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Crucial Takeaways From Berkshire Hathaway’s Second Quarter 2022 Earnings

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Berkshire Hathawa BRK.B BRK.B y’s (BRK/A, BRK/B) slipped to a loss of over $43.7 billion in the second quarter versus a profit of over $28 billion in the same quarter of 2021. Thanks to sharp declines in the stock market, that result is dominated by losses from the investment portfolio since unrealized gains from their portfolio are included in earnings. Operating earnings, which remove the distortion from market changes and better reflect the firm’s earnings power, for the quarter rose sharply by 39% versus 2021. Year-to-date operating earnings rose by 19% over the same period in 2021. Providing an illustration of the value from share repurchases, per-share operating income for the second quarter increased by 43% versus 2021.

Because the Covid-19 pandemic negatively impacted most businesses, including Berkshire, in early 2020, comparing current results to pre-pandemic 2019 results is helpful. Operating earnings for the second quarter of 2022 are 51% above 2019. And thanks to share repurchases, operating earnings per share are a whopping 68% above 2019.

A further look into the different operating segments in 2022 shows strong earnings growth across most segments versus 2021. Notably, the operating income for all segments is significantly above the pre-pandemic levels of 2019.

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Insurance: Second quarter investment income was 56% higher than 2021 and 27% better than 2019, primarily due to higher interest income from short-term investments. Investment income was depressed by ultra-low interest rates implemented in response to Covid, but the Federal Reserve has raised rates aggressively in the second quarter to fight inflation. Investment income should continue to see improvement as the Federal Reserve is likely to be in hiking mode for the remainder of the year. While underwriting results were positive overall, Geico had an underwriting loss. Geico continues to suffer from more frequent auto claims and rising claims severity due to the higher valuation of used vehicles. Geico has posted an underwriting loss year-to-date, which drove the 53% decline in Berkshire’s year-to-date underwriting profit relative to 2021. During the annual meeting earlier in the year, there was a question about the strength of Berkshire’s Geico car insurance business relative to Progressive PGR (PGR). Progressive has done better than Geico recently based on their earlier adoption of telematics. Geico recently moved in that direction, and it will be instructive to see if Geico can close the gap in the coming years.

The two most essential concepts in insurance investing are “float” and underwriting profit. In simple terms, float is created for insurance companies because insurance premiums are paid before any claims are made by the insured. Insurance companies can invest the float, sometimes for years, before insurance losses are reimbursed. Berkshire has a history, unlike many insurance companies, of earning an underwriting profit, meaning that their float costs them nothing and makes them money in addition to allowing them to earn a profit off of investing the float. An underwriting profit means the insurance premium exceeds all insurance claims and expenses. Berkshire had an underwriting profit for the second quarter of 2022, year-to-date 2022, and calendar years 2021, 2020, and 2019. Berkshire’s float was flat at approximately $147 billion versus the level on December 31, 2021, and above the $138 billion on December 31, 2020. Though float is not as valuable in a low interest rate environment, its value increases as yields rise. Float per share has increased to $99,961 from $98,960, aided by share repurchases.

Railroad: Berkshire owns the Burlington Northern Santa Fe (BNSF) railroad operating in the U.S. and Canada. Net operating earnings rose 10% over the same quarter in 2021 and 24% over pre-covid 2019. Revenue was higher due to higher pricing and a fuel surcharge driven by higher fuel prices, while volume was slightly lower.

Utilities and Energy: This business generally provides steady and growing earnings, which one would expect from what primarily consists of regulated utilities and pipeline companies. In June 2022, Berkshire bought the Berkshire Hathaway Energy Company (BHE) common stock owned by Greg Abel, Berkshire’s Vice Chairman – non-insurance operations, for $870 million, and Berkshire now owns 92% of BHE. A question about a possible conflict of interest stemming from Abel’s partial direct ownership of a Berkshire subsidiary was asked at the annual meeting, so this transaction ends any concern in that area. Interestingly, this group also operates Berkshire Hathaway HomeServices (BHHS), the largest residential real estate brokerage firm in the country. The slowdown in housing activity is evident in the results. The 2022 earnings suffered from lower mortgage and refinance activity thanks to higher interest rates and a decline in closed brokerage transactions.

