CRM - Buffett's Berkshire: Q3 Results Display Its Predictability And Durability

2023-11-13 11:19:13 ET

Summary

• Nothing very new was contained in Berkshire Hathaway's Q3 Report but a few subtle details suggest areas worth pondering.
• Insurance was the star performer serving its purpose as a diversifier against most other businesses.
• BNSF may be signaling a period of slow growth while BHE added to expected costs of the PacificCorp litigation.
• The answers to questions about reduced buybacks involve both Berkshire's price and the hurdle provided by high fixed income returns.
• A hint in Buffett's adherence to short T Bills may suggest he is holding cash in hopes a large high growth opportunity comes along.

There was very little that was new in Berkshire Hathaway's ( BRK.A )( BRK.B ) third quarter earnings which came out Saturday November 4, and nothing very new is what we have come to expect. As usual, CEO Warren Buffett had nothing to add to the numbers. Buffett has often said that the general obsession with quarterly reports does more harm than good. It focuses investors, managements, and analyst savants on the short term prospective. My own take is that the sensible approach is to look at quarterly results for any new trends or tendencies that will have a long term impact. Such developments are rare with Berkshire which changes direction at the pace of an aircraft carrier.

A good approach when it comes to quarterly results is to skim the obvious stuff and look with a magnifying glass at subtleties which may suggest an important trend emerging. A casual reading often tells you the wrong thing. The obvious one is the nominal top line earnings which have been distorted since 2016 by the FASB requirement to report unrealized gains and losses in Berkshire's portfolio of publicly traded stocks (a rule which applies to all corporations but has a major impact on Berkshire). This produces large and highly volatile swings that tell you nothing you didn't already know by simply glancing at the market occasionally. Berkshire's stock portfolio of $350 billion is much more volatile than Berkshire's operating businesses and makes up about 45% of Berkshire's $767 billion of total market cap. A 20% market correction could thus drop Berkshire's book value by around 10% - but in the long term it is stable and growing. Savvy investors have come to realize this and ignore the top line.

Berkshire is a company of few real surprises, strong diversification, proven durability and high predictability. Very few events should rattle investors or pose a serious problem for Berkshire management. The one such event in the thirty-odd years I have followed Berkshire was the pandemic and ensuing lock down of the economy in 2020. At the Annual Meeting in May Buffett's face seemed to reflect concern. The fact that he didn't rush to buy suddenly cheap stocks including Berkshire itself had to do with the fact that it was as if a large asteroid had randomly dropped from the sky and had the potential to threaten Berkshire's very diverse collection of companies. It was important to hold a large cash position for operating subsidiaries which could turn out to be in real trouble. After the fact, Buffett critics had fun talking about things he sold early or did not buy at the bottom, but there's a huge difference between the limited knowledge available at the time and knowledge with the benefit of hindsight. The long term takeaway from the troubled look on Buffett's face is the level of intensity with which he takes responsibility for all of Berkshire's stakeholders.

The Power Of Diversification - Especially Helpful If A Bit Random

Most headlines on Berkshire's Q3 earnings focused on the large improvement in its insurance earnings. Was this news? This is one of the most important questions for investors to ask. I recently had a 2-minute debate with a chum over whether Galileo or Copernicus was the scientist put to death for his beliefs. An aged Galileo recanted and left the probably apocryphal story of his muttering "but it (the earth) still moves."

I had a brief second thought on Copernicus. Was he killed? I looked it up and found that he died in his bed at age seventy. It was obvious. If Copernicus had been killed by anti-science idiots we would all have heard about it. It would have stood out like the murder of Archimedes by the Roman soldier ("stand out of the sun," Archimedes told him). The name and image of Copernicus would fly everywhere on the flag of science along with Archimedes. Alas, he died in his bed like the rest of us and the only surprising detail we remember was that he was wrong about planets going around the sun in circles. They actually go around the sun in ellipses, circles being unstable. The thing to suss out about Copernicus is the subtle and very small but important detail he missed.

That's how to think about earnings reports. We already know the big things. It would have been astonishing news if Berkshire's PC and reinsurance businesses had not performed well. If half of Florida had been flooded or blown into the ocean we would have had plenty of time to lean forward in our seats and brace for it. All that we would have lacked would have been the exact numbers. The fact that Berkshire had a very good insurance year is like Copernicus dying peacefully in his bed. All we learned on November 4 was that good insurance underwriting combined with a much higher return on cash held in T Bills were the main things that helped increase operating earnings which the bean counters toted up to 41%..

