Berkshire Hathaway: Buffett The Buyer Is Back
Summary
- Berkshire Hathaway spent $51.1 billion on new stock investments in 1Q 2022. This does not look like a market timing move.
- More income from float is needed when inflation is impacting underwriting performance.
- Increased investment income will help the company's earnings power now and will still be there after T-bill rates come down.
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Big Buys To Improve Earnings Power, Not Time The Market
Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) released 1Q 2022 results on April 30, just before the start of the annual meeting. The meeting is fun to listen to and usually generates more headlines, but the 10-Q tends to be more informative to serious investors who have heard Buffett's nuggets of wisdom many times before. Nevertheless, even the meeting provided some insights into Berkshire's buying binge so far this year.
The most stunning observation from the 10-Q is that Berkshire spent $51.1 billion on new stock investments in 1Q. (The company also sold $9.7 billion of equities in the quarter.) This $41.1 billion net increase in stock investments nearly matches the drawdown in the cash balance of $41.2 billion. Berkshire's cash and cash equivalents (Treasury bills maturing in 3 months or less) within the Insurance and Other segment totaled $102.7 billion at the end of 1Q, compared to $143.9 billion at the start of the year. This also ends a long stretch of Berkshire's cash increasing in parallel with its insurance float, which increased $1 billion to $148 billion in 1Q.
It's tempting to think with the S&P 13% off its highs that Buffett is making some kind of market bottom call. However, at the meeting Buffett provided two examples of his inability to time the market well. The first was his "Buy American" article from October 2008 which missed the eventual bottom by 5 months and over 25%. He was also honest about missing the March 2020 bottom. Hopefully, the Buffett permafans heard that and will no longer feel compelled to defend him in the comments whenever someone brings that up.
Instead, I suggest that inflation is beginning to cut into insurance underwriting profits and Buffett recognizes that the float now needs to work harder to generate investment income to create a satisfactory overall return for the insurance business. The new environment is clear from the overview of the insurance underwriting results.
Berkshire Hathaway 1Q 2022 10-Q
It's not unusual for Berkshire's underwriting profit to swing widely from quarter to quarter and occasionally be near zero or negative. However, this is usually due to a significant catastrophic event like a hurricane causing a lot of claims to come in at once (a higher claims frequency). GEICO is now seeing higher claims severity, meaning more cost per claim. As noted in the 10-Q:
GEICO's pre-tax underwriting loss in the first quarter of 2022 reflected increased claims severity, primarily due to significant cost inflation in automobile markets, which accelerated in the second half of 2021. Increases in used car prices are producing increased claims severities on total losses and shortages of car parts are contributing to increased claims severity on partial losses. In addition, injury claims severities continue to trend higher than general inflation rates.
Claims severities for collision coverage were the biggest impact, up 20%-22% from last year. I expect GEICO to raise premiums to try to recover these higher costs, but that will be difficult in such a competitive industry. Auto insurance is basically a commodity product that is only differentiated by the cleverness of the mascot / spokesperson in the TV ads. Customers will gravitate to the lowest-cost option as long as there are minimal switching costs.
In the 1980s, underwriting losses were common, but this was not a big problem when the float could be invested in government bonds that generally paid higher than the cost of the float. For a company like Berkshire Hathaway that could get better investment returns than 7%-9% in Treasuries, it was even less of a problem.
Berkshire Hathaway 1994 Shareholder Letter
Since the 1990s, underwriting profits at Berkshire have become more common. In the last decade, bond yields shrank to near zero and equities have become more expensive. In that environment, Buffett was content to keep most of the insurance float in cash and let underwriting drive the profitability of the insurance business. Now, however, underwriting has become more challenging because of inflation. Interest rates are also going up, but it's not certain they will go up enough to generate an acceptable return on cash. A 2% increase earns another $0.7 billion per quarter. This about equals the drop in underwriting income in 1Q, but it is uncertain how long rates would stay that high.
I can't read Buffett's mind, but the recent buying spree seems designed to improve insurance investment income, which would more than offset the struggling underwriting profitability during this inflationary period. He is not swinging for the fences by trying to buy growth cheap or making a Ben Graham deep value play. Instead, Buffett is buying reliable generators of income with low risk of capital losses. Let's look at the recent major purchases to see how they fit this model.
Berkshire's Recent Acquisitions
Chevron
Chevron (CVX) may have been the biggest surprise, and you had to look in the footnotes to a table in the 10-Q to see that it is now one of Berkshire's top 4 stock investments, valued at $25.9 billion at the end of 1Q. I have been critical of Buffett for not going bigger into energy in 2020 but to be fair, lots of smart people were worried about the durability and investability of the oil industry given the worldwide push for more renewable fuels. The reaction of the energy market to the Russian invasion of Ukraine shocked most of the world back to reality that fossil fuels will remain valuable and in demand for a long time. Even so, Chevron is one of the more practical oil majors when it comes to greener energy, focusing on hydrogen, biodiesel and jet, and carbon capture and storage. These are technologies adjacent to their current areas of expertise rather than lower-margin solar and wind.
Chevron has a 3.63% dividend yield. It did not cut the dividend in 2020 like some other majors and has instead been a consistent grower. Berkshire's stake is estimated at 174.5 million shares or 8.9% of the company. This is up from 38.2 million shares held at the end of 2021.
