Berkshire Hathaway: Everyone Has Misunderstood What Warren Buffett Is Doing

Summary

• An update on performance of Berkshire Hathaway since my March article.
• A review and analysis of the Q1 2020 operating results.
• My notes and takeaways from the 2020 Annual Shareholder’s Meeting.
• Calculating the Intrinsic Value of Berkshire Hathaway.

Image by Exileofthemainstream

In the business world, the rear-view mirror is always clearer than the windshield.

- Warren E. Buffett

Introduction

In my first article, Capitalizing on the Correction, published amid the stock market sell-off on March 4th, I detailed five companies that I thought had a favorable risk/reward long-term among the market chaos.

In hindsight, I was slightly overzealous in the situation. COVID-19 anxiety grew, and the market continued to sell-off until March 23rd. I based my analysis upon the situation in China and other Asian countries that had dealt with COVID-19 well, and the stock markets responded accordingly with minor drawdowns of 15-20% similar to where the various recommendations had fallen by on March 4th. However, we soon learnt:

1. The data from China was/is less than accurate.

2. The virus had already spread beyond what testing at the time had shown in the United States.

3. More and more countries began reporting first cases of COVID-19.

4. The health systems in various countries could not handle an exponential increase in COVID-19 cases that some scientists projected.

5. The Government response to flatten the curve meant enforcing partial or full economic shut-downs in over 100 countries around the world.

A combination of these factors contributed to the S&P 500 (SPY) falling -35% by March 23rd. Other contributing factors were obvious margin calls, unwinding of risk parity trades, and last, Saudi Arabia and Russia starting an oil price war (as discussed in my second article Resolving the Mexican Stand-off in Oil Markets today).

It's been approximately two months since my first article and this how the five stock recommendations have performed:

Data by YCharts

In one word - Abysmal.

First, I apologize if anyone followed me directly on my analysis. Second, though most of these are underperforming the S&P 500, I didn't recommend them for traders to own for 2 month holding periods. Third, there seems to be a value-stock sell-off in the last week as Berkshire Hathaway (BRK), ViacomCBS (VIAC) and Discovery Inc. (DISCA) are all down 10%-20% with no news. Fourth, I added to some positions as prices fell further, and I will update you as they announce Q1 2020 earnings.

This brings me to Berkshire Hathaway, who announced earnings on May 2nd 2020 and held its Annual Shareholders Meeting then too.

BRK is my largest individual stock position. Despite its exposure to financial stocks, ex-ante it was also my most favored risk/reward. There is some bias here that I contend with as I completed my MBA at Columbia Business School - it's where I discovered Value Investing - and Warren Buffett became a hero of mine. But putting that aside, I am still disappointed by the stock performance and the underlying activities this past quarter.

In this piece, I'd like to share my takeaways of both the Q1 results and the Annual Shareholders Meeting. There have been various commentaries on the meeting, yet there are several nuances I think most investors have misunderstood. I hope to shed some light on these aspects amongst my notes.

Q1 2020 Results

On May 2nd 2020, Berkshire Hathaway reported its earnings. The 10-Q can be found here for your reference. Here are the important aspects relevant for my discussion:

1. Q1 Revenue increased from $60.7bn to $61.3bn (+1.0%)

2. Operating earnings increased from $5.55bn to $5.87bn year over year (+5.7%)

3. Q1 Net Loss of $49.75bn - includes $70.28bn of investment/derivative losses

4. Berkshire Hathaway made no new investments but issued debt:

1. Insurance float was $130bn - an increase of $1bn from December 2019

2. Cash and short-term investments increased from $128bn to $137bn since December 2019

3. Shares repurchased were $1.74bn. Note the prices were approximately $214 per B share Buffett stopped buying.

Notes and Analysis

The important thing to realize here is that due to a change in accounting rules last year, the change in $ value of the investment portfolio now runs through the income statement. The -35% drawdown in the S&P 500 has caused significant GAAP losses for the company. Ironically, it's the complete opposite of the previous quarter and annual results. In my earlier article, I noted the record profits, and that I predicted Buffett to be repurchasing shares:

Only a week ago, Buffett released his annual letter to shareholders for 2019. In it, he mentions the $81bn of earnings last year (because of gains in their equity portfolio). Some of this has now retraced, however, using a trailing Price/Book of 1.15 implies BRK at $200 where it is today is below their buyback threshold or where they peg intrinsic value. Buffett was buying back stock at $205 last year and in his 2019 requested parting shareholders with $20M+ to call their office.

