In the last newsletter, I offered my perspective on the Dow Jones Transportation Index (DJTI) in the form of proxies that most everyone finds familiar. As expounded on in March, planes, trains and automobiles are important foundations of a successful U.S. economy and equity market. When reflecting on topics for May’s missive, it became clear while reading Berkshire Hathaway’s latest annual report that expanding on the trifecta might not only be fun, but also prove informative in a very portfolio specific way.
It will not come as a surprise to readers who have owned Berkshire Hathaway (BRK.A & BRK.B) for a number of years, or to those who may have just purchased the company stock last year, that its per-share market value experienced a drop of 12.5% in 2015. While somewhat disappointing, we concluded the decline created an attractive discount to the company’s fair market value. Select legacy holdings and new positions were subsequently increased and added, respectively. While it is impossible to predict long term results, we are pleased to share that BRK.B (share class owned by Clearview clients) were up just over 10[i]% through the end of April.
While Berkshire’s per-share market value dropped 12.5% last year, it is worth noting the company’s per-share book value increased by 6.4%. According to the 2015 annual report, this book value appreciation was attributable to an increase in Berkshire’s net worth of $15.4 billion. Readers should think of net worth and book value as the intrinsic or real value of all the individual companies that comprise Berkshire Hathaway.
As also explained in the annual report, Mr. Buffet and his Vice Chairman, Charlie Munger, view the multitude of companies under the Berkshire umbrella as four separate businesses. This helps to present them in a way more closely aligned with their balance sheet and income characteristics and for the casual shareholder, a logical way of thinking about the hundreds of businesses Berkshire owns. With a nod to last month’s transportation commentary, these four major sectors of operations include 1) Insurance (automobiles); 2) Regulated, capital-intensive businesses (trains); 3) Manufacturing, Service and Retailing (planes) and 4) Finance and Financial Products. A more in-depth look at each follows.
Combined, Berkshire Hathaway’s insurance companies generated just over $1.8 billion of underwriting profit in 2015. The property & casualty (P&C) branch of the insurance industry has been a driving force behind Berkshire’s growth since 1967 when they acquired National Indemnity and National Fire & Marine. Berkshire has since acquired numerous insurance companies with the most highly visible being what started as the Government Employee Insurance Company and what is now known as GEICO. Very few do not recognize the well-known, “15 minutes could save you 15% or more on car insurance” advertising tagline and the green gecko. Rounding out the Berkshire family of insurance companies are BH Reinsurance, General Re, Berkshire Hathaway Specialty Insurance along with a group of smaller companies that primarily underwrite commercial coverage.
The P&C business is attractive because insurers receive premiums upfront and pay claims later. The collect now, pay later business model leaves P&C companies holding large sums of cash, otherwise known as “float”. While some of that money will go to pay the claims of policy holders, the insurance company can invest the “float” for their own benefit. Policy holders will come and go but assuming the insurance company maintains effective underwriting practices and grows the number of policy holders at a steady rate, float can (and has at Berkshire) increase substantially. According to the 2015 annual report, in 1970, Berkshire’s insurance companies had a combined $39 million in float. In 2015, the figure stood at almost $88 billion.
Competition and low interest rates put significant pressure on all insurance companies and often lead to operating with underwriting losses. These subnormal returns relative to other businesses is the cost the industry pays to maintain its float which can be highly profitable. The annual report indicates Berkshire has operated at an underwriting profit for 13 consecutive years, with a pre-tax gain for the period totaling $26.2 billion. Continuing this positive track record will require disciplined underwriting and risk evaluation. Both of which, according to the annual report, are the fabric that blankets Berkshire’s insurance culture Old Testament style.
Complementing the P&C business are General Re and BH Reinsurance. Reinsurance is a practice employed by insurance companies that want to reduce their own risk. The company that is trying to mitigate or reduce their risk (the ceding company) buys insurance from other insurance (the reinsurer) companies. This practice helps reduce the likelihood that a single (insurance) company would be solely responsible for compensating policy holders for significant losses like those experienced in the aftermath of a natural disaster like a hurricane. Like the P&C business, success is dependent on effective underwriting and risk evaluation.
