Buffett Is Managing Your Expectations Of Berkshire Hathaway Stock (NYSE:BRK.A)

The Annual Letter – Better Quality, Tougher Message

I cover Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) quarterly here on Seeking Alpha. Since my Buy rating in last quarter’s article, the stock is up about 20%, beating the S&P 500 index fund (SPY). Most of that return came in just the past 5 weeks.

The shares are now trading over 60% above book value, and my regular sum-of-the-parts analysis indicates the stock has reached fair value, as I will show below. Don’t just take my word for it, though. Also pay attention to Berkshire’s slowing buyback activity and Warren Buffett’s own words in the annual letter.

This year’s letter is a massive improvement from last year’s, which caused me to express my disappointment in the most-read article of my nearly 5 years on Seeking Alpha. This year, Buffett prefaced the letter with a fitting tribute to the late Charlie Munger, who Warren described as the “architect” of Berkshire Hathaway. Warren credits Charlie for shifting his focus to buying wonderful businesses at fair prices instead of the Ben Graham method of buying fair businesses at bargain prices. Warren displays unusual humility for a billionaire in considering himself the “construction crew” of the building that is Berkshire while Charlie was the designer.

As for the letter itself, Warren again reminds us that he writes as if explaining the business to his sister, Bertie. I can only guess Bertie must have given him some feedback on last year’s letter, because this one is much more like the letters of old, with more emphasis on the details of Berkshire’s businesses. But first, Warren does the necessary job of managing investor expectations. As we have heard before but bears repeating, Berkshire’s size is now so large that it is unlikely to generate outperformance through M&A activity. As Warren writes,

There remain only a handful of companies in this country capable of truly moving the needle at Berkshire, and they have been endlessly picked over by us and by others. Some we can value; some we can’t. And, if we can, they have to be attractively priced. Outside the U.S., there are essentially no candidates that are meaningful options for capital deployment at Berkshire. All in all, we have no possibility of eye-popping performance.

Also worth restating is the key philosophy of Berkshire, “Never risk permanent loss of capital.” This means maintaining a rock-solid balance sheet and having the cash on hand for either a large insurance disaster or a freeze-up in the financial system such as occurred in 2008.

With this size and financial conservatism, Berkshire will provide relative safety, but not massive outperformance. Warren again manages our expectations when he writes,

With that focus, and with our present mix of businesses, Berkshire should do a bit better than the average American corporation and, more important, should also operate with materially less risk of permanent loss of capital. Anything beyond “slightly better,” though, is wishful thinking. This modest aspiration wasn’t the case when Bertie went all-in on Berkshire – but it is now.

The letter then features two non-controlled investments that Berkshire increased its stake in during 2023, Occidental Petroleum (OXY), and the five Japanese trading companies (OTCPK:MITSY) (OTCPK:MITSF) (OTCPK:ITOCY)(OTCPK:ITOCF) (OTCPK:SSUMY) (OTCPK:SSUMF) (OTCPK:MARUY) (OTCPK:MARUF) (OTCPK:MSBHF). The meat of the letter though, is a discussion of two of Berkshire’s largest owned businesses, BNSF Railroad and Berkshire Hathaway Energy. Both businesses underperformed in 2023 and Buffett gives us an honest assessment of both.

I will get more into the details in my business-by-business discussion, but overall I am pleased with the return of the more comprehensive and detailed letter this year. The careful stewardship of capital and willingness to recognize and confront issues makes Berkshire worth keeping as a long-term investment. However, the run-up in share price to my fair value estimate and the high P/B of 1.6 makes the stock a Hold rather than a Buy at this time.

Insurance

Insurance finished the year as the star of the group. This is due in part to the lack of large catastrophic loss events such as hurricanes in 2023. This is in contrast to 2022 with Hurricane Ian and 2021 with Ida. At Geico, underwriting performance has improved greatly this year, rebounding to a combined ratio of 90.7 compared to a loss in 2022. Geico’s premiums earned increased $280 million even though policy count fell by almost 10%. Rates went up, but the bigger improvement came in loss expenses, which were down $4.5 billion. Frequency of claims was lower even though claim severity continued to increase because of inflation. Geico also saved on advertising costs by not trying to push policy count.

Berkshire’s other primary insurance businesses enjoyed nearly $1 billion higher underwriting profit in 2023 as well. The companies benefitted from the lack of significant catastrophes but also gained customers from the 4Q 2022 acquisition of Alleghany. The reinsurance businesses had a similar story, but underwriting profit for the year did not increase as much because the retroactive reinsurance business increased their estimate of ultimate liabilities from higher asbestos, environmental and other casualty claims.

