Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) recently released its second-quarter results, and the business is doing quite well. Insurance revenue was up significantly and the company ran a nice underwriting profit. Revenue grew nicely in Berkshire's other segments, as well. However, the company's 12-figure cash problem is still alive and well.
In this episode of Industry Focus: Financials, host Shannon Jones and Fool.com contributor Matt Frankel discuss the important numbers, why Berkshire's cash has built up, and one recent development that could help alleviate the problem.
A full transcript follows the video.
This video was recorded on Aug. 6, 2018.
Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. It's Monday, August 6th. On today's Financials show, we're talking about Warren Buffett's Berkshire Hathaway. We'll discuss their latest quarterly performance, what's up with that massive pile of cash they've been hoarding, and how that's forcing Buffett and company to change their minds when it comes to one particular corporate rule. We'll dive into what that particular change is and ultimately what it means for Berkshire shareholders.
I'm your host, Shannon Jones, and I'm joined in the studio via Skype with financials guru and one of the hardest-working Fools I know, Matt Frankel. Matt, how are you?
Matt Frankel: Good! How's everything over there?
Jones: It's going well! I must say, the heat is taking over here in D.C., but I'll take the heat over the torrential downpours any day.
Frankel: Yes, definitely. South Carolina is hot and rainy.
Jones: Same here. Before we dive into the latest on Berkshire, Matt, let's actually catch our listeners up on what exactly Berkshire does, and more importantly, how in the world is it so awesome at making money?
Frankel: First of all, a lot of people don't think of Berkshire as a financials sector company, but in reality, it's the largest financials sector company. The reason for it is, at its core, Berkshire is an insurance company. Warren Buffett loves the insurance business. He started buying up insurance companies shortly after he took the reins of Berkshire Hathaway -- which, at the time, was a textile manufacturer. It owns insurance subsidiaries. Geico is probably the most well-known one. Gen Re, a reinsurance company, is the biggest of their insurance subsidiaries. That's why we include it in the financials sector -- at its core, it's an insurance business.
It also owns a collection of other subsidiary companies, about five dozen of them, ranging in all kinds of industries, from consumer goods to housing to automotive parts. Just to mention a few of the commonly known ones: Dairy Queen is a Berkshire subsidiary; BNSF Railroad is a subsidiary; NetJets, the private jet leasing company, is a subsidiary; Duracell; Fruit of the Loom; I could go on. Berkshire has this big collection of businesses which all generate cash flow for the company. Because it has all of these businesses, they can use their money wherever they see fit to grow each business as necessary.
In addition to that, Berkshire has a big, big stock portfolio that's very closely followed. Warren Buffett views this as a big competitive advantage, that Berkshire is willing to invest money in companies that it doesn't control. A lot of big insurance companies are not willing to do that. Berkshire's stock portfolio is worth over $200 billion as I'm speaking.
While he has about four dozen companies in his portfolio, there are six that are really the big standouts. There's Apple, American Express, Wells Fargo, Bank of America, and Coca-Cola. Between the five of them are about 70% of the stock portfolio value. Berkshire also has a big stake in Kraft Heinz, more than a quarter of the company. That's accounted for under a slightly different method, so it's not technically included in the stock portfolio, but it's worth about $20 billion. It's a pretty big holding. And, as Shannon mentioned, Berkshire also has a lot of cash that adds value to the company, which we'll get into a little more later.
Jones: Matt, you mentioned, at its core, Berkshire Hathaway is an insurance business. Generally speaking, there are two ways insurers make their money. They write a policy, you pay a premium, and they pay you if you get into an accident. Granted, money is definitely lost on that side of the business, especially when there are a lot of claims. Think about last year's devastating hurricane season, which certainly had an impact on Berkshire Hathaway. We'll talk a little bit about that in a moment. But, they make up that money when it comes to their investments.
Matt, as you went down, Berkshire is most well-known for its investment portfolio. All of those companies, including Apple -- which, by the way, became the first trillion-dollar company by market cap last week. Our own Dylan Lewis did an Industry Focus episode last Friday, August 3rd, on that topic and what it means. I certainly encourage you to check it out. But, really, when it comes to Berkshire Hathaway, all eyes generally tend to be on what's in its portfolio, what's it investing in, and the like.
With that Matt, let's actually dive into Q2. How exactly did they perform? Just to give our listeners perspective, Berkshire always puts up a pretty impressive showing, for the most part. Particularly this time, rebounding in areas that did take quite a bit of a hit over the last year. But, it wasn't exactly an apples-to-apples comparison this quarter vs. the year prior. That was mainly due to an accounting rule change. Matt, what can you tell us about that change and how it impacted earnings this particular quarter?
