Berkshire Hathaway's Post Party Hangover

The real story here isn't the derivative contracts or the investment holdings, it is that indeed, "the party is over". This was quoted from Berkshire Hathaway's (BRK.A) Chief Warren Buffett in his annual letter earlier this year in regard to insurance results.

Here are the details:

Net income fell to $1.06bn, or $682 per share of Class A stock, marking the fourth consecutive decline in net quarterly profits. Berkshire's operating earnings, which exclude investment and derivatives losses that were recorded for accounting purposes but largely unrealized, slid 19 per cent to $2.07bn. Given the slide in the economy, the fall in operating earnings should not shock anyone nor be unexpected.

Berkshire Hathaway recorded $1.01bn in losses on the value of some investments and derivatives for the third quarter, compared with $2bn in gains in the third quarter of 2007. Berkshire said that the amount of investment and derivative gains or losses it reported "in any given quarter or year is usually meaningless".

Most of those losses stemmed from unrealised losses on derivatives contracts. Again, true. Given the fall in the market, and the option contracts Buffett has written, one can only expect from quarter to quarter large swings in wither direction here.

Now we get to the real problem.

Berkshire said profit from underwriting insurance fell 83 percent to $81 million amid the most costly hurricane season since the record storms of 2005. Its reinsurance group, which sells catastrophe coverage to other insurers, posted a $166 million pretax loss for the quarter. Profit from selling policies at car insurer Geico Corp. fell 27 percent to $246 million. Berkshire typically gets about half its revenue from insurance.

Hurricanes Ike and Gustav cost insurers a combined $10 billion when they struck the Gulf Coast in September, according to preliminary data althought it is not clear what portion of this is Berkshire's.

Berkshire, is, for all it various parts an insurance company.

Back in July I wrote:

For all its holdings, Berkshire is essentially an insurance company. It has operated under "perfect" conditions for the last two years according to Buffett and eventually to run must end. Premiums are already falling and as houses are re-poed and fewer new cars are purchase, insurance premiums derived from those products will fall accordingly. I know people who are looking at homeowners and auto policies for way to decrease coverage and save money. Whether or not this is a good idea is irrelevant (I do not think it is), it is happening. Throw in a hurricane or two (we are due) and insurance could suffer quite a poor year.

(For more on Berkshire's insurance read this former post)

So what about the future? Buffett has invested billions in Goldman Sachs (GS), Dow Chemical (DOW) and GE (GE). These bets will all pay off long term. But, in the next year or two, one has to believe that the insurance industry must turn around if you are to believe Berkshire will.

There really isn't anything one should be able to point to on the horizon that would return the industry to its 2005 -2006 glory years. Those were in essence "bubble years" in insurance also. As housing has fallen, so have results there. If that is true, then half of Berkshire's results will suffer.

Is Berkshire "in trouble"? No. To say otherwise would be foolish.

Buffett's investments will pay off down the road. But, rather than helping earnings grow, they just may have the role of slowing or mitigating the decline.

Disclosure: Long Dow, GE

Comments

[valueconvert]

The author gives no basis for believing that the insurance cycle will remain soft. Is there a chance that the decline in asset prices has reduced the underwriting capacity for p&c and reinsurance? How does the demise of AIG impact pricing?

Also, what about valuation? At the end of Q3, BRK's insurance ops held stocks, bonds and cash worth about $82k per share. This probably fell to $76k thru the end of October. Non-insurance operating earnings (pre-tax) are on a run rate for about $7k per share. Current price of 110k less the 76k in securities means the market is paying about 5x pre-tax for the non-insurance businesses. While I don't believe these are trough earnings yet, they are pretty far off the peak.

I like to look at adjusted book value (bv + float + 1/2 deferred taxes) to get an idea of when the stock is in the buy range. If it is at or below adjusted book, I believe that it is reasonably price- provided that I believe the combined ratio can continue at 100% or less. I believe current ABV is about 119k.

To sum it up, the insurance business is underwriting profitably, the operating businesses' earnings are declining because of the weak economy and the stock is in a buy range.

What will it take to get the stock moving? We probably need to see the price of their major investees start to move. It would really help to see GS recover.

2008 Nov 11 09:06 AM

[SteveR]

This is a well written article and everything here is fairly factual. However, what may be missing, in my opinion, is the bigger picture. Certainly, the insurance business profits are suffering. And yes, float growth may not grow as nicely in the upcoming few years. However, all of this is tempered by the fact that money that was sitting on the sidelines can now be put to use. Buffet finds the current valuation of stocks very favorable. The fixed investments that were returning say 5% can now be put into equities. Based on Buffet strengths and past history, a 5-10 year return of 15% is not at all out of the question. I don't know the exact figures, but somewhere around 30-50 billion that used to get 5% is now going to 15%. That long term windfall far outweighs the short term hiccup in insurance business. What is happening now is a best case scenario, BRKA is dropping and future returns are rising, all the while nobody (in the business press) can see it happening. Time to back up the truck.

2008 Nov 11 11:31 AM

[BSexposer]

Good job Todd - way to pat yourself on the back for basically REPEATING exactly what Buffett said in last year's shareholder letter and acting like you're a seer or something - truly hilarious! BTW, since you last pumped SHLD on August 28th it has lost 50% of its value - why don't you write an article about THAT prediction, mr shld shill.

2008 Nov 11 12:50 PM

[justapirate]

Warren Buffet has NEVER hyped his stock price...nor any of his investments. On the contrary....he has at times said his stock(Berkshire) was overpriced! I think the last time he said it was 'overpriced' it was trading at about $40,000 per share.....the guy just can't seem to get it right! What a fool.....though....he is the smartest fool around! Well, maybe he's got it wrong this time. There is always a first time. Until then, Mr. Sullivan's comments are short term, shallow, actually silly.

2008 Nov 11 03:52 PM

[wab]

In October, the largest insurer in the world AIG needed a huge government bailout. Other large insurance companies such as Swiss Re are reporting balance sheet weakness. The demand for insurance is dropping, but the ability of insurers to write insurance policies is also dropping. The main municipal bond insurers have collapsed. The economy is in recession meaning people will gravitate towards the low cost insurer - GEICO. Under these conditions its hard to see that Berkshires float and unearned premiums will not increase over the next few years. People will want policies with an insurer that can pay. And the float dollars are coming into a world of 10%+ returns (Goldman Sachs, GE, Constellation, Wrigley, Dow Chemical, Muni Bonds etc etc)

The more the balance sheets of other insurance companies weaken, the more stock values drop, the more private business becomes distressed the more valuable Berkshire becomes, even if book value drops in the short term.

While the operating earnings of many of Berkshires businesses are falling, their market positions are increasing and their moats are expanding.

At current prices, Berkshire is currently a AAA rated 10%+ pretax bond, 7%+ after tax bond (excluding insurance earnings) that is set to increase over the coming years.

Compare this to the alternative AAA option - US Treasuries - and the conclusion I think is quite straight forward. The window of opportunity may be short .

2008 Nov 11 09:55 PM