Manufacturing, Service and Retailing: This segment consists of many diverse businesses, so this analysis will focus on a few significant themes when looking at this segment. Berkshire’s aerospace exposure remains substantial despite selling its publicly traded airline holdings earlier in 2020. Berkshire previously took a $10 billion impairment charge on the Precision Castparts (PCC) business due to its exposure to the COVID-disrupted aerospace industry. PCC’s pre-tax earnings rose in the second quarter relative to 2021, primarily due to higher demand for aerospace products. Berkshire sounded more optimistic about the outlook of PCC with a rebound in domestic flight and the need for narrow-body aircraft. Management suggested that future growth is predicated on the ability to increase production since the company has suffered from worker shortages and a restart in Boeing 787 production. Berkshire’s FlightSafety and NetJets continued to see a sharp rebound, with training hours up 29% and customer flight hours rising 25% year-to-date versus 2021. Unfortunately, the earnings of aviation services were dented by increased costs, including those for subcontracted aircraft, due to the sharp jump in customer flight hours.

Housing-related businesses like Clayton Homes, Shaw, Johns Manville, Acme Building Products, Benjamin Moore, and MiTek posted sharply higher earnings relative to 2021. Berkshire continues to note that prices were increased to offset cost pressures, and supply chain disruptions remain an issue. Perhaps the early signs of a slowing housing market are showing up in the group, with higher selling prices due to higher costs being the primary driver of revenue growth rather than unit volume and product mix. The most significant portion of the retailing segment is Berkshire Hathaway Automotive (BHA), owning over 80 auto dealerships. BHA had lower quarterly revenues despite a higher average unit sale price. Unit sales were lower, reflecting significant new vehicle supply shortages attributable to the global computer chip shortages and other supply chain disruptions. Berkshire noted that second-quarter apparel and footwear revenues plunged relative to 2021. In addition, earnings were lower for their furniture retailers, including Nebraska Furniture Mart, with prices higher due to increased costs but lower transaction volumes. This weakness in some of the retailing exposed businesses is not a surprise, given similar statements from others in the industry. Berkshire’s McLane unit had lower profits in 2022 versus 2021. McLane is a wholesale distributor to retailers and restaurants. The decline in earnings was primarily due to supply chain constraints, labor shortages, truck driver shortages, and higher inventory costs. Berkshire continues to expect the challenging environment for McClane to continue through 2022.

Other: The segment has a significant profit for the second quarter and year-to-date 2022 primarily due to foreign currency gains and an increase in equity method earnings at Kraft Heinz (KHC) and Pilot. The foreign currency exchange rate gains were generated from bonds issued by Berkshire Hathaway and denominated in British Pounds, euros, and Japanese Yen. Investment losses from non-U.S. dollar investments generally offset these gains. These foreign currency liabilities are not a concern as Berkshire has significant assets and earnings denominated in these foreign currencies. This segment includes companies’ profits that must be accounted for under the equity method due to the size of ownership and influence on management. The after-tax equity method earnings have Berkshire’s proportionate share of profits attributable to its investments in Kraft Heinz (KHC), Pilot, Berkadia, Electric Transmission of Texas, and Iroquois Gas Transmission Systems.

Berkshire bought back $1 billion of its stock in the second quarter. Until an announcement in mid-2018, Berkshire had only made repurchases when the stock was trading at less than 1.2 times the price to book (P/B) ratio. While that constraint is now relaxed, it is still a good indicator of the general range when aggressive repurchases will likely be seen. Berkshire’s P/B ratio was between 1.2 times to above 1.5 times during the quarter, so it makes sense that the pace of repurchases slowed. Berkshire only intends to repurchase shares when the “repurchase price is below Berkshire’s intrinsic value, conservatively determined.” The P/B ratio remains a reasonable proxy for gauging Berkshire’s intrinsic value. It worked well this quarter since Berkshire only acquired shares in June, and the price-to-book didn’t fall below 1.2 times until then. Still, Warren Buffett and Charlie Munger’s judgment about its intrinsic value versus other available uses of capital could differ from that simple measure in the future.

