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Berkshire Better Positioned for Negative Rates

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here with Matt Coffina. He is the editor of our StockInvestor newsletter. We're at the lunch break of the Berkshire Hathaway meeting, and we're going to talk about his thoughts on the first half.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: Let's start with interest rates. This has come up at a few meetings now. What is their view on rates and how is it impacting Berkshire's investment decisions?

Coffina: Sure. So, several of the questioners were curious about how low or negative interest rates are going to affect Berkshire. The biggest impact is really felt in the reinsurance business. So, in general, insurers are collecting premiums before they have to pay claims. That float is a major source of value for Berkshire. But reinsurers, in general, are really struggling to invest that flow at attractive rates of return.

The advantage that Berkshire has is they can really invest in areas outside of fixed-income assets. So, Buffett gave two real reasons for that. One is, they have such a huge capital buffer that they don't need to hold as much high-quality bonds in reserve and then they also have so many other noninsurance sources of income that regulators give them a lot more leeway in terms of how they invest that float. So, Berkshire is certainly affected by low and negative interest rates, but not nearly as much as other reinsurers.

Glaser: You own Union Pacific in your portfolios in StockInvestor. There was a lot of discussion about railroads, particularly if the decline is more secular in nature. Are we seeing kind of a terminal decline, particularly in coal volumes, or more cyclical? What's your view on that? Do you agree with them that this will pass, with the exception of the coal volume declines?

Coffina: Yeah, it's been a really tough time to be a railroad investor. Berkshire obviously owns BNSF. I own Union Pacific in my portfolio. But all the rails are suffering from the same series of problems, which is a sluggish industrial economy in general. Really autos have been the only bright spot in terms of volumes. Even intermodal lately has been turning negative. Then the biggest problem spot being coal. So, this was an unusually warm winter. On top of that a lot of utilities were concerned about service disruptions that occurred a few years prior, especially at BNSF. So they kind of held more coal in reserve and then you get the warm winter on top of that, they just have much more coal on hand than they really need. And so, this has been a really, really difficult year for the rails.

I think that that coal decline, and Buffett agrees, is secular in nature. We're going to see less and less coal use to generate electricity over time as it's displaced by natural gas and renewables, wind power solar, that sort of thing. But there is also going to be cyclical ups and downs within that. So, you probably won't see the kind of 30%, 40% fall-off in coal volume that we saw this year be continued, but we don't really expect much of a recovery either.

Glaser: So, there was another big discussion about Valeant Pharmaceuticals, particularly Sequoia's stake in Valeant, and Buffett had some pretty strong words about their business model and people should have steered clear. When you evaluate a business, how do you think about making sure you're not kind of falling into a trap like that?

Coffina: Buffett maybe feels some responsibility for what's gone on at Sequoia fund. He recommended the fund to his partners 40 or 50 years ago and it was a great recommendation for many, many years. But in the last year or so Sequoia made much too big of an investment in Valeant and of course, Valeant has kind of fallen apart.

Buffett really talk about pattern recognition and the fact that they have seen this story again and again over the years. So they sort of smelled something fishy right away with Valeant, and I think we do need to be concerned about these kinds of situations. There were a lot of red flats at Valeant. For example, they were very reliant on non-GAAP earnings. They really promoted their non-GAAP numbers. If you went off the GAAP earnings, they were earnings very little money or even posting losses in a lot of years. 

Management was very, very ambitious. He actually gave the example of if you have a management team that's very intelligent and very energetic you also want them to have a lot of integrity. If you don't have that last ingredient, you'd actually prefer that they would be dumb and lazy. So, he was basically implying that Michael Pearson at Valeant and the management team there was very energetic and very intelligent, but maybe lacked some integrity, and so it's a business model that was always sort of fishy and has obviously unraveled here. He is glad that he has stayed far away from it.

Glaser: Finally, Buffett defended the price he paid for Precision Castparts by saying that it's a worth more within Berkshire than it would be independently. Do you think it's the case that a lot of businesses really...the cost of being a public company is diminishing from management's focus and their ability to drive earnings?

Coffina: Yeah, Buffett really signaled out the management team at Precision Castparts as being their strongest asset, especially the CEO, and he thinks that one of the main advantages that they are going to get as a part of Berkshire is that the CEO can just focus entirely on the operations, making sure that they are developing the best parts for aircraft engines primarily.

He has spent most of his time on that previously, but he also had a lot of distractions, like having to participate in quarterly earnings calls, having to talk to investors, lenders and that sort of thing. So, as a part of Berkshire he can really focus all of his attention on the business and Berkshire thinks that that's going to be beneficial. 

And we would agree with that. The tough thing about being Berkshire is that you obviously have to pay a pretty significant premium to buy any kind of company outright. The advantage in Precision Castparts case is that the stock price is cyclically depressed. They have been having some cyclical challenges. So, they paid a premium, but the price they paid was not that different than where Precision Castparts had been trading a year or two previously. So, Buffett really needs to wait for those kind of cyclical downturns and find that as an opportunity so that he can pay a premium to acquire the company while still paying a reasonable price overall.

Glaser: Matt, thanks for your thoughts.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.