Berkshire Hathaway: Making The Grade

Stock Market

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Making Up Ground

Last quarter, I started my review of Berkshire Hathaway (BRK.A) (BRK.B) with the observation that the stock had seriously underperformed the S&P index fund (SPY) since the start of 2019. I concluded that it might take a serious bear market for Berkshire to catch up. No one knows if a bear market has started, but the S&P has dipped into 10% correction territory since hitting an all-time high on the first trading day of 2022. Berkshire, on the other hand, has held up quite well. This has considerably narrowed the performance gap with the S&P over the last 3 years.

Berkshire Hathaway vs. S&P 3-year chart

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Berkshire is also now beating the S&P on a 10-year and longer basis. This is due in part to support from buybacks, which at $27 billion in 2021 matched the company’s free cash flow. Berkshire has continued buying back stock in 1Q 2022 although the pace has slowed down a bit. Berkshire’s stock portfolio has also done well with more value-oriented investments like financials and Japanese trading companies recently picking up the slack from the largest holding Apple (AAPL). The trading mistakes of 2020 are becoming less significant.

To fully appreciate the reasons for Berkshire’s resurgence however, we have to also look at the operating companies. If we do, we see good growth not only year-on-year but on a 2-year basis vs. 2019 to put pandemic effects in perspective. More importantly, margins grew in the non-insurance businesses and are generally higher than peers other than insurance and BNSF railroad.

The market is clearly seeing this improvement, as my sum of the parts model shows Berkshire shares closer to fair value than they have been in some time. Nevertheless, the stock remains a buy because of a factor the model does not pick up. That is, optionality of Berkshire’s $144 billion cash balance to generate more income through rising interest rates or (finally) opportunistic purchases if general market valuations continue to fall. But first, let’s look at the businesses and see how they grade out compared to my last review.

Insurance

The insurance business can be hard to value based on current earnings because they fluctuate year-to-year depending on the number and severity of “mega-cat” losses like hurricanes. So, my grade is based on things more in the companies’ control like earned premium growth and expense ratio. We can look at loss ratio but only as a comparison to other companies within the same year.

GEICO is the best-known and largest of Berkshire’s insurance operations, but the division also includes other primary insurance companies and reinsurance.

Premiums Earned, $ million
2021 % of total
GEICO $ 37,706 54.3%
BH Primary $ 11,575 16.7%
Reinsurance $ 20,197 29.1%
Total $ 69,478 100.0%

Data Source: Berkshire Hathaway 2021 Form 10-K

GEICO has lagged other companies like Progressive (PGR) and Allstate (ALL) in premium growth. GEICO continues to excel at managing expenses, however. With more driving and higher repair costs due to auto parts inflation, loss ratios rebounded from 2020 by 8 points at GEICO which is not as bad as Progressive’s 12-point increase. The combined ratio is now only about a point over Progressive and Allstate vs. around 2.5 points in 2020.

GEICO vs Progressive and Allstate

Data Source: Company Earnings Releases

Berkshire’s other primary insurance businesses continue to be star performers with impressive premium growth of 20% last year and an improving loss ratio. Berkshire has done a great job here in recent years by adapting GEICO’s direct purchase model to small business insurance.

The reinsurance business is especially hard to evaluate based on short-term performance. 2021 was a particularly bad year for significant catastrophe events, with losses from Hurricane Ida, flooding in Europe and Winter Storm Uri totaling $2.1 billion. The similar total for 2020 was $0.7 billion, although there was an additional $1 billion attributable to the pandemic. Of course, these are just estimates and can be revised up or down in future years, impacting reported earnings. 2021 had a significant $0.7 billion benefit from downward revisions of prior-year losses.

Putting it all together, GEICO improves slightly to a B- as it narrowed the combined ratio gap with peers but still had lower premium growth. The other primary businesses deserve a solid A for growth and reinsurance deserves an A for delivering an underwriting profit in a year with so many weather-related losses.

Grade: B+

BNSF Railroad

As one of a handful of Class I railroads, Berkshire’s 2010 purchase of BNSF was in line with Buffett’s stated preference for businesses with high barriers to entry. It went against Buffett’s long-held desire for businesses with low capital requirements but given Berkshire’s growing size and cash generation, it was understandable that Buffett would relax his criteria.

