Another Industry on which Berkshire Could Have Been Built
The insurance industry has been the backbone on which Berkshire Hathaway has been built. Warren Buffett has discussed the benefits, as well as the pitfalls, of the insurance business throughout his career. Despite the topic being widely analyzed in recent years thanks to Buffett, opportunity still exists in this space. However, there is a different industry that could provide a similar launching pad to a business owner trying to create the next Berkshire Hathaway type conglomerate.
Background on the Insurance Industry
The dynamics of the insurance business result in very little capital requirements in terms of tangible assets. To write insurance, you just need to have the ability and willingness to make a promise to pay out claims in the future. Unlike an auto company like Ford, insurers don’t need any factories, inventory, or much equipment in order to operate. Although there isn’t any need for capital in terms of tangible assets, insurance companies do need to have capital in terms of cash reserves to help it pay claims. The underwriting results for an insurer can be volatile, and each firm needs to make sure that it has enough cash reserves to help it survive a protracted downturn. Many insurance companies invest their capital, which is their shareholders’ equity on the balance sheet, in stocks. In addition, the amount of capital that the firm has influences how much revenue it can produce, and therefore how much leverage it wants to take on. Many firms write premiums that are close to the level of shareholders’ equity that it has, as this equity is the capital that it can fall back on in case of losses. Firms that write premiums that are two or three times higher than its shareholders’ equity could be considered to have high operating leverage.
Another unique aspect of the insurance industry is in the liability section of the balance sheet. Insurance companies produce float, which arises from the fact that insurers get paid first but pay out claims later. These liabilities typically show up as unearned premiums or loss adjustment expenses. This means that insurance companies receive cash upfront that they can invest, but that there is an offsetting liability. This leads to zero net shareholders’ equity from this situation. Almost all insurance companies keep the assets that arise from the float in some sort of mix of cash or bonds.
It is important for every single type of company to understand its true cost of revenue, also known as cost of goods sold. However, insurance companies have a more difficult time than most other industries in figuring out its cost of revenue. Insurers basically have to estimate the cost of their insurance policies, and only the highest quality insurance underwriters are able to consistently produce an underwriting profit on those policies. It would be very difficult for a company like Ford to set a price for its car if it was unsure on how much a car costs to make. This is the situation that insurance companies find themselves in though.
An insurance company like Berkshire has the ability to drastically reduce volume without suffering permanent damage. The insurance group of Berkshire has proven its willingness to reduce premium volume in the past if the prices were too low. This is one reason for the long term success of Berkshire. Management at Berkshire created a culture that allowed for reductions in volume, but more importantly the cost structure of the insurance business allowed for this outcome. In the insurance business, you have the loss ratio and the expense ratio. The loss ratio represents the losses on insurance policies, while the expense ratio represents the overhead expenses from underwriting. If sales were zero, then the loss ratio would be zero. In the 1970’s, for example, the expense ratio of Berkshire was often in the 30% to 35% range. However, the vast majority of this expense ratio was variable. In 1978, commissions and brokerage expenses made up 76.7% of the underwriting expenses of Berkshire. If sales were zero, then there would be zero commissions or brokerage expenses. Salaries, taxes, licenses, and other underwriting expenses totaled $11.8 million in 1978, which was a very small expense compared to the overall operations of Berkshire. The company could have funded this overhead indefinitely if it wanted to, even if sales at the insurance group were zero. This eases the pressure of chasing bad revenue that would turn out to be unprofitable later on.
Similarity between the EPC Industry
Certain businesses within the engineering, procurement, and construction (EPC) industry share many similar characteristics to the insurance industry. Many firms have little capital requirements, produce float, and have an unclear cost of revenue. Not all of these characteristics are positive, but they do make for an interesting comparison to the industry that Warren Buffett built his fortune on. In particular, I am going to focus on a company called Argan (AGX) that operates in the EPC industry mostly through a subsidiary called Gemma Power Systems.
Argan is a very capital-light business. The firm had shareholders’ equity of $325.6 million at the end of fiscal 2022. At the same time, it had $440.5 million of cash and investments on the balance sheet with zero debt. For comparison, receivables amounted to just $27 million and PP&E registered at $10.5 million. One reason why the company keeps so much cash on hand instead of paying it all out as a dividend is to protect against losses during difficult years. The EPC industry can be volatile, and there will be some ups and downs over time. Additionally, Argan could experience cost overruns at projects, and the losses incurred from cost overruns can be extreme. This can be the case at any EPC firm, but it is especially important to firms like Argan who operate on fixed price long term contracts. Similar to an insurance company, Argan wants to have capital reserves in the form of shareholders’ equity to help protect against future losses that may arise from time to time.
The reason that Argan’s cash balance exceeded its shareholders’ equity value was because of float. In this case, the float basically comes from deferred revenue and accounts payable. The duration of the float can vary between insurance companies, but in the case of Argan I am sure that the float is much more of a short term liability. This means that Argan wouldn’t be able to earn as much of a return on investing the float as an insurance company who is able to invest in long term bonds. Argan should keep the assets that are created from float in the form of cash, which means that Argan has one less revenue stream than an insurer who has interest income from bonds. Although its float may not contribute to its earnings, the float can be helpful to Argan from a cash flow perspective when its business is growing.