As big as Geico’s underwriting improvement was, investment interest income provided a similar boost to 2023 earnings. Thanks to the increase in interest rates on Berkshire’s massive cash pile, interest income was $6.1 billion in 2023, up from $1.7 billion in 2022 (pre-tax).

BNSF

Buffett spent a page and a half of the letter discussing issues with BNSF. The first one is a fact that has been recognized in the past: it is a capital-intensive business. This does not necessarily make it a bad investment, as it was purchased in 2010 at an attractive price of $26.5 billion. Since then, Berkshire has spent $22 billion above depreciation on capital improvements. Nevertheless, the asset value of BNSF on the balance sheet is about $70 billion, but Buffett estimates the replacement value of the railroad at about $500 billion.

Buffett also recognized the difficulty of railroad jobs and the resulting shortage of labor and high wage inflation. While this is common to the industry, it has impacted BNSF more, as written in the letter:

Though BNSF carries more freight and spends more on capital expenditures than any of the five other major North American railroads, its profit margins have slipped relative to all five since our purchase. I believe that our vast service territory is second to none and that therefore our margin comparisons can and should improve.

What’s missing is a discussion of how margins will improve, which I hope will happen when Greg Abel is on stage for the annual meeting.

Berkshire Hathaway Energy

Until recently, I have been describing BHE as the standout performer of the group, but the PacifiCorp subsidiary is now facing lawsuits over fires in Oregon and Northern California. The company has accrued $1.6 billion pre-tax in 2023 for these issues, but the ultimate costs may be significantly higher. I am not a lawyer and can’t predict the ultimate damages, so I will just refer the reader to Note 27 of the 10-K which discusses the cases in more detail.

In the annual letter, Buffett laments the regulatory environment that resulted in big problems for PG&E (PCG) and Hawaiian Electric (HE). Buffett called not recognizing this regulatory risk a “costly mistake”, but he is confident that Berkshire can withstand any negative surprises. Still, this episode seems to have put a damper on Berkshire’s desire to do more utility investments in the western states.

If that wasn’t enough, the real estate business (which is part of BHE) is being sued along with other realtors in an antitrust case for artificially inflating real estate commissions. No costs for this have been accrued yet, but that is only because they can’t be reasonably estimated at this time. Again, I recommend reading Note 27 of the 10-K for details.

Aside from the accrual for the PacifiCorp legal issues, most of the other utilities performed in line with 2022. The exceptions are Northern Powergrid in the UK, which many probably did not realize also engages in gas exploration and production. The unit wrote off some exploration costs, had lower production volumes and prices, and was subject to a new energy profits tax in the UK. The real estate business also barely broke even due to slower activity in the housing and mortgage refinancing market. These two units reduced BHE’s income by $300 – $400 million compared to 2022.

Pilot Travel Centers

Berkshire bought the second tranche of Pilot in 2023, paying $8.2 billion for 41.4% of the company and taking ownership up to 80%. Berkshire bought the final 20% of Pilot in January 2024, paying $2.6 billion. This came after a legal dispute between Berkshire and the Haslam family, the former owners, over the accounting methods used to determine the earnings of the company on which the purchase price would be based. We can see that things came out favorably for Berkshire, as the price of the overall company declined from $19.8 billion (8.2/0.414) for the second tranche to $13 billion (2.6/0.2) for the final 20%.

On a fully-owned basis, Pilot earned about $1 billion pre-tax in 2023, so it will be a nice addition to Berkshire going forward without the headaches of the former business partner.

Manufacturing

Manufacturing earnings improved about 2.4% from 2022. In the Industrial group, Precision Castparts, the subject of an impairment charge in 2020, has recovered thanks to a strong aerospace market. Lubrizol is finally improving. Volumes are still down a bit but margins have improved, resulting in stable performance vs. 2022. Marmon and IMC both benefitted from acquisitions and organic growth.

Building products continued to struggle with a slowdown in the housing market. Consumer products had slightly higher earnings due to acquisitions and better margins, offsetting bigger declines at RV maker Forest River and the clothing and shoe businesses.

Service And Retail

Service and Retail had similar earnings growth as Manufacturing, up 2.6% in 2023. Within Services, the aviation businesses (NetJets and Flight Safety) had a good year while electrical component seller TTI was a drag. The Retail business was flat in 2023. Food distributor McLane had a nice jump in earnings, up 68% from $271 million to $455 million on better gross margins and lower fuel costs.

Investment Portfolio

Buffett no longer lists Berkshire’s top 15 stock holdings in the annual letter, but that does not bother me so much, as investors should focus more on the operating businesses that now make up so much of the company. We can still see the top 5 holdings in the 10-K, and those make up 79% of the portfolio. Berkshire made a small purchase of Apple (AAPL) early in the year and a small sale in 4Q, leaving the position down only 1% by share count. Berkshire made a bigger sale of Chevron (CVX) earlier in the year, but bought some of that back in 4Q, still ending with a position that is down about 25% by share count.