In addition, Berkshire made other purchases. Berkshire made $6.2 billion in stock purchases for its portfolio while selling $2.3 billion in stocks for a net additional investment of $3.9 billion in publicly traded equities. One purchase was additional shares of Occidental Petroleum OXY (OXY). Berkshire now owns approximately 17% of the outstanding shares of Occidental, with a market value of $9.3 billion at the end of June. More about the possible reasons for the Occidental investment is here. Berkshire expects to close on the purchase of Allegheny Corporation (Y) in the fourth quarter for approximately $11.6 billion in cash. Allegheny shareholders approved the transaction on June 9.

Summary: Quarterly results are generally not meaningful for Berkshire since it is managed with a focus on increasing long-term value and not meeting quarterly hurdles. This ability to take advantage of time arbitrage has served the company and shareholders well over the years. The goal in looking at the results is to see if the segments are generally operating as expected and consider the capital allocation decisions made by Warren Buffett and Charlie Munger.

Operating earnings for the second quarter of 2022 grew by 39% over 2021. In addition, 2022 operating earnings are 51% above pre-pandemic 2019 levels. 2022 year-to-date operating earnings growth is similarly impressive at 51% and 40% above 2021 and 2019, respectively. In recent years, a significant capital allocation decision was made to increase share repurchases. This activity signals that Buffett and Munger believe Berkshire Hathaway’s price is below their intrinsic value estimate. If they are correct (and there is no reason to doubt them), the purchases are a value-creator for the remaining shareholders. Operating earnings per share for 2022 are now 68% above 2019, benefiting from the share repurchases! The slowing repurchases in the second quarter reflect the higher valuation of Berkshire until June and the ability of the duo to find some other opportunities with an attractive risk versus reward for investing capital.

One of Berkshire’s crown jewels in insurance businesses, GEICO, continues to be challenged by the impact of the pandemic. The underwriting loss at GEICO was disappointing, but results should improve as auto claims normalize with auto pricing. The performance differential versus Progressive (PGR) will also be part of the equation to get the business back on track. The better news was the investment income from the insurance business continued to rebound sharply as the Federal Reserve aggressively raised short-term interest rates. Excluding the insurance business and consistent with the S&P 500 data, cost pressures have caused profit margins to decline relative to second quarter 2021 levels. Even though non-insurance margins are lower than 2021, margins remain higher than the pre-pandemic second quarter of 2019.

Berkshire’s stock price trailed the S&P 500 in the second quarter, declining by almost 23% versus a total return of -16% from the S&P 500. Year-to-date through the end of June, Berkshire’s price is almost -9%, while the S&P 500 has a total return of nearly -20%. Despite additional investment purchases, cash levels were above last quarter. Berkshire retains a fortress balance sheet with cash and equivalents of over $101 billion, which provides flexibility to take advantage of opportunities, including repurchasing its own stock. Berkshire has stated that there would be no stock repurchases if it would cause cash levels to fall below $30 billion.

Despite the headline loss in the second quarter, Berkshire’s businesses are performing exceptionally well, aside from woes at GEICO and some slowing due to macroeconomic headwinds. Shareholders should take comfort in knowing that the firm continues to be managed to survive and emerge stronger from any economic or market downturn. Berkshire retains its Fort Knox balance sheet and a diversified mix of businesses. The firm maintains the unique ability to take advantage of significant opportunities when disruptions or crises provide them.

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Banks Are About To Face The Same Tsunami That Hit Telecom Twenty Years Ago

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I fear global bank regulators are about to make a decision that will unintentionally “obsolete” the banks, by prohibiting a coming tech pivot. Making this mistake would guarantee that the tech industry continues going around the banks, right as internet-native payment technologies are starting to scale.

The telecom sector offers a cautionary tale: When Voice-Over-Internet-Protocol (VOIP) was invented in 1995, most people disparaged it as a technology that couldn’t scale and wasn’t a threat to the telecom giants. Then, circa 2003, the technology to scale VOIP arrived – broadband – and within a flash, most of the telecom industry’s copper-wire networks became obsolete. Useless relics.

