I recently read a great article in Fortune magazine about the CEO of American Express. In the article, I learned some key information about the credit card industry and confirmed my theory on the impact that the new credit card regulations will have on the industry. As you might have guessed, a cap on interest rates will simply mean less credit available for high-risk customers.
The most important point of emphasis I took away from the article was the importance of not taking on excessive debt (i.e., maintaining a strong balance sheet), especially when times are good. Some companies began to really get into trouble when the credit crisis hit because they had been relying on credit just for everyday operations. Others took on excessive debt to fuel growth. They probably figured that times would always be good and that, therefore, their financial policy would be sustainable indefinitely (this also violates one of our major rules, which is always, always have an exit strategy).
Maintaining a strong balance sheet fits my mental model of pricing discipline in the insurance industry. Insurance premiums tend to fluctuate based on the recent risk history of whatever is insured (when people go a while with no wrecks, they see less value in having insurance and, therefore, want lower rates). When the premium rates start to drop, insurance companies are reluctant to give up customers, so many insurers cave and offer policies at lower and lower rates. However, lower rates mean lower profitability and, eventually, money-losing policies because the claims will generally be the same regardless of the premiums. Therefore, the best companies maintain pricing discipline and refuse to drop their rates below a certain level. They willingly give up business rather than write a policy that will ultimately lose money.
The lesson is that there will always be a day of reckoning for those companies that don’t maintain discipline. It just takes a long-term focus to understand that. Luckily, we are generally only interested in companies who demonstrate a long-term focus.