A new year brings new opportunity for Berkshire Hathaway (BRK.A 0.64%) (BRK.B 0.54%). It's my view that 2018 could be the company's best year yet, as three major trends should drive its profit higher.
1. Tax reform's biggest winner
Berkshire Hathaway is already one of the biggest winners from corporate tax reform. I expect its book value to surge by as much as 13% when it reports fourth-quarter earnings. This book value jump will be driven primarily by a one-time drop in estimated taxes it will pay on gains in its investment portfolio. Berkshire currently accounts for future taxes based on a corporate tax rate of 35%. With corporate taxes falling to 21% in 2018, Berkshire's deferred tax liabilities will necessarily decline, leading to a leap in book value.
Image source: Matt Koppenheffer.
Beyond an immediate increase in book value, the Omaha-based holding company will benefit from lower corporate taxes on the profits earned from its operating businesses. From BNSF to Geico and Dairy Queen, Berkshire Hathaway's business units generate the vast majority of their profit from domestic operations. For this reason, Berkshire is wildly believed to be one of the single largest beneficiaries from a cut in corporate taxes.
2. Rising interest rates fuel profits
At the annual shareholders meeting this year, Buffett explained that he thought Berkshire Hathaway's intrinsic value grew at an average annual rate of about 10% over the last decade, but he warned that future returns would be lower if interest rates remained near generational lows.
Seven months after the annual meeting, we know that interest rates are finally headed in the right direction. One-month U.S. Treasury yields stood at 0.7% at the time of Berkshire's annual meeting. Today, one-month Treasuries yield 1.2%, and the Federal Reserve is positioned for three more 0.25-percentage-point increases in rates in 2018.
Berkshire Hathaway is very interest rate sensitive. Its insurers make more money when rates are higher, as the returns they earn on their float increases. Likewise, its public stock portfolio is stuffed to the brim with banks, which stand to profit as rates drive margins higher.
Finally, Berkshire Hathaway has a lot of excess cash on its balance sheet. The company ended the third quarter with roughly $109 billion of cash and cash equivalents, which will generate more income as rates rise. These gains should more than offset marginally higher borrowing costs for Berkshire's BNSF railroad and Berkshire Hathaway Energy, which finance their large capital investments with borrowed money. Rising rates are a clear tailwind for Berkshire's earnings power.
3. Insurance profits should rebound in 2018
It's fair to say that 2017 was a bad year for the insurance industry due to hurricanes and other natural disasters. In all, 17 named storms generated an estimated $200 billion of damage, though only a portion of these losses are insured. In the third quarter of 2017, Berkshire estimated that its insurers lost $3 billion pre-tax to Hurricanes Harvey, Irma, Maria, and an earthquake in Mexico.
The losses were widespread, dinging the results of all of its insurance units. Berkshire said Geico lost $500 million to hurricane damage. Its reinsurance companies, General Re and BH Reinsurance, lost approximately $2.3 billion to natural disasters. BH Primary Group rounded out the list with $225 million in estimated pre-tax losses from catastrophes. After generating underwriting profits 14 years in a row, Berkshire is likely to post an underwriting loss in 2017.
Large insurance losses in one year typically plant the seeds for a future harvest of outsize profits, however. In 2016, Buffett warned that reinsurance would be less profitable in the future, as insurers were competing aggressively on price to win business. His negative view on reinsurance may change as the industry licks its wounds and reprices policies to account for large losses this year.
Swiss Re estimated that the insurance industry lost $95 billion to five calamities in 2017, which could lead to a hardening market and higher prices for reinsurance, a potential boon for Berkshire Hathaway in 2018.
