Berkshire: Why The Financial Bets?
When Warren Buffet makes major changes to the Berkshire (BRK.A) portfolio, the market keenly takes note. The rationale behind Berkshire’s maneuvers in airlines and financial services is of particular interest, especially as profits in Berkshire’s own insurance business continues to take a hit. Berkshire looks to be on track to post its first year of losses in the insurance underwriting business since 2003.
Several storms are wreaking earnings havoc in the insurance business. General Re’s underwriting liabilities for Cyclone Debbie in Australia are behind a drop in Berkshire’s pre-tax earnings of 61% to $2 billion in the first half of 2017 over the year-ago period. The damage from Hurricane Harvey in Texas in August, which is estimated to be $180 billion, is expected to weigh on second half-year earnings. Buffet says auto insurer GEICO could easily be liable for the loss of 50,000 cars.
Berkshire’s diversification strategy has gradually decreased its insurance segment’s earnings share, with a drop of 8% in the last two years alone to 26% in 2016. Recent trading activity in the Berkshire portfolio reveals several strategic market shifts.
As the US Federal Reserve begins its gradual increase in interest rates, financial services stocks are poised to benefit. Berkshire has been increasing its position in financial stocks.
In August, Berkshire became the largest shareholder in Bank of America (BAC) by exercising its option to buy 700 million shares, bringing its stake to 6.5%. This follows an increase in its stake in Bank of New York Mellon (BK) by 52% to 50 million shares during 2Q. It maintains a 10% stake in Wells Fargo (WFC) and has asked regulators for permission to increase its stake in American Express (AXP) from 17% to 25%.
While exiting GE (GE), formerly a major holding, Berkshire bought a $512 million stake in a GE spin-off, Synchrony Financial (SYF). The GE exit is in sync with Berkshire’s current investment strategy. After all, GE is no longer your father’s business; with its refocus on its core industrial business it is once again your grandfather’s business. GE exited most of its financial services business GE Capital in 2015, once responsible for about 50 percent of earnings, to focus on growing the industrial business to 90 percent of revenues by 2018.
Flying Low on Airlines
Less obvious is why Berkshire is reducing its exposure to US airlines while the region is leading the global airline industry in profitability. Up until March, Berkshire was adding to its US airline positions. Shares have been sold in American Airlines (AAL), Delta (DAL) and United Continental (UAL), but Southwest (LUV) has been added. Higher costs in 2017 related to rising fuel prices may have been behind the move.
In the first half of 2017, the international airline industry registered its highest traffic growth in 12 years. Global airline total revenue passenger kilometers, or RPK, grew 7.9% over the first half of 2016. While the airlines benefited from a strengthening global economy, airfare price reductions also helped fill seats.
North American traffic slid for the second consecutive year by 0.3% over the year-ago period to 4%. Despite the slight traffic decline, North American airlines are expected to be the most profitable for a second consecutive year in 2017 with net profit margins of 8.5%, versus 4.1% for the global airline industry.
Consolidation in the US airline industry has helped it lower its weighted average cost of capital and operate more efficiently. The three sold off airlines have a WACC in the low 7% range, in line with the industry average. While the industry return on invested capital (ROIC) has exceeded WACC in 2015 and 2016. American Airlines, Delta, and United Continental have appeased concerns that higher fuel costs could lower investment returns with ROICs of 17.8%, 26.9% and 20.9%, respectively.
Longer term, rising fuel costs in 2017 and beyond could put some strain on margins. Crude oil prices have risen from an average of $43 per barrel in 2016 to $49 by the end of August. By the end of August, the average jet fuel price was $62.8/barrel, an increase of 12.5% from a year ago. Hurricane Harvey, however, has slowed refining operations and placed at least temporary downward pressure on crude oil prices.
Harvey may be bad news for insurance but could be good news for airlines and the financial services, which will help finance the reconstruction. The more diversified portfolio will soften the impact.
Berkshire’s book value per share at the end of 2016 was $172,108, an increase of 18% from 2014 when Walmart (WMT), IBM (IBM), Verizon (VZ), Proctor and Gamble (PG) and Johnson and Johnson (JNJ) — all now sold off— were top holdings.
Berkshire Hathaway’s stock, a perennial outperformer of the overall stock market, is up 11% year to date, trailing the S&P 500 by 1.14%, versus its outperformance of the S&P 500 by 2.07% with a return of 16.5% over the 5-year period.
Buffett is still heavily tied to financials and insurance for a reason. Rising interest rates should help be a boom, as will decreased regulation. All in all, Buffett is positioning himself for the future of the financial industry — and despite the near-term headwinds brought by the likes of Hurricane Harvey, etc. insurance will still be a ‘good’ business. Berkshire remains a solid business that no activist investor will touch for many years to come — even after Buffett is gone.