Bitcoin is a “Money Over Internet Protocol,” as is Ethereum, potentially. Just as VOIP moves voice data around the internet natively, Bitcoin and Ethereum move value data around the internet natively. Most people disparage Bitcoin, Ethereum, et al. as protocols that can’t scale and can’t possibly threaten the incumbent financial industry, just as they denigrated VOIP. But the scaling technology is now here – it’s called the Lightning Network, which is a Bitcoin layer 2 protocol. Its throughput capacity roughly equals that of Visa, and payments made over Lightning cost virtually zero. There are other scaling technologies, too. If I’m right and scaling technologies for internet-native money protocols have arrived, then many legacy systems operating in the financial system today will be obsolete within a handful of years.

As CEO of a new breed of bank – a dada-bank (“dollar and digital asset bank,” defined as a depository institution authorized to handle both and pronounced like “databank”) – my company lives with the problems inherent in the banking industry’s antiquated legacy systems every day. Culturally, banks have a history of building complex, “walled garden” IT systems. Fintechs sprang up in recent years to provide efficient front-ends that act as “middleware” between antiquated back-end systems and the user experience demanded by customers. Culturally, fintechs build the opposite of banks’ IT systems – fintechs generally build their systems to be as open and “low-walled” as possible to create network effects. Had banks done this, fintechs wouldn’t need to exist! But, until “Money Over Internet Protocols” came along, banks still had a role because fintechs still needed to partner with a legacy bank to settle their customers’ US dollar payments.

“Money Over Internet Protocols” at scale are truly a threat to traditional banking because they enable money to move outside the traditional, antiquated payment rails. To date, the US banking industry has lost roughly $600 billion, or 3% of its deposit base, to the crypto industry – and that happened before the “Money Over Internet Protocols” scaled! Despite all the legal, regulatory, accounting and tax problems faced by their products, and all the criminals and fraudsters running rampant (who should be in jail), the tech industry has proven its ability to go around the banks.

It will take Lightning a few years to lay down that proverbial broadband (scaling) infrastructure before the “Money Over Internet Protocols” hit their tipping point at scale. But make no mistake, it’s happening. The proverbial undersea cables that scaled VOIP are being laid before our very eyes.

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But the “aha!” of these “Money Over Internet Protocols” isn’t cost or scale. There are two “ahas” that matter far more: integration speed/cost and developer communities.

  • Integration speed/cost: Anyone in the world can become members of these emerging payment networks in the span of a few hours, using equipment that costs a few hundred dollars.

Banks’ IT systems will never be able to compete with that.

It’s not even a question whether legacy technology architectures can compete with these emerging protocols, for the simple reason that it’s fast, cheap and easy to join these networks. I recall a recent conversation with a B2B payments company, whose executive was very proud that his team whittled down to only 3 months the time required for its business customers to integrate with its system. In the legacy world, 3 months is impressive. But the paradigm has shifted: payment system integration time is now measured in hours, not in months or years – and in a few hundred dollars, not a few million dollars. It’s obvious which approach will win.

  • Developer communities: Open, permissionless protocols have huge developer communities, which compounds the speed of their ecosystem development and network effects. Network effects are all about compounding. The code libraries and developer tooling available for Bitcoin and Ethereum are critical infrastructure that banks’ proprietary systems cannot replicate. Moreover, these developer communities organically create interoperability. Banks’ “walled garden” systems with closed groups of developers will never be able to keep up with their pace of innovation.

So, what could be the role of banks in the world I’m describing? Answer: banks become software application providers, providing access-controlled applications that run on top of the open, permissionless protocols and to make them accessible even to unsophisticated users, just as the telecom companies do with VOIP. I’ll bet very few of us use the command line interface to make a phone call – even though we could use it if we wanted to, most of us pay to use telecom providers instead because they make the user interface so easy.

That’s what banks will do, too: provide access-controlled applications to ease the use of “Money-Over-Internet-Protocols.” Huge, successful businesses have been built exactly this way – as access-controlled applications running on top of open, permissionless internet protocols. Auto companies are just one of many examples – they’re software companies now, albeit providing software that runs on a different type of hardware.

