Tens of thousands of investors will make the trip to Omaha this weekend for Berkshire Hathaway's (NYSE:BRK-A)(NYSE:BRK-B) annual shareholders meeting, an event that Warren Buffett describes as "Woodstock for Capitalists."
Here's what shareholders should be paying attention to in the company's first-quarter earnings report (May 4) and at its annual meeting (May 5).
1. Some new, funky accounting
In his annual letter to shareholders this year, Warren Buffett warned investors about an upcoming change in accounting that would lead to what he called "truly wild and capricious swings in [Berkshire's] GAAP bottom-line."
In the past, the gains or losses in Berkshire's vast equity portfolio were reported "below the line" in other comprehensive income until the investments were sold. These gains or losses will now flow through net income, leading to wild swings in its reported profits from quarter to quarter.
Many of Berkshire's largest investments lagged the market this quarter. Wells Fargo stock dropped 13% compared to a 3.9% decline for the average bank. Though American Express shares rallied after its first-quarter earnings report, shares were down by nearly 6% at the end of the first quarter. And Kraft-Heinz shares fell by nearly 19%, though the company is accounted for a little differently given Berkshire's sizable stake.
In a note to clients, Kai Pan, Morgan Stanley's property & casualty insurance analyst, wrote that the company could report a loss due to mark-to-market impacts relating to its stock portfolio in the first quarter. Of course, Berkshire's operating businesses are likely to produce billions in profits.
But while the reported numbers may change, what's unlikely to change is how Buffett scores his performance as an investor. The company's book value on a per-share basis will almost certainly remain Buffett's yardstick. (The accounting change has no impact on Berkshire's reported book value.)
2. Rising railroad volumes
The railroad rarely surprises because BNSF Railway, which provides freight transportation services, discloses its carload volume before Berkshire reports earnings. We know from its first-quarter carload report that BNSF's total carloads increased 3.1% compared to the year-ago period.
Grain and chemicals carloads increased by about 7.1% and 4.9%, respectively, compared to the year-ago period, though coal-related carloads (which make up roughly one-third of its volume) declined by about 2.7% year over year.
It's fair to describe BNSF as a royalty on economic output and trade domestically and abroad, as it makes its money moving raw goods and finished products all around the United States. Though pricing per carload remains a question mark, investors should be pleased by a low-single-digit increase in volume, which sets the stage for a good quarter for BNSF.
3. Can its insurers get back in the black?
Berkshire Hathaway's insurance companies are truly some of the best in the world, booking consistent underwriting profits that allow Buffett to work his magic with the "float" they generate through the normal course of business.
But as good as Berkshire's insurers may be, when the fortunes of the whole industry change for the worse, its insurers are unlikely to escape unscathed. Last year, Berkshire's 14-year streak of underwriting profits came to an end, thanks to hefty hurricane losses, wildfires in California, and an earthquake in Mexico. To be sure, 14 years of back-to-back underwriting profits is a really extraordinary result. Berkshire was due for a bad year.
This quarter, its insurers are likely to report underwriting profits. Investors can look to Progressive as a proxy for GEICO's results. The car insurer reported that its combined ratio fell to 88.4% in the first quarter, down from 91.7% last year, despite double-digit increases in the number of auto policies in force.
Likewise, The Travelers Companies, a proxy for Berkshire's commercial and personal property & casualty insurance business, reported an underlying combined ratio of 92.4% in the first quarter of 2018, a figure which excludes catastrophe losses.
After large losses last year, investors will want to see that Berkshire can raise rates on policies, which, if losses normalize, should lead to higher profits in the years ahead.
4. Moats in manufacturing
The Omaha conglomerate's manufacturing businesses, many of them based in the United States, should be natural beneficiaries of a lower corporate tax rate. As mature, slow-growing businesses, Berkshire's manufacturers are highly profitable, enjoying pre-tax profit margins in excess of 13% last year.
Berkshire's industrial businesses (Precision Castparts, Lubrizol, IMC, and more) generated approximately half of its manufacturing-related revenue last year, but made up more than two-thirds of the manufacturing segments' pre-tax profits. These major manufacturers will likely drive any big swings in profit this quarter, since they produce the highest margins of its manufacturing units.
Companies that comprise its building products segment should continue to benefit from increased domestic construction spending. Berkshire's subsidiaries produce flooring, insulation, roofing, bricks, paints, and more. When a new building goes up, one or more of Berkshire's subsidiaries likely made money from its construction.
5. Power to the people
While profits for most of Berkshire's businesses ebb and flow, Berkshire Hathaway Energy is as consistent as it gets. A sponge for Berkshire's excess cash, BH Energy largely operates power plants in regulated markets, where pricing is controlled by local regulators. These businesses allow Berkshire to deploy billions of dollars and earn a respectable, if unremarkable, return.
In light of rising interest rates and inflation, we'll have to see what Buffett thinks about the nearly guaranteed returns offered by investments in regulated utilities. Serving 8.8 million retail customers in the United States and abroad, BH Energy is already one of the largest utilities in terms of earnings and capacity.
6. Berkshire's war chest
It's my view that the most important business to Berkshire Hathaway is the one it doesn't own -- yet. With $116 billion of cash at the end of 2017, Buffett & Co. have a lot of money, but few places to put it to work.
Buffett wrote in his letter to shareholders this year that business prices have kept him on the merger and acquisition sidelines. He wrote that finding businesses to buy at "a sensible purchase price" was "a barrier to virtually all deals" that Berkshire reviewed in 2017.
If Buffett were able to deploy most or all of its excess cash in acquisitions, it would have a pronounced impact on the company's earnings power. As an example, suppose that Berkshire were to spend $100 billion acquiring businesses at an average price of 20 times earnings. Its annual operating earnings would grow by $5 billion. Last year, Berkshire reported operating earnings of $14.5 billion.
7. Buffett's view of the world
Warren Buffett and Charlie Munger will take the stage to field hours of questions from analysts and individual shareholders at the annual meeting. I expect a few topics may ultimately dominate the discussion:
- Succession. Is the appointment of Greg Abel and Ajit Jain to the company's board of directors indicative that one (or both) will become the next CEO/Co-CEO?
- Brand power. Buffett has long said that he likes businesses that "buy commodities, sell brands," but its consumer staples investments including Coca-Cola and Kraft-Heinz have been market laggards. What do Bufffett and Munger think about the future of branded consumer staples?
- Acquisitions and capital allocation. How much longer will Berkshire sit on record amounts of cash? Would Berkshire consider a large deal, perhaps one to acquire part or all of General Electric, a company often discussed as a potential target for Berkshire?
Berkshire is likely to report a record amount of cash just as discussions about succession become all the more important. Aged 87 and 94, respectively, Warren Buffett and Charlie Munger freely admit to investors that time isn't on their side. Perhaps this will be the year that the two legendary investors give an outline for who, exactly, will run the show after they exit the stage.