Incremental annual dividend income for Berkshire: $774 million
Occidental
Occidental (OXY) was already well-known to Berkshire, which helped finance their acquisition of Anadarko in exchange for preferred shares and warrants. Still, Buffett did not consider being a long-term holder of the common stock until he claims to have simply listened to the earnings call and liked what he heard. The discussion above on Chevron applies here, plus the potential to quickly pay off the debt from the Anadarko deal and begin raising the dividend.
The dividend now stands at $0.13 quarterly for around a 1% yield, intended to be sustainable down to $40 WTI. At higher crude prices, the company can buy back stock and increase the dividend per share. Berkshire now owns 14.6% of the common stock, or 136.3 million shares valued at $7.5 billion.
Incremental annual dividend income for Berkshire: $70.9 million with potential to increase
HP
Buffett hasn't said much about Berkshire's investment in HP (HPQ) but he now owns 121 million shares, or 11.5% of the company, valued at $4.4 billion. PC's and printers had a demand spike during the work-from-home trend, but are not a high growth business. They are a cash cow, however. The printers, most of which require the use of OEM replacement cartridges, are a classic razor/blade model that Buffett is familiar with from his long-time investment in Gillette (PG).
The dividend has been raised every year since 2011 and is now $0.25 quarterly for a yield of 2.7%.
Incremental annual dividend income for Berkshire: $121 million
Activision Blizzard
One of Berkshire's investment managers bought 14.7 million shares of Activision Blizzard (ATVI) in 2021 as a value play when the stock was beat up from the harassment scandal at the company. We learned at the meeting that Buffett increased this stake to 9.5% of the company (74.2 million shares worth about $5.6 billion) as a classic arbitrage trade after Microsoft (MSFT) made a takeover bid for the company. Buffett engaged in these types of trades regularly in his partnership days and even more recently when he owned Monsanto before it was bought by Bayer (OTCPK:BAYRY). The company pays an annual dividend of $0.47, but the main attraction is the $95 deal price relative to the current $75.60
Incremental annual dividend income for Berkshire: $34.9 million
Capital gain for Berkshire if deal closes: $1.51 billion
Others
The investments above add up to about $36.5 billion not counting the CVX and ATVI Berkshire already owned at the start of the year. The 13-F should be out around May 15 to help identify another $14.6 billion of investments, although foreign stock holdings will not be listed. Buffett mentioned at the meeting that he "topped off" his holdings in the Japanese trading companies and owns about 5.85% of each, but that is probably just around $1 billion. He also mentioned ownership of three German stocks but provided no other details.
More To Come
Berkshire is not done, having already committed to buy Alleghany (Y) for $11.6 billion of $848.02 per share. This deal is expected to close in the fourth quarter. This "mini Berkshire" is hard to value based on earnings, but Buffett is paying 122% of book value, which is less than Berkshire's P/B of 144%. The real value may be the opportunity to get more aggressive with Alleghany's investment portfolio, which at the end of 2021 had $17.2 billion in bonds and short-term investments, and only $3.7 billion in equities.
Berkshire is also scheduled to buy another 41.4% interest in Pilot Flying J travel centers in 2023 to bring its ownership up to 80%. Prices were not disclosed, but the business would be worth around $1.5 billion total based on a similar P/S ratio as TravelCenters of America (TA). Operating income of Pilot would be around $300 million based on similar operating margin as TA. So, in 2023, Berkshire would be spending an incremental $621 million and getting an incremental $124 million in operating income.
Impact on Earnings Power
For about $50 billion of cash, Berkshire is getting the following returns
- $1 billion annually in dividend income with the potential for growth
- $1.5 billion arb profit with the opportunity to reinvest it when the deal closes
- 100% of Alleghany's income with the opportunity to optimize their investment portfolio to earn higher returns
- 41.4% more of Pilot Flying J income
These payouts will stay the same or grow no matter what interest rates do in the future. Meanwhile, Berkshire still has around $100 billion in cash which will benefit from the higher T-bill rates as long as they last.
Conclusion
Berkshire Hathaway has delivered great results at BNSF Railroad, Berkshire Hathaway Energy, and most of the Manufacturing, Service, and Retail businesses. You can read my previous Berkshire articles for more details. Insurance has also done well, but underwriting income is now being challenged by inflation. This development appears to be the catalyst for Warren Buffett to begin deploying more of Berkshires still huge cash hoard. After years of "lethargy", the company made over $50 billion in new investments in 1Q 2022 with more to come. These are neither aggressive growth nor deep value plays. These new investments deliver steady income and dividends with the potential for growth. Risk of losing principal is also low with the possible exception of Activision Blizzard.
Berkshire's continued to buy back its own shares at a slow pace of $3.2 billion in 1Q even as the external buying spree was going on. Buybacks stopped so far in 2Q however. At $323 per B share, the stock may finally be near Warren Buffett's conservative estimate of intrinsic value. Nevertheless, the new investments will increase earnings power going forward.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of BRK.B, ATVI either through stock ownership, options, or other derivatives. 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.
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Disc; long ~22% portfolio brk.b
- Charlie Munger