Earned premiums were up 25% but much of that was owing to the 2022 Alleghany acquisition. Inflation costs which damaged 2022 results were abating while customers proved willing to accept an increase in prices. There were next to know catastrophes. This helped Property and Casualty quite a bit and provided a tremendous boost to Berkshire Hathaway Reinsurance Group which raked in profits in 2023 with its results up $1.4 billion. Will the same great results recur in Q4 or 2024? Who knows? There is a wonderful randomness to the insurance business and there's little predictive power from year to year although with climate change it has become important to trace annual results when a small piece of new data points toward possible modifications in long term trends.

It's with GEICO that managers need to look carefully to work through the true meaning of results. The tricky thing with GEICO is that it has been hard to discern clearly whether bad results in recent years have come from management mistakes or circumstances beyond their control. In broad outline it looks like GEICO wrote too much business at too low a rate. It's the third time this has happened in GEICO's long history with the first two occasions putting its future in peril. This time the pandemic disruption did it no favors and it was also hit extremely hard by inflation with its combined ratio soaring to 100/107, an unheard of number for the normally conservative Berkshire. Management undertook to sacrifice volume, jack up prices, and focus on profitability. Subsiding inflation helped and the combined ratio improved by more than 17% to 89/100. Was a one time circumstance or was it the result of the new management approach? Is it an improvement which will extend into the future? There's the first important and meaningful question to emerge from the Q3 report. If GEICO is fixed and can go forward successfully, Berkshire's insurance area will return to providing results generally very good but uncorrelated to all its other businesses.

What Didn't Look So Good Was BNSF

It's hard to believe that the Burlington Northern Santa Fe merger is now a decade and a half in the past. Purchased in 2009 for $44 billion including debt it roughly tripled in value within a half dozen years as placed by rank order in Berkshire Annual Reports. Green initiatives then began to impact coal volumes and slow growth in revenues. Analysts at the time were generally confident that BNSF would replace coal with petroleum and petroleum products among other things but the Q3 Report with earnings falling YOY from $1.4B to $1.2B becomes another data point suggesting decline. Revenues fell 12%, 20% more than the 10% at Union Pacific ( UNP ), the railroad with which it is most often compared.

Cost cutting will likely be the immediate response, but there is increasing evidence that growth has leveled off. Cost cutting only helps once. Slower growth wouldn't be an existential threat to Berkshire but would imply a change of roles for BNSF from a growing subsidiary to a provider of steady cash returned to Omaha. These are normal stages for a mature and aging business, not too threatening for a durable business like a railroad, but the maturing process is something for both investors and management to keep an eye on.

One thing slowing growth at BNSF suggests is the need to become more observant when it comes to slowing growth in major Berkshire subsidiaries. Another Berkshire "unit" to keep an eye on might be Apple ( AAPL ). So far Apple has been able to reinvigorate itself from time to time, but it is no longer a spring chicken as tech/consumer companies go.

Are There Legitimate Long-Term Worries About Berkshire Hathaway Energy?

Short answer: probably not. The major driver of bad news for Q3 was the decision to set aside an additional $1.3 billion in estimated pre-tax loss for PacifiCorp {PPWLO) to pay for fire damage in Oregon and Northern California. Only the blind could fail to see this coming. The PacifiCorp lawyers would argue that climate change and the fires themselves were the culprit. The lawyers for the litigants would argue that PacifiCorp is backed by the deep pockets of Berkshire Hathaway and should pay up (paraphrasing invisible ink between the lines). The fire damage case will eventually recede into the past and BHE should resume being a major growth area for Berkshire.

Meanwhile the HomeService unit which oddly resides inside of BHE had a revenue decline of 14% dragging down the energy group. In the last few days the CEO of the National Association of Realtors stepped down because of a legal outcome in which several companies were involved, HomeService among them, and were found guilty of anticompetitive practices in which the seller was forced to pay a commission to the buyer's broker. I'm sure it raised the question inside Berkshire as to whether Berkshire Hathaway Energy is the ideal location for HomeServices.

Easy Predictability: Why So Few Share Buybacks?

Despite the fact that the answer should be obvious to all Buffett followers, this question probably ranked third in most headlines after the 41% increase in operating earnings and the strong performance of Berkshire's insurance subsidiaries. The answer comes with two factors: Berkshire's trending stock price and the hurdle provided by higher interest rates.

Even a glance at Berkshire's YTD stock chart will make it obvious that Berkshire was bouncing around between $300 and $310 during the first quarter, a price that made the stock attractive enough to account for Buffett's $4.4 billion in buybacks. Berkshire rallied through the second quarter, jumping a stair step to a price of $325 or more so that there were fewer moments when it was outright cheap. In Q3 it jumped another step into the $350s. That's reason number one. Rational investors, and Buffett certainly is one, prefer to buy things when they are cheap.

