Berkshire reports its biggest quarterly loss ever. Buffett does mid-course correction.

In the business world, the rear-view mirror is always clearer than the windshield.

Warren Buffett

On 2nd May 2020, Omaha based financial conglomerate Berkshire Hathaway (NYSE: BRK.B) reported a net loss of $49.75bn for the 1st quarter of 2020, its biggest quarterly loss ever. This includes $70.28bn of mark to market losses in investments and derivatives. Berkshire stock has corrected more than 10% - from $190 to $170 - from mid April to mid May on the back of these results. This 10% correction is in stark and dire contrast to the SP500, which has moved up by about 3% - from 2783 to 2863 - over the same period.

Granted that the bulk of the losses reported by Berkshire are mark to market losses which is system-wide and holds true for everybody - what was the reason for the markets to punish Berkshire stock by 13% vis-à-vis the SP500 in the span of just one month? The only explanation is that the markets were not very comfortable with Berkshire’s investment holdings anymore, in light of the impact of the Corona pandemic on the world economy. Buffett himself pre-empted this move by selling all airline stocks in his portfolio, including American Airlines, Delta Airlines, Southwest Airlines and United Continental. Berkshire owned approximately 10% of each of these airlines and no doubt the unloading of such a big quantity of shares in the stock market would have been possible only at rock bottom prices. Suffice it to assume that Berkshire would have taken a significant hit in this share sale. More importantly though, in selling all airline stocks together, Buffett debunked his own ‘Buy and Hold for life’ philosophy once and for all. We at Attainix Consulting have been saying consistently that the ‘Buy and Hold’ approach does not make sense in the Knowledge economy anymore, since new upstart businesses can disrupt existing established business very quickly. But now that the master himself has reneged on his own words, I guess his actions will speak louder than his words to the millions of his ardent followers worldwide!

But hold on we are not finished diagnosing the action of the markets on Berkshire stock yet. It appears that the markets discovered a bigger problem lurking underneath in the Berkshire folio. See the top 15 holdings in the Berkshire portfolio at the end of 2019 below. What do you notice?

Well I noticed 3 stocks in Airlines, 6 stocks in Banks/Investment Banking, 2 stocks in Card services, 2 stocks in Technology and 1 stock each in Credit Ratings and Beverages. If ever a case was to be made for putting too many eggs in the same basket, then the above portfolio would win hands down! Of the top 15 holdings, 3 are in Airlines and 9 are in Financial Services – of which 4 are Banks. Buffett sold all his Airlines stocks because he believes people will not fly so much anymore after the pandemic – also the fact that video communication has woven itself in every one’s lives. But what about Banks – will their non performing assets not swell as a result of the pandemic? Sure they will, and that is exactly why the stock markets have been punishing the Berkshire stock. The problem for Buffett is that his Bank holdings are so large that he cannot hope to sell them like he sold the airlines, without disturbing the entire market and shooting his own foot! 

So there you have it – the world’s greatest investor has been found to hold multiple stocks in the same sector in his top 15 holdings – a mistake which even a novice portfolio manager would not make. But such is the aura of mega investors that when the going is good such mistakes are overlooked as genius moves. No wonder then, this situation reminds me of one of Buffet’s own quotes – “Only when the tide goes out do you discover who's been swimming naked”. 

Having said all of the above, I should remind you though that Warren Buffett is still sitting on $137bn of cash. This is like an elephant gun which he can use to correct his own mistakes over time. But can you? Do you have tons of cash that you can deploy to correct blunders in your own portfolio that have been exposed by some unforeseen event? If not, get help. Hire an expert to advise you on your portfolio, if nothing else to detect and avoid common blunders well in time.

Berkshire loses $25bn for the qtr. Buffett soothes the pain with words of wisdom.

If you call a dog’s tail a leg, how many legs does it have? Four, because calling a tail a leg doesn’t make it one.

Abraham Lincoln, re-quoted by Warren Buffett

Omaha-based financial conglomerate Berkshire Hathaway (NYSE: BRK.B) reported a staggering loss of $25.1bn for the December 2018 quarter largely due to its 27% holdings in Kraft Heinz (NYSE: KHC), which itself reported a $12.6bn loss in the fourth quarter. Kraft Heinz also wrote down the value of its iconic brands by $15.4bn and disclosed an SEC investigation into its accounting policies, procedures and procurement related internal controls. This news spooked the stock markets which wiped out more than $12bn in the stock’s market cap last Thursday and left its shares trading at its lowest value in the past 4 years. All of this had a cascading effect on Berkshire which had to mark-to-market its losses in KHC as expenses as per new regulatory changes that are part of GAAP. Despite this huge loss for the quarter, Berkshire reported annual profits of $4bn for the entire calendar year of 2018. In his letter that accompanies the annual results, Warren Buffet - chairman of Berkshire - warned shareholders that they should get used to such huge swings in quarterly profits because they own a huge equity portfolio worth $173bn which can fluctuate by up to $2bn in a single day! For the benefit of investors, here are nuggets of wisdom that I could glean from his letter this year.

