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Quarter-End Insights

Financial Services: Berkshire Is Bigger Than Buffett

Although the wide-moat firm is unlikely to grow book value like it did in the past, future returns should still come in solidly and consistently above the firm's cost of capital.

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  • The financial-services sector remains reasonably undervalued and recently traded at a market-cap-weighted price/fair value estimate ratio of 0.94.
  • Berkshire Hathaway will survive the departure of Warren Buffett and Charlie Munger. With the company's next CEO expected to fill the role of capital-allocator-in-chief, we see two strong candidates in line to take the top job: Ajit Jain, who runs Berkshire's reinsurance operations, and Greg Abel, who heads up Berkshire Hathaway Energy. Although Jain is probably the first name on the board of directors' list for the position, we believe Berkshire would likely be better served longer term by having him focus on overseeing the entire insurance business while Abel--working closely with Jain, as well as Ted Weschler and Todd Combs--focuses on properly allocating Berkshire's capital.
  • Berkshire will eventually focus on returning more cash to shareholders. During the past three calendar years, Berkshire has generated an average of $16.3 billion annually in free cash flow. With investment opportunities few and far between, the company continues to build up large amounts of cash on its balance sheet, which we think (barring investment opportunities) should be dedicated to dividends and share repurchases longer term. While Berkshire's share repurchase policy is well-known, we believe the firm could easily return one third of its annual free cash flow to shareholders. That said, we don't expect that to occur until after Buffett departs the scene.

 

We think two big concerns--a belief that Berkshire Hathaway's (BRK.B) size will prevent it from growing at a decent clip in the future and that the company's shares will get pummeled once Buffett no longer runs the show--have kept some investors on the sidelines. Although we believe that the wide-moat firm is unlikely to consistently grow its book value per share at a double-digit rate, something that happened nine times during 2001-15 and 40 times during 1965-2015, we think that Berkshire can grow its book value per share at a high-single- to double-digit rate going forward, much as we've seen since the start of the new millennium. This type of growth should leave returns solidly and consistently above the firm's cost of capital, which we estimate to be 7.8% right now (and somewhere closer to 6% when adjusting for the no-cost float generated by its insurance operations), something that we've come to expect from companies with wide economic moats.

Who will ultimately fill Buffett's shoes is still a big unknown. Berkshire's own succession framework has evolved some over the years, with Buffett's three main jobs--chairman, chief executive, and chief investment officer--expected to be handled by one nonexecutive chairman, one CEO, and one or more investment managers overseeing the firm's investment portfolio. While the Buffett family will not be directly involved in managing the business once he departs the scene, despite being involved in a handful of charitable foundations that will continue to be recipients of his fortune in planned annual transfers, he would like them to help pick and oversee the managers who do end up running the show longer term. This explains the recommendation he has made for his son, Howard Buffett, to serve as nonexecutive chairman, ultimately acting as a guardian of the company's values and adding "one extra layer of protection" for shareholders once he is gone.

Looking more closely at the role of chief investment officer, it looks like Buffett has settled on handing off this responsibility to Todd Combs and Ted Weschler. That would leave the role of chief executive as the last piece of the puzzle in Berkshire's succession plan. We continue to envision the main role of the next CEO at the firm to be one of capital-allocator-in-chief. Buffett has, however, noted that the job requires more than investing prowess. He has said that he would not want to put someone in charge of Berkshire who only had investing experience, with no operational experience to speak of, and has noted in the past that he would not have learned as much as he has about operations through the years had he stuck solely with investments.

If the company's next CEO is expected to do nothing more than act as a caretaker for the business, tending to the needs of the managers that run all of the different subsidiaries, overseeing the actions of the investment managers that handle the company's investment portfolio, and dealing with the capital-allocation decisions and critical risk assessments that need to be made during any given year, we could not think of a better candidate than Ajit Jain, who oversees Berkshire's reinsurance operations, as well as a fair number of companies in Berkshire Hathaway Primary Group.

Not only does Jain understand risk (across a wide range of industries) better than just about anyone else at Berkshire, but Buffett has admitted on countless occasions that Jain has "probably made a lot more money" for the firm than Buffett has over the nearly three decades he has been with the company, continually singling him out for praise.

