Developments in telecoms, insurance and private equity in 2005

While Kurm’s value has increased in the quarter, certain significant events led to a very bad performance in January. The key cause of the January decline is the takeover of AT&T by SBC. Kurm has large direct and indirect investments in telecoms companies, one of which is Wiltel, whose largest customer is SBC. The market is extremely worried that SBC will transfer all its business from

Wiltel to AT&T fibre-optic networks, resulting in substantial revenue loss to Wiltel and the erosion of value. Of course, this is all now factored into the price. What the market does not seem to have priced properly are certain provisions in the agreements between SBC and Wiltel which require compensation for such loss of business, and it is unlikely that these recent events will result in eventual losses for Kurm.

It is very ironic that AT&T is being taken over by SBC, which was once part of AT&T before AT&T was broken into several smaller companies including regional telecoms companies like SBC, known as “Baby Bells.” AT&T’s complacency and poor management led to the decline of a great American monopoly business, as it lost revenue and market share to more nimble competitors. This will become a classic case study in business schools.

Kurm’s focus on business fundamentals in its investment approach and the avoidance of fads and fashions has allowed recent investments in telecoms when so many were afraid to invest: of course, it also meant that the company avoided the excesses telecoms bubble. One of the investments the company was advised to make last year was in MCI, Inc.

MCI emerged from scandal and bankruptcy with a clean balance sheet, extremely accurate accounts, and tremendous cashflows, as well as the assets in which it had so expensively invested, all available at bargain prices. Of course, covering all this were the clouds of scandal, of gloom over telecoms sector and of the one-bitten-twice-shy mentality of investors who had lost money heavily in the previous bubble. These clouds enabled investment at a discount to business values. MCI is now coveted by both Verizon and Qwest in a widely reported takeover battle, which has already made our investment very profitable, and this will be reflected to a degree in the next valuations you receive.

Another theme this last quarter has been the investigation by regulators of various insurance practices. I had written in the last letter about the investigation into insurance brokers and had expressed the view that none of Kurm’s investee companies would be tainted by the emerging scandal. This proved to be correct, as we have always endeavoured to identify executives and entrepreneurs with outstanding ethics, as this is the only way to ensure that shareholders benefit in the long-term from good business economics.

Currently, the insurance industry is facing another investigation, and has lost one of its most renowned leaders, as Hank Greenberg, head of AIG, has resigned. This company has been investigated for the manipulation of its stock price and of its earnings and balance sheet. It had entered into certain “finite insurance” contracts with General Re, a subsidiary of Berkshire Hathaway, and Warren Buffett has been asked to testify. I am very confident that there will be no finding of wrong-doing on the part of Warren Buffett as there is really no motive for him to do so.

A comparison of the cultures and incentives at AIG and Berkshire is quite instructive. AIG’s whole compensation structure has depended on the share price so that there is every incentive for the company to try to smooth earnings and hide losses. Warren Buffett has often clearly stated that he is not interested in smooth earnings, and would even prefer “lumpy” but higher returns. In addition, the valuation of Berkshire Hathaway’s shares is not really based on the earnings alone. Most executives at Berkshire subsidiaries are incentivised to focus on long-term generation of cash flow and value and are all independently wealthy.

Berkshire Hathaway’s balance sheet is solid. Moreover, the company has insurance float of US$46.1 billion, waiting to be invested in the right opportunities. This, together with my faith in the integrity and ability of the executives leaves me very confidant. Nevertheless, I am attending the company’s AGM and will report to you on any developments when I next write to you.

Kurm’s large involvement in Private Equity-type investments has increased with the acquisition on 1^st January of stakes in two limited partnerships with excellent track records. Last year, the company had taken part, through such vehicles, in syndicates investing in Symetra (the old Safeco life insurance business) and Transamerica Leasing. I have been told that these investments are progressing extremely well and look forward to sharing good news on these soon.

The investment in Alchemy Partners has not so far yielded any results, as the funds have not been invested in any transactions. However, this is not a bad thing, when so many Private Equity houses seem to be chasing deals at incredibly high prices, fuelled by banks looking to lend at very imprudent multiples to cash flow. This environment is part of a credit bubble and will come to an inevitable end.

Both in public and private markets, Kurm’s capital is in the hands of disciplined and contrarian managers and executive with much integrity. Their patient, conservative approach, focused on longterm business values, will be able to take advantage of the uncertainty and volatility expected in the global economy this year.