Warren Buffett is taking a lot of flack lately. Over the past decade, shares of his Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B) have been trashed by the S&P 500. Of course, Buffett has told us that it shouldn't come as a surprise for Berkshire, which has become a massive collection of cash-cow businesses, to underperform the market during bull runs.
Now that we are in a down year, and with the risks of a protracted recession ahead is Berkshire Worth buying? Or would investors be better off to buy JPMorgan Chase (NYSE:JPM), one of Berkshire's biggest stock holdings and the biggest bank in the U.S.? Let's take a closer look and see which comes out ahead.
Berkshire's long losing streak
Berkshire has doubled investor's money over the past decade, but the SPDR S&P 500 ETF Trust (NYSEMKT:SPY) has delivered 244% in total returns over the past 10 years. To put it bluntly, Berkshire Hathaway shareholders have been lapped by the market over the past decade:
Will Buffett prove right that the company is more resilient during market downturns? So far in 2020 that hasn't proven to be the case with the market bouncing back so quickly:
A big part of the reason why Berkshire has underperformed the market this year is that a large portion of the stocks in the Berkshire portfolio have lost substantial value this year and not bounced back:
Bank stocks in particular have weighed heavily on the Berkshire equity portfolio this year. The banks featured on the list above make up more than 30% of the Berkshire portfolio. As the chart shows, they have as a class severely underperformed the S&P 500.
2 things need to happen for Berkshire to win
The bull case for Berkshire is partly underpinned on expectations that the banking sector can emerge from the COVID-19 crisis both unscathed and highly profitable. The good news is I expect that will likely prove the case.
The market recently reacted negatively to news that the Federal Reserve was going to put some restrictions on what big banks could do with excess capital, including halting share buybacks and freezing dividends at current levels, but I think it's a move to keep financial markets liquid, and less any deep concern about the financial strength of the banks.
Second, Berkshire's wholly owned subsidiaries needs to remain the strong cash-cow businesses we have seen, continually pouring more cash on the balance sheet that Buffett and his lieutenants can allocate to drive even more growth.
If these two things happen, Berkshire looks like a winning investment from here:
Berkshire shares look like an excellent value. At less than 1.2 times book value, Berkshire shares are significantly cheaper than the roughly 1.4 times they've usually sold for over the past decade, and they also trade for a nice discount on a cash flows basis.
The case for JPMorgan Chase
If you only measured through the beginning of 2020, JPMorgan Chase had been one of the best-performing stocks in the Berkshire portfolio over the past several years. Over the five years prior, the stock was up 154% in total returns, more than twice the total returns of the S&P 500 over the same period.
Then came 2020:
Between the crash in interest rates, the Fed's latest move to restrict how much capital it can return to shareholders, and the worrying state of the economy, pessimistic investors have sent the mega-bank's stock price down by one-third this year.
And to be blunt, the worst could be yet to come. In the first quarter, JPMorgan joined its megabank peers by taking massive loan loss provisions to set up its balance sheet for the ongoing recession. We won't get our first look at how its financial results have held up during the recession until mid-July when management reports the second quarter.
It's a near-certainty the results will be a big step backwards from last year's second quarter. Lending activity has fallen dramatically, and the sharp decline in interest rates since the beginning of the year are likely to have taken a bite out of net interest margins (the spread between what a bank pays for capital and what it earns on loans).
So long as the economy is under pressure from COVID-19, it's not going to be a great time to be a banker. With cases on the rise, there's good reason to be concerned about the rest of 2020 and perhaps even into 2021.
And that's before we consider the impact of interest rates on JPMorgan's earnings:
The Fed has said they intend to keep interest rates low for an extended period of time, possibly for multiple years, depending on how quickly the economy recovers from the downturn. Simply put, banks like JPMorgan just won't earn as much money with interest rates down this low.
Here's the question investors must ask: Does the current valuation, about 1.2 times book value, offset the potential for much lower profits over the next several years?
I think it depends on how safe the dividend proves to be. With a yield of 3.8% at recent prices, JPMorgan has a lower bar to deliver better returns than Berkshire, which has no payout.
Is Berkshire or JPMorgan the better buy?
Coming into this, my expectation was that it would be JPMorgan, hands down. The upside for banking is clearly there over the long run, and I don't think this is anywhere close to a repeat of the Global Financial Crisis in the short term.
But with that said, if banks like JPMorgan do well, that's good for Berkshire, and likely a good sign that its operating businesses are doing well too. Moreover the low interest rate environment is good for Berkshire subsidiaries like its utilities and railways that use large amounts of long-term debt, so it's reasonable to expect Berkshire's returns could improve while JPMorgan's profits take a hit from lower rates.
Lastly, I still expect Berkshire to bag a big acquisition; there are still plenty of great businesses trading for big discounts to their pre-COVID prices. And while Buffett and co can put some of Berkshire's $137 billion in cash to work, JPMorgan could be handcuffed by the Fed for an extended period of time.