While we firmly believe that Jain's name is first on the list of candidates that Berkshire's board of directors has put together to replace Buffett when that becomes necessary, we think the odds of him taking the top job are 50/50. Jain is a private person who, in our view, is likely to be uncomfortable under the spotlight that would come from not just running Berkshire but following in the footsteps of the Oracle of Omaha. He has also been on the record on several occasions in the past saying that he is not interested in the job.

This is the main reason we regard Greg Abel, who has not only run Berkshire Hathaway Energy but has been involved in every kind of deal the firm has done over the past 20 years, so highly. With insurance still such a complex and integral part of Berkshire's operations, it makes more sense, in our view, for Jain to stay put, eventually overseeing all of Berkshire's insurance operations (especially as Geico's Tony Nicely moves closer to retirement himself) and have Abel, who falls into the "relatively young" category and has a lot of operational experience with a capital-intensive firm that has also been fairly acquisitive, assume the CEO role once Buffett leaves the scene.

Abel has been in the enviable position of having a ton of capital to work with, given that BHE does not pay a dividend (all while the company's publicly traded peers pay out 60%–70% of their earnings annually), and has produced exceptional returns in a highly regulated industry, making the case for him even stronger. That said, we would expect Abel to not only work closely with Combs and Weschler--who were brought on to focus primarily on the firm's investments and corporate capital allocation decisions--but avail himself of Jain's guidance on capital allocation decisions should he be selected to run the show.

In our view, simply believing that the rest of Berkshire's Class A shareholders will continue to ask nothing more of the company's board of directors and management team--other than to continue running things in accordance with the principles that Buffett has laid down over the years--might not be the best strategy for managers to follow in the long run. Although there are some issues that might limit Class A shareholders' ability to eliminate their stakes in the firm, with the most obvious being the lack of liquidity of the share class, as well as the tax implications for long-standing holders of the shares (30 years ago the Class A shares were trading at $2,900 per share), there is nothing keeping them from walking away from their investment in Berkshire once Buffett (who was likely the biggest reason they invested in the company) is no longer running the show.

That said, Berkshire has laid out a well-defined share-repurchase program, being willing to buy back shares at prices below 1.2 times its most recently reported book value per share, which we feel has effectively put a floor under the company's stock. From our perspective, the buyback program is notable for being open ended, as it does not (and continues not to) specify a maximum number of shares or a dollar amount that can be spent, only noting that repurchases will not be made if they would reduce Berkshire's consolidated cash equivalent holdings below $20 billion.

While share repurchases are acceptable to Buffett, the idea of Berkshire paying a dividend continues to be anathema to him. At this point, he has no plans to pay a dividend, and we don't expect that to change so long as he continues to run the show. That said, in holding off on paying a dividend, Buffett, in our view, is actually providing the managers that follow in his footsteps an extra arrow in their quiver that they would not have had available to them had Berkshire started paying a dividend before Buffett left the scene. Because they are likely to be under a much bigger microscope than Buffett ever was and are already up against a giant hurdle in that they will be following in the footsteps of one of the best capital allocators the market has ever seen, admitting that they are unlikely to ever come close to matching Buffett's track record and that Berkshire generates and retains too much excess capital could go a long way toward buying them the time they'll need to prove themselves.

Regional Banks Outlook

China
Chinese banks generally reported slowing growth in the first half of the year, and we don't expect much change in the near term. Fee income weakness was in settlement and financial consulting services, and certain price cuts in bank card and settlement-related fees, and lower growth in income related to wealth-management products as interest-rate spreads narrowed. For net interest income growth, the banks broadly recorded a mid-single-digit decline, attributable to loan rates repricing 125 basis points after five interest-rate cuts in 2015; the value-added tax reform that started in May; and lower interbank asset returns and banks increasing their allocation toward bond investments.

