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Margaret Moran
Margaret Moran
Articles (448) 

Buffett on Market Mood Swings: A Look at Berkshire's 2020 Results

Conglomerate made record share repurchases, Buffett reflects on his most recent mistake

On Saturday, Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) disclosed its earnings report for the full year of 2020, which ended on Dec. 31. Buffett also released his highly anticipated annual letter to shareholders of the conglomerate.

Buffett kicked off the report by outlining its revenue for the year, which totaled $42.5 billion and was further broken down into $21.9 billion of operating earnings, $4.9 billion of realized capital gains, a $26.7 billion gain from unrealized capital gains due to the rise of share prices in its equity portfolio holdings and, finally, an $11 billion loss from write-downs in the value of a few subsidiary and affiliate businesses.

Operating results were down 9% compared to 2019, and Berkshire made no sizeable acquisitions (in relation to the overall size of the conglomerate). Perhaps the most notable development was that Buffett, who over the last few years has noted that large-scale bargains have virtually disappeared, seems to have fully embraced large-scale share repurchases as currently being the best method to return cash to shareholders. In total, Berkshire repurchased approximately 5% of its own shares throughout 2020.

In addition to developments in Berkshire's fully-owned and operated businesses, the annual report also gives investors insight into the conglomerate's equity portfolio and Buffett's latest comments about this part of the business.

Earnings results

As of the year's end, Berkshire employed approximately 360,000 people worldwide, mainly in the U.S. Buffett also highlighted that the conglomerate owns more domestic assets in its home country than any other publicly traded company with U.S. fixed assets valued at $154 billion. The balance of cash, cash equivalents and U.S. Treasury Bills stood at $67.08 billion, up from $64.90 billion in 2019.

As mentioned above, operating results were down 9% overall. Net earnings per share attributable to Berkshire shareholders came in at $26.66 billion compared to the previous year's $49.82 billion.

Broken down by segment, Insurance - reinsurance brought in $657 million in 2020 versus $325 in 2019, Insurance – investment income came in at $5.03 billion versus $5.53 billion, Railroad was $5.16 billion versus $5.48 billion, Utilities and energy increased to $3.09 billion versus $2.84 billion, Manufacturing, service and retailing was down to $8.30 billion versus $9.37 billion and Investment and derivative gains were $31.59 billion versus $57.44 billion. The Other category recorded a loss of $11.31 billion primarily due to goodwill and indefinite-lived intangible asset impairment charges of $11.0 billion.

As investors expected, Railroad and Retail suffered the biggest impacts from the Covid-19 pandemic, leading to year-over-year declines. However, while many feared that the insurance business would take a huge hit, that does not seem to have been the case. In his letter, Buffet reiterated the strength of Berkshire's insurance business that comes from being able to control a hefty amount of capital far surpassing competitors:

"Berkshire now enjoys $138 billion of insurance 'float' – funds that do not belong to us, but are nevertheless ours to deploy, whether in bonds, stocks or cash equivalents such as U.S. Treasury bills. Float has some similarities to bank deposits: cash flows in and out daily to insurers, with the total they hold changing very little. The massive sum held by Berkshire is likely to remain near its present level for many years and, on a cumulative basis, has been costless to us."

Buffett's mistake

The biggest area of loss by far was the goodwill charges the conglomerate recorded in 2020. Of these $11 billion in charges, $9.8 billion were attributed to Berkshire's 2016 purchase of Precision Castparts, a manufacturer of components for the aerospace, industrial gas and defense industries.

Indeed, this was one of the first orders of business on Buffett's annual letter. The investor wrote the following on what he appears to consider one of his biggest mistakes in quite a while:

"The final component in our GAAP figure – that ugly $11 billion write-down – is almost entirely the quantification of a mistake I made in 2016. That year, Berkshire purchased Precision Castparts ("PCC"), and I paid too much for the company.

No one misled me in any way – I was simply too optimistic about PCC's normalized profit potential. Last year, my miscalculation was laid bare by adverse developments throughout the aerospace industry, PCC's most important source of customers.

In purchasing PCC, Berkshire bought a fine company – the best in its business. Mark Donegan, PCC's CEO, is a passionate manager who consistently pours the same energy into the business that he did before we purchased it.

