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Warren Buffett Bags an Elephant
What a difference a month makes.
In late February, Warren Buffett lamented that today’s overheated market held “little that excites” him. Berkshire Hathaway entered 2022 with $146 billion of cash on hand — and seemingly nothing to spend it on.
Ever since releasing his annual letter, though, Buffett has been one busy guy.
Buffett then went one better with last week’s announcement that Berkshire Hathaway has agreed to purchase Alleghany Corp. for $11.6 billion. This ranks as his biggest acquisition since spending $37 billion on Precision Castparts in 2016.
Some thoughts on Buffett’s big move…
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(1) Bringing a “Baby Berkshire” into the fold
Alleghany’s business is pretty simple: insurance underwriting, investing the resultant “float” in securities, and then purchasing select companies outright.
The New York-based holding company/conglomerate closely resembles how Buffett runs Berkshire. Albeit on a much smaller scale.
Alleghany’s insurance setup includes TransRe, RSUI, and CapSpecialty — all operated in a very conservative, Berkshire-like manner by CEO Joe Brandon.
No surprise there. Brandon led Berkshire’s massive General Re unit from 2001 to 2008, before switching over to Alleghany in 2012.
In fact, Buffett trumpeted Brandon’s involvement in the deal as a major plus. “Berkshire will be the perfect permanent home for Alleghany, a company that I have closely observed for sixty years,” Buffett said in a statement. “I am particularly delighted that I will once again work together with my longtime friend, Joe Brandon.”
So don’t expect a steep learning curve for Brandon and Alleghany.
But, like Berkshire, Alleghany doesn’t stop at insurance. Its portfolio of non-financial businesses and investments includes two companies, Jazwares (the toy maker behind Squishmallows) and W&W Steel, that earn more than $1 billion in annual revenue. A third, IPS (Integrated Project Services), is expected to join the Billion Dollar Club in 2022.
Alleghany’s Roundwood Asset Management handles the company’s investments, with 72% in fixed income securities and 16% in common equities. That bond portfolio, in particular, should benefit from rising interest rates.
And, while a smaller piece of the puzzle, Alleghany owns some very interesting stock.
(2) It’s all about “float”
The asynchronous nature of insurance — a company receives premiums from customers, but doesn’t pay out anything until claims come due — creates “float”. This collect-now, pay-later model leaves insurers holding large sums of money that can be invested to create a new avenue of profitability.
Even better, if the insurer’s underwriting breaks even, this float is basically free. The company pays nothing for access to lots of investable money.
If there’s a secret to Warren Buffett’s success, it’s his expert use of float to drive greater and greater returns for Berkshire Hathaway.
In 2021, Alleghany reported $195 million profit from underwriting, meaning its $12.9 billion of float comes at no cost to the company.
Float can be a dry subject (and confusing, too). I get it. But it’s the key to understanding both Berkshire’s past success and why Buffett wants Alleghany now.
(3) Buffett pays a fair price — and sticks it to Wall Street
Berkshire’s offer of $848.02 per share represents a 29% premium over Alleghany’s average stock price in the last month. So, at first glance, it looks a tad on the pricy side.
However, the offer price is just 1.26 times the company’s book value. When Berkshire traded at a similar valuation throughout much of 2021, Buffett was buying back shares hand over fist. While Alleghany is no Berkshire, he likely sees this price tag as quite attractive nonetheless.
Buffett’s long-standing disdain for Wall Street bankers also popped up in this deal’s final price. Berkshire actually offered $850 per share, but stipulated that any financial advisory fees paid to investment bankers by Alleghany must come out of their end.
Buffett famously shuns investment bankers on (almost) all of his acquisitions. As he wrote in his 2014 letter, “Money-shufflers don’t come cheap.”
So Alleghany footed the bill ($27 million to Goldman Sachs) and, as a result, their shareholders will receive $1.98 per share less when the deal closes later this year.
(4) People LOVE to see Buffett spend money
Berkshire Hathaway, already up nearly 14% this year, rose another 5% last week after news broke of the Alleghany acquisition.
Over the past few years, Berkshire traded at an oddly-low valuation — perhaps as “punishment” for holding lots of cash amid Buffett’s relative inactivity. For whatever reason, Berkshire’s money really burns a hole in other people’s pockets.
The more impatient among the chattering classes of media and analysts even questioned whether current market conditions had passed the 91-year-old by.
The truth is likely far simpler: The legendary value investor had little interest in spending money in a market trading at sky-high valuations. And, on the rare occasion that something interesting did pop up, SPACs and private equity quickly bid prices up to unreasonable levels.
That won’t last forever, though. As the market cools off and the buying frenzy subsides, opportunities like Alleghany arise and Buffett will have the chance to put Berkshire’s prodigious cash pile to work.
In the meantime, investors are downright giddy at seeing Buffett dole out cash again.
(5) Berkshire could still be out-bid
While both sides tout this $11.6 billion deal as a win-win, Alleghany did secure for itself a 25-day “go-shop” window during which it may seek out better offers from other companies.
But, even if someone else is willing to pay more, Berkshire still has a lot in its favor. Namely, Warren Buffett and Charlie Munger will allow Alleghany to continue operating independently once under the Berkshire umbrella.
Talk is cheap, especially during big M&A deals, but Berkshire boasts a nigh-unimpeachable history of hands-off management. (Munger once joked that Berkshire prefers “delegation just short of abdication” when dealing with subsidiaries.)
That being said, another company could swoop in and steal Alleghany. The company’s share price closed at $860 on Friday (1.4% above Berkshire’s offer), showing that there’s some sentiment on Wall Street that a rival bid could yet emerge.
If that were to happen, Berkshire would likely bow out immediately. Buffett doesn’t do bidding wars.
Disclosure: This is not financial advice. I am not a financial advisor. Do your own research before making any investment decisions.