10 Questions That Should Be Asked at Berkshire's Annual Meeting

Wide-moat-rated Berkshire Hathaway’s BRK.A/BRK.B annual meeting this weekend will be a significantly smaller affair. Earlier changes to the format on Berkshire’s part, as well as the constraints imposed by the coronavirus pandemic, will result in no shareholders in attendance in Omaha and just CEO Warren Buffett and Greg Abel (vice chairman of the noninsurance business operations) taking questions from the three journalists who have historically run shareholder questions by Buffett and vice chairman Charlie Munger.

The traditional analyst panel has been waylaid, but given all that has taken place this year, we believe hearing answers to the panel’s questions would have been insightful, especially since there is so much unknown about the impact that the COVID-19 pandemic and subsequent economic shutdown will have on many businesses and industries, let alone Berkshire’s own operations. At the very least, we expect that the company’s results will be affected in the near term by historically low interest rates, increased credit and equity market volatility, and a deep recession that could take some time to crawl out of. Following are 10 questions we would like to ask.

Question 1: Is Berkshire's preferred model for acquisitions keeping it from doing deals? In a recent interview with The Wall Street Journal, it was put to Munger that in the current environment "hordes of corporate executives must [surely] be calling Berkshire begging for capital," to which Munger replied, "[n]o, they aren't…[t]he typical reaction is that people are frozen…[some, like the airlines, are] negotiating with the government, but they're not calling Warren…[e]verybody's just frozen…and the phone is not ringing off the hook."

This goes back to a question we asked at least year’s meeting about Berkshire’s model perhaps being too “pull” oriented as opposed to “push.” With so much capital already out there in the hands of private equity and other larger investors in pursuit of the types of larger deals Berkshire would like to do, and the preferred process being to wait until sellers (or their representatives) call up Berkshire or drop by the offices, are there potential deals or investments that Berkshire is missing out on right now because the company is not close enough to (or informed enough about) the markets or companies in need of financial assistance or investment?

Question 2: How much cash and cash equivalents should we consider as being counted toward reserves? Munger also told The Wall Street Journal that he regards this "as a time for caution rather than action" and that Berkshire right now is kind of "like the captain of a ship when the worst typhoon that's ever happened comes…[w]e just want to get through the typhoon, and we'd rather come out of it with a whole lot of liquidity…[w]e're not playing, 'Oh goody, goody, everything's going to hell, let's plunge 100% of the reserves [into buying businesses].' "

Our question here relates to how we should think of cash reserves. While Berkshire’s large equity investment portfolio and bond holdings have generally been far greater than the company’s required insurance loss reserves, Buffett has noted for years that he likes to keep around $20 billion in cash on hand as a backstop for the insurance business. Given that the size of the company’s insurance operations continues to expand, and that we are now seeing an unprecedented event that could require greater levels of liquidity to meet claims that may have been considered low probability in the past, is that an adequate level of dedicated cash reserves for Berkshire, or does that number need to be higher--say $25 billion or $30 billion?

Question 3: Has Berkshire ramped up its share repurchases? When Berkshire changed its share-repurchase program at the end of July 2018, it said the new program would allow Berkshire to repurchase shares when Buffett and Munger believed "the repurchase price was below Berkshire's intrinsic value, conservatively determined." This effectively removed the floor that had existed under Berkshire's shares and created a bit less certainty about where Berkshire might be willing to buy back stock. For example, in the back half of 2018, Berkshire bought back just over $1.3 billion of stock for 1.40 times trailing book value per share and 1.39 times pending book value per share. During 2019, the price paid was somewhat lower, as the more than $5.0 billion of stock that Berkshire repurchased was picked up for 1.36 times trailing book value per share and 1.29 times pending book value per share.

With the shares trading off meaningfully this year, we expect that Berkshire bought back a fair amount of stock during the first quarter and early part of the second quarter. If not, then why not? And if so, then what sort of run rate would Buffett be willing to commit to for share repurchases? Given the amount of cash Berkshire continues to hold, and the current regulatory approval to declare up to $21 billion as ordinary dividends during 2020, we believe that the company could easily buy back $1.5 billion-$2.5 billion of common stock per quarter.

Question 4: Can Berkshire increase its equity stakes in banks following the new Federal Reserve guidance? At the beginning of the year, the Federal Reserve issued a final rule that would update and revise, to some degree, its framework for finding "control" under the Bank Holding Company Act of 1956. As we read it, the new rule clarified the existing rules and interpretations related to control determinations, which were ambiguous and not always transparent, and relaxed some previous presumptions of control. Overall, though, it still seems to be filled with a lot of gray area, requiring ongoing conversations between equity investors like Berkshire and the Fed when it comes to their investment stakes. Looking at some of Berkshire's Form 4 filings since the end of January, when the Fed released its revised rule, it appears that the company has been adding to some of its bank holdings--picking up another 23 million shares of Bank of America BAC, 9 million shares of Bank of New York Mellon BK, 19 million shares of U.S. Bancorp USB, and another 24 million shares of Wells Fargo WFC--with at least Bank of America creeping up above the old 10% threshold that in the past would have forced you to trim your position. We would like some insight into how the new rule will influence Berkshire's ability to invest more heavily in the banks and whether the amount of business that it does with any of these banks would limit the stake that it could hold in that company.

