Introduction
Earlier this week I
felt like I was accused. In a message from an investment committee colleague
who is a retiring senior officer of an institution I was thanked for being a
teacher to him. This upset me because I always wanted to be with the “good
guys,” the students. For I believe I am a lifelong student of human behavior,
particularly in terms of investments. In that search I am always looking for
sources of knowledge and wisdom. One of the lessons I learned from my otherwise
much too liberal education was that the Bible is more than an inspirational
document about morality. Selective chapters and verses can provide lasting
insights into economics, agriculture, military tactics and strategy, training,
law, sociology, psychology, management development, and leadership among other
lessons.
In a similar fashion, a
continuing study of the ever changing Berkshire Hathaway can be very
instructive as to how one should lead his or her investment life. As a
long-term owner of the stock both in a private financial services as well as
personal accounts, I attempt to read almost all that is published on the
company. I am not totally successful as the amount published by the company is
voluminous, including various commentaries by its twin leaders Warren Buffett
and Charlie Munger. It is popular with some “arm chair” critics to cast doubt
as to the current wisdom of various moves that the company is making on
numerous multi-tiered chess boards.
The purpose of this
post is to share with our community what I learned in reading just one
document. Almost all of my comments come from reading and thinking about the 45
page 10-Q document filed with the US SEC addressing the third quarter of 2015.
Please do not interpret this as a recommendation to buy the stock which would only
be appropriate after a thorough understanding of one’s current portfolio, time
horizons, and views. However, it is a recommendation to various colleges and
graduate schools to use a study of certain aspects of the company including
accounting, contracts, global economics, management approaches, personnel and
personal development, insurance risk management, financial and economic history
and developing a long-term, loyal shareholder base.
Financial Services
While it is much more,
Berkshire Hathaway is essentially a financial services holding and portfolio
management company. For the quarter 80% of the revenues came from insurance and
other related sources. This simple title covers many different activities. It
is somewhat like celebrating a winning horse without recognizing the
contribution made by the jockey, trainer, breeding and ownership elements
including many whose names we do not know. Some may downplay its contribution,
for in the quarter as insurance underwriting contributed only 9% of operating
earnings. What they are missing is the generation of insurance float which at
the end of the quarter stood at $86.2 Billion up $2.2 Billion from year-end. In
many ways this is the single most important figure in the financial statement.
The float was essentially the source along with operating cash flow that led to
a $133 Billion investment portfolio housed within the insurance complexes. For
those of us who grew up within the brokerage community, float represents margin
debt without interest cost. If one applied all of the float to the total net
assets of the company one could take a somewhat exaggerated position that the
company is 33% leveraged. However, the key value of the float is as excess
capital that can be applied in a matter of hours as part of, in essence, rescue
missions for sound, high quality companies that need cash and Berkshire’s
imprimatur and are willing to pay preferred dividends or interest way above
markets rates plus equity “kickers.” These companies have included GE, Goldman
Sachs*, Bank of America*, Dow Chemical, Mars, among others.
Insurance is not the
only source of financial earnings for Berkshire Hathaway. If one looks through
the activities of its railroad, utilities, and energy, the objective is to
convert its own and others capital through operations into financial gains that
are soundly leveraged. In the third quarter these activities produced 18% of
total revenues. Finance and financial products represented the rest of the
revenues even after a $764 million believed to temporary loss in derivatives
Messrs. Buffett and
Munger clearly believe in the long-term attractiveness of financial services
investing, which reinforces my personal biases. (Friday saw bank stocks rise
sharply, with JP Morgan Chase* up 2 points on almost double the volume of
Thursday, perhaps its timing is right) Berkshire has devoted some $ 48.9
Billion to financial services stocks with 74% in Wells Fargo and American
Express. It believes in well chosen concentration; including the two mentioned
above, some 58% of its equity investments are in just four stocks. The only one
of which is showing a loss against purchase price is IBM which is down some $2
Billion from a cost base of $11.7 Billion.
Not being a registered investment company it is treating the decline as
temporary and not writing down its value. (This option is available to private
investors and not registered participants and could be a useful approach as
long as the investor is highly confident of recovery to purchase price. While I
might like to do this personally, I am afraid my clients’ financial people are
more interested in immediate liquidating values to meet their funding
obligations with money to spare.)
