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October 21, 2008
Certificates of Confiscation? (White Mountains' are a buy.)

I came of age during the 1970s, an era of inflation. Bonds, which had been in a bear market since World War II, were derisively referred to as "certificates of confiscation" by the great insurance investor and perpetual stock bull, Shelby Cullom Davis. He was not wrong.

Interest rates rose sharply in the early 1980s, instilling in me a profound distrust of fixed-income securities and a lasting fear of inflation. Inflation, after all, is a man-made phenomenon — too much money chasing goods and services. Nothing I have seen in my lifetime indicates that the federal government is capable of reining in spending.

So why should I like bonds?

Furthermore, I know lots of rich people, and not a one of them got that way by buying bonds.

So stocks it has been for me. In my 30 years of investing I've hardly ever bought bonds (except for short-term Treasurys). Yes, every now and then I dipped my toe into the world of fixed income, but only for "special situations." I bought some junk bonds in the early 1980s. Later, I bought some busted first mortgage bonds, and now and then I bought convertible bonds trading near conversion parity. In the last decade I made one — that's it, ONE — bond investment.

Any equity investor, however, must always compare the attractiveness of stocks to bonds. And right now, thanks to the worldwide financial crisis, corporate bonds are looking mighty attractive to me. They are, for the first time I can recall, "special situations."

But before I get to that, I'll say something about insurance stocks. They're pretty cheap. On a price-to-book-value basis, property/casualty stocks are the cheapest they've been in decades. Of course, the asset side of most companies' balance sheets have not yet been marked down to reflect the carnage in the stock and bond markets, but still, an enterprising insurance investor can find any number of situations that are interesting. Some are even compelling.

But insurance companies, when you get right down to it, are just big piles of bonds. So an equity investor might want to question whether he wants to own these piles. But if he decides he does, then he might want to consider owning the debt of some of these companies instead. The stocks of Hartford Financial Services Group Inc., MetLife Inc. and Prudential Financial Inc., for example, all trade at big discounts to book value. I don't own these companies (they're too complicated for me), but others may consider them to be their cup of tea. If so, then how about their bonds? All three companies are investment grade (their bonds are in the "A" range) and all have bonds that yield in the neighborhood of 10%. It's axiomatic that if the stocks of these companies are worth anything then the bonds are money good.

I haven't bought any of these bonds and probably won't, but I've bought some others. I'll tell you about one.

White Mountains Insurance Group Ltd. is a good business run by capable people. Its main operations are OneBeacon Insurance Group Ltd., White Mountains Re Group Ltd. and Esurance Insurance Co. The company has compounded its book value over the long term at a respectable rate. Its four basic "operating principles" are extremely sensible, and just the sort of thing many companies forget.

Here they are:

* Underwriting comes first
* Maintain a disciplined balance sheet
* Invest for total return
* Think like owners

Perhaps even more significant is what White Mountains doesn't care about. Because these principles are so sane I'll repeat them verbatim (in italics):

White Mountains cares least about:

* Reported operating earnings according to generally accepted accounting principles

Trying to produce a regular stream of quarterly operating earnings often produces disaster. Trying to manage your company according to generally accepted accounting principles can often be silly. We prefer to measure ourselves as we would hope our owners measure us — by growth in intrinsic business value per share.

* Growth in revenues

We applaud owners who reward executives on premium growth. This often provides fine opportunities for us later.

* Market share

Often introduced by business consultants. In our personal experience chasing market share has produced the biggest disasters in our business. Often, we have profited later from that excitement.

* Strategic purchases

We have never made a strategic purchase … maybe we will someday. We often sell to strategic buyers. Our problem is we really don't have much of a strategy other than to increase intrinsic business value per share.

White Mountains' operating businesses have good enough ratings: "A" and "A-." And the company's stock is now trading below reported book value. I gave considerable thought to buying the stock but decided against it. Instead, I bought the bonds. The Fund American Companies' 5.875% senior notes maturing May 15, 2013, are "fully and unconditionally guaranteed" by White Mountains. They're rated investment grade but are trading like junk. I bought the bonds yesterday at a 13.7% yield to maturity, a remarkably high rate for four-and-a-half year paper. Why bother with White Mountains' stock when its bonds are this cheap?

The price of White Mountains' bonds isn't indicative of any particular problem at the company. Rather, it's a sign of distress in the credit markets in general, and of financial companies in particular.

White Mountains isn't likely to go bust. And, at a 1,100-basis-point spread over Treasurys, I'm being compensated handsomely for that modest risk.

Up with certificates of confiscation!