Thoughts on the Berkshire Hathaway Annual Letter & Report
I’m going to try to take this topically. ?Here goes:
On Acquisitions
Buffett still has a strong desire for more acquisitions. ?After $18B to buy?52.6% of Heinz (counting in the low strike warrants), and all of NV Energy through MidAmerican, there were additional?bolt-on acquisitions $3.1B after additional payments of $3.5B to buy the rest of Marmon ?and Iscar. ?After all that, the cash level at BRK was virtually unchanged from the beginning of 2013.
He might like to own far more of Heinz in the future:
Though the Heinz acquisition has some similarities to a ?private equity? transaction, there is a crucial?difference: Berkshire never intends to sell a share of the company. What we would like, rather, is to buy?more, and that could happen: Certain 3G investors may sell some or all of their shares in the future, and?we might increase our ownership at such times. Berkshire and 3G could also decide at some point that it?would be mutually beneficial if we were to exchange some of our preferred for common shares (at an?equity valuation appropriate to the time).
And he might want to buy more utilities:
NV Energy, purchased for $5.6 billion by MidAmerican Energy, our utility subsidiary, supplies electricity?to about 88% of Nevada?s population. This acquisition fits nicely into our existing electric-utility?operation and offers many possibilities for large investments in renewable energy. NV Energy will not be?MidAmerican?s last major acquisition.
The Powerhouse Five
MidAmerican is one of our ?Powerhouse Five? ? a collection of large non-insurance businesses that, in aggregate, had a record $10.8 billion of pre-tax earnings in 2013, up $758 million from 2012. The other companies in this sainted group are BNSF, Iscar, Lubrizol and Marmon.
If you look at BRK earnings now, leaving aside derivatives, one-third of earnings come from insurance, and the rest stems from the industrial & utility enterprises. ?[Note: Buffett uses the word “sainted” which he used in the 1980s to describe a group of much smaller private companies that he owned in full then. ?He doesn’t mean holy, but leading and valuable. ?They are driving the economics of BRK.
None of the Powerhouse Five did badly in 2013, though Marmon was a little weak. ?It’s difficult to find any part of BRK that did badly in 2013. ?BNSF was particularly impressive, and I am glad that I thought it was a good move when Buffett bought it, because too many criticized it at the time.
As an aside, it’s interesting how much MidAmerican is pouring onto wind and solar power.
Debt
I’ve always thought Buffett was clever with debt issues. ?He never guarantees the debt when he takes over a company. ?He is willing to live with the complexity of subsidiary debt issues. ?But hear these quotations from the Annual Report:
- Berkshire does not guarantee any debt or other borrowings of BNSF, MidAmerican or their subsidiaries.
- BNSF?s borrowings are primarily unsecured.
- All, or substantially all, of the assets of certain MidAmerican subsidiaries are, or may be, pledged or encumbered to support or otherwise secure the debt. These borrowing arrangements generally contain various covenants including, but not limited to, leverage ratios, interest coverage ratios and debt service coverage ratios.
- The borrowings of BHFC, a wholly owned finance subsidiary of Berkshire, are fully and unconditionally guaranteed by Berkshire.?
Buffett only guarantees the debt of a small finance subsidiary, and nothing more. ?The rest of the debt is non-recourse to BRK, and so bondholders take their chances on a subsidiary failing.
Derivatives
Our credit default contracts generated pre-tax losses of $213 million in 2013, which was due to increases in estimated liabilities of a municipality issuer contract that relates to more than 500 municipal debt issues. Our credit default contract exposures associated with corporate issuers expired in December 2013. There were no losses paid in 2013. Our remaining credit default derivative contract exposures are currently limited to the municipality issuer contract.
The equity puts are way out of the money, and only municipal issues remain among his fixed income derivatives. ?BRK “made” $4B on the derivative positions in 2013, something that will be impossible to repeat.
Give Buffett credit, though, because he structured some clever trades that have made a lot of money. ?Value investing won vs option pricing. ?At present, the future performance of the derivatives is?close to immaterial, unless we have significant municipal defaults.
Insurance
A few qualitative notes: Buffett mentions that GEICO has passed Allstate to become #2 in Auto insurance. ?He later mentions State Farm (#1 in Auto, I think the first time he has mentioned it):
Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous?in most years that it causes the P/C industry as a whole to operate at a significant underwriting loss. This loss, in?effect, is what the industry pays to hold its float. For example, State Farm, by far the country?s largest insurer and a?well-managed company besides, incurred an underwriting loss in nine of the twelve years ending in 2012 (the latest year for which their financials are available, as I write this). Competitive dynamics almost guarantee that the?insurance industry ? despite the float income all companies enjoy ? will continue its dismal record of earning?subnormal returns as compared to other businesses.
But after mentioning State Farm’s abysmal underwriting, though Buffett doesn’t say it is such, he mentions how well BRK has done:
As noted in the first section of this report, we have now operated at an underwriting profit for eleven
consecutive years, our pre-tax gain for the period having totaled $22 billion. Looking ahead, I believe we will
continue to underwrite profitably in most years. Doing so is the daily focus of all of our insurance managers who
know that while float is valuable, it can be drowned by poor underwriting results.
BRK had a light year for catastrophes, which inflated their income somewhat. ?It also seems that they put the poor deal that they did with Swiss Re behind them.
Buffett also talked about the “float” growing — assets held for future payment where no interest has to be paid. ?It’s $70B+ now. ?More on that later.
Buffett also trumpeted a move into Specialty Insurance. ?He poached a team from AIG in 2013 to start this. ?Specialty Insurance means niche markets with very careful underwriting guidelines. ?I’m sure that Berkshire will do this well.
Finally, the insurers have good underwriting and reserving. ?BRK still has a underwriting profit over the past eleven years, and they continue to release reserves from prior year claims.
The Structure of Berkshire Hathaway [BRK]
Though insurance no longer provides the majority of income for BRK, it is crucial to BRK’s functioning. ?The insurance companies own almost of the industrial and utility enterprises. ?BRK has little?in fixed income and cash vs insurance reserves. ?Buffett says:
Payments of dividends by our insurance subsidiaries are restricted by insurance statutes and regulations. Without prior regulatory approval, our principal insurance subsidiaries may declare up to approximately $13 billion as ordinary dividends before the end of 2014.
There is a rule of thumb in P&C insurance. ?Claim reserves are funded by high quality bonds of equivalent length ?Unearned premiums are funded by short-term debt like commercial paper. ?Surplus funds are invested in risk assets, like equities.
With BRK, more is invested in risk assets than the rule of thumb would allow. ?I’m not sure how the Risk-based Capital formulas allow this. ?Other insurance companies can’t do this.
Notes
Buffett uses his private investments in?real estate investing to show the difference between private & public investing. ?This explains why we should be slow to trade. ?He also says:
Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.
And as such, an investor in that state of ignorance should index.
Other Notes
Those who want to ask questions at Buffett’s annual meeting should send questions to:?Carol Loomis, of Fortune, who may be e-mailed at cloomis@fortunemail.com; Becky?Quick, of CNBC, at BerkshireQuestions@cnbc.com; and Andrew Ross Sorkin, of The New York Times, at arsorkin@nytimes.com.
Some have complained about a lack of transparency at BRK, and I have to disagree. ?BRK is a collection of small and large businesses. ?The annual report adequately talks about all of BRK, but gives less time to smaller issues. ?BRK is the fifth largest company by market cap, and Buffett reveals more of his intentions then most CEOs.
I have more to say regarding Intrinsic Value & Compounding, but that will have to wait.
Full disclosure: Long BRK/B for myself and clients