We are lucky to have him running things. I believe I was right in concluding that PCC would, over time, earn good returns on the net tangible assets deployed in its operations. I was wrong, however, in judging the average amount of future earnings and, consequently, wrong in my calculation of the proper price to pay for the business."

In other words, just like with Buffett's decision to sell out of the four major U.S. airlines at the beginning of the year and regard those investments as a mistake, the investor holds that if he had properly accounted for the risk of black swan events such as the Covid-19 pandemic, he would have placed far less value on Precision Castparts. The uncertainty was not worth the price paid.

Repurchasing shares

"In no way do we think that Berkshire shares should be repurchased at simply any price. I emphasize that point because American CEOs have an embarrassing record of devoting more company funds to repurchases when prices have risen than when they have tanked. Our approach is exactly the reverse," Buffett wrote.

Buffett believes that the reason why buybacks are the best option for Berkshire at the moment is the same reason why they have been such a successful strategy for Apple Inc. (NASDAQ:AAPL), which is Berkshire's largest holding at 43.61% of the equity portfolio.

Apple simply generates too much cash to invest it all in growing the business, so it has used some of the excess to increase shareholders' ownership of the company. Berkshire now finds itself in the same situation – its cash generation surpasses the ability to effectively utilize that cash given the lack of attractive deals on the market.

In addition to increasing shareholders' ownership of Berkshire, Buffet illustrated that buybacks also increase their ownership of Berkshire's equity portfolio:

"Our cost for that stake [of Apple] was $36 billion. Since then, we have both enjoyed regular dividends, averaging about $775 million annually, and have also – in 2020 – pocketed an additional $11 billion by selling a small portion of our position.

Despite that sale – voila! – Berkshire now owns 5.4% of Apple. That increase was costless to us, coming about because Apple has continuously repurchased its shares, thereby substantially shrinking the number it now has outstanding.

But that's far from all of the good news. Because we also repurchased Berkshire shares during the 21⁄2 years, you now indirectly own a full 10% more of Apple's assets and future earnings than you did in July 2018.

This agreeable dynamic continues. Berkshire has repurchased more shares since yearend and is likely to further reduce its share count in the future. Apple has publicly stated an intention to repurchase its shares as well. As these reductions occur, Berkshire shareholders will not only own a greater interest in our insurance group and in BNSF and BHE, but will also find their indirect ownership of Apple increasing as well."

A note on investments

Unlike with quarterly earnings, Berkshire's annual earnings report comes after the release of its portfolio updates. Thus, we already have been able to see what Buffet and his investing lieutenants were buying and selling during the fourth quarter of 2020.

Buffett's most notable sales for the quarter included a 6.05% reduction in the Apple position and a 58.84% cut to its Wells Fargo (NYSE:WFC) holding. He also more than doubled the Verizon Communications (NYSE:VZ) investment and added 28.1% to Merck & Co. (NYSE:MRK), both of which are positions that Berkshire initiated in the third quarter of 2020. You can find the full list of Buffett's recent trades here.

The main message Buffett had for investors regarding the equity portfolio in his annual letter was that the conglomerate's decision to pursue large-scale share repurchases will benefit shareholders by increasing the per-share ownership of the investments.

Conclusion

Like most businesses, Berkshire had a roller-coaster year in 2020 due to the pandemic, which has even caused Buffett to lament his lack of foresight in failing to account for the unexpected global catastrophes.

However, Berkshire's insurance, railroad and energy businesses, which make up a large part of the backbone of the company, remained relatively unphased due to their status as essential businesses that customers cannot go without even when other aspects of their daily lives are disrupted. The Energy business was further boosted by Berkshire's acquisition of substantially all of Dominion Energy's (NYSE:D) natural gas transmission and storage busines.

The most dramatic downslides hit Precision Castparts, which derives most of its income from the aircraft industry, and of course the equity portfolio, which crashed along with the rest of the market in February and March before rebounding to higher levels than ever before. This caused Buffett to reiterate once again that investors should not pay too much attention to net earnings, as GAAP rules state that the company must include unrealized equity portfolio gains and losses as part of net earnings. The mood swings of Mr. Market should not be confused with the far more consistent operations of real businesses.

Disclosure: Author owns no shares in any of the stocks mentioned. The mention of stocks in this article does not at any point constitute an investment recommendation. Investors should always conduct their own careful research and/or consult registered investment advisors before taking action in the stock market.

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