Insurance Australia Group (IAG) and Berkshire Hathaway

There’s been some staggeringly misinformed comment regarding Berkshire Hathaway’s partnership and equity stake with IAG (announced on 16 June 2015). 

Commonwealth Bank analyst, Ross Curran asked Mike Wilkins (IAG’s Chief Executive) and Nick Hawkins (IAG’s CFO) one of the most naively stupid questions I’ve ever heard. He asked whether IAG had given Berkshire 20 percent of its business in exchange for the 3.7 percent equity stake that Berkshire made in IAG!

Let’s get a few things straight.

Firstly, the equity stake that Berkshire took in IAG is completely incidental to the much more important partnership arrangement that the two companies have entered into (they just happen to have been announced at the same time which somehow managed to confuse both analysts and media alike). They could have entered into the latter agreement without Berkshire taking any equity interest in IAG, it doesn’t matter because that has nothing to do with their arrangement. It just so happens that Buffett believes that IAG is a well-run, cheap company with a strong franchise that he was happy to pay $5.57 per share for (and don’t think for one minute that he would buy a stake in any company that he didn’t believe in, no matter what the size of that stake was).

For someone like Ross Curran to confuse this side equity deal with the fee-based partnership arrangement suggests to me that Ross isn’t the brightest analyst we’ve ever seen.  Hey Ross, a couple of billionaires called earlier, they want to buy 3.7% of the Commonwealth Bank and get your Board to give them 20 percent of your profits for the next 10 years– sound like a good deal for the bank Ross? No? Then how stupid do you think IAG are?

For some media outlets like the Australian Financial Review (James Thomson) to pick it up as if it was some great insight is laughable. On the other hand, one of the few analysts who does seem to have had a much sounder understanding of the implications of the deal was Jan van der Schalk at CLSA.

The really important deal was the ceding of 20 percent of IAG’s insurance premium to Berkshire in return for Berkshire paying 20 percent of the claims and also insurance operating costs plus what Buffett described as a large annual payment. In Buffett’s own words describing the payment: “substantial – a payment of a size that virtually no other insurance company in the world would pay, and that we have never paid before.”

Buffett is a person of great integrity, so I would accept his statement. However, because we do not know what the size of that payment will be, we simply don’t know who got the better deal and whether it is earnings dilutive etc. This is actually something that should have been mandatory for both parties to disclose.

The main points are as follows:

·        The equity deal that Berkshire did was completely incidental to the partnership agreement with IAG, anyone confusing the two is displaying their ignorance;

·        Notwithstanding the above point, the equity deal is a huge endorsement of IAG’s management and business model (make no mistake, Buffett wouldn’t touch 99 percent of ASX listed entities with a barge pole and nor should you);

·        IAG is not entering into this deal with Berkshire under distressed conditions (unlike for example Goldman Sachs did during the GFC), so there is no requirement to give Berkshire a great deal;

·        We do not know the details of the payments that Berkshire will make to IAG over the life of the agreement, so any earnings dilution calculations etc. undertaken by pseudo analysts are purely guesswork;

·        Buffett has basically put a floor under the IAG share price at $5.57, if it does go lower, you can buy at less than Berkshire (and personally, I’m happy to);

·        The benefits for IAG are the freeing up of significant capital and greater earnings stability (IAG has made underwriting losses in two of the past five years); and

·        Contrary to what some pundits have written, unless Berkshire never intends on repatriating its Australian dollar investments, it is going to be subject to currency risk.

Traps with CFD Providers: A Cautionary Tale

I was contacted recently by someone who had traded CFDs over foreign stocks for the first time and had an unpleasant surprise regarding the way in which CFD providers calculate the profit or loss on these trades.

Most people would assume that the profit or loss from holding share CFDs denominated in a foreign currency would equate to the result that one would get from holding the underlying physical shares, however, this is definitely not so and can be an expensive lesson to those uninitiated in the ways of CFD providers.

An example will illustrate what I’m talking about.

In Table 1 below, we take the example of someone based in Australia (with an account held in Australian dollars) buying 1,000 shares in a US listed company at $US 50.00 per share. The cost of these shares is $US 50,000 and at the time the trade is entered into, the $A is worth $US 0.78, so the Australian dollar cost is $64,103.

When the trade is closed, the price of the stock has fallen to $US 48.00 per share, but the Australian dollar has also fallen against the US dollar and is now worth $US 0.765. Therefore, the position’s value in Australian dollars is $62,745 and the actual loss in Australian dollars is $1,358 ($62,745 less $64,103). This is the result that would have been achieved if physical shares were being held.

However, the trader holding CFDs, is in for a nasty surprise because their CFD provider simply calculates the trade loss as $US 2,000 ($US 50,000 original cost of the position less $US 48,000 closing value of the position) and then simply converts that loss at the current exchange rate (i.e. 0.765), leaving the trader with a $2,614 loss (or twice what they would have had if they had held the physical shares)!

Back in late 2013, I wrote about a trade I had done in Berkshire Hathaway. Had I been holding that trade as CFDs (which I was not), my profit would have been only 60% or so of the actual profit that I made. So, this is an important concept to understand for those of you who are new to trading CFDs over foreign companies.

Table 2 gives an example of making a $US 2 profit on each share (the opposite of the example in Table 1). Once again, the unfortunate trader has a worse result than he would have experienced had he been holding the physical shares.

 
There are three clear lessons from this:

1.    Holding CFDs over foreign shares WILL NOT give you the same result as holding the underlying physical shares traded on an exchange (if you hold your CFD account in your home currency);

2.    If your home currency is depreciating against the currency in which the foreign share is denominated in, you will ALWAYS achieve a worse result than holding the physical shares (the opposite is true if your home currency is appreciating, your profits will be larger and your losses smaller); and

3.    If you wish to trade CFDs over foreign shares, you may want to hold the funds in your CFD account in that foreign currency to avoid the above issue.

CFD traders would be advised to be very cautious trading foreign CFDs with Australian dollar denominated accounts in the current environment.