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Berkshire Hathaway, Inc.(NYSE:BRK) is a holding company that, through its insurance subsidiaries actively invests its float, or the money taken in from premiums before claims are paid out. Berkshire owns stock or shares in a diverse group of over 50 public and private companies in industries including manufacturing, retail, energy, and finance.

The company is famously managed by Warren Buffett, who was named CEO of the year for 2008 by Morningstar, an independent investment research firm.^[1] Buffet has compounded Berkshire's book value (a key valuation metric of the company) over 24% annually for nearly 43 years.^[2] Buffett has managed this feat by successfully reinvesting Berkshire's float in wholly-owned private companies as well as publicly traded stocks like Coca-Cola, Wells Fargo (WFC), American Express, and Procter & Gamble Company (PG).

Buffett has achieved Berkshire's success by a combination of superior underwriting and investments in companies with durable competitive advantages. However, Buffett himself has cautioned investors about the hindrances of Berkshire's enormous size and the difficulties achieving the same out-sized returns going forward. Also, because Berkshire has a significant number of insurance policies as well as significant investments in many different sectors including banks and manufacturing firms, its portfolio and the company's profits are exposed to risk in the event of prolonged and widespread economic downturn. Warren Buffet's successor as the head of Berkshire after Buffet's eventual departure has not yet been announced, and has caused concern about whether the company will continue to outperform the market.

[edit] Business Overview

Below are relevant operating data for Berkshire, including insurance metrics. As evidenced by the charts below, Berkshire's underwriting discipline has led to a negative cost of float (i.e. underwriting gains/losses as a percentage of insurance float) over the previous three years. No-cost or negative cost float allows the company to enjoy investment income and gains without having to pay claims in excess of premiums taken in. In other words, the company operates at an underwriting profit, such that it takes in more in premiums than it pays out in claims.

Revenue and net income has been positive, but uneven between 2006 and 2008.^[3]

Over the past few years, BRK has been able to increase both its Revenue and Operating Income significantly. It has outperformed the market in nearly all categories. However, for the third quarter 2008, Berkshire’s net profits declined 77% - the fourth straight quarter decline for the company. Berkshire's operating income and revenue both fell 18% and 17% respectively. Despite these falling trends, the company's net worth rose from $118 billion in June 2008 to $120.2 billion in November.^[4]

Berkshire typically earns about half of its revenue and profits from its insurance businesses. In 2007, its net underwriting gain came to $2.18B, and Berkshire said it anticipates that price competition in most of its insurance markets will reduce underwriting profits for the rest of the year. Berkshire Hathaway’s net earnings from its non-insurance businesses reached $4.099 billion in 2008.^[6]

[edit] Trends and Business Drivers

[edit] Increased risk from slowing economies, Hurricanes, and Global Climate Change

The economic downturn increases BRK's risk as it acts as an insurance company and invests heavily into a many well known companies - banks included. This puts Berkshire at risk since it relies of the strength of its investments and in a relatively uncorrelated loss from insurance. A prolonged or widespread economic crisis would severely hurt BRK.^[9] A large part of Berkshire's insurance operations focus on underwriting hurricane and earthquake risk. Risks related to these policies are generally very difficult to assess and model given the year-to-year variability of hurricane frequency and intensity as well as the potential for long-run shifts in patterns in light of the effects of global warming. Indeed, Berkshire CEO Warren Buffett has stated that many fat-tailed risks (i.e. large but infrequent occurrences) are dealt with more by sensible underwriting judgments than quantitative models. To be sure, though, Berkshire has a very large asset base and AAA ratings in the event of catastrophic insurance losses. As of 2008, it had set its loss reserves at around $56B ,^[10] and in its pricing, the company prepares itself for a risked loss of up to $6.5B. BRK will face financial trouble if its losses from an economic downturn or weather conditions exceed its expected limits.^[11]

[edit] Berkshire's massive size limits the potential for outsize returns

Building Berkshire's book value depends on the company's ability to reinvest the large sums of cash flowing into the company and the over $40 billion already in its coffers. The company generates cash flow and float of some $150 million per week,^[12] which is typically reinvested in either fixed-income securities, equities, or private companies. As the stock and the flow of cash at Berkshire grows, the company's returns will continue to approach those of the market and it becomes increasingly difficult for Berkshire's to sustain its historical returns of over 20% per year.^[13]

[edit] Succession of Warren Buffett

Berkshire Hathaway owners have become increasingly concerned about the future of management at the company. Warren Buffett has led the capital allocation decisions of the company since its inceptions and has not announced plans for a successor in the case of death or incapacitation. The company intends to split the current CEO role into two roles: CEO (covering operations) and Chief Investment Officer (cover capital allocation and investment decisions). Buffett recently launched a search for the future CIO, and many speculate that GEICO chief Tony Nicely, reinsurance guru Ajit Jain, or GEICO's Louis Simpson will succeed Buffett as operational CEO.

