forbes.com
Buffett and Cheap Oil Don't Mix
By Martin Sosnoff
A GALLON OF GASOLINE is
cheaper than a liter of Coca-Cola. This is bad
news for Coke, bearish for Berkshire Hathaway,
specifically, and generally a worldwide
depressant. It doesn't help banks and brokers
dealing in emerging market bonds, either.
Oil below $10 a barrel is biting into Mexico,
Venezuela, Indonesia and all the Middle East oil
producers, also Norway. Their 1998 budgets
were based on $17 oil. Ten-dollar oil spells
deficits in the billions, weakening currencies and
more geopolitical risk for everyone. It's hard to
find even an energy security analyst who thinks
an early recovery is in the cards.
This is also bad news for Warren Buffett. Buffett
stands today immobilized by his own successes
in franchise-based equities like Coca-Cola,
American Express, Geico, Washington Post Co.,
Disneyland and Gillette. Berkshire's equity
portfolio, overweighted with almost $13 billion in
Coca-Cola out of $31 billion in specified
equities, underperformed the S&P 500 by 20
percentage points in 1998. Coke performed
particularly poorly relative to other pricey
securities, like Pfizer, Microsoft and Lucent,
which virtually doubled in 1998 and are not so
dependent on emerging markets.
Unless you believe worldwide reflation is coming
soon, it's hard to see 1999, either, as a vintage
year for Berkshire Hathaway. There is a strategic
problem with Berkshire's portfolio of insurance
operating companies. After an eight-year bull
market, the capital-to-surplus ratios of most
fire-and-casualty underwriters is woefully
underleveraged. Normally, the
premium-to-surplus ratio for underwriters is
closer to 2-to-1. Today it's almost 1-to-1. This
has caused everyone to shave premium rates, but
it is also topping out the investment income line,
which is where the carriers make their money.
The same goes for re- insurance worldwide.
Gen Re runs a 1-to-1 premium-to-surplus ratio,
with little growth on its premium revenue line.
The company is too smart to take bigger risks
for lower rates, and is determined to maintain its
combined ratio of losses and expenses at 100 or
below. Aside from capital gains on its portfolio,
which is heavily weighted in bonds and
municipals, earnings are flattening out.
To get going, Buffett needs to make a timely
entry into equities with as much as $10 billion to
$15 billion of Gen Re's investment portfolio, plus
$5 billion or more of Berkshire's cash. Where is
he going to put the money in a market priced at
24 times forward 12-month earnings? Being fully
invested regardless of price isn't Buffett's style.
I like what he's doing with Geico. Going for
market share against State Farm and Allstate
makes sense. I can see Geico picking up market
share points over the next three years, but only
15% of the total market is available for
switching. Allstate retains over 90% of its
customers with good service, and the industry's
15% that switches is not the highest-quality
business. So Geico will grow its cash flow at
15% or better, but this will penalize near-term
earnings. That's vintage Buffett: He'll take cash
flow over earnings anytime.
But put it all together and what do you have?
Berkshire Hathaway as a stock peaked at
$89,000 last year and trades closer to $60,000
currently. For Berkshire to see $89,000 again,
Buffett's going to need the following: worldwide
reflation to lift Coca-Cola; a chance to reinvest
his cash, some $25 billion of Gen Re's portfolio
and growth in Gen Re's premiums in a soft
worldwide reinsurance market.
All this suggests Buffett is likely to press for
another big acquisition before long in order to get
some growth.
If Warren Buffett has to scramble to make
money in these conditions, what does this say for
the average investor? It says that if he or she
owns 30-year zero Treasury bonds, he or she is
in good shape for the new year.
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