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Sunday night's announced "merger of equals" between Allied World and Transatlantic Re is a new baseline of sorts for the insurance industry. For the first time that I recall, a well-regarded U.S.-listed company (AWH or AWAC) plans to issue stock at a significant discount to its own book value for an acquisition.  AWAC rationalizes that the deal is accretive to its tangible book value and ROE. How could it not be, since AWAC is buying assets that are cheaper relative to tangible book than AWAC's own. TRH has admitted that the deal is dilutive to its shareholders, but offered no apology.

The people who benefit from this merger are the boards and managements of both companies. The Allied World CEO gets to run the combined company. Great for him, and like all insurance CEOs he will do well financially. The TRH board members keep their jobs because they all roll over to the combined company. TRH CEO Bob Orlich gets to retire, something he has wanted to do for awhile. He will do well financially.  In short, this is a fabulous deal for insiders.

Not so much for shareholders. 

By "weaklings" I mean that both of these are quality companies that have, like the rest of the industry, been trampled by catastrophes and suffer from weak core earnings in the soft market. AWH is mainly a specialty insurer. TRH is mainly a reinsurer. As such, AWH business mix is preferred by investors because less volatile and considered to have more of a "franchise" to the extent there is any such thing in the commodity insurance industry. 

Having now looked at the companies' joint presentations I am even less impressed. This is a merger in search of a rationale. The presentation contained dozens of bullet points that amounted to stating over and over in various ways that the combined companies will be bigger and more diversified (or "diworsified," in insurance parlance). While it is true that there are capital efficiencies that come with size and multiple entities in regulated domiciles, size alone does not justify an inadequate price.

Worse, TRH shareholders are facing a taxable deal because it has been structured as the acquirer for tax purposes even though it is selling itself to AWAC (management persists in calling this a merger of equals, which is a fiction that is mostly tolerated, except in deals that severely disadvantage one set of shareholders, as this one does).

To that very point, I did not appreciate management's non-response on the conference call when Jim Agah asked about why the taxability of the transaction was not disclosed. He also asked about the interests of the Davis Funds, which own nearly a quarter of the stock and 9.9% of the voting interests, acquired at a low tax basis. Management responded the Davises had acquired their stock at a price roughly equal to the deal value. so this was not a problem. This is rather shocking. The company acted as though it doesn't keep track of its largest shareholder or how long they have held their position. Most of the Davis shares were acquired more than a decade ago. The company should have had a ready and correct answer to this question that showed careful thought about how the tax implications of the deal would affect its largest owner, and the answer should have indicated why the price was still appropriate despite this disadvantage.  This omission is glaring and sheds some light on management's thoughts as it pursued this deal. Today, the Davises filed an 8-k indicating they may oppose the deal and look for a higher bidder.

 Full disclosure, I am long TRH and as of now, am in the money on this deal, despite the tax hit. However, I don't think the price is nearly high enough. TRH would have been better off transitioning to a new management, restoring its book value and underwriting results post the 1Q11 cats, and waiting for a higher multiple before selling. In addition, I wonder if TRH considered other partners -- the presentation had some rather vague language that made me think, perhaps not.

We're living in a bread-and-circuses economy. My latest Bloomberg column discusses the reasons why.

 A comment on Berkshire's buy of Mastercard. There is speculation that this is a Todd Combs position. I don't know if that's true although Buffett, historically, has owned a short list of financials and not varied much from it.

The payment processors face both headwinds and tailwinds such as one time items depressing current cash flows, new technology and regulation, and there's a lot of discussion going on about both. What follows is not a detailed analysis of fundamentals but rather a discussion of margin of safety. MA is trading at 19X trailing 4Q free cash flow. This is an expensive valuation. One very rough way of measuring downside is that during the financial crisis the stock traded down to 12X FCF, a number that was 72% of current 4Q trailing.

One version of the bull case on valuation: if FCF doubled, the stock could reach $555 at today's multiple. 

Under what circumstances could that happen?  MA has a tithing business model and virtually no capex. The essence of your bet on this stock is long inflation. You are betting that cash flows will grow quickly even if the economy is terrible and customer unit purchases fall or remain stagnant. As protection in this scenario, MA is a terrific inflation hedge.

The current price provides a cash flow yield of 5.1%. If cash flows did double overnight, cash flow yield also would double and become more attractive. (Under that scenario, I think I would rather buy BRK than MA.) Either way, the stock will compound at whatever rate the economy grows plus whatever rate of inflation +/- growth from changes in the business, competition etc.  The stock at this price either is betting on the come or, put another way, bought as if it were a TIP but with unlimited "interest rate" adjustment and unlimited equity risk. (Like most stocks, the longer the holding period, the higher the equity risk from the business model coming apart. Assuming this risk away is a fallacy in buy-and-hold investing.)  

Today's price doesn't contain enough margin of safety to justify treatment as a bond surrogate in this manner, not in my portfolio. It may be, however, that somebody in Connecticut or Omaha has such modest return expectations from the market as a whole that to them, the margin of safety really is adequate. That's actually possible, so  I'm really not knocking the decision to purchase MA. Berkshire has such a limited universe from which to buy, from a market cap perspective. Fortunately we small fry have better alternatives because we can go down the scale in market cap.

 In other news, it appears that Sokol, who is well-known as no shrinking violet, may fight any attempt to throw him under the bus. Berkshire is now firing back. Statement from Sokol's lawyer:

Statement of Barry Wm. Levine, attorney for David Sokol

 I am profoundly disappointed that the Audit Committee of Berkshire Hathaway would authorize the issuance of its report to the public without the care and decency to ask even a single question of Mr. Sokol. Mr. Sokol had been associated with the Berkshire Hathaway companies for 11 years. During this time, his indefatigable efforts helped create enormous value for the Berkshire shareholders. He deserved better. While I take issue with much of the Committee’s report, I briefly make the following points. If the Audit Committee had asked, it would have learned that:

• Mr. Sokol had been studying Lubrizol for personal investment since the summer of 2010; such investments are specifically allowed by his employment agreement.
• Mr. Buffett was told twice, not once, about Mr. Sokol’s ownership of Lubrizol stock before Mr. Buffett engaged in any discussions with Lubrizol.  
• Contrary to the Audit Committee’s statement, Mr. Sokol’s Lubrizol shares were not acquired pursuant to a “100,000 limit order.” Rather, they were purchased as a result of several limit orders, over a period of days, at specified prices, for the day only, in order to acquire the stock at low prices. At that time, Mr. Sokol had no reason to anticipate that Mr. Buffett would have any interest whatsoever in Lubrizol.

I have known Mr. Sokol and have represented his companies in business litigation since the mid 1980s. I know him to be a man of uncommon rectitude and probity. He would not, and did not, trade improperly, nor did he violate any fair reading of the Berkshire Hathaway policies.

 Berkshire Hathaway Inc. News Release

OMAHA, Neb. -- April 28, 2011

 (NYSE: BRK.A; BRK.B)—Ron Olson, a partner in the law firm of Munger Tolles and

Olson and an attorney for Berkshire Hathaway Inc. made the following statement

in response to reported comments from David Sokol’s attorney:

 “Mr. Sokol was interviewed at least three times regarding his Lubrizol trading

activity and contacts with Citi bankers. In connection with the preparation of

the audit committee report, a request for a further interview with Mr. Sokol