• Focus on operating earnings (EBITDA) rather than Net Profits. Berkshire goes one step further than EBITDA and includes manager compensation and restructuring expenses (if any) when calculating operating earnings. This conservative approach is in stark contrast to the frequent Wall Street practice of excluding a variety of real costs when computing operating earnings. For the record, Berkshire’s operating earnings soared 71 percent from a year ago.
• Book Value has lost its relevance it once had. Despite the volatility of stock markets, market price provides the best measure of business performance.
• Succession planning at Berkshire has been executed beautifully and is working like a charm.
• Berkshire’s business goal remains unchanged over the years i.e. to buy well-managed businesses that have durable economic attributes at reasonable prices.
• Buffet favors buyback decisions by investee companies. His reasoning is that when earnings of investee companies increase and their shares outstanding decrease (due to buybacks), then the investor’s pie increases without any additional cash outflow to the investor.
• Berkshire is a financial fortress and is sitting on more than $112bn in cash and cash-equivalents. At least $20bn of this cash is untouchable as a safeguard to protect the insurance business from losses resulting from external calamities. The remaining cash is not getting deployed because in the current market, prices are sky-high for businesses that have decent long term prospects. Berkshire has been holding more than $100bn in cash for six straight quarters now!
• Buffet does not focus on quarterly results and neither does the company give out any earnings estimate. His reasoning is that focusing on quarterly numbers encourages bad corporate behavior and induces managers to start ‘fudging’ earnings in order to meet their targets.
• The reduction in US corporate tax rate from 35% to 21% greatly boosted the earnings of Berkshire starting last year. Consequently it also boosted the intrinsic value of Berkshire stock.
• Berkshire’s insurance business is the engine that has been propelling its growth since 1967. It has operated at an underwriting profit for 15 of the last 16 years, except 2017.
• Berkshire uses debt sparingly for financing its operations, except for its asset heavy businesses like railroad and energy. Berkshire does not need to use debt because it has amassed a net worth of $349bn over the years and also leverages the float provided by the insurance business.
• Buffet attributes much of Berkshire’s success to the American tailwind – a reference to the steady growth in the American economy over the past decades. In the future he hopes to invest significant capital across American borders as well.

The subtext

Reading between the lines of Buffet’s letter, here are some points that I noted for myself.

• The world’s greatest investor is not infallible and his investment in Kraft Heinz is proof that even he can make mistakes – big mistakes!
• Buy and Hold as an investment strategy does not work, again as proved by the huge loss reported by Kraft Heinz. It is therefore prudent to always watch for warning signs of trouble and exit a troubled holding before disaster strikes. Could Buffet have seen this one coming? Sure he could, you could too. Take a look at the page for Kraft Heinz from our icTracker database. You will observe that Economic Value Added (EVA) for this stock was continuously negative until March 18 when it went slightly positive for the first time. Thereafter it turned negative once again in June 18 and September 18. That was two quarters of warning and enough time for Buffet to exit his holding in Kraft Heinz during that period.
• Does Buy and Hold strategy encourage emotional bias towards a stock? It possibly does, again as shown by the Kraft Heinz episode. If as an investor you ignore the warning signs of trouble despite obvious indications then you are definitely afflicted by emotional affection towards the stock, which is never a good thing for any long term investor.
• Do tailwinds exist in economies other than the American economy? Sure they do. Buffet himself admits so and is in fact preparing for investing significantly in other emerging economies (such as India IMHO). Berkshire’s recent investment of $300mn in Paytm is proof and is just the beginning. Therefore we can expect more action from him in the future in the sub-continent.
• Despite the extra-ordinarily big loss for the quarter, Berkshire stock price has compounded at an annual rate of 20.5% from 1965 until 2018, in contrast to the S&P500 which has compounded at only 9.7% during the same period. In other words, a dollar invested in the S&P500 in 1965 would have appreciated to $150.19 by the end of 2018. The same dollar invested in Berkshire however, would have appreciated to a whopping $24,726.27 in the same period! In the process, it would have outperformed the S&P500 by a multiple of 164! The question naturally arises - should you invest in Berkshire at this time? Let me put it this way – the $25bn loss is too big even for Berkshire to digest quickly. If you are already invested in Berkshire, then you can ride out the storm along with Buffet. If on the other hand you are planning to make a fresh investment today in the stock markets today, there are many more attractive options available at this time.

Happy Investing!