What about central banks? What would be their role in the world I’m describing? No different. They’ll become providers of a software application for issuing fiat currency that runs on top of open, permissionless protocols, too.

That brings me back to my fear that global bank regulators (specifically, the BIS) are about to make a decision that “obsoletes” the banks. Why? Because the BIS is proposing bank capital treatment that would effectively block banks from interacting with open, permissionless protocols. If they do that, they are guaranteeing that the tech industry will just keep going around the banking sector.

The biggest concern of global bank regulators with banks using open, permissionless protocols, I suspect, is compliance. But banks don’t need compliance to be built into the base layer of their IT systems. Compliance can be built into applications that run above the base layer, and which control access. In fact, that’s what banks are already doing today with TCP/IP. Every bank uses TCP/IP, and yet strictly controls access to their online banking platforms. Criminals and sanctioned countries use TCP/IP today too, but banks have the tools to block them from using banks’ applications. Same thing with Bitcoin and Ethereum – banks have the tools to block illicit finance from using their applications. It’s easier to police illicit activity on open blockchain systems than it is in legacy systems.

At its pivotal juncture telecom was a heavily regulated industry, just like banking is today at its pivotal juncture. How, then, did the telecom companies pivot to become software companies and avoid obsolescence? Answer: regulators enabled them to make that pivot.

That’s what banks will become, too – software companies – but only if bank regulators enable banks to make the same pivot. If they don’t, then it will be obvious, looking back 10 years from now, why the tech industry won.

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Will Putin’s Military Mobilization Mean The End Of His War?

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Could Elvira Nabiullina be the next Russian President?

Last Monday evening I was driving along the contours of Cork harbour, not far from East Cork. The area has many claims to fame – for example, a local (Edward Bransfield) is credited with having discovered Antarctica in 1820. Less triumphantly, some local villages like Whitegate, Aghada and Farsid lost one third of their male populations during the Crimean War.

At the time, a great number of soldiers died from disease and the lack of basic medical procedures – whilst the French and British armies fought side by side against the Russians, casualties were far relatively far higher on the British side because of inferior medical equipment and practice – hence the acclaim with which Florence Nightingale’s techniques were greeted.

I thought of this recently when I read a post on the very different medical kits supplied to Ukrainian and Russian troops, respectively. Setting aside propaganda and donations from the West, the Ukrainian kit looked modern while that of the Russian soldiers could well have come from a museum or horror show. In that respect, the apparent wilting of the Russian army is not surprising.

Filaytev Diaries

More supporting detail on this comes from the 140 page long diaries of Pavel Filyatev, a career paratrooper in the Russian army who, driven to despair by the chaos within his regiment (in Kherson), wrote a long account of his experience in the Russian army. Armies are not pleasant places but his account of the systematic mistreatment of the Russian soldiers, their undernourishment, disorganization in battle and embarrassing under-equipment is telling, not just of the Russian army but of the Russian state. Needless to say, he is now in hiding beyond Russia.

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In that context, the mobilization of largely experienced soldiers to start with, and the co opting of prisoners into the Russian army, opens up many risks – for both Ukraine and Russia. Additionally, the coming referenda on the accession to the Russian Federation of the Luhansk, Donetsk, Zaporizhzhia and Kherson regions is a sneaky, deadly moving of the geopolitical goalposts. Any attempt to liberate these areas of Ukraine would now, in the eyes of the Kremlin, an attack on Russia itself, and it has the right to respond as it sees fit.

From a military point of view, this elevates the risks around Ukraine, and in particular heightens the probability of a strategic mistake or tail event (i.e. such as the destruction of a NATO satellite or an attack on a Baltic state). Putin’s move also increases the risk of socio-political risk within Russia. As I am not a military expert but prefer to write on economic development and the rise and fall of states, I will focus on that.