The cost of revenue can be unclear for a company like Argan due to the fact that it operates on fixed price long term contracts. In many cases, Argan is on the hook for extra costs that come in above budget. In many projects, this is not a problem. Every once in a while though, the costs of a project can greatly exceed estimates. This could be due to delays in sourcing equipment, unanticipated technical problems, poor execution, or inflation. Argan has had a history of profitability though, so it has shown an ability to estimate its costs accurately and execute on its plan. This would be comparable to an insurer who has a history of profitable underwriting. When analyzing an insurance company, the most important aspect is understanding its underwriting ability. In the case of an EPC firm like Argan, analyzing its ability to execute and avoid cost overruns is crucial.
Argan, just like Berkshire’s insurance business, has the ability to drastically reduce volume without suffering permanent damage. The overhead of Argan is often a single digit percentage of revenue, and amounted to $47.3 million in fiscal 2022. The company has enough capital to fund this overhead for almost 7 years even if sales were zero. This means that Argan can be patient and wait for projects that make sense from a budget perspective. The firm can avoid taking on difficult projects that could risk cost overruns, and will have less temptation to bid too low of a price to win a contract. If the overhead costs of a company are too high, management might be forced to chase revenue in order to justify remaining in business. This is not the case for Argan or for Berkshire’s insurance operations.
Building the Next Berkshire Hathaway
Next, I would like to discuss what Warren Buffett looked at in his acquisition of National Indemnity, and how that relates to the Argan example. The quote below from Buffett’s 2017 letter to shareholders explains the rationale behind the National Indemnity acquisition, which was his first entrance into the insurance field.
Buffett mentions that National Indemnity had $6.7 million of tangible net worth at the time of the acquisition. This figure was the capital or shareholders’ equity that National Indemnity had at the time. Buffett was able to invest the full $6.7 million in stocks once he took over the company, and he would have invested that same amount of money in stocks anyway had he not acquired National Indemnity. This means that the $6.7 million portion of the acquisition could be ignored, so Buffett basically paid $1.9 million of goodwill to own the company. The insurance company had $19.4 million of float, most of which Berkshire would invest in bonds. Even if Berkshire could just earn a 1% yield on those bonds, then that would amount to annual income of $194,000. This equates to a return of 10.2% on the $1.9 million of goodwill Berkshire paid. Not only would the bond portfolio be expected to earn far higher returns than that, but National Indemnity usually produced an underwriting profit as well. This was a very attractive acquisition by Berkshire.
In the case of Argan, the firm’s shareholders’ equity of $325.6 million could be ignored in the purchase price of a hypothetical acquisition because the owner would be able to invest that amount in stocks. Based on the $38.19 per share stock price at the end of May 18th, Argan has a market value of $565.8 million. This would leave goodwill of just $240.2 million if the company could be acquired at this valuation. Over the last 10 years, the firm has averaged net income of $34.4 million. This would equate to a yield of 14.3% based on the $240.2 million of goodwill in this hypothetical transaction. Argan did lose $42.7 million in fiscal 2020, but that was due to a reduction in revenue from a lag time in between projects. The loss wasn’t really from any cost overruns at projects. It provides some evidence to the fact that management might be willing to deal with a drop in sales if the right types of projects are unavailable. Besides that year the firm was profitable the rest of the previous decade. The worst level of net income in the past decade was a profit of $23.3 million in 2013 other than the net loss in 2020. To put in perspective how important the excess cash could be, if a skilled investment manager could earn 10% per year in the stock market, that would nearly double the company’s entire net income in the first year.
Safety of the Conglomerate Structure
An important aspect of Berkshire Hathaway is the safety it has provided for shareholders. The country has experienced many difficult economic periods since Buffett took over Berkshire in 1965, but Berkshire’s solvency was never even remotely questioned. This safety is the result of the skilled management of Buffett, but it also is the result of the conglomerate structure that Buffett built. The structure can be replicated at a place like Argan.
Over the decades, Berkshire has avoided paying a dividend. Until recently, the company hadn’t repurchased much of its own stock. For over 50 years, all the earnings were retained and plowed back into the business. Berkshire kept adding to its capital through retained earnings, which provided a soft cushion of reserves it could fall back on. Berkshire invested some of its capital in stocks, but the firm also made plenty of acquisitions over the years. These acquisitions both increased and diversified their earning power, which led to the corporation being a safer place for shareholders. Berkshire’s insurance subsidiaries, like National Indemnity, could operate with higher operating leverage within Berkshire than it could as a stand alone entity. If the insurance industry went through tough times, Berkshire had excess capital and would have profits coming in from its businesses outside of insurance. Argan could start retaining 100% of its earnings, diversify its earning power through acquisitions when opportunities arise, and invest an amount in stocks that is equal to its shareholders’ equity figure. If a project experienced cost overruns, the corporation would have excess capital at the parent company level, and eventually could have profits rolling in from businesses outside of the EPC industry. Not only would Argan become a safer corporation, but it would turn into a compounding machine like Berkshire Hathaway.
At the time of writing this, I don’t own stock in any of the companies mentioned.
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