Warren Buffett's conglomerate Berkshire Hathaway (BRK.A 0.03%) (BRK.B +0.14%) reported third quarter results last Friday, with somewhat surprising news. Berkshire continued to sell down its largest equity holdings Apple (AAPL +2.08%) and Bank of America (NYSE: BAC) in significant fashion.
Berkshire sold another 25% or so of its Apple stock, bringing total year-to-date sales to 600 million shares, or around two-thirds of its stake since the beginning of the year. Additionally, Berkshire sold another several billion dollars worth of Bank of America, which had been the conglomerate's second-largest holding.
Not only that, but Berkshire also didn't repurchase any of its own shares for the first time since mid-2018. All told, Berkshire's cash pile swelled to a whopping $325.2 billion, up from $276.9 billion at the end of June.
While Buffett has always admitted he doesn't know what the market will do in the short-term, these actions certainly point to caution at the very least. While taxes and succession make the list of potential reasons behind these sales, the sales also indicate perhaps another bigger fear.
NYSE: BRK.B
Key Data Points
Inflation and interest rates
Today's sales could be an ominous sign. Back in 1969, Buffett dissolved his partnership that held most publicly traded stocks and returned cash to his partners, as he claimed he didn't see many undervalued securities anymore. Instead, he turned his attention to running Berkshire Hathaway, then a textile mill, as a holding company. That eventually grew into the conglomerate we know today.
Buffett was perhaps prescient, as the 1970s then proved to be one of the worst decades ever in the stock market. Returns were essentially flat for the decade, even as earnings grew, as the price-to-earnings ratio of the market went from about 20 times earnings to just 7 times earnings. Yikes!
The reason for such a terrible decade? Inflation. After the profligate government spending in the 1960s, inflation took off in a big way in the 1970s. The Federal Funds rate ended 1970 around 4%, but then surged to as high as 20% in the early 1980s, after Fed Chairman Paul Volcker took decisive action to bring down inflation, causing quite a bit of economic pain.
Could Buffett be anticipating a similar spike in inflation and long-term interest rates? Here's why the sales of Apple and Bank of America, as well as another stock Berkshire actually recently bought, indicate that could be the reason.
Why higher rates would hurt Apple
Buffett has always looked for stocks that are somewhat resistant to inflation. Pricing power is among the most coveted of attributes Buffett likes to find in his portfolio companies. That's when a company can raise prices to compensate for inflation without losing customers.
Apple's customers love its products, giving the company some pricing power over rivals. That's no doubt why Buffett bought the stock back in 2016. However, iPhones and laptops are high-ticket items as well. Therefore, there may be a limit as to how much more Apple can squeeze from its customers if inflation begins to run hot.
Apple is also a large and mature company now, growing revenue just 6.1% last quarter. Yet it also trades at a high valuation over 36 times earnings. That's a stark contrast from 2016, when it traded around 12 times earnings at its lows
AAPL PE Ratio data by YCharts
Apple's business is probably not in danger, as the iPhone remains central to our lives. But its stock could take a massive hit if interest rates were to spike, and the P/E ratios of stocks were to fall. While Apple may fair better than other tech stocks in that scenario, today's valuation may not leave much margin of safety.
Bank of America is sensitive to rising rates, too
Some may be confused as to why Buffett may be selling Bank of America. After all, its P/E ratio is much lower at 15, which is not particularly high or low for a bank. And in theory, if longer-term interest rates go up, Bank of America could theoretically make more money on higher loan yields and net interest margins.
But there are also a couple reasons that may not be the case. If higher interest rates cause a recession, that would be bad for underwriting results.
Moreover, Bank of America has a potential danger on its balance sheet. During the pandemic when interest rates were low, BofA bought lots of long-term "risk-free" Treasuries and mortgage-backed securities at low rates. However, as interest rates spiked during the post-pandemic period, the value of those securities fell. In the third quarter, Bank of America had $85.7 billion in unrealized losses on these securities.
Since Bank of America says it has no intention of selling those "risk-free" securities before maturity, it can classify them as "held-to-maturity." Therefore, the bank doesn't have to count those unrealized losses against its tangible common equity of $200 billion.
But those losses amount to a significant chunk of Bank of America's current equity. And if long-term interest rates spiked further, those losses would increase. Now, current rules would say that BofA wouldn't be in danger of seeing its equity fall. However, it's likely Buffett doesn't feel totally comfortable with that scenario, especially if interest rates were to spike more significantly.
Image source: The Motley Fool.
Buffett's recent buy could also be a sign
Buffett and/or his lieutenants Todd Combs and Ted Wechsler haven't only been selling stocks. One notable buy this year was Chubb (CB 0.51%), the largest publicly traded property and casualty insurance company.
Chubb has long catered to wealthier clientele with its "Masterpiece" homeowner's insurance product that conveys pricing power in the market.
Insurance companies are interesting in that they are more dependent on the insurance cycle rather than the economic cycle. Moreover, if an insurance company is in a favorable position, it can raise prices along with inflation. Furthermore, insurers' bonds, which account for a lot of their net income, are constantly rolling off and then reinvested. Chubb's bond portfolio duration is only around five years, not 10 or 30 years like certain Treasuries or mortgage-backed securities. So Chubb would theoretically be able to reinvest expiring bonds more quickly into higher-yielding securities than BofA, and generate more investment income quicker.
Don't panic, but be aware
Of course, both Apple and Bank of America still represent larger holdings for Berkshire than Chubb, though Chubb was just bought and the others are in the process of being sold. So it's possible Buffett is merely taking risk off the table on certain outsized positions he deems to be fully valued.
Still, investors have been concerned that some of the policy proposals from both presidential candidates could increase government deficits and inflation. Inflationary concerns would harm many stocks, including Apple and Bank of America, as outlined above.
Therefore, as the new president comes to office and the Federal Reserve seeks to deal with the remaining post-pandemic inflation, investors should be attuned to these risks. After all, Buffett appears to be at least somewhat concerned.