Frankel: For the quarter, Berkshire earned about $4.87 per share. By the way, I'm talking about the class B shares, since that's what most people listening own. I don't own any A shares, I don't know about you.
Jones: Me neither. [laughs]
Frankel: [laughs] Maybe someday. $4.87 per share is almost triple what it earned the same quarter a year ago. But, the accounting rule change you're referring to is, now Berkshire has to include unrealized profits from its stock portfolio, which, as we mentioned, is pretty massive, in its earnings total. So, if its stocks go up in value, that makes it look like Berkshire earned a lot more than it did. That was the case for the second quarter, even though it hasn't actually made anything unless it decides to sell those stocks. On the other hand, if its stock portfolio has a particularly bad quarter, which has happened in the past, it can look like Berkshire posted a big loss on paper -- that actually happened in the first quarter -- even though it didn't actually lose any money. Berkshire itself tells investors the past couple of quarters that its earnings number is pretty meaningless.
To really get a sense of how it's doing, you need to go a little bit further. I'll run through its main ways of making money. Its insurance revenue, just from collecting premium income, was up 14% year over year. Its railroad, utilities, and energy revenue, which is another one of its big, core businesses -- I mentioned to BNSF Railroad -- was up 11% year over year. Its services and sales revenue, which is pretty much everything else, was up about 6% year over year. So, its business grew very nicely, it just wasn't the nearly tripling that its earnings would make it seem.
Jones: Great point. For shareholders, for investors, for anybody following Berkshire Hathaway, it's important to keep that in mind, especially moving forward when they report out earnings. As you saw this quarter and even last, it can certainly distort the way that the company itself is actually performing.
Really, overall, a stellar quarter across multiple business segments, as you discussed. Particularly in the insurance business, which did see a pretty nice rebound considering the massive losses that it incurred over the past year. But, there's really one figure that stays on the mind of just about every Berkshire shareholder and investor, and that's that $111 billion in cash. That's right, $111 billion in cash on the balance sheet. That's important for many reasons. We'll discuss why on the other side of the break.
Matt, you mentioned Berkshire ending with $111 billion in cash on the balance sheet, a figure that's really continued to grow over the past couple of years, and in an environment where the ability to deploy and put that cash to good use has, for the most part, run rather dry.
Before we get into that, I will say, if I had $111 billion in cash in my bank account, first of all, I wouldn't be complaining, by any means. I can guarantee you, in the Jones household, it would not be a problem. But, when it comes to companies, and it comes to having growing, massive cash hoards, it's not always a good thing. First, tell us why that's not always a good thing for companies. Second, let's talk about how Berkshire prefers to use its cash.
Frankel: Berkshire views its cash as a problem, and for good reason. Warren Buffett likes having about $20 billion in cash on the sidelines at all times to take advantage of opportunities as they come up. This is how he made some of his best investments, during the financial crisis, for example. That still leaves about $90 billion more than Buffett wants to have sitting around. The problem is, this is $90 billion -- which is almost a fifth of Berkshire's entire market cap -- that's sitting around earning virtually nothing. Yes, it's a good problem to have, in that it's better than not having enough cash or having a big amount of debt to worry about. But, it's as if one of your biggest business segments ground to a halt and stopped earning revenue.
Berkshire is trying desperately to find ways to use its cash. Buffett likes to use his cash in a few main ways. First, it should go without saying that he wants to make sure that the needs of the businesses Berkshire already owns are taken care of. Beyond that, he wants to be able to acquire whole companies to add to that list of about 60 subsidiaries that I mentioned. He hasn't been able to do that recently. The big obstacle that he's mentioned is valuation. It's no secret that the stock market has been on a tear over the past decade or so. That's really pushed up valuations in the stock market, as well as in terms of acquisition opportunities. Buffett specifically mentioned that price was the biggest obstacle to getting any deals done. He's found a few that he liked, but they couldn't come to an agreeable price that's attractive by Buffett's standards.
Beyond that, as I mentioned, Buffett likes to invest in individual stocks. They've had some success on that front recently, to be fair. The cash hoard at the end of 2017 was over $116 billion. It's actually gone down a bit. Berkshire added massively to its Apple stake in the first quarter. During the second quarter, we won't find out until next week what stocks Buffett bought, but it looks at first glance like he did some serious buying.
One interesting point to note is, the $111 billion in cash is exactly $2.4 billion more than they had last quarter. After Bayer bought Monsanto, which was a Buffett stock, that's exactly the cash infusion they took in. Aside from that, it looks like Buffett was pretty successful at deploying all of the excess cash generated by its businesses. We'll have to see what Buffett bought and sold, but it looks like they've had some success buying stocks, but not to the point where it's significantly whittling away at their cash hoard.
