On Saturday, Warren Buffett (Trades, Portfolio)’s Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) disclosed its earnings report for the second quarter of 2021, which ended on June 30.
For the quarter, the conglomerate’s operating earnings were $6.69 billion, up 21% from $5.51 billion in the same period a year ago. Overall earnings, which include equity investments, increased 6.8% year over year to $28 billion. The strong operating results were driven by significant economic recovery compared to a year ago.
The economic recovery, combined with the U.S. government and the Federal Reserve showing their willingness to take drastic measures in order to support increasing amounts of debt for large- and mega-cap businesses, has also driven stock prices to record valuation levels. According to the Buffett Indicator, a total market valuation measurement comparing the market cap of a country’s companies to its gross domestic product, the U.S. stock market is “significantly overvalued.”
In the midst of this overvalued market environment, Berkshire repurchased $6 billion worth of its own shares in the quarter, bringing year-to-date share repurchases to $12.6 billion. While a slowdown from the first quarter and a further drop from the $9 billion worth of repurchases made in the fourth quarter of 2020, $6 billion is still a significant amount. The stock now has a three-year average share buyback rate of more than 2%.
Investors keep expecting Berkshire to make one or even a few large-scale deals with its cash pile, but given Berkshire’s continuation of its share buyback spree, is it possible that Buffett sees the company as a better value investment opportunity compared to the other equity securities, acquisition targets or business investments that the cash could be going to instead?
Operating earnings shine
As a company, Berkshire Hathaway seems to be making strong progress in terms of recovering from the pandemic. Year over year, operating earnings have shown growth of 21% compared to only 6.8% for overall earnings, which include the equity portfolio.
However, the second quarter of 2020 is a flattering comparison no matter how we look at it. Berkshire’s operations mainly include its insurance business, railroad operator BNSF, Berkshire Hathaway Energy and a variety of retailers and manufacturers. Many of these businesses were negatively impacted due to customers staying at home more often, losing their jobs or choosing to save their money in case of emergencies during 2020.
In the insurance segment, revenue from premiums increased compared to a year ago, as did leasing revenue and sales and service revenue, though insurance losses and the cost of sales and services increased accordingly. Insurance is Berkshire’s main “powerhouse” that provides float to help fund its investing portfolio.
While Berkshire’s insurance businesses attract customers with their ability to offer lower prices and take on riskier policies that other insurance providers can’t handle, insurance is still a relatively recession-proof business. This is because as the prices of goods and services rise, the more the insurance on these goods and services is going to cost, giving insurance companies significant pricing power.
For BNSF, earnings came in at $1.9 billion before tax, up from $1.4 billion a year ago. Berkshire Hathaway Energy grew from $533 million to $739 million. The Manufacturing and McLane Company segments more than doubled to earnings of $2.7 billion and $84 million, respectively. Pre-tax service and retailing income nearly tripled to $1.1 billion.
Is Berkshire undervalued?
Below is a chart of the shares outstanding for Berkshire’s class B stock over the past few decades. As we can see, the share count increased slightly in 2009 and 2010 before remaining fairly even for a while. In 2019, share repurchases began at a slow pace, gradually picking up speed in the past couple of years:
Due to its efficient operational model and strong balance sheet, Berkshire’s various business weathered the pandemic fairly well, all things considered. Thus, it should come as no surprise to those who follow the company that even a famous value investor like Buffett doesn’t seem to have reduced his assessment of Berkshire’s intrinsic value.
In fact, the average price for Berkshire’s class B shares in the second quarter of 2021 was $278.90 compared to $242.84 in the first quarter of 2021, $220.63 in the fourth quarter of 2020 and $204.37 in the third quarter of 2020. Berkshire’s share buyback policy is to repurchase shares when Buffett and his partner Charlie Munger (Trades, Portfolio) “believe that the repurchase price is below Berkshire's intrinsic value, conservatively determined,” so it seems reasonable to assume that Buffett and Munger still believe the stock to be undervalued even around the $278 range.
Buffett’s golden rule for investments
While it seems likely that Buffett still considers Berkshire’s stock to be trading below its intrinsic value, thinking of the shares as undervalued is far from the only reason why he might choose to up the pace of share buybacks. It may simply be that the Oracle of Omaha considers everything else to be too overvalued at the moment, and when things are overvalued, there is a higher chance of accidentally buying at the top and ending up in a loss-making position. While there are still some cheaper stocks, Buffett may consider them to be cheap for a reason, or he may believe Berkshire to be the better choice.
One of Buffett’s often-quoted golden rules of investing goes like this: "Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1."
Having spent the early years of his career following the same style of value investing as Benjamin Graham, Buffett has typically looked for the best ways to earn money without taking on too much of a downside risk. It seems he might now be exercising caution in the markets as record low interest rates cause unprecedented changes to the financial landscape.
Buffett on the "sea change" in finance
At Berkshire Hathaway’s annual shareholder meeting this year, Buffett talked about how near-zero interest rates have completely altered the financial landscape, warning that the consequences of easy money policy are an “unanswered question.”
“It causes stocks to go up, it causes business to flourish, it causes an electorate to be happy, and we'll see if it causes anything else,” Buffett commented regarding the Fed’s near-zero interest rates and purchases of corporate debt.
“It’s been a sea change,” Buffett said. “It was designed to be that — that’s why the Fed moved the way they did, they wanted to give a massive push.”
Buffett noted that these policies make stocks in general look like bargains by merit of offering the only real yield potential in financial markets (unless you want to get into distressed debt, options or something even riskier). Moreover, with government support for stock prices, the general market sentiment is that stock prices will go up forever.
“Interest rates are to the value of assets what gravity is to matter,” Buffett said. “If I could reduce gravity’s pull by about 80%, I'd be in the Tokyo Olympics jumping.”
While easy money policies can help businesses stay afloat in crucial times, the drawback is that they reward inefficient and loss-making business practices. Businesses whose top executives bleed them dry to make themselves millionaires without care for the long-term prospects, or who make poor business decisions that lead to unprofitable operations, can then take on increasing amounts of debt or even get taxpayer-funded government bailouts.
In a healthy capitalist system, poorly run businesses have traditionally been allowed to fail so that they can be replaced with better businesses. While this rule will certainly continue for smaller business with less access to massive amounts of cheap debt, these are essentially uncharted waters for the financial world because the rules of the game have changed. The long-term effects are unknown.
Conclusion
Buffett’s Berkshire is continuing to snap up its own shares. Given Berkshire’s policy on share repurchases, we can be reasonably certain that Buffett believes the stock is a good value opportunity at current levels. However, the question of whether Buffett thinks it is one of the greatest investment opportunities on the market is a lot more complicated.
Berkshire’s businesses seem to be recovering well from the economic recession triggered by the first wave of the Covid-19 pandemic. The equity portfolio is also benefiting from both the economic recovery and the Fed’s historic easy money policies, which are driving more capital toward stocks as an asset class.
Overall, it seems like Berkshire is continuing to chug along with a preference for lower-risk investments due to the changes and uncertainty in the financial landscape. We will have to wait for the company’s 13F before seeing if it made any major stock investments during the second quarter.
