Notes on Wesco Financial (Charlie Munger) Letters to Shareholders (1987-2009)
1985 Letter Notes
Munger writes extensively in this letter about the dangers inherent in the Savings & Loans industry that were years ahead of the early 90's S&L crisis. He makes his stance clear: it was highly irresponsible to insure these institutions and their depositors as the managers grew at all costs by offering sky-high interest rates on deposits just to attract more funds and used the deposits to fund ever growing loan portfolios with riskier and riskier credit quality. As interest rates were increasing rapidly in the early 80's, he wisely chose to sit on the sidelines as many S&L's granted high interest accounts just to expand depository funds available for lending. The section detailing his opinions on the excesses of mortgage lending in the S&L industry reads like a prelude to the 2007-2009 real estate crisis. The root causes were somewhat the same - excess leverage.
Wesco Reinsurance division was started with $45M in equity from Wesco Financial under the direction of Warren Buffett at Berkshire Hathaway, who owned 80% of Wesco at the time. Wesco Reinsurance immediately reinsured 2% of Berkshire Hathaway's subsidiary Fireman's funds premiums from 1985-1989, effectively giving them 2% of the company's book of business. It is interesting to note that Buffett used Munger's company, which he owned 80% of, to reinsure the Fireman's fund's book of business. It generated over $60M in premiums during 1986, available for investment purposes for Wesco. Seems to me that this was a move to get Munger's resources into the insurance industry.
Another little nugget that continues to show up in the reinsurance business letters I've read is that this business serves a highly commoditized product - namely, peace and security in the form of money paid out for an specific (bad) event occurring. So, what form of competitive advantage can be gained in the industry? Munger and Buffett often write in their letters about how the financial strength of Wesco and Berkshire Hathaway is their biggest advantage. In the reinsurance industry, returns can be wonderful for years due to very long-tail risks (low probability, high cost events). However, when the proverbial lightning strikes and many reinsurers become insolvent due to catastrophic events, the remaining players' not only pick up the pieces of competitor's books of business but their financial brands improve in the eyes of their clients and customers.
Finally, as I noted in Week 10 reading, savings and loan institutions as well as steel warehousing and metal work businesses are not particularly high return on capital businesses and typically are not associated with economic moats. Charlie made this clear in his 1985 letter that while he was looking for such high return businesses at reasonable prices to purchase outright, that they were hard to come by. And thus his quote at the end of the letter (emphasis mine):
"Wesco is trying more to profit from always remembering the obvious than from grasping the esoteric (including much modern "strategic planning" and "portfolio theory"). Such an approach, while it has worked fairly well on average in the past and will probably work fairly well over the long-term future, is bound to encounter periods of dullness and disadvantage as it limits action. Moreover, this approach is being applied to no great base position. Wesco is sort of scrambling through the years without owning a single business, even a small one, with enough commercial advantage in place to pretty well assure high future returns on its capital. In contrast, Berkshire Hathaway, Wesco's parent corporation, owns three such high-return businesses."
1986 Letter Notes
Not much to report in this letter, other than general updates for Mutual Savings & Loan, Precision Steel, Wesco Reinsurance, and Bowery Savings Bank (a recapitalized distressed bank in which they invested a minority equity position in 1985). It was pretty impressive however, how big of a difference the reinsurance business made on the bottom line from just one year of operations - it contributed over 55% of normal net operating income in 1986 vs. -5% in 1985. This illustrates the lumpiness of reinsurance as a case in point.
1987 Letter Notes (page 40)
Salomon investment - $100M @ 9%, convertible into common equity at $38 per share or more in 1987 after the massive stock market crash and operating losses at Salomon (classic strategy of protect downside and participate if the upside happens).
Great quote from letter:
"When Wesco's parent corporation acquired control, Wesco's activities were almost entirely limited to holding (1) some surplus cash, plus (2) a multi-branch savings and loan association which had many very long-term, fixed-rate mortgages, offset by interest-bearing demand deposits. The acquisition of this intrinsically disadvantageous position was unwisely made, alternative opportunities considered, because the acquirer was overly influenced by a price considered to be moderately below liquidating value. Under such circumstances, acquisitions have a way of producing on average, for acquirers who are not quick-turn operators, low to moderate long-term results. This happens because any advantage from a starting bargain gets swamped by effects from change-resistant mediocrity in the purchased business. Such normal effects have not been completely avoided at Wesco, despite some successful activities, including recent investment in General Foods."
