Critical Takeaways From Berkshire Hathaway’s Earnings

Berkshire Hathaway’s (BRK/A, BRK/B) quarterly earnings are worth reading even if you do not own the stock because Berkshire can provide a broad look at the economic rebound from COVID-19 due to its many operating businesses. In addition, it is managed by two of the greatest investors and capital allocators of all time.

Berkshire bought back a record $6 billion of its own stock in the second quarter bringing the year-to-date total to $12.6 billion. Until an announcement in mid-2018, Berkshire had limited repurchases to when the stock was trading at less than 1.2 times price to book (P/B). While that constraint is now relaxed, it is still a good indicator of the general range when aggressive repurchases will likely be seen. Berkshire’s P/B was 1.3 times at the beginning of April and is currently 1.4 times after rising to 1.5 times during the quarter. Berkshire only intends to repurchase shares when the “repurchase price is below Berkshire’s intrinsic value, conservatively determined.” Since the company was trading between 1.2 and 1.3 times book in the first quarter, it is logical that the share repurchases slowed somewhat in the second quarter. The P/B ratio is used as a proxy for gauging Berkshire’s intrinsic value. Still, Warren Buffett and Charlie Munger’s judgment about its intrinsic value versus other available uses of capital could differ from that simple measure.

Berkshire is outperforming the S&P 500 return year-to-date by over four percentage points, and it rose 8.8% in the second quarter versus 8.2% for the S&P 500. Berkshire retains a fortress balance sheet with cash and equivalents at $144 billion versus $138 billion at the end of June 2020, which provides flexibility to take advantage of opportunities, including repurchasing its own stock. Berkshire has stated that there would be no stock repurchases if it would cause cash levels to fall below $30 billion.

Berkshire’s quarterly earnings of over $28 billion rose only 7% versus the same quarter in 2020. That is essentially a function of lower gains in the investment portfolio since unrealized gains from their portfolio are included in their earnings. Operating earnings, which removes the distortion from market changes and better reflect the firm’s earnings power, for the quarter rose by 21% versus 2020. Providing an illustration of the value from share repurchases, per-share operating income for 2Q rose by 29% versus 2020.

A further look into the different operating segments versus the second quarter of 2020 shows the strong rebound in the economically exposed railroad and manufacturing, service and retailing groups. Notably, the operating income for all significant segments except investment income from insurance is above pre-pandemic levels.

Insurance: Investment income was lower in the second quarter primarily due to lower income from short-term investments. With interest rates at historic lows and not likely to move higher soon, investment income is expected to remain relatively depressed. GEICO was the major contributor to the decline in earnings from underwriting. COVID caused average claims to be significantly below normal in 2020. Geico policyholders increased driving frequency in the second quarter of 2021, and claims increased.

The two most essential concepts in insurance investing are “float” and underwriting profit. In simple terms, float is created for insurance companies because insurance premiums are paid before any claims are made by the insured. Insurance companies can invest the float, sometimes for years, before insurance losses are reimbursed. Berkshire has a history, unlike many insurance companies, of earning an underwriting profit, meaning that their float costs them nothing and makes them money in addition to allowing them to earn a profit off of investing the float. An underwriting profit means that the insurance premium exceeds all insurance claims and expenses. Berkshire continued to make an underwriting profit for the second quarter and first six months of 2021. Berkshire’s float increased to approximately $142 billion on June 30, 2021 from $138 billion on December 31, 2020.

Railroad: Berkshire owns the Burlington Northern Santa Fe (BNSF) railroad operating in the U.S. and Canada. As the economy rebounded in 2021, BNSF has seen growth in activity over the COVID-impacted 2020 levels. Berkshire’s 34% increase in second-quarter railroad operating income is directionally correct compared to other publicly traded railroads. BNSF and other railroads also surpassed their pre-pandemic peak operating earnings for the quarter.

Utilities and Energy: This business generally provides steady and growing earnings, which one would expect from what primarily consists of regulated utilities and pipeline companies. Interestingly, this group also operates Berkshire Hathaway HomeServices (BHHS), the largest residential real estate brokerage firm in the country. Housing has been a significant strength of the U.S. economy, so it was not a surprise that BHHS has shown sharply higher earnings both in the second quarter and year-to-date.

Manufacturing, Service and Retailing: This segment consists of many diverse businesses, so this analysis will focus on a few significant themes when looking at this grouping. Berkshire’s aerospace exposure remains substantial despite the sale of its publicly traded airline holdings in 2020. Berkshire previously took a $10 billion impairment charge on the Precision Castparts (PCC) business due to its exposure to the COVID-disrupted aerospace industry. While PCC posted lower second-quarter sales versus 2020, Berkshire’s FlightSafety and NetJets saw a sharp rebound. Berkshire expects PCC to remain depressed for the remainder of 2021 due to inventory levels, so revenues and earnings for 2021 should be below pre-pandemic levels.

Housing-related businesses like Clayton Homes, Shaw, Johns Manville, Acme Building Products, Benjamin Moore, and MiTek benefited from the housing boom. They posted higher earnings for the second quarter and relative to pre-pandemic levels. The largest portion of the retailing segment is Berkshire Hathaway Automotive (BHA), owning over 80 auto dealerships. BHA saw a significant increase in new auto sales. Pre-tax earnings in the quarter for the overall retailing group significantly exceeded pre-pandemic 2019 levels.

Other: This segment includes companies’ earnings that must be accounted for under the equity method due to the size of ownership and influence on management. The primary drivers of the loss in this segment for the quarter were acquisition accounting expenses and foreign currency exchange rate losses. The acquisition expenses relate to amortizing intangible assets from past purchases. The foreign currency exchange rate losses were generated from bonds issued by Berkshire Hathaway and denominated in British Pounds, euros, and Japanese Yen. These foreign currency liabilities are not a concern as Berkshire has significant assets and earnings denominated in these foreign currencies.

Summary: Quarterly results are generally not very meaningful for Berkshire since it is managed for long-term performance and not to meet quarterly hurdles. This ability to take advantage of time arbitrage has served the company and shareholders well over the years. The goal in looking at the quarterly results is to see if the segments are generally operating as expected and consider the capital allocation decisions made by Warren Buffett and Charlie Munger.

Second-quarter operating earnings rebounded 21% over the pandemic-impacted 2020 levels, reflecting the sharp recovery in the economy. In addition, second-quarter 2021 operating profits were 9% above pre-pandemic 2019 earnings. While the purchases have likely slowed due to valuation, a significant capital allocation decision was made to increase share repurchases in recent years. This activity signals that they believe the price of Berkshire Hathaway to be below their estimate of intrinsic value. If they are correct (and there is no reason to doubt them), the purchases are a value-creator for the remaining shareholders. Second-quarter per-share operating earnings are now 17% above 2019 with the benefit of the share repurchases. The repurchases also signal that they are not finding many other opportunities with what they judge as better risk versus reward for investing capital.

Berkshire continues to retain its Fort Knox balance sheet and a very diversified mix of businesses, so shareholders should take comfort in knowing that the firm continues to be managed to survive any economic shocks thrown at it. This conservative management style may relatively “hurt” profits when times are good but positions the firm to take advantage of significant opportunities when disruptions or crises provide them. Unfortunately, the opportunity for Berkshire to make a large purchase is likely limited right now due to a large amount of cash looking for acquisitions targets, including the SPACs.

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