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The Science of Hitting
The Science of Hitting
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Berkshire Hathaway: A Satisfactory First Half of the Year

A look at Berkshire's results through the second quarter of 2020

Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) recently reported results for the second quarter of fiscal 2020. For the quarter, Berkshire recorded $56.8 billion in revenues across its collection of businesses, down by roughly 11% from the year ago period driven by declines at Burlington Northern Santa Fe (BNSF), Precision Castparts, Lubrizol, Marmon and McLane. GAAP earnings in the quarter totaled $26.3 billion, driven by more than $31 billion in investment and derivatives gains. As I've discussed in the past, these figures tell us very little about the economic reality at Berkshire in the quarter. The more important figure for shareholders is the $5.5 billion in operating earnings that the company generated in the second quarter, a 10% decline from the year-ago period.

Year to date, Berkshire has generated $17.5 billion in cash flow from operations, a 4% increase over the first half of 2019. Interestingly, the company was a major seller of equities in the second quarter, which has resulted in nearly $12 billion of net sales throughout the first six months of the year.

Now that the company has released its 13-F, we can see that those sales included the liquidation of its holdings in the major U.S. airlines, as well as a meaningful reduction in financials like Wells Fargo (NYSE:WFC) and J.P. Morgan (NYSE:JPM). At quarter's end, Berkshire's equity investments had a total market value of $208 billion, with the largest position, Apple (NASDAQ:AAPL), accounting for an astounding 44% of the total ($92 billion).

The sale of equities and immaterial M&A in the first half of 2020 led to another increase in Berkshire's cash and short-term investments, which totaled $143 billion at quarter end. As recent inactivity and growing cash balance suggest, Berkshire continues to struggle to find ways to effectively allocate large amounts of capital. The only notable counterexample of late in the $4 billion deal announced to acquire energy assets from Dominion (D) in July, which is expected to close later this year. Personally, while I've long given Buffett and his partner, Charlie Munger, the benefit of the doubt, I'm honestly a bit perplexed by what's going on. The one thing I take solace in is the fact that Berkshire could put tens of billions of dollars to work quickly if the right opportunity arose. We'll see if the market offers them anything large and enticing in the months to come.

Insurance float totaled $131 billion, an increase of 5% over the past year. The fact that Berkshire has continued to grow float off of a massive base over the past decade is quite impressive, particularly in light of something that Buffett told shareholders in 2011: "It's unlikely that our float will grow much – if at all – from its current level." Thankfully, Buffett was wrong: Berkshire's insurance float has increased by roughly $60 billion since he wrote that.

Importantly, Berkshire has reported sizable underwriting gains alongside its growth in float. Digging into the insurance businesses, it was an interesting quarter for GEICO, with written premiums declining by roughly 7% due to the 15% premium credit being offered to all voluntary auto and motorcycle customers (the GEICO Giveback). The company initiated the Giveback to account for the fact that the pandemic had resulted in a meaningful reduction in loss and loss adjustment expenses; put differently, much of the short-term benefit to the company from less accidents in recent months will ultimately be returned to GEICO policyholders.

Note that the company's loss and loss adjustment expenses declined by more than 20% in the second quarter, resulting in pre-tax underwriting gains of more than $2 billion and a combined ratio of 75%. As outlined in the 10-Q, this will quickly revert back to normal:

"As policyholder driving increases, claims frequencies are expected to increase and as the effects of the GEICO Giveback program on earned premiums increase, GEICO could experience pre-tax underwriting losses over the second half of 2020, which would offset a portion of the pre-tax underwriting earnings generated in the first half."

Earned premiums for Berkshire Hathaway Primary Group (BHPG) declined by 2% in the quarter, reflecting reduced exposures and premium refunds related to the pandemic in the workers' compensation and commercial auto businesses. The underwriting results, which are inclusive of estimated losses related to the pandemic, have still been satisfactory through the first six months of the year with a combined ratio of 98.6%.

Earned premiums for Berkshire Hathaway Reinsurance Group (BHRG) increased double-digits to $2.7 billion, primarily due to new property contracts. Year to date, BHRG has reported a combined ratio of 115%, with more than ten points ($575 million) attributable to losses and loss adjustment expenses tied to the pandemic.

Revenues at Burlington Northern Santa Fe (BNSF) declined by 22% in the second quarter to $4.6 billion, primarily due to an 18% reduction in railcar volumes led by a 39% decline in coal volumes.

To put those results in context, Union Pacific (NYSE:UNP) reported a 24% decline in revenues and a 20% decline in volumes in the quarter. Despite the significant volume headwind, BNSF did a good job controlling expenses, with the operating ratio actually improving year-over-yea. Granted, they were lapping weather related issues in the first half of 2019. As a result, after-tax segment earnings fell by 16% in the quarter and have declined by 10% year to date.

At Berkshire Hathaway Energy (BHE), revenues fell 6% in the quarter to $4.7 billion, with year-over-year declines in both the energy and the real estate operations. Pre-tax earnings declined by roughly 10% in the quarter, with segment net earnings increasingly low-single digits from the year ago period as the business continues to benefit from wind-powered electricity production tax credits; the effective tax rate for the segment in the third quarter was negative 31%.

Manufacturing, Service and Retailing (MSR) revenues declined mid-teens in the quarter, with broad based weakness across the segment. This had an outsized impact on profitability, with adjusted segment pre-tax net income down by more than 40% year-over-year. I used adjusted because Berkshire took an impairment charge of more than $10 billion in the segment in the second quarter, primarily reflecting an impairment in the value of Precision Castparts (PCC) as a result of significant declines in their aerospace business. In addition, the company announced that PCC had reduced its workforce by roughly 30% in the first six months of 2020. As noted in the 10-Q, management believes the duration and severity of the pandemic and its long-term impact on commercial air travel and the aerospace industry remains unclear.

Conclusion

While the more economically sensitive businesses within Berkshire reported uninspiring results in the quarter, I think the overall results were satisfactory. Where I'm struggling, as I alluded to earlier, is on Berkshire's capital allocation. Simply put, I struggle with Berkshire's large and growing cash balances, particularly in light of what Buffett has said over the years about the impact of persistently low interest rates on valuations, his preference for owning businesses over holding cash, etc.

More so than anytime that I can remember, I'm struggling to see the logic of some of the high-level decisions being made at Berkshire. The out, as I mentioned above, would be if Berkshire was able to close a large deal (meaning tens of billions of dollars). Given the fact that public market valuations have risen meaningfully in the past few months – and private market valuations have likely followed – I won't be holding my breath.

Disclosure: Long Berskhire Hathaway and Wells Fargo.

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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Comments

4shekhar
4shekhar - 4 months ago    Report SPAM

As always, a great report. Science of Hitting, I am confused about Warren's action on the sale of JPM, WFC in second quarter but no sale of BAC. In July and Aug, he buys more BAC. Could you say that Warren was concerned about the effect of the COVID-19 on banking sector during 2nd quarter, so he sold the bank stocks. May be in July, the COVID-19 concerns were reduced, then he bought more BAC? Still, WFC had been much cheaper than BAC, why did Warren sell WFC in 2nd qtr and buy more BAC in 3rd qtr? Thanks.

The Science of Hitting
The Science of Hitting - 4 months ago    Report SPAM

4shekhar - I spoke about that on my podcast with my friend Bill Brewster (link below). The short answer is that I don't know either, but it's a good lesson on following people you respect into investments. As always, we have to make our own decisions. Thanks of the comment!

https://anchor.fm/the-science-of-hitting/episodes/Episode-7-Bill-Brewster-ei9r67

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