Question 5: How does Berkshire feel about those stakes in the airlines now? Several years ago, we asked a question related to Berkshire's initiation of stakes in the four major U.S. airlines: American Airlines AAL, Delta Air Lines DAL, Southwest Airlines LUV, and United UAL. At that time, we pointed out that the airline industry seems to have few, if any, advantages--that even with the consolidation over the past 15-plus years, the barriers to entry for the airlines are few and the exit barriers are high, and the industry also suffers from low switching costs and intense pricing competition and is heavily exposed to fuel costs, with rising fuel prices being difficult to pass on and declining fuel prices leading to more intense pricing competition. While the industry, in our view, is only ever one giant oil price spike away from having serious problems, we weren't surprised by the speed in which a black swan event like the COVID-19 pandemic brought the airlines to their knees.

With regard to Delta, it was interesting to see Berkshire acquire close to 1 million additional shares at the end of February only to turn around and dispose of 13 million shares (as well as 2.3 million shares of Southwest) at the start of April. We’re not sure if this is just portfolio reallocation, given the increased risk to the industry, or the start of a larger move to eliminate the airline holdings from the stock portfolio completely. That said, what are Berkshire’s options here? In past cycles, Berkshire has not had to compete so heavily with the government and other providers of capital to throw a lifeline to companies, taking high-single-digit coupon-paying preferred stock and warrants to buy common stock in lieu of a capital injection and the Buffett Seal of Approval.

Question 6: How attached is Berkshire to its investment in Occidental/Anadarko? When Berkshire first agreed to invest $10 billion with Occidental Petroleum OXY last year, the trade-off was that Berkshire would receive cumulative perpetual 8% preferred stock, along with warrants to purchase up to 80 million shares of Occidental's common stock at an exercise price of $62.50 per share in return for the capital infusion and the Buffett Seal of Approval. Since then, Berkshire has acquired some 18.9 million shares of Occidental at $40-$50. The company also recently received, in lieu of cash, its first quarterly preferred stock dividend from Occidental in the form of 17.3 million common shares, which was worth more than $250 million--representing a premium over the $200 million cash payout that was due.

Our question here is twofold. First, Berkshire’s preference for preferred stock (which receives preferential tax treatment when held on the books of the insurance business) is well known, but we wonder how the tax treatment for preferred stock dividends works when the dividend is paid in common stock as opposed to cash. Does Berkshire need to immediately sell those shares to retain the preferential tax treatment, or can it continue to accumulate shares as long as Occidental remains in a position where it needs to pay Berkshire in common stock in order to conserve cash? Second, would Berkshire consider accumulating shares in Occidental here, given that the share price is significantly below the exercise price attached to the warrants and it looks more like we are nearer the bottom of the oil price trough than we are closer to more normalized pricing (knowing that if Occidental ends up filing for bankruptcy, all of this common stock would be worthless)?

Question 7: Should Berkshire have been better prepared for the COVID-19 pandemic? Bill Gates has been a friend of Buffett's since the early 1990s, was a director on Berkshire Hathaway's board during 2014-20, and through the Bill & Melinda Gates Foundation continues to receive large annual grants of Berkshire's Class B shares from Buffett's estate. He has also been a very vocal advocate for the prevention of the spread of infectious diseases for much of the past two decades, even giving a TED talk in March 2015 about how the world was ill prepared for the next major outbreak. As we look at a global economy basically at a standstill, as we try to limit the breadth and depth of the COVID-19 pandemic, what insight (if any) did Berkshire take away from Gates over the years that would have had the company better prepared for the current environment (perhaps as simple as keeping the company from underwriting pandemic-related insurance or reinsurance)? Also, a few years ago Buffett had talked about the need for Berkshire's operating subsidiaries to protect their economic moats from a potential "Amazon-ing" of everything. Was the same focus put on the company's preparation for an eventual pandemic, given the warnings that were coming from Gates?

Question 8: What is Berkshire's exposure to pandemic-related claims or underwriting credits? Berkshire has historically used the size and the strength of its balance sheet to take on large amounts of supercatastrophe underwriting, which covers events like terrorism and natural disasters. It also does a fair amount of business disruption and workers' compensation underwriting through its commercial underwriting operations. There has traditionally not been a lot of pandemic-specific insurance products, despite an increase in outbreaks the past decade or so, because the risk is not well understood and therefore difficult for insurers to price. But with policies that do cover companies for business disruption or event cancellation explicitly excluding pandemics for that reason, we've been seeing claims (as well as lawsuits) pop up the last month or so.

