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Great Wisdom from Buffett's Insurance Business

Mar 11, 2016

In this issue:
» FMCG stocks losing their sheen?
» Advancing automation and our upcoming recommendation
» ....and more!
0.00
Radhika Pandit, Managing Editor of ValuePro

I wrote to you last week about how Buffett's annual letters to shareholders are a great source for timeless advice on investing. His latest letter lived up to expectations. In it, he touched on investing in utility companies, which I discussed last week.

But that's not all. There is more investment wisdom in that letter. And this time it is from Berkshire's insurance business. An article in Fortune drew parallels between insurance and investing based on Buffett's letter.

To go deeper, let's first see what Buffett has to say on insurance:

  • At bottom, a sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can't be obtained.

How can we apply this to investing? Let's look at each of the four points one by one.

Understand all exposures: There is no doubt that from a longer-term perspective equities are a great asset class that can help you build wealth. But you also need to understand that it is not all about wealth building. Investing wisely is also about protecting your capital.

This means you need to understand the companies whose stocks you want to invest in, including the sector dynamics, and only invest in companies whose business model you can grasp. This will then also give some perspective on any likely risks.

Newspapers and TV channels talk a lot about themes and sectoral ideas. But you should not be swayed by this. Themes are nothing but short-term fads that die as quickly as they came. And investing in sectors rather than stocks is fraught with risks because of too much exposure to one particular sector. Rather, investors are better off sticking to a bottom-up approach that emphasises individual companies.

We also strongly believe in sticking to the principles of asset allocation when it comes to managing your overall equity portfolio. This means you should invest across large caps, mid caps, and small caps, but there is a weightage that you need to assign to each.

Conservatively assess the prospect of losses: I wrote to you this week how it's futile to track daily stock price movements. You should instead focus on a company's earnings growth and the overall performance over a few years. This is to ensure that the fundamentals of the businesses aren't deteriorating. A few quarters of subpar performance during an economic slowdown shouldn't be alarming. From a portfolio perspective, it makes sense to exit stocks where the fundamentals are no longer great or if the valuations have become ridiculously expensive. This is to maximise gains and minimise losses in your equity portfolio.

Premium that will deliver profits after covering losses: While building equity portfolios, the intention is always to include the best possible stocks at attractive prices. But despite your best intentions, there will always be stocks whose returns are underwhelming. That's okay. The point is that ultimately the winners from your portfolio will more than compensate for the ones doing badly.

Walk away if premium can't be obtained: After doing your research on stocks and the ones you want to include in your portfolio, you are bound to have certain expectations of the kind of returns you want to achieve from your portfolio. This means taking a good long look at your portfolio once in a while. If your return expectations are not being met from the current set of stocks, you might want to look at churning your portfolio a bit. But it is important that this does not become a frequent exercise.

So, you see, there is a lot to learn from not just Berkshire's equity portfolio but from its insurance business as well. It is certainly an approach that I follow while managing the ValuePro portfolios.

ValuePro is a portfolio-based recommendation service. My team and I have built two equity portfolios. The stocks that we select for them meet all the stringent 'Buffett-would-buy' criteria. Indeed, not only are the business fundamentals of these stocks great, but the valuations are attractive too. Why not take a look at ValuePro and see these stocks for yourself?

Do you think there are great takeaways from Berkshire's insurance business when managing your equity portfolios? Let us know your comments or share your views in the Equitymaster Club.


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2.50 Chart of the day

FMCG stocks witnessed a historical bull run during the period 2009 to mid-2015. These stocks were among the preferred class of equities for their stable growing businesses. Their good performance came when other major sectors (automobiles, capital goods, power etc.) showed disappointing growth. Robust fundamentals and defensive nature of these stocks had ratcheted the valuations of FMCG companies

But the last few quarters have been troublesome. The earnings performance have been disappointing to say the least. This had fizzled out the valuations of major FMCG stocks.

Rerating on card for FMCG players?

Apart from lower crude prices, that have helped the companies input costs, things have not worked in their favour. Major companies are witnessing top line growth challenges. While the rural theme failed to pick up, companies are facing challenges from new brands. In fact, many companies are coming up with freebies and discounts to attract sales, but even this is not helping them. So, in this context, the current valuation of the sector still seems expensive.

For valuations to be justified, the earnings growth of FMCG companies will have to pick up. Until and unless the risk and reward becomes favorable, the FMCG pack may continue to see further erosion in its valuations.

3.50

The most hailed economic advantage of India, demographic dividend, is at the risk of becoming a liability. Think about it. What's biggest challenge for the nation's workforce in the next decade?

'Robotics and Automation' - We have talked on this subject on various occasions. The global trend towards automation and robotics is picking at a fast pace.

The Indian corporates too are increasingly looking to take the advantage of automation. Even the government has made digitization and innovation a priority. As per the finding of GE Global Innovation Barometer, reported in today's Mint, automation could be a big threat to job creation in India. In long run, if jobs continue to go to machines, skilled and unskilled youngsters without jobs, could lead to social unrest.

While this indeed remains a grave economic concern, innovation in the need of the hour. Companies and businesses cannot survive if they do not adapt to changing technological landscape.

As analysts, we keep constantly looking for companies that take lead in this regard. Our Hiddden Treasure team has spotted one such opportunity in the small cap space - a company that is way ahead of its competitors in terms of technology and claims to be the only in the world to have complete back end integration.

The team will be releasing its recommendation soon. Make sure you do not miss the upcoming Hidden Treasure recommendation report.

4.45

After opening on a flattish note, the Indian markets have witnessed alternate bouts of buying and selling in the subsequent hours. At the time of writing BSE Sensex was trading higher by about 114 points. BSE Mid Cap index is trading higher by 0.13% while the BSE Small Cap index is trading lower by 0.12%.

4.50 Today's Investing mantra

"I don't look to jump over 7-foor bars: I look around 1 foot bars that I can step over" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Bhavita Nagrani (Research Analyst).

Today's Premium Edition.

How Patriotism Will Help Bajaj Auto to Sell Motorcycles

Bajaj Auto is launching a new bike made from the 'invincible metal of the INS Vikrant'. The company expects patriotism, the INS Vikrant name, and the smart pricing to drive the demand. Can the brand live up to the story? Read more to find out...
Read On...Get Access

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