VALUE: After Hours (S07 E34): Buffett – General Re: Defensive Strategy in Action

During their recent episode, Jake Taylor and Tobias Carlisle discussed General Re: Defensive Strategy in Action. Here’s an excerpt from the episode:

Tobias: So, the first one was General Re. I think General Re was really interesting, because it came– Buffett had made the Coca-Cola investment, and he’d put about a third of Berkshire’s capital into Coca-Cola and then inside three years, it had tripled, and so it had become a very serious part of Berkshire Hathaway. That was still in the early 1990s. And then, they went into a large growth market where Coca-Cola absolutely ripped. I think it got to 40 times earnings, something like that.

Jake: Might have been 60, if I remember right.

Tobias: 60? 60 times earnings?

Jake: Yeah.

Tobias: And Berkshire itself.

Jake: Either way, it’s fully priced.

Tobias: It made up a big chunk of their investable assets and then they were overvalued to three times book value, something like that, around that time as well. So, it was very, very expensive on what was clearly elevated assets.

Jake: Yeah. So, an elevated internal mark on Coke, probably and then the container holding that is at 3x book value.

Tobias: And if you sell your Coke, you pay tax at the marginal rate of 35%. So, selling’s not really an option. And in addition to that, you might never get back into Coke again, because there’s no guarantee that Coke trades cheaply. I don’t think that Coke has really ever got cheap since he bought it. I think it’s got less overvalued, but I don’t think you could ever say that he would have been able to get back in.

All the time during that holding period, he’s been getting very substantial dividends and they’re now 50% of what he invested into Coke on annual basis. So, even though the price got well ahead as an investment, it’s been an extraordinary success. But that was 25 years ago that it got to that level of overvaluation that still hasn’t worked off and so, he had some–

That creates a problem. And that’s a really good problem to have, but it’s still a problem where if Berkshire Hathaway– And now, we know, because there was a collapse in 2000. If Berkshire Hathaway follows, the rest of the market probably gets cut in half at least and maybe more than that, because Coke was down by 50%, Berkshire was overvalued relative to the Coke. Berkshire would have come down a lot too. And so, one of the principles of The Art of War of Sun Tzu’s is that you defend first. So, you have to be defensively minded and you have to try to avoid ruining.

We’ve had lots of discussions about this in the past, but avoiding ruin is like– If you go to zero, it doesn’t matter how well you’ve compounded before you get to zero. There’s no coming back.

Jake: These are all ergodicity lessons that we had.

Tobias: Exactly right. What’s his name?

Jake: Luca-

Tobias: Luca. Yeah.

Jake: Dell’Anna. Yeah.

Tobias: Thank you. Yeah, Luca Dell’Anna’s got that great. Luca Dell’Anna has explained ergodicity really well in his book. And it’s a great concept. We should get him back on again to discuss again in the future. But the whole idea of Sun Tzu is avoiding rule and avoiding this zero. So, the way that you do that is you’re defensively minded, you defend first. He has lots of these little principles for defending that are great and that apply to equity investment in business and so on.

And so, Buffett’s solution for it is to merge with Gen Re. There had been discussions beforehand, they had worked together on deals, they knew each other really well, they had discussed merging previously, but the valuation wasn’t attractive from Berkshire’s perspective. And so, finally, they came to terms and they were able to do that deal. They achieved it by issuing stock in Berkshire. So, they diluted their Coke problem and substituted this overvalued equity with probably undervalued bond portfolio, because Gen Re was heavily invested in bonds.

Gen Re had some restrictions on it as well. It wanted to expand internationally and it was on a quarter by quarter. It was reporting quarterly. They were unwilling to invest, because then that would show up as a bad quarter. And so, they were constrained a little bit. Whereas Berkshire doesn’t have those constraints. They still have to report. They just ignore those constraints, which you’re allowed to do evidently.

Jake: Well, plus the capital. The balance sheet behind it allows them to turn what was debt holdings into eventual equity holdings.

Tobias: And so, they do that deal. They dilute down the Coke, the bonds replace the Coke overvaluation. And then, in 2000, when the rest of the market collapses, all of those bonds rally, which bonds sometimes do in a collapse. It’s no guarantee that they do that in the future. But they did on that occasion and Berkshire did extraordinarily well. They had all of this investment capital right at the bottom of the market, where everybody else was really struggling, which set them up for a huge 2010 and into the future.

I think that it’s an example of how being defensively minded, and defending and avoiding ruin is actually a huge positive, and it helps you gain and be offensive at a subsequent time. So, that’s why I think it’s a really powerful example of using those sort of principles in an investment context.

Jake: Just to think about the mindset at that time, for Buffett, four years before that, he had just nuked $400 million on a Dexter Shoes deal that he did with stock. And so, you would think like, that was a bit of a cat that sat on the hot stove, and yet he was cognizant enough to– that it’s still a good idea to do it, even though he’d been hurt by it. Is there anything in Sun Tzu about keeping an open mind about these things and maybe not fighting the last war, necessarily?

Tobias: It’s a great line. Its possibly there, [chuckles] but I can’t take off the top of my head. It’s a good line. It’s a good idea. There should be, if there’s not.

Jake: Yeah. We’ll put it in there.

[laughter]

Tobias: In the second edition?

Jake: Yeah, second edition. The Carlisle translation.

Tobias: One of the things that I love about all of the deals in the book, really, is how heavily criticized they are at the time that he does the deals. It’s funny, they’re criticized for often for reasons that have nothing to do with what actually eventually happens. But one thing that everybody missed that Buffett missed too that now is the thing that everybody remembers about that deal, funnily enough, it’s not the fact that he did very well out of the bonds. Everybody remembers the weapons of mass destruction, derivatives exposure which–

One of the criticisms of Berkshire, is that they don’t do that very deep diligence. I was a corporate lawyer. That’s pretty standard form to do these incredibly deep diligences. I don’t know, perhaps that did happen. But it doesn’t matter. They didn’t uncover this issue until down the track and they discovered that they had written these incredibly complex contracts, where really neither side knew [chuckles] if they were ahead or behind or if they owed money or if they were owed money, or they both assumed that they were owed money, or it was–

Jake: Yeah. Both sides are marking.

Tobias: Both sides are winning.

Jake: Yeah. [chuckles] Yeah. It cost them how much to get unwind those?

Tobias: I think it’s significant, but still not particularly material in the context of the entire transaction, even though he devoted lots of pages to saying why he had made a mistake and why it was a huge mistake and flagellating himself, which is classic Buffett, to do that, even though it was a hugely successful deal. But I think now, if you ask most folks about Gen Re, they would say, “Well, it’s weapons of mass destruction and derivatives rather than a really positive outcome.”

Jake: [crosstalk] mistake. Not a–

Tobias: Yeah, it was a mistake.

Jake: Not a masterstroke of strategy.

Tobias: And one that he compounded by issuing stock for, even though– Really, that’s what made it such a great transaction that he issued stock, got back debt, got back bonds that rallied into a crash and diluted out the Coke. So, it was a masterful transaction. So, one of the things that Sun Tzu says is, “You keep all of your plans silent. You don’t let people know what you’re doing.”

Jake: So, Gen Re shareholders don’t want to feel like they got fleeced, right?

Tobias: Right. And you might want to do that transaction again in the future. You might want to do something similar in the future.

Jake: Or, maybe Bank of America is sitting there, and you might want to give them a call from the bathroom.

[laughter]

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