One variation of poker is Omaha Hi-Lo, in which the highest and lowest hands split the pot. But in order to win, players must declare whether their hand is competing for the high split or the low split. Essentially, "bad" cards can still be winners but it's not enough to have winning cards; you must be able to correctly size up your hand.
Not too long ago, investors were treated to an exceptional display of Omaha Hi-Lo. In this case, however, the cards were companies and the element of luck was replaced with the inevitability of time. Here, the players were Berkshire Hathaway and General Reinsurance.
For over a year, Warren Buffett, who heads Omaha-based Berkshire Hathaway, had expressed a desire to buy General Re, a premier reinsurance company. The deal as finally structured was a beyond-the-textbook case of sizing up the risk-reward.
Berkshire Hathaway acquired General Re in a pooling-of-interests, exchanging 20% of Berkshire shares for all of Gen Re's stock.* The price was 16x earnings (the average stock in the S&P 500 Index was selling for almost twice that P-E multiple).
From a business point of view, General Re is a better company as part of Berkshire Hathaway than it was as an independent company. The reinsurance business is lucrative but volatile; opportunities and risks change dramatically from quarter to quarter and from year to year. As a publicly traded company, Gen Re was under pressure to show consistently good results in an inconsistent business. Berkshire, however, is focused on long-term value, which will allow Gen Re to aggressively pursue opportunities when they present themselves and to be patient when they don't.
From an investing point of view, the beauty of this deal becomes apparent. To understand why, understand first how General Reinsurance makes its profits. As with all insurance companies, Gen Re receives cash in the form of premiums with the responsibility to pay cash for incurred losses. Over time, the incurred losses Gen Re pays are about the same amount as the premiums it receives which is good! (Most insurance companies show underwriting losses, paying out more in claims than they receive in premiums.)
The logic behind this illogic is timing. Premiums are received now; claims are paid later. Between now and later, insurance companies can invest the money, known as the float, and whatever they earn on that money is theirs to keep. In Gen Re's case, the return on investment has averaged about 4% per year after-tax.
Meanwhile, Berkshire Hathaway's investment return has been many times that rate. If Warren Buffett can earn 12% on General Reinsurance's float, profits will triple and the effective cost of the acquisition will be less than 6x earnings!
In effect, Berkshire Hathaway could buy Gen Re at a significantly cheaper price than anyone else, because no other buyer could get Buffett to invest the float. Now that's knowing how to size up a hand and how to play it Omaha-style.
* Historically, Berkshire Hathaway has preferred to buy companies for cash rather than stock unlike most CEOs who prefer to pay in stock to avoid goodwill amortization (see Acquisitions), Warren Buffett hasn't wanted to dilute existing Berkshire shareholders (the largest being himself) by issuing new shares. This acquisition was an exception: Gen Re insisted on shares instead of cash and the price of Berkshire shares were selling at an all-time high relative to book value.