Coming soon! The business that made Buffett a superinvestor...
(Sep 16, 2015)
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In this issue:
» Where are FII's fleeing from?
» Lesson for mutual funds and rating agencies from Amtek Auto
» Global market updates
» ....and more!
Every business needs money, or capital, as we say in financial jargon. Now, capital comes at a cost. Businesses that do not earn enough to cover the cost of capital do not take long to go bust.
But what if you had a business that could get capital for free?
What if that capital kept growing year on year?
And what if you could invest the free capital for years before you return it?
Warren Buffett often admits that the insurance business of Berkshire Hathaway has been his 'fountain of free funds'. The free funds have allowed Buffett to invest in the best businesses and hold on to them for years on end. This fountain of free funds is Buffett's little secret to becoming the superinvestor that he is.
Insurance is probably the only business where you can 'legally' hold tons of money that you do not own. That too for years! The premium that is received upfront becomes the free float. It keeps coming from the same customer for years and from more customers every year. And once the underwriting costs are covered, the free float actually becomes better than free.
People pay the insurance company for holding their money in the hope that they have to never claim it. Or at least not any time soon!
If the logic seems too good to be true, reckon this: Berkshire's free float grew from less than a billion dollars in 1990 to over US$60 billion in 2010. This means the free money compounded at over 22% each year for nearly 20 years. So even after meeting some claims and providing for underwriting costs, the business was a goldmine for Buffet.
Why am I elaborating on the unique virtue of the insurance business?
Well, India has at least half a dozen large insurance companies. The regulator (IRDA) allows these companies to list after being in operation for 10 years. But so far none of them have shown the inclination to do so.
Mind you, most of these companies saw their premiums grow in double digits over the past decade. Plus a miniscule proportion of Indians are adequately insured. The ratio of premiums paid to GDP is just 3.9% in India, well below the global average of 6.3%. The growth opportunity is huge!
But their absence from the bourses deprives minority investors the opportunity to own GEICO-like insurance businesses. GEICO, if you recall, has been not just Buffett's but also Graham's multibagger.
However, regulatory changes could open up this goldmine to Indian investors. IRDA is now set to make it mandatory for the large insurance companies in India to get listed.
The first ones to line up will be the top private sector insurers with assets under management exceeding Rs 600 billion. Mind you, as in every other business, this sector has its share of rotten apples. The crux of every business is the quality of management and its capital allocation skills. Ones that fail these metrics will not do well irrespective of the amount of free float.
So instead of jumping headlong into every insurance business that gets listed, you will have to do the basic quality checks. Also, unlike Buffett, you will not have a say on how the free float is used. Therefore, best to stick to managements that have a proven track record in capital allocation.
How do you plan to go about doing the quality check for insurance businesses about to get listed? Let us know your comments or share your views in the Equitymaster Club.
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Speculation on whether the US Fed will raise interest rates has dominated media headlines since the past month. And needless to say, stock markets globally have been grappling with fear and uncertainty ever since. The foreign institutional investors (FIIs) have lost no time in withdrawing their hot money from Asian and other emerging markets in a bid to be prepared to take the flight home. The chart shows the markets that have borne the biggest brunt of net FII outflows in last couple of months.. While the latest data for China is not available, we would suspect that China too ranks high amongst the top losers.
Net FII investment in Equities
Coming back to speculation, no one knows for certain if the Fed will raise the interest rates. However, a rate hike would mean risk of capital flight from the Indian markets too. And this could impact valuations across the board. Just as my colleague Radhika wrote in yesterday's issue of The 5 Minute WrapUp long term investors could in fact perceive the rate hike to be an opportunity in disguise.
According to us, a sharp correction could give investors the much awaited opportunity to selectively invest in fundamentally strong companies. Thus, investors can take the advantage of the beaten down valuations by investing in companies with strong balance sheets and wide moats.
The series of controversies surrounding Amtek Auto have far from ended. And finally it seems to have drawn the attention of market regulator SEBI too! The issue caught SEBI's attention after JP Morgan Mutual Fund faced issues due to its investment in Amtek Auto's debt paper. The fund restricted redemptions in two of its schemes; India Treasury Fund and India Short-Term Income Fund. This means that investors cannot exit from such schemes for some time. This action came after the down gradation of Amtek Auto debt, leading to sharp erosion in returns. These schemes have a collective exposure of about Rs 2 bn in Amtek Auto.
In the wake of this recent incident, the SEBI has widened its probe. SEBI is examining and seeking details from companies with high debt. But more importantly SEBI has issued a strict warning to mutual funds to get their act together and do their homework well before investing in debt papers.
One of the reasons for the oversight on quality of debt papers is lack of secondary trading of such instruments in India. Hence, the mutual funds value their portfolios based on data provided by the rating agencies. Consequently, any downgrade from the agencies impacts the value of such debt holdings too.
No doubt SEBI is looking to protect the interest of investors by tightening norms for mutual funds. But we see no reason why the regulator should let the rating agencies go scot free and allow them to change their ratings without being sufficiently answerable to investors.
Markets across Asia are trading higher today with China and Hong Kong leading the pack of gainers. The Indian markets were trading above the dotted line with the BSE-Sensex trading higher by about 254 points or 1% at the time of writing. Most sectoral indices were trading higher with the banking sector leading the gainers, while oil and gas and consumer durable stocks are the key laggards. The BSE midcap and smallcap indices are however trading lower. The European markets were also trading higher at the time of writing.
"You do not adequately protect yourself by being half awake when others are sleeping." - Warren Buffett
|| Today's investing mantra
Editor's note: There will be no issue of The 5 Minute Wrapup on 17th September 2015 on account of Ganesh Chaturthi.
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|This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Bhavita Nagrani (Research Analyst).
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