Reason number two was that by Q3 all stocks had competition from fixed income for the first time in a decade and a half. Buffett could get up to 5.5% on totally safe T Bills. That sort of safe return made all stocks, even Berkshire, appear less attractive. It should surprise no one that share buybacks dropped from $4.4 billion to $1.4 billion and in Q3 to $1.1 billion. Buffett is happy to be guided by arithmetic. For those looking to buy Berkshire for themselves, it may be helpful to note that Buffett loves it down around $300 to $310, likes it tolerably well at $325 to $330 and still likes it at least a little even at $350 and with an alternative safe asset offering 5.5%. That should help with your own decision. Buffett doesn't necessarily see Berkshire as overpriced. He probably just sees it as having a lower margin of safety with the high safe returns offered elsewhere.

Does Berkshire Drastically Need Renewal?

Short answer: not so much as to risk making a drastic mistake.

All but the youngest companies need renewal from time to time and in some respects Berkshire gets along very well without a constant renewing process. Its revenues continue to grow at about 7%, a number which should improve if high fixed income returns stick around, and its return on equity is around 10% - quite good for a company with diversification, predictability, and the durability of an aircraft carrier. It's still a good question, though, despite the difficulty of finding an addition that is large enough, young enough, and growing fast enough. Berkshire is now large enough that changing/updating its holdings has to come in large chunks. The last addition of that description was Apple, which Buffett snuck into our awareness over a couple of years as it became a huge winner. Even Apple now has a few gray hairs.

Apple can still serve as a model for renewal. So far small early-stage companies - Snowflake ( SNOW ) for example - haven't quite done the job. What Buffett knows, at least intuitively, is that solid companies which have been around for quite a while can still have a lot of growth and youthfulness ahead of them. One of the names I had a close look at recently is Salesforce ( CRM ), same general business as Snowflake but having proved itself.

Why do I bring up Salesforce? Not because I particularly expect Buffett to be jumping on it anytime soon, but the fact that it's in the same Customer Relationship Management business as Snowflake but in a more mature though still rapidly growing phase. I ran it by a close relative in the business and she said, sure, a great company. The parallel to Apple is that it arrived through a small Snowflake position initiated through one of Buffett's lieutenants (and Salesforce caught a small piece of it at the IPO, just as Berkshire did. Salesforce, however, is already in the Dow Jones Industrials, chosen, I'm pretty sure, to fill the same criteria Buffett might apply: proven enough to be added to a blue chip index, young enough to contribute future growth, and large enough to buy in size. Suitably priced (26 PE) at half its PE when the tech world was totally bonkers a couple of years ago and currently cheaper than Apple which has much lower growth expectations. Has Buffett noticed it? Again, who knows. Readers should feel welcome to offer their ideas in comments.

And A Subtle Hint

In comments to my recent article encouraging readers to buy bonds and extend maturities quite a few readers mentioned that Buffett isn't doing that - he's sticking with 3 and 6 month T Bills. How come? The answer may have to do broadly with the need for cash in case a large opportunity should come along - not just any opportunity but one contributing youth and growth to Berkshire's holdings. That's an important hint. Buffett is less concerned with the Fed dropping short term rates in the event of a softening economy than he is with the risk of missing a game changing new investment. That's how it reads between the lines.

The SA Quant System Just Dropped Berkshire From Strong Buy To Hold

Berkshire Hathaway presents obvious difficulties for the Quant System, one being its highly unusual place in the Multi-Sector Industry with some other systems calling it a financial and still others seeing it as an industrial. That raises difficulties in assessing Value, while Revisions don't fit too well with the Seeking Alpha's Quant system either because management makes no predictions and there are so few Wall Street Analysts. Where the Quant System shines is in the areas of Growth And Profitability, the main Factors For Longer Term Investors, along with Momentum which points to timeliness.

This is probably a moment to bear in mind the above paragraph when considering Berkshire's Quant Rating. After I finished my final draft of this piece the Quant ranking of Berkshire was dropped from Strong Buy to Hold. I had wondered if this might happen based largely on Valuation, Revisions, and Momentum. To me, Profitability and Growth look just fine. In my family portfolios Berkshire happens to be a Hold because I am already very overweight thanks to its success over the past two decades. Otherwise I would have considered it at least a Strong Buy because its Valuation looks to be a bit under fair value and it has a strong track record to support it. (This last paragraph was added early Monday morning after the Quant Rating shift.)

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