1988 Letter Notes (page 50)
Incredibly in depth discussion of Federal Savings and Loan Insurance Corporation's insolvency and what the preconditions were for such large scale losses in the S&L industry. I wouldn't do it justice to write the details here, as Munger has done in this letter, but suffice it to say that there were incentives for S&L institutions to compete for ever more deposits using higher rates of interest paid to depositors, and then invest these funds into ever riskier loans, expecting the FSLIC to insure them if (when) losses occurred. And low and behold, these losses did come to fruition, and were born by taxpayers in large quantities (billions).
Interesting discussion of 80% acquisition of New America Electric where Munger and Buffett invest alongside an owner-operator (the CEO who retains 20% ownership of the company), which has been their preferred method of private investment over the years.
1989 Letter Notes (page 71)
Interesting to note in this letter are the new convertible preferred stock investments in Gillette Company ($50M at 8.75%, convertible at $50/share), USAir Group ($12M at 9.25%, convertible at $60/share), and Champion International Corporation ($23M at 9.25%, convertible at $38/share). I remember reading about these investments Buffett made in his annual shareholder letters, so it is clear that he and Munger worked together to make these investments.
I really like this particular type of investment because it is a "heads I win, tails I don't lose too much" type of investment where the risk/reward ratio is very positively skewed. It essentially gives the buyer a high yielding fixed income instrument with an out-of-the-money call option on the underlying stock. So it has the protection of equity capital in the capital stack, but also offers significant upside, should the company continue to perform well fundamentally.
Finally, Munger highlights his embarrassment from New America Electric's first year of operation where it earned a meager $168,000 or 1.6% on purchase price in the prior year. It is always interesting to follow mistakes of the investment greats like Buffett and Munger to learn where they took a wrong turn. This operation's troubles stemmed from a consolidation to new facilities, which seems transient rather than permanent in its effect on earnings power. However, after reading several more letters, it seems that Wesco paid up too dearly for a company at peak earnings in a fiercely competitive industry.
1990 Letter Notes (page 90)
Munger writes a long diatribe against the then-current legislation in effect that attempts to address the Savings and Loan industry problems after the large insurance losses to the FSLIC in the late 80's. I won't even begin to detail his long list of potential solutions to the ailing industry, but they are well worth the read for their policy implications both then and now. He ends his diatribe with a nod to Buffett:
"This eccentric, who heads Berkshire Hathaway, Wesco's parent corporation, believes for some reason that accumulated wealth should never be spent on oneself or one's family, but instead should merely serve, before it is given to charity, as an example of a certain approach to life and as a didactic platform. These uses, plus use in building the platform higher, are considered the only honorable ones not only during life but also after death. Shareholders who continue in such peculiar company are hereby warned by our example in writing this section: some of the eccentricities of this fellow are contagious, at least if association is long continued."
1992 Letter Notes (page 117)
Wesco effectively ended its engagement in the savings and loan industry and rearranged its organization to allow for "a lower cost operation, with higher investment flexibility."
1993 Letter Notes (page 126)
This year marked the year of Wesco's entry into the super catastrophe reinsurance business ("super-cat"), when National Indemnity (another Berkshire Hathaway Subsidiary) ceded part of its reinsurance book to Wesco's insurance operation. Munger has an interesting discussion on the economics of catastrophe reinsurance in this letter.
1996 Letter Notes (page 161)
Wesco Financial's reinsurance division purchased Kansas Bankers Surety Company for $80M in an all cash deal. KBS specialized in insurance products tailored to midwestern banks, including directors and officers indemnity policies, bank employment practices policies, and deposit insurance.
1997 Letter Notes (page 171)
Salomon was merged into Traveler's Group Inc., which caused the unrealized gains in their common and preferred stock holdings in Salomon to be recognized at a large profit.
It is worth noting that Munger discusses his investments in convertible preferred shares of Gillette, Salomon, USAir, and Champion International. His investment in Gillette cost $40M, but after conversion to common equity, was worth $321.4M at the end of 1997. He and Buffett made four investments of the type: Salomon, Champion International, Gillette, and USAir. Their Salomon (then Traveler's) and USAir holdings were worth $119.3 more than their original cost (not including dividend payments in the interim) at the end of 1997. Finally, they made $4.2M after taxes on the sale of their Champion International Corporation convertible preferreds (not including dividends). This investment strategy played out very well over a period of years, especially after the conversion rights were worth significant sums.