Regulated, Capital-Intensive Businesses
Common to the companies in Berkshire’s regulated, capital-intensive businesses are large investments of cash in long-lived, regulated assets partially funded by large amounts of long-term debt. The Burlington Northern Santa Fe (BNSF) railroad and Berkshire Hathaway Energy (BHE) are the two primary companies in this line of business. These two companies invested around $11.6 billion in plant and equipment helping to keep them both competitive in the years to come.
Formed in 1995 by a merger between Burlington Northern and Santa Fe railroads, BNSF moved 411 million ton-miles of freight with 45,000 employees in 1996. In 2015, the company moved approximately 700 million ton-miles of freight with 47,000 employees equaling increases of 70% and 4%, respectively. BNSF moves about 17% of the country’s intercity freight as measured by revenue ton-miles whether transported by rail, truck, air, water or pipeline. Like most other rail companies of similar size, BNSF uses only a single gallon of diesel fuel to move a ton of freight almost 500 miles. Showing their advantage, BNSF carries 45% more ton-miles of freight than its closest competitor. All of this has been accomplished with safety improvements in reportable injuries which have fallen more than 50% since 1996.
Berkshire Hathaway Energy (BHE) is a holding company for several electric utilities in Iowa, Nevada, Oregon and Utah. BHE also manages gas pipelines and renewable energy projects. In Iowa for instance, 47% of the megawatt-hours sold to retail customers came from renewable wind generation. Planned projects estimate that figure to reach 58% by 2017. In 1999, the initial Iowa utility acquired by Berkshire produced 19 million megawatt-hours of electricity with 3,700 employees. Now, 3,500 employees produce 29 million megawatt-hours of electricity. Similar trends are being seen at PacifiCorp, the Oregon and Utah utility purchased by Berkshire in 2006. While not specifically stated, it could be speculated that Berkshire Hathaway will continue to seek steady, recession resistant earnings through traditional, regulated power generating companies while at the same time, taking advantage of federal tax credits provided to renewables that makes them competitive in certain parts of the country.
Manufacturing, Service & Retail
The 3 key business lines in this operational sector are industrial, building and consumer product companies that manufacture and sell a wide spectrum of goods from candy to jet airplanes. It includes well-known brands like Fruit of the Loom, NetJets, Dairy Queen and See’s Candies as well as lesser knowns like Shaw (flooring), Acme Building Brands (bricks, masonry and Wylie Coyote’s favorite source of delivered goods; just kidding on that last one!), Lubrizol (specialty chemicals) and Benjamin Moore (paints and coatings). Recently acquired Precision Castparts Corp. (PCC) is a leading supplier of aerospace components. Employing over 30,000 at 162 plants in 13 countries, PCC products are key components in most large aircraft.
Like other industrial companies in 2015, Berkshire’s industrials experienced revenue and income declines. Commodity cost drops in petroleum and metals used in some products resulted in lower average selling prices. This was particularly acute in specialty chemicals, metal cutting tools, copper wire and plumbing. Certain businesses tied more directly with the oil and gas industry also experienced lower sales to customers.
Helping to offset industrials, building materials saw increases over 2014 levels for some of the same reasons that created declines in industrials. Lower raw material and energy costs were primarily behind earnings and revenue improvements at companies like Shaw, Johns Manville (insulation/roofing) and Benjamin Moore.
Revenues from consumer product manufacturing were relatively flat in 2015. The Forest River Company, a manufacturer of motorhomes (car theme again), campers and trailers paced the consumer products line and offset declines in apparel and footwear sales from such companies as Fruit of the Loom, Brooks Sports (running shoes) and H.H. Brown Shoe Group.
Servicing and retailing were not singled out as primary drivers but this long list of independently managed companies is extremely diverse. NetJets (plane theme), Dairy Queen, TTI (electronic components), Nebraska Furniture Mart, Oriental Trading Company, The Pampered Chef and See’s Candies are just a few. Berkshire Hathaway Automotive operates 81 car dealerships in 10 states selling new and pre-owned cars, offering repairs and other related services. Berkshire owns over 30 daily newspapers operating in 11 states as well as television station WPLG in Miami, Florida. The McLane Company is one of the lesser knowns but they sell and distribute to a number of mainstream outlets. A wholesale distributor of groceries and non-food products, it also operates businesses that are wholesale distributors of distilled spirits, beer and wine. Customers include Wal-Mart, 7-Eleven and Yum!Brands, the holding company for KFC, Taco Bell and Pizza Hut.