*Held personally and/or
by the financial services fund I manage
In a somewhat different
situation in terms of Tesco, Berkshire took a write down of $ 678 million, but
did not sell the stock which shows that it lost faith in the ability to get
back to purchase price but thought that this summer’s prices were unnecessarily
depressed. Looking at fourth quarter UK prices Berkshire may be able to salvage
some of its admitted loss.
Viewing Berkshire as a
Source of Investment Inputs
I found the following
nuggets useful to aid my broader investment thinking. I will be happy to expand
upon any of these with our regular subscribers.
After a super-heated
second quarter, I was not totally surprised that the summer proved to be slow
for many of the operating activities. What did disappoint me is that in many of
the financial activities sales slowed materially more than seasonally. This
slow-down hit our financial services stocks particularly in the asset
management business.
Luckily for Berkshire
the big bet on Kraft Heinz paid off with the carrying value of this common
stock, including additional investments, jumping to $15.8 Billion from $3.95
Billion at year-end. The characteristic boldness of the management is a
hallmark of the way it understands the importance of moving decisively when
opportunity knocks looking for massive capital deployment.
As predicted by Mr.
Buffett, the reinsurance business has fundamentally become less attractive due
to excess capital being deployed by new entrants into the business who are
lowering premiums. For the nine months Berkshire Hathaway Reinsurance Group saw
its underwriting gain drop to $247 million from $617 million for the prior nine
month period. Once rates move back to attractive levels they are likely to
return to the leadership of the big ticket business. The General Re subsidiary
has analogous experience, dropping to $ 58 from $322 million operating gains in
the same periods. The ability to tolerate these cyclical swings shows the
benefit of the overall financial strength even with GEICO suffering a sharp
increase in accident claims in the first half of the year ($213million vs. $746
million) before level results occurred in the summer driving quarter. One of
the acknowledged skills of the company’s activities is risk management. In the
long run it seems to know which risks the company should take. For example, it
will undoubtedly turn the $130 million insurance property loss in China this
year to higher revenues next year with substantial rate increases.
As part of its large
diverse holdings of operating companies, managers are responsive to problems as
shown below:
1. In response to a 37%
decline in NetJets, it paid penalty fees for canceling aircraft purchase
orders.
2. Sale of unprofitable
operations within Fruit of the Loom.
3. One of the
transportation companies is in the business of leasing cranes, the decline in
the US business was being offset by gains in Australian infrastructure gains.
One of the reasons I
believe that a study of Berkshire is appropriate for many MBAs is what they can
learn from studying both the company’s mired accounting policies and capital
development. In the first case the company made two $1.7 Billion acquisitions
this year. In the first the Van Tuyl Group, now known as Berkshire Hathaway
Automotive, will amortize the purchase goodwill. (The timing to participate in
both the shrinking of the dealer community and getting close to peak annual
auto sales seems good.) At the very same time it bought AltaLink a Canadian
distributor of electricity which Berkshire will not amortize the purchased
goodwill. By definition these two acquisitions will produce significantly
different booked returns even though economically they perhaps should be
similar.
The final revealed tool
in Berkshire’s tool kit (which most investors are not aware of) is the ability
of Berkshire to swap some of its security holdings which have appreciated in
price, for some very specific operating subsidiaries of that company. This is a
classic example of swapping investment assets for operating assets. I suspect
that not only are these transactions tax free, but the new operating assets
will be carried at the original costs of the transferred investments. This is
another example that the stated book value of $151,083 for each “A” share is
vastly understated under any reasonable liquidation program. To my mind the 20%
premium that Mr. Buffett has suggested for buybacks would be a real bargain.
Bottom Line
I opened this post with
an initial view of the Bible as a good teaching device for many subjects.
However, in the end to be completely accepted it requires a good bit of faith.
Because of the creativity and brilliance of Warren Buffett and Charlie Munger
and the complexity of their structure and accounting, a somewhat similar level
of faith may be required.
Question of the week:
Will you share what lessons can be learned from a study of Berkshire
Hathaway?
_________
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A. Michael Lipper,
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