The Capacity to Suffer: Google, Amazon, Berkshire and Geico, Plus a Few Things about Equity Index Put Options and Earnings Management
This post is about Tom Russo’s talk at Google from 29th of September, 2015. The talk is about 1 hour and 11 minutes. If you do not have the time to watch this talk, please take a few minutes and read the part below transcribed from the talk, where Tom Russo explains the concept of the capacity to suffer and why this is such a powerful concept. The capacity to suffer is a mental model that I think should be added to each and every investor’s toolbox.
In the end of this post you’ll find the video itself, and also the slides shown by Russo.
Okay, let’s hear (or, rather read) what Tom Russo had to say about the concept of the capacity to suffer, and how to think about it to be able to understand it and apply it to other businesses that we will analyze in the future (emphasis added).
I’d say the best example of a company, too, that had the capacity to suffer. One is inside this room. You know, you think about all the kind of projects that Google incubates, burdening profit, with an idea, maybe, of where it’ll end up, but in some cases not even. That’s extraordinarily powerful. And you have lots to show as a result of that. That scale would be a very interesting one, because I think you have an awful lot to show for the willingness to suffer.
And Amazon. Amazon’s way out even beyond you guys. I’m not sure that they’ll ever report a profit. But they certainly have the capacity to suffer. So do their shareholders. Well, of course they get rewarded for it. The price has gone up so much.
So the businesses that we’ll look at are more traditional. Berkshire is the best one. That’s why I learned this subject. Warren talks about it all the time. But, Geico’s a great example. Much like confectionary in China, it’s expensive, it turns out, to bring on an insured, auto insured. And so when Warren bought control of Geico, he asked the CEO why they only had two million policyholders, and the CEO said, because it’s too expensive to grown. Every new policy we put on the book loses $250 in the first year. An ongoing insured make $150 per year of operating profit for the company. So you have two million policyholders making $150 a year, so they were reporting $300 million of profits. And if they wanted to grow a million new policies the next year—because as Warren said, they had the best business, under-penetrated, the market should have more of them. So why not grow it by a million policyholders? What would happen to the operating income that year? It would go from 300 to 50 assuming that the other business didn’t grow at all. Now no public company can endure that kind of volatility. The activists would be on that thing so quickly. Inside Berkshire, it didn’t matter. Warren controls 40% plus of the stock. He’s never told investors that he’s in the business of manufacturing reported earnings. No one get stock options. He gets paid a $100,000 a year. It’s all about owner’s equity, intrinsic value, and how do you grow that with certainty as best as you can? Well, no better investment than to take that $2 million insured base up because of its persistency and its low claims, lack of adverse selection as they grew. They had a lot of room. And by the way, even though the first year cost, reported loss of a new insured was $250 upfront, the moment they signed up the net present value, lifetime value of each insured, $2,000. That’s a $150 stretched out forever, brought back. Now, so for the mere inconvenience of reporting a $250 loss upfront, they put on $2,000 of value. Warren got it. Today, 14 years later, they have 11 million policyholders. And in the annual report he said to investors, because he’s a fair partner, if you’re thinking of selling the business, your shares in Berkshire, understand that book value doesn’t capture all that we’ve got that’s good. And he said, for instance, at Geico we’ve added $20 billion of value since we bought it. Now that’s that $20 billion that comes from those 9,000,000 new insured. And the only way you get there is by having the capacity to let the income statement bear the burden. And over that time they took their annual ad spending from $30 million up to $1 billion. And you’d all know that, because watching television is really a series of Geico advertisements these days.