The other two options that most companies use to return capital to shareholders are dividends and buybacks. Buybacks, we'll get into in a second. Buffett would rather let his cash build up than pay a dividend. He's very anti-dividend. He thinks, if shareholders want income off their shares, if they want a 3% yield, they should simply sell 3% of their shares every year, which would be a better strategy in his mind. There really haven't been too many options. He's been limited in attractive opportunities recently, which is why the cash hoard has ballooned as much as it has.
Jones: To give a little more color in terms of the lack of opportunities and lack of attractive acquisition targets, you have to remember that Berkshire isn't the only player in this space that's looking to acquire. You have your major private equity firms, you have alternative asset managers out there, that also have huge piles of cash, and that honestly are willing to pay quite a hefty premium to acquire some of those companies. These are companies like Blackstone Group, Apollo Management. They're also shopping. This makes the M&A space very competitive. You have tons of money chasing the same types of deals, which makes it hard for Berkshire in the long run to find a true bargain, which we know is ultimately the MOA for Warren Buffett.
Going back to something you said, one of the questions is, why not dividends? Why not return capital to shareholders via dividends? You covered all the highlights. If you think about it, too, first of all, Buffett loves, himself, receiving dividends. He doesn't want to pay it out. Really, Buffett thinks he can make more money for shareholders by investing their money than they can make for themselves. Honestly, it's hard to argue against that when you're looking at annualized returns of 20% since 1965. That's double what the S&P returned over that same timeframe. It's hard to argue against that.
I believe, too, Matt, back in 2014, there was actually a shareholder proposal that came up. A shareholder said, "Why don't you pay dividends?" It was interesting, I believe the vote came back 98% against Berkshire Hathaway paying out dividends. Really, what that said and speaks to is the fact that, Warren Buffett, we trust you, please reinvest these earnings for us on our behalf, we know you can continue to grow this. Dividends, like you mentioned, really out of the question.
Which brings us to the point of buybacks. When it comes to deploying cash, you have, first of all, a lack of attractive targets, you have this growing stockpile cash. Berkshire just announced it's changing its policy when it comes to buying back its own shares. Let's talk about what exactly is changing when it comes to that policy, and what that actually means for investors.
Frankel: Berkshire has always had a buyback policy where they're allowed to buy back shares. The problem is, Buffett wasn't allowed to buy back any shares unless they were trading for 120% of book value or less. The problem is, that hasn't happened in several years. The board thought that the 120% level was significantly below intrinsic value. Buffett agreed. He was very eager to buy back shares if it ever got to that point. But, with how well the stock market has been doing, it really hasn't. That took the buyback option out of Buffett's toolbox.
Now, what they just did is, the board approved an amendment. They scrapped that 120% of book value limit. For context, the stock is currently around 140% of book value, so, not a ton above, but still too high to buy back under the old arrangement. Now, they're allowed to buy back shares any time that Warren Buffett and vice-chairman Charlie Munger agree that the shares are, indeed, below their intrinsic value. There's no limit to how many shares they can acquire, there's no time limit. This is in effect until the board changes it again.
It's interesting to note that today is the first day they're allowed to buy back shares under that new arrangement. One of the conditions was, they had to wait until their second quarter earnings were released, which happened on Saturday, and today is Monday. So, they could actually be buying back shares as we speak.
Jones: Matt, the inevitable question is, do you see Warren Buffett, Berkshire Hathaway, buying back shares any time soon?
Frankel: Yes, and I'll tell you why. Berkshire's total market cap as I wrote this, I ran some of the numbers, is about $514 billion. Of that, about $206 billion of it is his stock portfolio. Another $111 billion of it, as we mentioned, is cash. That means the market is valuing all of Berkshire's other businesses, all 60 or so of them -- Geico, Duracell, the railroad, etc. -- at less than $200 billion. I believe that's less than their intrinsic value.
Whether Buffett and Munger believe that remains to be seen. As you mentioned, Buffett wants a deal. Whenever he's buying anything, whether it's an entire company, a stock, or shares of Berkshire, he wants a deal.
Do I think it's a compelling value? Yes. I'm a Berkshire shareholder. I think the shares are attractively priced at the current level. But will Buffett? That remains to be seen. Not only could they be buying back shares right now, but they could end up giving us some insight as to how much Buffett and Munger think Berkshire shares are actually worth -- in other words, how high will they get before they start buying them back? So, this will be a very interesting development over the next few quarters.
Jones: Yes. Much to keep an eye out on looking ahead. Certainly, we'll be sure to let you know when and if that happens. All in all, Berkshire Hathaway this quarter, continuing to fire on all cylinders, and really making smart and necessary strategic changes that should continue to reward shareholders in the long-term.
That's it for this week's Financials show. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so, don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Shannon Jones. Thanks for listening and Fool on!