[edit] Berkshire competes with private equity purchasers for acquisitions of wholly owned subsidiaries

Berkshire's favored investment is in large, privately-held businesses. As such, the company competes with private equity money to find target acquisitions, and increased activity in the space has led to heightened competition and fewer deal opportunities. Berkshire differentiates itself and attracts sellers of businesses by offering them long-term ownership, the hallmark of the company's investment strategy. Often sellers are family or individual owners looking to monetize their interest in a closely-held business. They seek a buyer who, unlike most private equity firms, does not look toward an "exit" of the business and are less likely to interfere with how it is currently managed. Berkshire must maintain its investing track record to continue attracting deals at favorable prices.

[edit] Competition

[edit] Investments

Berkshire operating subsidiaries compete against a diverse array of companies in each of its many industries. While generally the businesses operate in industries that are highly competitive, Warren Buffett has focused on acquiring subsidiaries with competitive advantages, which he calls economic "moats," enjoying substantial differentiation or cost-advantages.

In its stock selection, the company seeks similar characteristics, but due to its size, must compete for favorable prices against the substantial sums of money invested in large-cap securities. As shown by the accompanying chart, Berkshire's equity portfolio consists mostly of large, well-known companies. Buffett must continue being able to deploy large sums of capital into these opportunities at favorable prices. As evidenced by the large portfolio weightings of the stocks owned by Berkshire, Buffett is not afraid to make very sizable bets when he believes a company has a durable competitive advantage and is available at a reasonable price.

^{[14] [15] [16]}

[edit] Insurance Market Share

Some competitors of its bread-and-butter insurance operations are as follows: Please note that Geico was acquired by Berkshire in January 1996, however, do to its significant size it is useful for comparison.^[17]

Below is a table of estimates of reinsurance company market shares. In 2007, $168 billion in premiums were written. This is 9.8% higher than the previous year, when $153.1B were written in 2006. The reinsurance industry is largely comprised of a few international firms who hold large market share positions in addition to a smaller, fragmented base of firms with more insignificant global market positions. Firms compete on a mix of price, terms, and financial strength. Notably, Berkshire has the highest credit rating available (AAA), and one of the most proven capital structures in the world.^[19]

[edit] Share Classes

Berkshire Hathaway has two classes of stock, A Shares and B Shares. The B-shares represent 1/200th voting rights and 1/30th ownership rights of the A-shares. The B-shares can not be easily transformed into A-shares. BRK's ownership of B-shares gives it a significantly smaller authority in a given company, but are also less expensive.^[21]

[edit] Footnotes

1. ↑ International Business Times: "Morningstar Names Warren Buffett of Berkshire Hathaway as Its 2008 CEO of the Year" 7 Jan 2009
2. ↑ Forbes Newsletter Watch "Investment Newsletters Un-Buffetted"
3. ↑ ^{3.0 3.1 3.2 3.3} BRK 10-K 2008 Item 8 Pg. 58
4. ↑ Forbes "UPDATE 2-Berkshire Hathaway profit tumbles 77 percent" 8 Nov 2008
5. ↑ BRK 10-Q 2009 Item 1 Pg. 3
6. ↑ BRK 10-K 2008 Item 7 "Results of Operation"
7. ↑ BRK 10-K 2008 Management's Discussion "Insurance-Underwriting" p.29
8. ↑ BRK 10-K 2007 Item 7 "Insurance-Underwriting" p.29
9. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.19
10. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.20
11. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.18
12. ↑ Charlie Parker/CBS Interview with Warren Buffett, July 2006
13. ↑ Forbes Newsletter Watch "Investment Newsletters Un-Buffetted"
14. ↑ BRK SEC 13F-HR, Institutional Holdings, Filed: Nov. 14, 2007
15. ↑ Fat Pitch Financials "Berkshire Hathaway Portfolio Holdings as of September 30, 2008" 17 Nov 2008
16. ↑ BRK Q-3 13F 2008 "Investment Discretion"
17. ↑ BRK 10-K 2008 Item 1 "Business" p.3
18. ↑ Insurance Information Institute: Major Players "Top Ten Writers of Private Passenger Auto Insurance By Direct Premiums Written, 2007"
19. ↑ Insurance Information Institute: Media "REINSURANCE INDUSTRY" 21 July 2008
20. ↑ Insurance Information Institute: Media "Top Ten Global Reinsurers" 21 July 2008
21. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.21