I'd be shocked if he isn't buying back stock right now with his $100bn+ war chest. Berkshire Hathaway, if itself isn't eating itself, will put extra capital to work in this market. It's an anti-fragile organization, and one could expect to earn 10% annualized returns from these levels.

Aforementioned, Buffett bought back stock at $214 versus the price of $200 where I saw the opportunity. As of May 6th, the stock sits at $175. (I will circle back to this later in my Intrinsic Value calculation)

If we put the investment portfolio aside, the year over year operating earnings are not so bad. However, COVID-19 will affect the Q2 operating results more than Q1, as noted in the report:

Most investors don't realize that Buffett's cash levels often match the insurance float levels each year. In recent years, many investors jump to the conclusion - "Buffett can't find anything to buy in an overpriced market" - without understanding for over a decade he keeps substantial liquidity on hand to compensate for potential insurance liabilities. Historically float earned the company decent positive yields, similar to how a Long-Short hedge fund would generate a few extra %-points a year in alpha, because of short-sale proceeds sitting in Treasury securities. However, ever since the financial crisis and the era of quantitative easing, both Long-short hedge funds and Berkshire Hathaway have not earned the usual 3-4% they were once accustomed to. This is one of the overlooked reasons for Buffett's lagging performance versus the S&P500 over the last decade.

But one thing is for certain here unlike the 1:1 float to cash ratio I describe, is that cash ($137bn) sits higher than float ($131bn) by $6bn currently. This indicates to me that Buffett is expecting $6bn in claims or litigation efforts for claims over the coming year or more, in response to COVID-19.

Last, note that the last share repurchase was between March 2nd and March 10th. I am disappointed by the minimal shares bought in Q1, but also the fact he stopped repurchasing shares very early in March, even though the stock continued to fall and sits -18% below $214 (the last level he bought at). My conclusion (based upon comments made in the Annual Shareholders Meeting) is that he was speaking with several companies for financing deals over the 2nd and 3rd weeks in March (before the Fed's policy responses were in full motion) and he expected putting capital to work at a better return that stock repurchases. Little did he know that the market would turn on a dime and distressed companies could get financing through Government programs, Fed monetary backstops and capital markets. Capital allocation works well when you are the only one with supply in a tight market. Buffett is used to this, especially in the 2008-09 credit crunch. This time, however, the Fed's response has been large (6 trillion dollars) and quick (less than two months).

It was necessary and correct despite criticisms from many investors. Buffett even commended their actions in the Shareholder's Meeting.

The second reason share repurchases seized is - as Buffett alluded to in the Q&A section of the Shareholders Meeting (below) - "The facts changed":

The discount to intrinsic value didn't improve, which indicates the market priced in a fall in intrinsic value quite fairly. This is disappointing as a Berkshire Shareholder to hear, but when you are a part owner of an investment holding company that owns 100+ subsidiaries, it is not surprising that an economic shutdown will have accelerated the death of antiquated businesses in retail and the likes that Buffett has collected over the 50 years.

The third reason the share repurchases stopped is that the range of possible economic outcomes for the coronavirus means that a potential bet (buying back shares) may not have a possible expected value. Buffett likes certainty in making investments, whether it was the historic net-nets (cigar butts), to American Express and Coca Cola, to avoiding technology names for over a decade until Apple (AAPL). He won't make further share repurchases until the range of outcomes narrows again.

This is the same reason he has not made new stock investments in the S&P 500 drawdown of -35%. Most investors and commentators are suggesting Buffett is fearful or waiting for the market to fall further. I disagree. It is because from where Buffett stands, handicapping the odds of the pandemic only 2 months in, is more difficult than most presume.

Further, most commentators are surprised by the fact the S&P 500 is only down -10.9% YTD and the Nasdaq is up +3.58% in a global recession/depression. They therefore exclaim the market will crash again. This misses the fact that the market is being as discriminatory as Buffett in pricing risk here. Check out the chart below and specifically the iShares S&P500 Value ETF (IVE) and Vanguard Small Cap Value ETF (VBR):

Data by YCharts

Berkshire Hathaway, is underperforming the value ETF following the Shareholders Meeting, with a YTD return of -23%:

Data by YCharts

I bring this up because the Company was mostly trading in lock-step with Apple (AAPL) until recently because of their enormous investment in the AAPL stock. But this correlation has decoupled in the last month. BRK now trades with large cap financials (XLF) which are in a drawdown of -30% equivalent to small cap value stocks!

