Questions We'd Like Answered at Berkshire Hathaway's Meeting

Susan Dziubinski: I'm Susan Dziubinski with Morningstar. Berkshire Hathaway is holding its virtual annual shareholders meeting on Saturday. Joining me today is Morningstar's Gregg Warren. He covers Berkshire Hathaway for us, and he wants to talk a little bit about some questions he'd like to see answered this weekend. Thanks a lot for joining us today, Gregg.

Warren: Thanks for having me, Susan.

Dziubinski: What would be some of the key questions you would have for Warren Buffett and Charlie Munger regarding the impact of the COVID-19 pandemic on Berkshire Hathaway?

Warren: I think if we look back, last year's meeting was a bit unsettling for a lot of investors and shareholders, because there was the shock of the pandemic and the uncertainty created. I don't think Warren did himself any favors, because he really didn't have a lot of straight answers for what the potential impact was going to be. So, we've had a chance to go through, we've seen some of the reserves they've put aside for potential insurance losses, and I think we've also started to see some of the impacts on the businesses. So we've got a clearer picture going into this meeting.

And I think probably one of the first things I'd ask is on the insurance side. We'd like to see something like this, an event like this, leading to some hardening of pricing. So, the question is, "Have we seen pricing improved for insurance, reinsurance post-COVID?" And if that's happening, that's good news for the industry and potentially good news for Berkshire, because there could be policies that they'd be willing to underwrite now that they may have passed on in the past. We'd also like to hear any sort of updates Buffett might have about litigation potential. Most of the insurers have so far been able to avoid paying claims for the pandemic, because most policies don't cover it. And the argument on most consumers parts is, "Hey, I have a business, it was disrupted. The government forced me to shut me down. So you should cover that." Some of that's in the courts right now. It hasn't really gotten much traction, but I'm just curious to see what he has to say on that regard.

And then we think about the noninsurance business. We'd like to know if the cost controls that were put in place in manufacturer, service retailing, some of the other economically sensitive businesses, like the railroads, whether or not those policies are going to help improve profitability as you move forward. Are those sustainable? Cutting down on staff or cutting down hours or whatever, how sustainable is that going to be for them? Or are we likely to see a return to more normalized profitability as we move forward?

And then we'd be curious to see about whether or not there were any capital allocation plans within the organization that may have been put on hold last year. There was a lot more uncertainty. It certainly wasn't until the back half of the year that Berkshire themselves started putting the money toward investments and some acquisitions. I'd be curious to see if there was any stuff that was put on hold and whether or not we're going to see an acceleration to capital spending the next several years, which would be good as long as it's in good return-providing projects.

Dziubinski: Now there's been some tax talk that's been coming out of Washington the past week or so. Would you have any questions for Berkshire about that?

Warren: The corporate tax issue, which is basically the idea that the corporate tax rates are going to go up in the near term with this potential infrastructure bill that's working its way through Congress. We've been talking about that internally for about nine months or so. The expectation being that the Biden administration would lead to an increase in the statutory rate, which if you recall in 2017 was reduced from 35% to 21%. So, a lot of the conversation the past six to nine months has been, "Well, where does it go? Is it 25%? Is it 28%?" I know back during the Obama administration, they were talking about reducing the corporate tax rate. The target then was 28%. So we'll have to see where this settles out. We, internally, have been projecting a mid-20s rate anyways in a lot of our evaluations coming up until now, and it sounds like we're going to get that way across the board as we move forward. We'll have to see how it pans out with the bill that's in Congress and how they narrow that down.

For a lot of companies, it seems like it's probably going to be a 3% to 5% reduction and maybe fair values overall. Berkshire is a little bit unique, though. They have the combination of the hit on the corporate tax line but also what it does to deferred tax liabilities. They have a very, very large investment portfolio. They also have some deferred tax liabilities associated with the energy business. When we saw the cut in 2017, it almost ended up being somewhat of a wash. Because they got a huge benefit coming back from the taxes going down, but then it also diminished the value of those deferred tax liabilities. From that perspective, we would expect that this would probably have a negligible impact on Berkshire with the tax rates going up. We'll have to see what it works out to be once we get it through the system. But overall, we wouldn't expect as much as we'd see with some of the other companies we cover.

Dziubinski: And what about Berkshire and cash? It still has a lot of cash on the books, of course. What questions would you have about that topic?

Warren: The big question for Buffett is does he feel right about the fact that in 2017, he sat there and said, "I can't sit here three years from now with $150 billion in cash on the books and tell our shareholders I'm doing it right by them." I mean, it almost seems like it's pigeonholed him, because they've gotten close to that balance level, I'd say probably half of the past eight quarters at different periods. And there's not a whole lot of investment opportunities. There's not been a whole lot of acquisition opportunities. So, really, their only option has been share purchases. And ideally, you'd like to see a company buying back stock at a discount to intrinsic or fair value. And it's not always going to be a guarantee that's going to be the case.

If the company is generating $5 billion, $10 billion a quarter in free cash flow, if we move out over the next two, three, four years, and the first part of the equation doesn't change, as in they have no real outlets for investments or acquisitions and they're buying back stock, at what point does the stock become too pricey to buy back effectively? I think that's one of the big issues with the cash balances. The tax changes will help that a little bit, because it would slow down the free cash flow a bit, not a whole lot, but it'll help slow down that acceleration of free cash flow over the next four or five years.

But I think the key here is, does Buffett at some point down the road have to consider a dividend? Because if you're no longer getting value with the capital, how do you get it off the books overall? I guess the argument could be made that it's better to buy back the stock at a premium than it is to give cash away for nothing. But at the same time, it's shareholder returns we got to be thinking about. So the shareholders, if they get the dividend, they're probably likely better off than they are pre-buying back the stock at a premium.

Dziubinski: And then lastly, Gregg, there's always questions when it comes to Berkshire about succession, right?

Warren: It'll be interesting. It's been quite a while since there's been a serious discussion about succession at the meetings. I'd be curious with Greg Abel, from the noninsurance businesses, and Ajit Jain, from the insurance businesses. With them now up on the panel, taking questions with Warren and Charlie, I think there is a lot more curiosity about who the real candidate is. My personal feeling is it's probably Greg Abel. He's a younger guy. He's had a lot of acquisition-related experiences in a lot of different areas. He's done vulture investing. He's done buying a public company, buying a private company. There's a lot of different things that he's been able to do.

Ajit is fantastic. He's a brilliant guy. And Warren's always said that he's kept him from doing more dumb things on the insurance side than not over the years. But Ajit is not really the capital allocation kind of guy along those lines. And quite honestly, Ajit is not interested in being the guy that follows Warren Buffett in the CEO role. I think Greg is probably a good fit for the firm.

But I'd be curious to ask them. If we had a chance and they would answer it honestly, I think I'd really like to see if they'd talk a little bit more deeply about the bench, who they have further down. We've seen quite a few changes over the last several years within the management ranks. Not only Todd Combs going over running Geico now, but there's a new CEO in place at Burlington Northern, people keep advancing within the energy business, there's always some changes going out with MSR. I'd be curious to see really who they feel the next slew of good solid candidates that could run things at corporate might be as we move down the road.

Dziubinski: Well, Gregg, we'll see on Saturday which of these questions get answered. We appreciate your time and your insights today. Thanks for joining us.

Warren: Thanks for having me, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.