3 Burning Questions for Buffett
Insurance, railroads, and share buybacks are on Gregg Warren's mind ahead of Berkshire Hathaway's annual meeting.
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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar.com. Berkshire Hathaway is hosting its virtual annual meeting this Saturday, and here with me today is Gregg Warren, Morningstar's analyst who covers Berkshire Hathaway, to talk about some questions that he might like to see answered at this weekend's meeting.
Gregg, thank you for joining me today. Now your first question ties to the COVID-19 pandemic and specifically Berkshire's exposure to pandemic-related claims in its insurance businesses.
Gregg Warren: Yeah. On the claims fund, Berkshire's always been historically poor about delineating where their exposures are, especially on this kind of business that is underwriting policies that cover things like business disruptions or event cancelations. For example, we generally don't know about claims related to, say, super catastrophe or catastrophe losses until they pop up in the company's quarterly or annual results. While we can generally assume a certain level of hurricane, earthquake, and other natural disaster exposure and tend to write in losses midway through our five-year forecast to compensate for venture losses, it's a bit harder with this particular kind of business, that is business disruption, event cancelations, which on the face of it look like the kind of business Berkshire would normally underwrite.
That said, coming into the current crisis, there were few pandemic-related insurance products in the industry overall, mainly because the risk is not well understood and therefore really difficult for insurers to price. Most insurance policies that do cover pandemics, or business interruption due to pandemics, tends to be very, very expensive for this reason. Where coverage for this kind of business disruption or event cancelation caused by a pandemic is offered, it's tends to be offered under very strict conditions and oftentimes gets syndicated out across the industry, so no one participant is left holding the bag if something does go wrong.
If Berkshire does have any exposure here, though, we expect to see it cropping up in the reinsurance business or in the primary group divisions. The reinsurance business provides PNC reinsurance coverage across a broad spectrum of different coverages, and the primary group offers everything from workers' compensation to commercial auto and property coverage. So we could see, if any claims crop up, they're likely to fall somewhere in those two different businesses.
What we have also seen so far within the industry, from what we've seen from companies reporting or from news reports over the past month, is on the auto insurance side, the personal auto insurers are either crediting back or rebating policies or premiums back to customers, anywhere from 15% to 20%, because there are far fewer cars on the road right now and therefore less incidents of accidents, which means your claims are going to be much lower. So the insurers have all figured out if they give back 15%, 20%, they're probably still earning a decent enough profit, but it's basically sort of the right thing to do for the end consumer.
And then we have seen some claims crop up from a few companies like Chubb and Travelers on the business option side of it. The key here going forward is how much of this is actually going to be covered by insurance companies and how much it was going to end up in the courts because insurance companies refuse to cover it because it's not covered in their actual policies.
Dziubinski: Now Gregg, you also have a question about Berkshire's railroad business, specifically about precision scheduled railroading. Tell us about that question.
Warren: Yeah. If we had the chance to bring a question up to Buffett and Munger again this year, we would bring this one back to the table. We did ask it last year, but it just seems like ... we never seem to get a really good full answer from them as to why they've not adopted precision scheduled railroading, which for those that aren't in the know, it's a strategy of constantly monitoring the rail network and imposing really strict coordinated schedules on the rail yards and basically the end customer to help maximize efficiency, drive down costs within the railroad. And it can be very, very powerful. And we've seen some of the railroads that have adopted it see anywhere from 400- to 500-basis-point improvements in their operating ratio. So, it does have a powerful effect on profitability.
BNSF has sort of avoided doing it for a long time because their attitude is "Well, it's not customer friendly, and customers won't be willing to adopt to the railroads' methodology of taking deliveries whenever the railroads insist on as opposed to vice versa." We'll have to see how this pans out. And one of my frustrations last year was them not really getting to the answer, which is, "Well, if everybody else has gotten the end customers to accept this, then it shouldn't be that much of a hurdle" and BNSF should be able to step in there and make the change and the adjustment in how they're running their business.
I noted earlier, in a different conversation we had, about the fact that BNSF right now on a profitability basis, is trailing most of its peers and especially Union Pacific, which is its closest peer in the Western part of the U.S., by 350, 400 basis points on a profitability basis. As soon as we get through this pandemic and, say, Union Pacific widens that spread out profitability to 600, 750 basis points, which is possible with precision railroading. At what point does Union Pacific decide that they'll take some of that excess profit and put it back into pricing and start taking share away from Burlington Northern.
So, it's an issue that we're concerned about, and we'd like some more details from management about how they're really addressing this. But again, it goes to sort of one of the two things we really pointed out when we did a piece back in the fall about Berkshire was--if there's anything that frustrates us from time to time, it's their hesitance and their dragging their feet when it comes to adopting new methodologies, new technologies when the rest of the industries are already on board with it.
Dziubinski: And lastly, you're curious about whether Berkshire bought any stock back last quarter. And if it didn't, why not?
Warren: When Berkshire changed its share purchase program back in July of 2018, there was an expectation that they would be buying back stock a bit more regularly and a bit more aggressively than they had in the past. They really set out a formal plan to buy back shares in September 2011 at prices below 1.1 times book value. They changed it to 1.2 times book value in December of 2012. The problem with that is, during that entire time frame, they really didn't buy back any shares at all, and yet all this cash kept building up on the balance sheet. So when they announced that they were going to make these changes and the repurchase going to be based on a conservative assessment of intrinsic value on Warren Buffett and Charlie Munger's part, there was a hope that there would be a bit more share buyback activity.
In fact, during that first quarter they were buying back shares at like 1.4 times book, which is the lower end of historical trading level. So the hope was that we'd start seeing at least shares bought back more aggressively. But during the fourth quarter of 2018, when the market sold off dramatically, they bought back very, very little stock. And then last year it was sort of hit or miss. We had a couple of quarters where it was a decent amount of stock buy back and a couple where it wasn't. Our expectation has always been that just, exclusive of what's going on with the balance sheet, the company is generating 5 to 10 billion in free cash flow a year. They could easily spend 1.5 billion to 2.5 billion a quarter on share repurchases without really even touching the cash that's on the balance sheet or anything else.
And as a matter of fact, the company gets about 4 to 5 billion a year just from the railroad businesses as a dividend that comes up through the system. So there's no reason why they can't be buying back that much stock. So if we went through another historic sell-off in the market, like we saw in late February to early April, and the company wasn't out there buying stock back aggressively, they're going to get a lot of grief at the annual meeting. And I think there's going to be a lot of frustrated shareholders saying, "Well, what's the point of saving all this cash if you're not doing something with it?" Especially now that it's going to be earning next to nothing again for at least the next two to three years.
Dziubinski: Well, Gregg, we look forward to getting answers to these questions and many others Saturday at the virtual meeting. Thank you for your time today, and we look forward to talking with you after the meeting for your take.
Warren: Thanks for having me.
Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for tuning in.