So while market averages seem stable, beneath the surface many stocks and sectors are still deep in bear market territory and this is what Buffett is pricing in with his inactions in both stock repurchases and new investments. In my opinion, the market is astute in pricing risk in this environment. More so than what many have you believe. In fact, Buffet in his opening monologue at the Shareholders Meeting said:

Warren Buffett: (50:17)

But Ben Graham, my boss, sent me over to the public library in New York to gather some information for him, something he could do in five minutes with a computer now, and I dug out something, and he went to testify, and on page 545 of this book, I knew where to look, I didn't have to go through it all, but the quote which I remember, and I remember because Ben Graham was one of the three smartest people I've met in my life, and he was the dean of people in securities business, he wrote the classic Security Analysis book in 1934, he wrote the book that changed my life, Intelligent Investor in 1949, he was unbelievably smart.

Warren Buffett: (51:09)

And when he testified, with the Dow at 404, he had one line in there right toward the start in his written testimony, and he said, "The stock market is high, looks high, it is high, but it's not as high as it looks." But he said, "It is high." And since that time, if we'll turn to the next slide, of course, we felt the American tailwind at full force, and the Dow, well let's see, when the Dow was … it went down on Friday, but when we made the slide it was about 24,000 so you're looking at a market today that has produced $100 for every dollar, all you did was you had to believe in American just by a cross-section of America, you didn't have to read the Wall Street Journal, you didn't have to look up the price of your stock, you didn't have to pay a lot of money in fees to anybody, you just had to believe that the American miracle was intact.

I think Buffett is pointing to the dispersion I describe above when he says: "The stock market is high, looks high, it is high, but it's not as high as it looks."

What is the intrinsic value today?

There are two components to the company:

1. Cash and Investments

2. Operating businesses

From the Balance Sheet:

Cash and Investments total is $353.5Bn at 31 March 2020:

In regards to the earnings of the operating businesses, we need to look at the 2019 Annual Report:

Operating earnings of the company in 2019 were $23.9Bn. Insurance-underwriting varies year to year so it technically makes sense to normalize it over several years to get a better picture, but since this is a low compared to 2018, I'll keep it as it is.

We need to provide some kind of multiple to make sense of the intrinsic value. So let's take a range:

In a good year, a 12x multiple seems fair to me and certainly over a 5 year period. But since we are in a recession, a haircut on normal valuation makes sense.

And finally, we need to sum the two parts:

There are two adjustments that could/should be made here:

1. The investment portfolio stands at March 31st stock prices and we are 1 month passed.

2. The operating earnings even at a compressed valuation may be permanently impaired in parts.

Since the Company's stock portfolio is underweight technology names apart from AAPL, I don't think granting it the assumed S&P 500 growth (+15%) since 31st March 2020. So let's only adjust it +5%.

Additionally, let's assume 20% of the 2019 earnings (from businesses that could be permanently impaired) are not coming back.

A quick check on this is to consider the P/B of BRK:

Data by YCharts

As you can see the 1.14 P/B is lowest it's been in 5 years (excluding the March 23rd absolute low).

But why isn't Buffett buying in April? Recall, what Buffett said in the earlier video:

Yeah, it was very, very, very short period where they were 30% less. But I don't think Berkshire shares relative to present value are at a significantly different discount than they were when we were paying somewhat higher prices. I mean, it's like Keyne said, or whoever it was. I don't know. The facts change. I change my mind. What do you do, sir? We always think about it, but I don't feel that it's far more compelling to buy Berkshire shares now than I would've felt three months or six months or nine months ago. It's always a possibility. We'll see what happens. Greg, you think about repurchasing shares?

We can do a quick check on this:

Data by YCharts

The current 1.14 P/B is the same as the March P/B he was buying at. Note the slump in Stock price in the last week calling the P/B to fall from 1.2x pre-meeting to 1.14x post-meeting, and because the stock price has fallen from $190 to $175 on Buffett's actions, rhetoric and financial stocks have slumped too.

With all that said, we may see marginal repurchases by Buffett in the next quarter if either the economy improves or the P/B value falls further. I remain a Berkshire Hathaway shareholder and added to my position after the Shareholders Meeting.

Thank you for reading. I have much longer notes on other discussions from the Shareholders Meeting. If you would like me to share and publish them here, please let me know in the comments.

Analyst’s Disclosure: I am/we are long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.