Berkshire Sidesteps Bond Rout, Builds Shareholder Equity

Monday, 05 Aug 2013 10:54 AM

 

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Warren Buffett’s preference for buying stocks and whole companies rather than bonds is helping Berkshire Hathaway Inc. weather a spike in interest rates better than other insurers.

Book value rose 2 percent to about $122,900 per Class A share in the three months ended June 30, Omaha, Nebraska-based Berkshire said Aug. 2. Insurance competitors including Allstate Corp., American International Group Inc. and Travelers Cos. posted second-quarter declines in the measure of assets minus liabilities.

Interest rates surged in the period after Federal Reserve Chairman Ben S. Bernanke signaled the central bank could begin to taper its $85 billion-a-month bond purchases this year. That wiped billions of dollars from insurers’ portfolios, which consist mostly of fixed-income securities. Buffett’s firm owns stocks valued at more than three times as much as bond holdings.

“He just plays a different game,” Tom Lewandowski, an analyst at Edward Jones & Co., said in an interview. “He can take more risk in his investment portfolio” than other insurers, because Berkshire keeps a lot of cash on hand and has other sources of earnings.

Buffett, Berkshire’s chairman, chief executive officer and largest shareholder, told investors in February 2012 that bonds were among the “most dangerous” assets. Yields, he said, weren’t enough to compensate for the risk of inflation. He reiterated that view in May, saying that Berkshire wasn’t buying corporate debt because of low rates.

Rising Yields

That proved a smarter way to maintain value during the second quarter as bonds fell. Yields on 10-year Treasurys climbed to 2.49 percent from 1.85 percent in the period, while the Standard & Poor’s 500 Index advanced 2.4 percent.

Travelers’ book value fell 2 percent to $66.65 per share in the three months ended June 30, the biggest quarterly drop since 2008. AIG’s declined 2.1 percent and Allstate’s by 4.2 percent. The slumps were led by unrealized losses on bonds in a quarter when the companies all posted higher net income.

Berkshire’s midyear results “show you just how well positioned” Buffett is on interest rates and the rebound in the U.S. financial system, said Tom Russo, a partner at Berkshire investor Gardner Russo & Gardner who oversees more than $5 billion. Berkshire emerged from the rate spike with almost “no scar tissue,” Russo said.

Adding Stocks

Buffett has long favored concentrated bets on stocks. Four holdings, Wells Fargo & Co., Coca-Cola Co., American Express Co. and International Business Machines Corp., accounted for almost 60 percent of the company’s $103.3 billion equity portfolio at the end of June, Berkshire said in an Aug. 2 filing outlining second-quarter results.

Berkshire continued to add stocks in the quarter, spending $4.64 billion for purchases, while selling $781 million. Most of the additions were in a category the company calls “commercial, industrial and other.” Unrealized gains on stocks advanced 3.5 percent in the quarter to $47.8 billion. Most of the securities are held at insurance units, such as Geico.

Berkshire is also buying whole companies. In May, utility unit MidAmerican Energy Holdings Co. agreed to acquire a Nevada power producer for $5.6 billion. The following month, Berkshire completed its deal with 3G Capital to take ketchup maker HJ Heinz Co. private.

Acquisitions transformed Berkshire from a failing textile maker into a $290 billion business in the past four decades and provide the company with diverse earnings. Second-quarter net income climbed 46 percent to $4.54 billion, or $2,763 a share, on Buffett’s derivative bets.

Railroad, Energy

Operating profit, which excludes some investment gains, was $2,384 a share, beating the $2,166 average estimate of three analysts surveyed by Bloomberg. Net income from the Burlington Northern Santa Fe railroad climbed 10 percent to $884 million, and the MidAmerican unit also posted a gain.

Berkshire’s book value is also helped by Buffett’s strategy of redeploying profits rather than paying a dividend. Allstate, the largest publicly traded U.S. home-and-auto insurer, pays a dividend as does New York-based Travelers, the lone property insurer in the Dow Jones Industrial Average. AIG, once the world’s largest insurer, last week declared its first quarterly payout since halting them during the 2008 financial crisis.

Each of the three companies has a larger bond portfolio than Berkshire. New York-based AIG said last week in a conference call that while rising rates hurt book value, they help boost sales of some annuities.

Unrealized Losses

Travelers said July 23 that second-quarter earnings weren’t enough to prevent the bond slump from eroding book value. The insurer said higher yields will have a “moderate impact” on investment income. Northbrook, Illinois-based Allstate said last week that changes to its portfolio, starting last year, helped cushion unrealized losses by about $400 million at the property-liability unit. The company still had a $2.2 billion decline in the quarter.

Representatives from AIG, Allstate and Travelers declined to comment. Buffett didn’t respond to a message left with an assistant.

Long-term, the rise in interest rates will help insurers that have most of their investments in bonds, said Edward Jones’s Lewandowski. Many already shortened the duration of their portfolios so that they can reinvest sooner at higher rates, he said. Most insurers hold bonds to maturity, meaning they would have never taken the gains that built up in earlier years unless forced to sell to cover claims, he said.

Buffett’s Path

Buffett’s company gained 0.4 percent to $177,243 at 9:45 a.m. in New York, and has rallied 32 percent this year, beating the 19 percent jump for S&P 500. AIG advanced 38 percent since Dec. 31, after repaying a bailout last year, while Travelers climbed 16 percent and Allstate is up 28 percent.

Berkshire’s approach carries risks that competitors aren’t willing to shoulder because of the volatility of stocks, said Doug Pawlowski, an analyst at Fitch Ratings. In that sense, Berkshire’s allocation is more akin to mutual insurers, which aren’t publicly traded and tend to be more tolerant of fluctuations in investment values, he said.

Buffett helps mitigate that volatility by maintaining a cash hoard that was $35.7 billion at the end of the second quarter and a statutory surplus at its insurance businesses of about $106 billion as of Dec. 31, according to the filing.

“Berkshire has chosen a path, and for them it’s been a successful path,” Pawlowski said. “I don’t think everybody could choose the same.”

© Copyright 2014 Bloomberg News. All rights reserved.

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