Another thing that Berkshire did was, the equity index put options. There’s a group that had $37 billion worth of equities, market value equities, around the world for different markets. And whatever the reason, that group had to be able to say their counterparties that $37 billion was not at risk. They needed for their collateral, whatever the reasons, to have $37 billion. And so Warren was asked to insure against the potential for that portfolio to decline in value. He sold them a put option. In return, we received $5.3 billion to invest, unfettered, for 18 years. It was non-callable and it had no collateral posting requirements, which are the killers in this business. So why did Warren get $5 billion to insure against the decline of equities over 18 years when, likely, the course of equity values is up over time? It’s because the people who needed that insurance had nowhere else to go. First, Warren had the capital. He had $50 billion of spare cash which sort of buttressed his claims-paying appeal. Other people who might take the $5 billion don’t have the capital balance sheet or the culture to provide for the ultimate payment if the world went to zero and they owed $37 billion. Warren has that, and the culture would honor that. The other thing, the more important thing, was nobody else would touch this stuff, because every quarter there is a mark to market requirement. And it absolutely crushes reported profits. So for example. After they signed it, received the $5 billion, the equity world markets collapsed and they had six quarters in a row of over $1 billion worth of charges to the income statement, some periods as much as $3 billion, because global equities collapsed. And every time it collapsed, they’d have to pass through the reported profits, the mark to market. OK. So at the end of the day he had $13 billion less in earnings cumulatively over that time. But he had $5 billion which he had to put to work. And that’s sort of the last story about Berkshire.
Another way in which you could see his capacity to suffer added enormous value was that during the crisis—well, during the period leading up to the financial crisis of 2007 and 2008, Warren, at the annual meeting, always lamented the fact that he had $50 billion cash hanging around on which he was only earning .01%. And that’s the safe return. That’s sort of the federal treasury bills that are secure. Since he kept it in cash, he might as well keep it secure. But he was only making .01%. If he had standard company practices, he never would have kept $50 billion of cash in overnight money. He would have gone out three, 10, 14, 40 years on a bond portfolio and would have had a 4% yield. He kept it at .01% because he didn’t trust inflation or credits to support having $50 billion in longer duration investments. The difference between 4% and 0.1% on $50 billion is $2 billion a year. That’s the amount he suffered by under reporting, because he kept his money in liquid treasuries. That requires a lot of suffering because $2 billion is a lot of money, even to Warren. Now ironically, to show you how American companies behave, at the same time that Warren was belly aching about only making .01%, General Electric had taken $100 billion of their borrowing and brought it into commercial paper overnight to capture those same low rates. Now it’s a different story for General Electric, though. You have businesses that have long-term funding requirements where you can’t responsibly borrow overnight to meet. You can do so if your goal is to manufacture earnings. And of a $100 billion in the overnight market, where they might be earning 2%—they may be paying two tenths of 1%, let’s say, maybe even .03% in the commercial paper market—they should have been paying 4%, exactly like Warren. In their case. they should have stretched out their liability structure. But by taking it all into commercial paper, investment bankers assured them that they could swap them out at any minute. They could go back long. They could go into yen, any currency they wanted. It was just a number after all, wasn’t it? Well, they forgot one thing, which is that overnight markets can shut down. And when Lehman burst, GE had $100 billion of overnight money that they couldn’t roll. Warren, happily, had $50 billion which he could use to help them out. And he gave them the right to $12 billion of his money at 12% with hundreds of million of shares of call options. In case the company did well, he would have the privilege of making the equity that they recklessly threatened by their non-owner minded ways. Now they were not at all unusual in this. This is what public companies do. They bring down the rest of the cost because it helps flatter. In GE’s case, that was $4 billion of manufactured income. Now this I would complain to you about. However, there’s one mega force on the landscape that’s done one worse than that, which is the United States government. We have taken our borrowing from $9 trillion to $18 trillion through QE, most of which was not invested but was transferred, to try to stimulate some kind of economic growth in the absence of a Congress that doesn’t meet. And we keep that money predominantly in overnight borrowings. The yield curve of the US Treasury is abysmally short term, and we are massively understating, when we look at our own deficit, what this country has put itself into, which is $9 trillion of additional borrowing coming through at sort of 1, maybe 1, 1.5%. And the real cost of that burden will be very apparent at some time when rates go up, uncontrollably by us, upwards beyond our control. Anyways, I hope that what, for me, has been most educational from the time I first heard Warren speak at Stanford to the present—this notion of how the capacity to reinvest surfaces is best illustrated by those three ideas in Berkshire. And there have been a whole series of businesses that have done it afterwards.
—Tom Russo, Talks at Google, September 29th, 2015
Tom Russo Talks at Google: Slides + Video
Click image below for full PDF of the slides shown by Tom Russo at his talk.