Looking at 2021 performance vs. closest peer Union Pacific (UNP), we see that BNSF delivered the same revenue growth in 2021. Both railroads improved their operating ratio. Union Pacific had more cost improvement but actually both railroads did the same on important costs like fuel, labor, and purchased services. UP’s costs declined in the “other” category while BNSF’s increased. Since this category could be one-off or irregular costs, I do not give it as much weighting in evaluating performance.

Revenues Operating Ratio
2021 2020 Growth 2021 2020
BNSF $ 22,513 $ 20,181 11.6% 60.9% 61.6%
UNP $ 21,804 $ 19,533 11.6% 57.2% 59.9%

Data Source: Company Earnings Releases

BNSF also gets an upgrade from last quarter.

Grade: B

Berkshire Hathaway Energy

Berkshire’s utility business has come a long way from its origins as Mid-American energy, acquiring other utilities in the western US, Canada, and the UK. In November 2020, BHE bought long-distance natural gas pipelines and a 25% interest in an LNG terminal from Dominion Energy (D). The issues with Russian gas in Europe should make the natural gas transportation and LNG business attractive for a long time to come.

Regardless of the Dominion deal, BHE is still a green energy powerhouse with its concentration of wind power in the US Midwest. As a result of federal subsidies for wind, BHE enjoyed a negative effective tax rate of -37% last year.

Compared to other utilities that are considered low-CO2 power producers, Exelon (EXC) and NextEra (NEE), BHE had superior growth thanks to the Dominion deal but also has much stronger operating margins.

Berkshire Hathaway Energy comparison

Data Source: Berkshire Hathaway 2021 Form 10-K

It’s hard to improve from near perfection, so:

Grade: A+

Manufacturing

Berkshire’s Manufacturing, Service, and Retail businesses are numerous and diverse, making it hard to do comparisons. In the industrial manufacturing subgroup, Precision Castparts continues to suffer from the pandemic and Boeing (BA) inflicted demand drop, and they do not see a near term recovery. Lubrizol suffered from Winter Storm Uri in Texas and an Illinois plant fire in the summer of 2021. As a result, the industrial manufacturing group was one of the few at Berkshire to not beat 2019 earnings in 2021. Nevertheless, they did improve from 2020 and had higher margins. Marmon and IMC were outstanding performers in this group.

The building products group had better sales growth than Masco (MAS) in 2021 but notably did not experience the drop off in margins that Masco did. The consumer products group had slightly lower sales growth than a blend of Winnebago (WGO), Energizer (NYSE:ENR), and Skechers (SKX), but continued to have better margins. These are proxies for Berkshire subsidiaries Forest River, Duracell, and the several shoe producers including Brooks.

Berkshire Manufacturing Performance

Data Source Berkshire Hathaway 2021 Form 10-K

Nearly all these businesses reported supply chain disruptions and cost inflation, so 2022 may not be as great a year, at least at the start. I still believe my statement last quarter that this division would be a good place for Berkshire to break its hands-off management policy and look for some cost efficiencies and economies of scale between the various manufacturing businesses.

Grade: B+

Service and Retail

Nothing changes on my assessment of Service and Retail from last quarter. Retail is now heavily dominated by Berkshire Hathaway Automotive which represents 64% of sales. This has been another well-timed acquisition with growing demand since the pandemic, although supply chain issues are now hitting here as well. The division continues to have lower sales growth but better margins than publicly traded Penske Automotive (PAG).

McLane still has tiny margins compared to the relatively high sales it has. Growth has been slow as well. It grew much less than Sysco (SYY) in the past year, although that is understandable with Sysco being much more dependent on restaurant sales. Berkshire should bend its rules on not selling low performing businesses to get rid of this division, as it recently did with the newspaper business. McLane would do much better in the hands of a logistics-focused company like Amazon (AMZN) allowing Berkshire to deploy the capital elsewhere. Berkshire could even check with Walmart (WMT) to see if they would like to have the division back to help support their multichannel strategy.

Revenues Pretax Earnings Pretax Margins
2021 2020 Growth 2021 2020 2021 2020
Retailing $ 18,960 $ 15,832 19.8% $ 1,809 $ 1,028 9.5% 6.5%
PAG $ 24,757 $ 19,853 24.7% $ 1,356 $ 705 5.5% 3.5%
McLane $ 49,450 $ 46,840 5.6% $ 230 $ 251 0.5% 0.5%
SYY $ 60,738 $ 51,298 18.4% $ 2,050 $ 1,591 3.4% 3.1%

Grade: B+

Berkshire’s collection of businesses performed well in 2021 nearly across the board. While we can thank a recovery from the pandemic, the businesses are also outperforming 2019.

