As Warren Buffett frequently explains, Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B) owns 10.25 companies that would be on the Fortune 500 if they were stand-alone enterprises. While that diversification brings in billions in profits with regularity, the profit generated by individual units and subsidiaries naturally ebb and flow from quarter to quarter.
Let's take a look at some of the moving parts as a preview to Berkshire's earnings report, which we expect to be released on February 25, 2016.
1. Massive investment gains
If Berkshire's net income looks a little inflated, don't be all too surprised. Net income includes gains from its investment portfolio, which should have performed spectacularly in the fourth quarter. A post-election boom in bank stocks should have been particularly good for Berkshire.
Berkshire's bank stocks, Wells Fargo, American Express, and US Bancorp, jumped 24%, 17%, and 21%, respectively, in the fourth quarter. Its Bank of America warrants more than doubled in value. Volatility near record lows and record highs in the S&P 500 should be good for its derivatives portfolio.
All this is to say that the quarterly fluctuations in its investment portfolio should result in massive bottom-line profits -- but investors need to take the long view. As Buffett cautions, unrealized gains and losses are often fleeting, and Berkshire is in the business of buying and holding for decades, not just for a quick intra-quarter gain.
2. Ups and downs in operating businesses
Berkshire's manufacturing revenue and profits will likely compare well to the prior year, helped by the addition of Precision Castparts and Duracell, which were put under the Berkshire umbrella in the first quarter of 2016. This is the last full quarter in which Berkshire's manufacturers get a super easy year-ago lap, as both companies were at least partially included in its results for the first fiscal quarter of 2016. Excluding their impact, pre-tax profits increased 2.9% year over year in the third quarter compared to a 57.3% increase when Precision Castparts and Duracell are included.
Although railroad traffic ended 2016 higher than 2015, BNSF will likely show another quarter of revenue and profit declines. Berkshire's second-largest contributor to pre-tax earnings reported that revenue declined in the first nine months of 2016 due to a decline in revenue per unit (down 6.5%) and car volume (down 6.6%). Lower demand for energy commodity shipments (coal and oil, primarily) are driving the bulk of the decline.
Buffett is still plenty happy to put money to work in rails, however. BNSF intends to spend $3.4 billion on capital expenditures in 2017, down from last year's plan of $3.9 billion. BNSF's budget will still give it the title of being the industry's biggest spender -- No. 2 Union Pacific will spend $3.1 billion next year.
Turning to Berkshire's insurance units, it's likely that Berkshire will report an underwriting profit across the entirety of its insurance lines, something it has done with regularity. For each individual unit, though, profits can be highly volatile from quarter to quarter. As with many car insurers, GEICO has recently raised prices to negate the impact of higher losses from greater frequency and severity of car accidents. We'll also have to see if Ajit Jain can work his magic with General Re, a Berkshire unit that has struggled, in part due to tougher competition in reinsurance and what Jain called a "gradual creep of corporate bureaucracy" in a letter to employees in August 2016.
3. How Buffett sees the world
The fourth quarter was an interesting one for Buffett. Berkshire Hathaway made a multibillion-dollar investment in airline stocks. He publicly campaigned for Clinton, but purchased more than $12 billion of stock after Trump's election.
Just days ago, a major Berkshire investment, Kraft Heinz, proposed the largest-ever takeover attempt in the food industry. Is Buffett encouraging his affiliates to go shop with promises of Berkshire-backed financing?
Berkshire has a lot of cash to put to work. It ended the third quarter with nearly $85 billion in cash and cash equivalents, which enables the company a lot of latitude to go shopping for its next big acquisition. Buffett's annual letter to shareholders may give some clues as to how he plans on putting Berkshire's cash to work.