Everything Warren Buffett: MORNINGSTAR: Berkshire Annual Meeting Preview

Tuesday, April 28, 2009

MORNINGSTAR: Berkshire Annual Meeting Preview

Saturday's event could be the most valuable in years for Berkshire shareholders.

By Bill Bergman | 04-27-09 | 05:02 PM

Berkshire Hathaway's (BRK.A ) annual meeting is scheduled for May 2 in Omaha, Neb. Berkshire hosts one of the most interesting (and fun) annual meetings in the corporate world. Loyal shareholders from all over the place descend on the city to share their perspectives and to listen to Berkshire leaders Warren Buffett and Charlie Munger for their thoughts on the company as well as the economy and financial system.

Well, we've had a historic period in financial markets since mid-2007 or so, and this has included very poor results for Berkshire Hathaway. Berkshire shareholders aren't used to a 40% decline in the market value of their investment, and that's what they've had since both the Class A and Class B shares peaked in late 2007. In 2008, Berkshire had the largest one-year decline in book value per share in its history.

We believe the annual meeting this year will include spirited discussion of some of the factors that led to the difficult results in 2008, how Berkshire managed those issues, and what Berkshire's leaders are planning along those lines in the years ahead. We expect a more serious tone and focused conversation, but we also expect the loyal shareholder base to react well. Finally, though it might make the meeting less interesting for casual observers, the new rule this year that all questions must relate to Berkshire could help make this meeting the most valuable in years for Berkshire shareholders.

We think that some of the main topics of discussion, formally and around the community, during the annual meeting weekend will include:

Berkshire's Equity Market Exposure. Berkshire's investment portfolio carries a relatively high share of equity investments, and in turn, about 90% of its equity investments are concentrated in fewer than 20 companies. Although Berkshire is a conglomerate, insurance operations still form a large share of the overall pie, and this kind of equity exposure is pretty high on the charts for insurers. Last year, we had one of the worst years for the stock market since World War II, and declining stock prices led to a material but manageable hit to Berkshire's reported capital position. Berkshire's exposure also includes put options it has written on equity indexes, and writing up the liability on those contracts also played a role in the firm's decline in book value last year. We are comfortable Berkshire has applied conservative values to these positions, however, and we think it's still likely that Berkshire will ultimately make a profit on these contracts.

Economic Sensitivity of Berkshire's Operating Subsidiaries. The growing community of companies that Berkshire has purchased and consolidates on its financial statements includes a significant number of firms that are very sensitive to economic conditions. This will be a very interesting topic to explore, formally and informally, at the annual meeting. Berkshire has more than 60 noninsurance subsidiaries accounting for greater than half of the firm's overall revenue, and they include firms in flooring, manufactured housing, paints, furniture, insulation, recreational vehicles, metalworking, and jewelry businesses, all of them sensitive to the economic downturn that started in late 2007 and intensified as 2008 progressed. I'm going to be listening closely to Berkshire's read on the overall economy and the prospects for a recovery in 2009.

Catastrophe Reinsurance Markets. The insurance industry took a significant hit to capital in 2008 following poor investment results as well as a relatively hard catastrophe-loss year (Hurricanes Gustav and Ike produced heavy insured losses, albeit not so severe as the record 2005 losses arising with Hurricanes Katrina, Rita, and Wilma). Capital underlies insurance underwriting, and with the hit to capital, the supply curve has shifted in. In turn, the demand for quality reinsurance has risen, and market rates for catastrophe reinsurance have risen significantly this year after several weak years. Berkshire wasn't immune to storm or investment losses last year, but its capital strength and underwriting value still stands out from almost every firm on the reinsurance market. Given the firm's historic independent underwriting posture, we anticipate fairly aggressive reinsurance underwriting this year in light of the opportunity in the dislocated market. Berkshire's catastrophe reinsurance businesses could provide an underappreciated source of potential cash flow in the near term, but another hard-loss year could await, as well.

Municipal Bond Insurance. Berkshire entered the public finance insurance business last year, forming Berkshire Hathaway Assurance Company. Berkshire's entry followed on the heels of significant market disruption. In fact, for some of the largest municipal bond insurers out there, 2008 was a disaster. They extended their business models into backing various sophisticated and ultimately destructive structured financial vehicles that failed spectacularly. As a result, the quality of insurance and relationships with some of the largest municipal bond insurers was called into greater question around the public finance field. Berkshire viewed this as an opportunity, and we still see it that way. But the long and difficult recession is placing greater stress on municipal finances, and higher-than-anticipated losses could arise.

There are few rewards without risk, however, and we see opportunity for Berkshire and its shareholders in each of these areas. Morningstar's equity analysts have fair value estimates for Berkshire's common stock investments that generally lie significantly above their current market values, and the excess of those estimates over market accounts for about 5% of our total fair value estimate for Berkshire. Berkshire's operating subsidiaries have been tested by the recession, but we have reasonably positive longer-term expectations for their performance with a significant contribution to Berkshire's overall fair value. Heavy hurricane-loss years are very difficult to identify in advance, but Berkshire tends to valuably gobble up market share in difficult times, and we don't anticipate the firm to change its stripes on this score in the current market. Similarly, the municipal bond insurance business doesn't lack risk these days, but we expect a well-capitalized and sophisticated new entrant, such as Berkshire, to reap rewards for its willingness to underwrite in unsettled market conditions.

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