The headlines say it all: Berkshire Hathaway's
The headlines are garbage. Berkshire's second-quarter performance was unbelievable. Not bad, not even good. Amazing.
You have to figure that Warren Buffett watches what passes as investment wisdom from the media and just chuckles. There are certain characteristics about insurance companies that do make analysis of their short-term results very, very hard. But the tendency remains among many to anticipate each quarterly report and then breathlessly declare companies successes or failures thereupon. As we've said many times, it's just not that easy. And if you don't make the simple adjustments that Mr. Buffett himself has instructed you to make, it's impossible to get it right.
This is the nature of the beast -- Berkshire Hathaway is horribly complicated. People who own it simply because Warren Buffett is in charge of the company are operating on blind -- albeit rational -- faith. Berkshire defies simple analysis. Berkshire even defies most complex analyses. But when articles begin with the fact that its earnings dropped 42% without so much as asking why, then you're pretty well assured to get a poor picture of what goes on in Omaha.
Things are great. Really.
Though he doesn't tell you what he thinks the company is worth, Warren Buffett certainly provides a road map to investors on how he evaluated Berkshire Hathaway and famously notes that every item that he uses is available in the annual report. But more specifically, Buffett notes that he measures the condition of Berkshire's operations by the measure of pretax earnings per share, excluding all income from investments. Wouldn't you know it: In the most recent quarter, Berkshire delivered pretax earnings ex-investments of $1.54 billion, which represents a 31% increase over last year's quarter of $1.17 billion. This isn't a normalized number -- Berkshire has added a few new subsidiaries, most notably Clayton Homes and former Wal-Mart
Last year, on the strength of Buffett's investments in junk bonds, Berkshire rang up investment gains of $905 million for the quarter. This year the company's investments registered a $112 million loss on investments. That's a billion-dollar swing that impacts reported results, but it doesn't affect the result that ought to matter the most: those ongoing operating results. Berkshire knocked the cover off of the ball, but it's hidden because of a few things, most notably the fact that investment results have for the moment turned south. Go figure -- Buffett's been shrilly noting the poor investing environment for the past year. But he's made something else just as clear -- with the exception of the tax impact, the timing of any and all capital gains events should be meaningless for evaluating this company (or most any other, for that matter).
And it must be noted that Buffett isn't saying this now, and he's not saying it just because this quarter happens to have a negative number in the investment account. In fact, he said it when the company had a nearly $1 billion gain to report. The market's not very good now, so Berkshire waits, cash in hand. So if its investment gains and losses don't define the beast, what does?
What Berkshire is, and how it works
First and foremost, one must recognize that this is an insurance company at its core. Insurance goes through fairly long and wild cycles in pricing. Insurance companies, particularly public ones, have a difficult choice in markets where competitive pricing means that the odds are that companies will eventually lose money on policies being written. Do the companies risk the quotational risk of having to explain to investors that their revenues dropped in the quarter, or do they adopt the policy of allowing their underwriters the judgment of not writing policies when pricing isn't in their favor? Many elect for the latter, and they compensate their underwriters based upon levels of production. Berkshire, on the other hand, lets its underwriters know that their jobs will not be at risk in periods when the market is soft -- it gives them all the justification they need to not write insurance when it would be a net negative for their company to do so in the long run.
So when Berkshire's report notes that its float (the money that it receives in insurance premiums that it has yet to pay out in claims) has dropped, that could mean many things, but what it most likely means in this case is that the markets for writing the various lines of insurance that Berkshire's subsidiaries carry have degraded. The market has just gone through one of the "hardest" pricing environments in its history -- a huge amount of good business could be written at great prices for the insurers. Berkshire wrote a ton of it -- its float increased by more than 55% in the three years that ended in December 2003. But the market has turned, and since the greatest sin at Berkshire is to write uneconomic policies, the shrinkage in float shows an institutional contentedness not to chase bad business.
In fact, in the quarterly report, though Berkshire claimed that the insurance business was running extremely well, they also noted that their business has been helped again by the lack of supercatastrophe in 2003 and 2004. This won't last -- there will always unfortunately be another disaster that will require that insurers break out their checkbooks. What exists in the interim is a situation that doesn't exactly offer unending opportunity to disciplined underwriters or investors: The insurance market is weakening, and there are scant few investments of a scale and at a discount that would attract some of Berkshire's billions. And so they wait.
Meanwhile, in the mud pits...
Another thing that was hidden in the headlines spouting about losses is much mention of the performance of Berkshire's various construction businesses, which are simply booming. In the last several years, Buffett has been the next best thing to apologetic for the boring companies that Berkshire has purchased: a paint company, a brick company, carpets, insulation, and so on. That sound you hear is money simply pouring out of these businesses. That sound you don't hear is any of the media outlets commenting on the rapid rise in earnings from these segments. No, we're too transfixed upon the absolute bottom line. That's a pity.
What may be most ironic is the fact that Warren Buffett is often closely identified with his investing prowess, Berkshire Hathaway is often (wrongly) called a mutual fund. Buffett is, of course, a phenomenal investor, but what he's done at Berkshire is create a business empire that spins off capital, and does so without regard to making things look one way or another on a quarterly basis.
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