Berkshire 3-year performance table

Data Source: Berkshire Hathaway 2021 Form 10-K

The improved operating company results help justify the recent stock outperformance. Let’s look at Berkshire’s investments to see if they are also helping.

Investment Portfolio

All the questionable portfolio moves in 2020 that have been discussed in earlier articles seem to be fading in importance when you look at overall results. For the more complete picture, we can look at the overall stock portfolio on Berkshire’s balance sheets and the purchase and sale amounts on the cash flow statement, plus dividend income. This reveals that cumulative performance over the last three years is better than the S&P. Last quarter, it looked like 2021 would be a large drag, but the portfolio recovered to nearly match the S&P with value stocks like financials and Japanese trading companies picking up the slack as Apple (AAPL) stalled out.

Berkshire portfolio performance

Data Source: Berkshire Hathaway 2021 Form 10-K

Looking at the top 15, we now see two more Japanese trading companies on the list due to both price appreciation and more purchases. Big pharma names left the portfolio after a short stay. Finally, there was about a 26% increase in Chevron (CVX) shares, a similar decrease in Charter Communications (CHTR), a small add to Verizon (VZ) and a small sale in US Bank (USB).

Berkshire top 15 stock portfolio

Berkshire Hathaway 2021 Form 10-K

The stock portfolio has always been appropriate for a company where capital preservation takes precedence over capital appreciation. Now, it has the additional benefit of being aligned with the value over growth preference of the general market. While that may not be a big concern of Buffett, it will be advantageous in a bear market if we have entered one.

Grade: B

Capital Management

Berkshire continues to hold cash on the balance sheet almost equal to insurance float. Cash and equivalents of $144 billion grew by $9 billion from 2020 while float of $147 billion also increased by $9 billion. There is no need to hold this much cash to cover unexpected insurance claims, and Buffett has stated a minimum target of $30 billion for that purpose. In the letter accompanying the 10-K, Buffett continues to lament his inability to find whole companies or stocks in this environment that meet his long-term investment criteria.

It’s pretty clear that these criteria are not going to be relaxed (fortunately), and a dividend is also not in the cards anytime soon. Therefore, the next best option is buybacks. After applying around 90% of Berkshire’s free cash flow to buybacks in 2020, they used over 100% of it, or $27 billion, for that purpose in 2021. (The increase in the cash balance was due to net sales from the stock portfolio. Debt was basically unchanged.) Buybacks provide a taxable return of capital only to those shareholders who want to cash out. Continuing shareholders see their stake in the company increase without having to buy more shares. Over the past two years, your fraction of the company went up 10% if you didn’t sell.

So far in 2022, buybacks have slowed to $1.2 billion through 2/23/2022. Perhaps the shares are approaching Buffett’s conservative estimate of fair value, minus a margin of safety. Looking forward, increasing interest rates will increase Berkshire’s investment income – a 1.5% raise would earn the company around $2 billion per year more. On the negative side, if inflation stays higher than this, the cash pile is still losing value in real terms.

If we are entering a garden variety bear market and not some black swan event like a pandemic crash, credit conditions will tighten, government bailouts will be less frequent, and conditions may finally return for Berkshire to put the cash pile to work. Due to the higher buybacks, Berkshire deserves a higher grade than I gave it last quarter for capital management, but the cost of inaction in the future is higher in an inflationary environment.

Grade: B

Valuation

I have gone through my sum of the parts model in detail in earlier articles. This one from 6 months ago describes the methodology more fully. It depends heavily on the valuation of peer companies to Berkshire’s various businesses. What the model shows now is that the market is valuing Berkshire more closely to its peers that in the recent past. The resulting value per B share of $326.58 is only 2.3% above market value just prior to the earnings release.

The caveats to this result are first, that insurance investment income should go up $1 – $2 billion with increasing interest rates. Second, the optionality to finally put cash to work in a general market downturn is not modeled. These factors make Berkshire a buy even though the model shows only slight undervaluation.

Berkshire Earnings Model

Data Source: Berkshire 10-K, Peer Company Financials from Seeking Alpha

Conclusion

Berkshire Hathaway operating company performance improved in 2021. The stock portfolio and cash balance are also now looking more aligned with the market environment given increasing interest rates and the correction in the S&P. Although the sum of the parts model shows the stock to be fairly valued, it is poised to keep outperforming if the general market downturn continues.

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