The Filaytev diaries say much about Russia. It is a country that until recently had poor levels of human development, especially in healthcare and life expectancy (which has been rising from low levels). In this context, Vladimir Putin’s vision of Russia as a superpower is hollow – unless a nation can sustain improving levels of human development (through education, good healthcare, freedom of thought) it will not sustain the core drivers of growth, such as productivity. This a lesson for China, the UK and the US to follow. In China and the UK (productivity is falling) whereas in the USA life expectancy had dropped sharply (below that of China).

Incompetence

In coming years, I am sure many will write about the surprisingly poor quality of the Russian army, and in the context of this note, it is simply another marker for poor quality development. This is perhaps one reason why when emerging market crises strike, they happen slowly, then very quickly. Incompetent institutions, poor rule of law and a prohibition on intelligent policy making can for some time be camouflaged by superficial growth, but all very quickly melt away in moments of stress.

The risk is that other institutions go the same way. As Putin announced the mobilization there were rumours that the highly regarded head of the Russian central bank, Elvira Nabiullina, had resigned (she had apparently tried to do the same in March). This has not been confirmed but raises the question as to the seaworthiness of the full range of Russian institutions in a stormy geopolitical climate. Increasingly, the pressure will be on Russia, and from multiple angles.

As a last word, I want to return to the Crimean War. It is not inconceivable that Corkmen from villages like Whitegate were shelled by Leo Tolstoy, at the time a young artillery officer. Tolstoy’s experience of war affected him greatly. In the context of Putin’s recent mobilization it is worth recalling some advice he gave to a young man ‘all just people must refuse to become soldiers’. Many young Russians are thinking the same today.

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World Will Have Nearly 40% More Millionaires By 2026: Credit Suisse

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The world will have nearly 40% more millionaires in 2026 compared with the end of last year, according to a report by the Credit Suisse Research Institute released on Tuesday.

The five-year outlook “is for wealth to continue growing,” said Nannette Hechler-Fayd’herbe, Chief Investment Officer for the EMEA region and Global Head of Economics & Research at Credit Suisse.

Higher inflation “yields higher forecast values for global wealth when expressed in current U.S. dollars rather than real U.S. dollars. Our forecast is that, by 2024, global wealth per adult should pass the $100,000 threshold and that the number of millionaires will exceed 87 million individuals over the next five years,” Hechler-Fayd’herbe said in a statement.

Buoyed by rising stock prices and low interest rates, global wealth increased global wealth last year totaled $463.6 trillion, a gain of 9.8% at prevailing exchange raises, Credit Suisse said in its annual “Global Wealth Report 2022.” Wealth per adult rose 8.4% to $87,489, it said.

All regions contributed to the rise in global wealth, but North America and China dominated, with North America accounting for more than half of the global total and China adding another quarter, the report said. In percentage terms, North America and China recorded the highest growth rates — around 15% each, it said.

The United States continued to rank highest in the number of the world’s richest with more than 140,000 ultra-high-net-worth individuals with wealth above $50 million, followed by China with 32,710 individuals, the report said. Worldwide, Credit Suisse estimates that there were 62.5 million millionaires at the end of 2021, 5.2 million more than the year before.

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By contrast, this year looks tough. “Some reversal of the exceptional wealth gains of 2021 is likely in 2022/2023 as several countries face slower growth or even recession,” the report said.

Rises in interest rates in 2022 have already had an adverse impact on bond and share prices and are also likely to hurt investment in non-financial assets, the Global Wealth Report noted.

Longer term, growth will recover, Credit Suisse predicted. “Global wealth in nominal U.S. dollars is expected to increase by $169 trillion by 2026, a rise of 36%,” from last year, it said.

The beneficiaries will be more spread out globally, the report predicted. “Low and middle-income countries currently account for 24% of wealth, but will be responsible for 42% of wealth growth over the next five years. Middle-income countries will be the primary driver of global trends,” Credit Suisse said.

Click here for the full report.

See related posts:

The 10 Richest Chinese Billionaires

Taxes, Inequality and Unemployment Will Weigh On China After Party Congress

U.S. Business Optimism About China Drops To Record Low

Pandemic’s Impact On China’s Economy Only Short Term, U.S. Ambassador Says

@rflannerychina

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