1998 Letter Notes (page 182)
Citigroup was merged with Traveler's, and Wesco became a holder of Citigroup convertible preferred shares.
1999 Letter Notes (page 192)
Wesco purchased 100% of CORT Business Services Corporation for $384M in cash. CORT was a leading furniture rental and sales company. Interestingly, 60% of the purchase price was 'goodwill' or the accounting entry that occurs when acquiring a company for more than stated book value. Clearly Munger thought that this represented a company with a durable economic franchise. If we back out of the numbers, we can see that CORT earned roughly 30% on book value of shareholders' equity pretax ($384M purcase price x 40% = $153M estimated book value, $46M / $153M = ~30%). However, as I soon found out, this would be too rosy of an expectation going forward.
2000 Letter Notes (page 200)
Wesco's position in Freddie Mac common shares that was bought in the late 80's for $72M was sold in 2000 for approximately $1.4 billion. Wesco made roughly 20 times their money pretax on the investment, and netted $852M after taxes. This works out to roughly a 28% compounded annual return over 11-12 years since Munger loaded up on Freddie Mac. As Munger always preaches, "few bets, big bets, infrequent bets."
2002 Letter Notes (page 216)
CORT furniture's fundamentals have declined precipitously from 2000 to 2002 with operating income down from $46M in 2000 to $2.1M in 2002. Perhaps they bought it at a cyclical high in fundamentals?
2003 Letter Notes (page 226)
CORT furniture's fundamentals continued to slide, reporting a $6.3M operating loss, while insurance operations reported profits, but declines from 2002.
2004 Letter Notes (page 235)
CORT's fundamentals rebounded with a $5M operating profit. Still, this is far below the $46M in 2000 when Wesco bought the business for $386M.
2005 Letter Notes (page 244)
CORT's business rebounded even more to $20.6M in operating earnings, and overall operating earnings were up to $77.9M from $47.2M in 2004.
Wesco recorded $216M in gains on sales of securities, but the entire amount was due to Gillette's merger with Proctor & Gamble, whereby Wesco received shares of P&G for their interest in Gillette.
2006 Letter Notes (page 253)
CORT's business expanded, recording $400M in revenue and $26M in operating profits. It seems that Munger purchased the company at a cyclical height in its earnings cycle and the general macroeconomic cycle, just before the internet bubble burst in 2000 and 9/11 happened in 2001. He paid for overoptimism, but never saw the returns.
Wesco Financial's Operating Income from 1983-2009
1983 - $8.4M ($2M in securities gains)
1984 - $10M ($13.1M in securities gains)
1985 - $8.3M ($41.5M in securities gains)
1986 - $11.9M ($4.5M in securities gains)
1987 - $16.6M ($1.2M in securities gains)
1988 - $23.5M ($1.6M in securities gains)
1989 - $24.4M ($5.9M in securities gains)
1990 - $25.0M ($.391M in securities gains)
1991 - $22.8M ($5.8M in securities gains)
1992 - $22.5M ($.147M in securities gains)
1993 - $20.3M ($1.1M in securities gains)
1994 - $24.6M ($.16M in securities gains)
1995 - $30.2M ($4.3M in securities gains)
1996 - $30.7M
1997 - $38.2M ($62.6M in securities gains)
1998 - $37.6M ($33.6M in securities gains)
1999 - $45.9M ($7.2M in securities gains)
2000 - $70M ($852.3M in securities gains)
2001 - $52.5M
2002 - $52.7M
2003 - $39.9M ($34.7M in securities gains)
2004 - $47.4M
2005 - $77.9M ($216.6M in securities gains)
2006 - $92M
2007 - $93.4M ($15.7M in securities gains)
2008 - $77M ($4M in securities gains)
2009 - $54M
Total of $1.05B in operating income, $1.3B in securities gains ($2.3B total) and an increase in book value from $124M to $2.5B from 1983-2009. Compounded book value by roughly ~12% over 26 years - and this does not include dividends. With dividends, this figure is more likely 13% - 13.5%.
Keep in mind that this record took place while Charlie was already Vice Chairman of Berkshire and helping Buffett allocate capital there as well as the fact that he had two clunker businesses operating for nearly the entire time - the savings and loan institution and steel business - that did not allow for much growth in earnings (his words, not mine!) - not bad relative to the fact that the S&P 500 with all dividends reinvested compounded from 1983 to 2009 at roughly a 10.5% clip annually.