Note that OXY shares are not included in the equity portfolio on the 10-K. OXY is listed separately as an equity method investment due to its large stake. Berkshire increased its stake in OXY in 2023 and Buffett made a strong defense of a robust domestic oil and gas business for national security in the annual letter.

Berkshire has been requesting confidential treatment in the 13F filings for one or more positions. This happens occasionally when the company is still building a position and believes disclosure would cause the market to run up the share price. We don’t know the identity of the secret stock, but we can see on the 10-K (Note 4) that the cost basis of stock in the “Banks, insurance, and finance” category increased $1.2 billion in 3Q and $2.4 billion in 4Q.

Overall, however, we can see that Berkshire was a net seller of stocks in 2023 as it was in 2022. Looking at the cash flow from stock purchases and sales on the cash flow statement, Berkshire spent $16.5 billion on stock purchases but sold $40.6 billion worth in 2023, for a net sale of $24.1 billion. That is about $10 billion less than the net stock sales in 2022. Some people like to read into this that Buffett has some general negative macro call on the economy and stock market. I doubt that, and rather believe that he evaluates companies individually and trimmed some of the more expensive ones at a time when cash investments are yielding 5.25%.

Capital Management

Berkshire continued to grow insurance float at a slow steady pace, adding $5 billion this year, reaching $169 billion. Berkshire’s cash and T-Bill position is now $163.3 billion, up $38.3 billion this year. I believe Berkshire’s conservative capital management philosophy now leads Buffet to balance cash and float roughly equally despite his earlier comments that the float funds other investments. It’s true that the cash is there if an opportunity comes up, allowing Berkshire to move quickly without arranging other financing. As Buffett warned us in the letter, though, it is highly unlikely that anything will come along big enough to consume a significant chunk of the cash pile.

Share buybacks were $9.2 billion for the year, about 1.4% of Berkshire’s starting market cap, a similar percentage to 2022. Buybacks slowed in December, compared to earlier in 4Q, and were limited to A shares. Since the start of the year, Berkshire has bought back 995 A share equivalents. It is possible this was done in early January when the price was still around $550,000 or $366.67 per B share. The slowdown in buybacks suggests to me that Berkshire shares could be nearing their intrinsic value as conservatively determined by Warren Buffett.

Free cash flow improved considerably in 2023 at $29.8 billion compared to $21.9 billion in 2022. Working capital like receivables, payables, and inventories consumed much less cash as inflation and supply chain constraints both became less severe in 2023. Capex was up a significant $4 billion in 2023, however, to $19.4 billion from $15.4 billion in 2022. This bears watching, but I am not worried as long as cash from operations is increasing significantly more as it did last year.

Berkshire Stock Valuation

My regular sum-of-the-parts valuation model is presented below.

I now value Berkshire at $419.17 per B share, only 0.5% above market price. This has narrowed considerably given the run up in share price this past month. The insurance business is valued slightly lower despite having the same underwriting plus interest income because the peer multiple has declined. BHE earnings came in slightly lower than the full year estimate I made last quarter, but utility peer multiples have declined as well. Despite the problems at BNSF, the railroad had a better 4Q relative to the first 9 months. Peer multiples for railroads have also increased, valuing BNSF higher. Manufacturing, Service, and Retail earnings came in about even with my last forecast, but Manufacturing peer multiples increased, valuing the business higher. All together, I value the fully owned businesses at $529.2 billion, down less than 1% from last quarter.

The stock investments plus the equity accounted businesses (mainly OXY and Kraft Heinz) increased in mark-to-market value by 10.6% and are now worth $376.5 billion. Summing it all up, the fair value for Berkshire is $905.7 billion. This is just $4.1 billion above the market cap at the close on the day before the earnings release, meaning Berkshire is now fairly valued by the market.

Berkshire’s price/book ratio has also entered pricey territory at 1.61, up from 1.45 last quarter.

Conclusion

Warren Buffett was back to his old form in this year’s Berkshire Hathaway annual letter. It is clear that he wants to manage investor expectations about future performance, reminding us that Berkshire’s size and conservative capital management make any game-changing moves unlikely. He was also honest about issues with BNSF and Berkshire Hathaway Energy. The legal issues at BHE that I first noted last quarter are slowly working their way through the courts, and a negative surprise in the billions of dollars is still a possibility. The balance sheet is strong enough to handle any negative judgments, but at some point, the stock could react negatively, creating a better buying opportunity than we have currently. The run-up in share price in the last few weeks has put it around my estimate of fair value, confirmed by the P/B of 1.61 and the slowdown in buybacks. Berkshire is a great, safe investment for the long-term, but is now a Hold due to valuation.