With that in mind, what exposure does Berkshire have to pandemic-related insurance claims, not only those policies that the company may have underwritten itself but syndications it may have been involved in? We’ve already seen Geico, much like the rest of the auto insurers, offer a 15% credit to auto and motorcycle insurance customers whose policies renew during the third and fourth quarters. Should we expect similar actions in Berkshire’s commercial auto lines, and how was that level of credit/rebate determined (noting that loss ratios should be meaningfully lower in the near term as far fewer cars are on the road)?

Question 9: What is going on at Geico? During 2016-17, Geico took advantage of a spike in industry claims and expenses (and a pullback in underwriting on the part of its peers) to ramp up its auto insurance underwriting, with written and earned premiums hitting a quarterly run rate of 15%-16% compared with around 10% on average previously. The downside to this action was a spike in the auto insurer's loss ratio into the 80s from the mid- to upper 70s, with Buffett noting at the 2017 annual meeting that first-year business, which comes with both acquisition costs and a higher loss ratio, tends to run almost 10 points higher than renewal business as a way of explaining away the dramatic rise in Geico's loss ratio. We had viewed that all as an opportunity to grab additional share and were willing to accept the spike in expenses if they generated a jump in market share. However, the change in share was not much different than Geico would likely have seen had it stayed the course. While the company did see a recovery in its loss ratio in early 2018 after it took pricing up, Geico's loss ratio deteriorated again in the last three quarters of 2019, even though its peers were not reporting a similar spike in their expenses. At the end of last year, in what seemed a surprise move to us, Todd Combs took over as CEO of Geico, replacing Bill Roberts, who had only been chief executive since June 2018. Is all of this a sign that Geico has lost a step, failing to take additional share when it was being aggressive with its underwriting, and seeing a spike in expenses when its underwriting was seemingly on a tighter leash? And will Combs continue to monitor the nearly $14 billion in investments that he had been managing before taking over at Geico, or will he just focus on the investment portfolio at the auto insurer?

Question 10: Has BNSF put itself behind the eight ball by not adopting precision scheduled railroading? While BNSF has been besting its closest competitor, Union Pacific UNP, on volume and top-line growth for much of the past five years, it has trailed its main peer on profitability, with BNSF's operating ratio being 350-400 basis points higher than Union Pacific's on average (as well as 200-250 basis points higher than the average of the other Class I railroads). With all of BNSF's Class I railroad peers at this point having adopted precision scheduled railroading in one form or another, the expectation is that this outperformance on the profitability line could exceed 750 basis points for Union Pacific (and 600 basis points on average for the other Class I railroads), leading to the potential to get more competitive on price, being willing to give up some margin to drive share gains. For several years, BNSF and Berkshire have noted that the railroad is in wait-and-see mode when it comes to precision scheduled railroading. With the gap in profitability already widening, where is BNSF with precision scheduled railroading, and what are the opportunities and drawbacks that Berkshire sees from the strategy, especially as we face the potential for meaningful business dislocation as a result of the COVID-19 pandemic?

Berkshire's Best Investment Opportunity Could Be Its Own Stock The equity bull market that began more than a decade ago has finally come to an end. While we had anticipated an eventual end to what had been a historic run for the markets sometime in the next three to five years, we did not see it ending with a black swan event like the COVID-19 pandemic, which has all kinds of ramifications for businesses, economies, and the markets.

We’ve always viewed Berkshire’s decentralized business model, broad business diversification, high cash-generation capabilities, and unmatched balance sheet strength as being providers of opportunities that might elude other companies, as well as offering some downside protection during a potential downturn. While results will be affected in the near term by a return to historically low interest rates, increased credit and equity market volatility, and a deep recession that could take some time to crawl out of, we think that the advantages in Berkshire’s diversified business model should allow the company to once again increase book value per share at a high-single- to low-double-digit rate once we get past the fallout from the COVID-19 pandemic.

While Buffett has lamented the dearth of investment opportunities during the past decade, which allowed cash to build up on Berkshire’s balance sheet (approaching $128 billion at the end of 2019), it has been a natural byproduct of the company’s disciplined approach to investing, lack of a dividend, and limited amount of share repurchases over the years. It looks as if investment opportunities have been waylaid in the near term due to an overabundance of caution and increased competition from not only private equity and other players but the federal government, which for the time being is offering better bailout terms to distressed companies. However, Berkshire still has a good investment opportunity in its own common stock, which fits more into our thesis that the company will eventually have to evolve from a reinvestment machine to one that returns much more capital to shareholders.

Berkshire’s shares are currently trading at just under a 20% discount to our fair value estimate, 1.25 times our projected book value per share for the first quarter of 2020, and 1.22 times and 1.15 times our projected book value per share for the end of 2020 and 2021, respectively. These are some of the cheapest levels we’ve seen in a number of years, providing a good entry point for long-term investors.