According to the 2015 annual report, after tax returns are sometimes exceptional running from 25% to over 100%. Some are steady producers between 12% and 20% while others leave Mr. Buffett questioning his evaluation of the economic dynamics of the company or the industry in which it operates. Evaluating the specifics of each would require a detailed review of the company’s balance sheet, income statement and corresponding footnotes. A task best left to the analysts that follow the individual companies. However, what does seem clear and intuitive to the novice and experienced investor, is the diversity these companies provide to Berkshire’s other operational sectors or business lines.
Finance and Financial Products
Leasing and rental operations make up the bulk of the finance and financial products sector and reflect another area driven by trains and automobiles. More specifically, freight cars, intermodal tank containers and semi-trailers. Marmon, which leases rail cars, containers and cranes, has a fleet of over 133,000 rail cars, expanded by the recent purchase of rail cars from General Electric. Connected to form a single train, the engine would be in Omaha and caboose in Portland, Maine.
Clayton Homes, the second-largest home builder in the United States is also in this group. The company sold over 34,000 manufactured homes last year or approximately 45% of this home type purchased by Americans. Clayton also underwrites mortgages for these homes. Originating and servicing loans in 25 states, its $12.8 billion mortgage portfolio carries an average loan of just under $60,000 requiring monthly principal and interest payments of approximately $520. Rather than selling the loans it originates to investors in the secondary market, Clayton retains all of the mortgages. While this carries a certain level of risk, the annual report points out that it motivates strong underwriting guidelines. As validation of this discipline, Clayton foreclosed on just 2.64% of the mortgages it originated in 2015 and boasted a 95.4% “current” payer rate.
The annual report does not necessarily place the Berkshire stock holdings under the category of finance and financial products, but the author believes this is a logical place to mention a few of its 15 common stock holdings. Holdings of the Kraft Heinz Company are excluded from this list because Berkshire is considered a control group. As an owner of over 52% of the outstanding shares, it is clear Mr. Buffet loves ketchup, Oscar Mayer hotdogs, Jell-O and Kool-Aid!
The American Express Company, AT&T, The Coca-Cola Company, Goldman Sachs, IBM, Wal-Mart and WellsFargo are all part of the Berkshire stable. These and the other stock holdings had a market value of over $112 billion at the end of 2015. Ownership ranges from over 15% (American Express) to just under 1% (AT%T). Not included in the author’s list but referenced as a highly valued holding in the 2015 annual report is Bank of America (ticker BAC). Berkshire has the option to buy 700 million shares any time prior to September 2021 for $5 billion. On 12/31/15, the 700 million shares had a market value of $11.8 billion. This option, if executed, would effectively make BAC Berkshire Hathaway’s fourth largest equity investment.
Buffet’s Personal Mutual Fund
It should be clear by now that in many ways, Mr. Buffet has created his own personal mutual fund. It is also evident that many of his acquisitions are in some way tied to planes, trains and automobiles. Unlike most of us who fulfill our love of these 3 mechanical inventions through scaled down hobbyist models, Mr. Buffet has “one-upped” all but a few in owning and operating the real McCoy. This summary is intended to give readers and clients that do not want to read the annual report, a brief glimpse of the companies and investments that comprise Berkshire Hathaway. In a recent Wall Street Journal article, Mr. Buffet explained that he writes his annual letter to shareholders in a way that his sister can understand. After reading the 2015 report, it is clear he tries his best to do this despite the complexity of the company and its holdings. Owners of Berkshire should take the time to read the report for themselves if for no other reason than to get a sense of Mr. Buffet’s style and the diversified manner in which he constructs his company. In the meantime, when dreaming of flying NetJets (I go commercial in coach!), wondering what it’s like to tour the West in a motorhome or watching a freight train pass by at a crossing, think about Berkshire Hathaway and admire the swath of America it owns and benefits through its investments.
[i] The facts and figures used in this summary were sourced from Berkshire Hathaway’s 2015 annual report. Readers are encouraged to reference the annual report to answer questions and to learn more about the company as it is an expansive resource on Berkshire’s many holdings.