them bulk items): “We therefore view medium and long-term prospects for our industry positively…We see a significant role for Wynnstay in supporting farmers with products and services to help drive sustainability and greater efficiency as well as to reduce carbon emissions, including the management of farm waste.” (2020 Annual Report)
Already things are improving: “The new financial year [starting 1st November] has started well. Stronger farmgate prices towards the end of 2020, along with the EU settlement and UK Agricultural Bill, have helped to buoy sentiment across the farming sector. Wynnstay’s performance to date is in line with management expectations, and we believe that our strong financial position and balanced business model puts us in an excellent position to make good progress over the coming year and beyond. We look to the future with confidence.” (2020 Annual Report)
Analyst’s expectations (only one analyst): EPS: 2021: 33.8p, 2022: 34.18p
Dividends: 2021: 15.15p, 2022: 15.8p
We have here a well-managed company with a sound business strategy, loyal customers, diversified product line/customer groups, strong finances and a history of good earnings relative to the current share price.
Oh, and a nice 4% dividend yield – and the directors are in the habit of lifting the dividend every year (for 17 years in a row).
Short note on changes in farm subsidies
While the UK government has “guaranteed” the current annual budget to farmers in every year of the current parliament, the basis on which the m……………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
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