My 6 observations on Berkshire’s 2015 annual report
One general remark upfront: The 2015 annual report wasn’t that exciting in my opinion. Actually, I didn’t plan to write a post on it. However, after reading a couple of posts on the topic, I though maybe some readers are interested because I haven’t seen those points mentioned very often elsewhere.
- Bad year for GEICO
GEICO had a pretty bad year in 2015. The loss ratio (in percent of premium) increased to 82,1% (from 77,7%), the Combined ratio increased to 98% and the underwriting profit fell by -60%. Buffett talks about the cost advantage a lot in the letter, but the only explanation forthe increase in loss ratios are found in the actual report:
In 2015, pre-tax underwriting gains were $460 million compared to $1.16 billion in 2014 and $1.13 billion in 2013.Throughout 2015, we experienced increases in claims frequencies and severities across all of our major coverages. Our lossratio, which is the ratio of losses and loss adjustment expenses incurred to premiums earned, in 2015 was 82.1% compared to 77.7% in 2014. As a result, we continue to implement premium rate increases where necessary.Losses and loss adjustment expenses incurred in 2015 increased $2.7 billion (17.1%) over 2014. Claims frequencies (claimcounts per exposure unit) in 2015 increased in all major coverages over 2014, including property damage and collisioncoverages (three to five percent range), bodily injury coverage (four to six percent range) and personal injury protection (PIP)coverage (one to two percent range). Average claims severities were also higher in 2015 for property damage and collisioncoverages (four to five percent range), bodily injury coverage (six to seven percent range) and PIP coverage (two to four percentrange). We believe that increases in miles driven, repair costs (parts and labor) and medical costs, as well as weather conditions contributed to the increases in frequencies and severities.
So they claim that overall “macro conditions” were responsible for this significant detoriation. There is however an easy way to verify this. One just needs to look at the annual report of Progressive, the other big US Auto insurer. This is their 2015 recap:
Although the Personal lines segment of Progressive includes other products as well, we can clearly see that the loss expense Ratio is more or less unchanged and car insurance is the majority of that business. So this doesn’t really fit with GEICO’s explanation. For me it is difficult to judge, but to me it looks like that GEICO has a specific loss and most likely underwriting problem. Maybe this is a result of the hunt for market share ? Who knows. Would maybe be a good question for the annual meeting.
One side remark: I did a little comparison of how Progressive would have perfomed against Berkshire over the last 5,10,15,20 and 25 years:
Interestingly, with the exception of the 10 year period, you would have done much better owning Progressive as a pure play direct insurer compared to Berkshire.
2. Very pesimistic view on (Re-)Insurance in general
Although Buffett is very upbeat on America in the letter, his comment on insurance in general and reinsurance specifically is extremely pesimistic. I do not recall having read something like this sentence before:
The prolonged period of low interest rates the world is now dealing with also virtually guarantees that earnings on float will steadily decrease for many years to come, thereby exacerbating the profit problems of insurers. It’s a good bet that industry results over the next ten years will fall short of those recorded in the past decade, particularly for those companies that specialize in reinsurance
So if you still look for a reason why he sold the MunichRe stake, here is the answer…..
3. No comment on Todd & Ted’s investment performance
Although he praises Todd Combs as facilitator for PCP deal, there is no comment on investment performance, neither “his” portfolio nor Todd & Ted’s.
Two things were interesting in my opinion about BNSF. First the comment on depreciations:
Indeed, the depreciation charge we record in our railroad business falls far short of the capital outlays needed to merely keep the railroad running properly, a mismatch that leads to GAAP earnings that are higher than true economic earnings. (This overstatement of earnings exists at all railroads.) When CEOs or investment bankers tout pre-depreciation figures such as EBITDA as a valuation guide, watch their noses lengthen while they speak.
That is interesting and unfortunately he doesn’t explain this further. Did BNSF underinvest in the past ? Is there specific inflation ?
Earnings: Operativ profit at BNSF increased 10% to ~6,8 bn USD from 6,2 bn, that’s around 27% of total operating earnings. However revenues went down at BNSF by almost 10%. How did that work out ? Let’s look at the details:
The explanation is simply that the fuel bill dropped by almost 50% or 2 bn USD. So BNSF’s improvent (and thereore Berkshire’s at a whole) was purely driven by a windfall gain in lower fuel costs. Without that, I am not sure if Berkshire would have shown an increase in operating profit.
Edit: Part of the decrease in fuel costs most likely has been “passed through” to customers. However from the report is is not possible to determine where th improvement came from. Fuel costs fell more than sales and all other costs remained more or less constant.
4. Tax “float”
Buffett’s “tax float” is now almost as high as his insurance float. On page 60 we can find that the net deferred tax liability is now 63 bn USD.
5. PCC loan:
Interestingly, Berkshire used a 10 bn USD credit line to pay for the PC acquisition. I cannot recall that he used a credit line before.
On January 29, 2016 we completed our acquisition of Precision Castparts Corp. (“PCC”). At that time, we acquired all outstanding PCC shares of common stock, other than the shares already owned (about 2.7 million shares or 1.96%), for aggregate consideration of approximately $32 billion. We funded the acquisition with a combination of cash on hand and $10 billion borrowed under a new 364-day revolving credit agreement. See Note 22 to the accompanying Consolidated Financial Statements. We currently expect to issue new term debt in 2016 and use the proceeds to repay the revolving credit loan.
He also plans to issue debt (from the HoldCo ?) to fund the purchase, again something I haven’t seen before. With around 61 bn USD cash at year end, the strategy is not really “self explaining”.
6. 2015 Earnings quality
Overall, I found the 2015 earnings quality relatively poor. Yes, operating profit increased, but without the BNSF fuel “windfall”, they would have fallen.
Net income was a “record” but if we look at Comprehensive Income, we see a different picture:
In the top line, net earnings increase every year, the “real” bottom line declines significantly. The reason is easy: Within the comprehensive income we see the mark-to-market losses (net) of the investment portfolio. And Buffett’s stocks clearly had better years than 2015.
For me, Berkshire is still largely a financial company and therefore comprehensive income is important. Buffett would clearly have investors to ignore this and look at operating profit instead.