Asset quality outlooks were mixed, as all banks saw lower bad debt formation. By industry, wholesale, manufacturing, and mining are major sources of bad debts, while transportation, utilities, leasing, and commercial services improved. Eastern and coastal areas still reported higher percentages of nonperforming loans than other regions, but with decelerating growth in these areas. Credit quality deteriorated faster in middle and western China, including Shanxi, Jiangxi, Henan, and inner Mongolia. Loans to small and midsize enterprises are also challenging.
Iris Tan, CFA

Australia
The big picture in Australia is playing out as expected. Australian GDP growth is about 3.2%, with expected declines to an average of 2.8% in 2017 and 2.6% in 2018. Longer term, we maintain our forecast of GDP growth averaging approximately 2.5%. Unemployment is expected to hold steady around 5.5%-5.7%, indicating spare capacity in the labor market. We expect the Reserve Bank of Australia to hold the 1.5% cash rate steady in the near term, but two cuts are likely to follow in mid-2017 as low inflation persists. Recent data on wages has also been soft, with growth in the wage price index steadying at 2.1% year on year in the second quarter of 2016. The recent data is consistent with our forecasts for wage growth to remain subdued through the forecast horizon.

Credit growth is about 6%, but the rate of growth is slowing modestly. We expect system credit growth to decline modestly to around 5% during the next few years.

Bad debts are trending higher from cyclical lows, but we don’t expect a sharp increase in bad debts as our base case is that the Australian economy holds together and muddles through as the economy transitions from the extended period of massive stimulus from the mining investment boom and historically high export prices.

Export prices have rebounded, with iron ore around $55 per metric ton (up 50% from December 2015 lows) and coking coal around $190, double the price it was in January 2016. Exports of liquefied natural gas are ramping up and will soon be making a significant contribution to GDP.

The Australian economy is benefiting from strong growth in residential construction, education, tourism, medical research, professional services, agriculture, and advanced manufacturing. Residential construction (particularly inner-city apartments in Sydney, Melbourne, and Brisbane) is at record levels, but the sharp increase in volumes is creating unusual uncertainty. The risk of residential property developer defaults and potential apartment prices falling is increasing risk for the economy and by default the major banks.

The population of Sydney, Melbourne, and Brisbane has grown by a third in the past 20 years and the state governments of New South Wales, Victoria, and Queensland are forecasting that the population of the three capital cities will double in the next two decades. Despite housing prices that continue to increase, demand for well-located detached housing in capital cities is expected to outstrip supply for several years at least.
David Ellis

Singapore
The main concern remains the Singaporean banks' exposure to the oil and gas sector. While most banks clarified their oil and gas exposure in previous results, DBS Group Holdings (D05) flagged a large nonperforming exposure before its second-quarter results, which renewed some concerns over the deterioration of its oil and gas exposure. However, we believe the deterioration is contained as the increase in nonperforming assets for all three banks are in line with our forecasts. We continue to expect credit cost to increase over the next two years as economic conditions remain challenging and the banks steadily draw down their allowance. Overall allowance coverage is prudent, ranging 100% to 125% on nonperforming assets. This is supported by steady profitability and improving capital position as all three banks saw their pro forma common equity Tier 1 ratio rising to 12.2% to 13.4%.
Michael Wu, CAIA

Top Picks

Affiliated Managers Group (AMG)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $195.00
Fair Value Uncertainty: Medium
Consider Buying: $136.50

AMG continues to trade below our fair value estimate, despite most of the rest of the U.S.-based asset managers rallying off of the market lows after the Brexit vote in late June. While some discount in the shares is warranted because of the company's greater exposure to emerging and developing markets, as well as the United Kingdom and Europe, which does increase its risk profile in the near term, we think that the fundamentals of AMG's business model, with a projected future organic growth profile that is on par with some of the better flow generators in the group, remains intact and that the current discount to the rest of the group presents a decent buying opportunity for long-term investors.

Commerzbank (CBK)
Star Rating: 5 Stars
Economic Moat: None
Fair Value Estimate: EUR 10.00
Fair Value Uncertainty: High
Consider Buying: EUR 6

Commerzbank reported a difficult first half, with low profits and weakening capital levels. Capital markets activity has declined, and its Mittelstandsbank division has been hurt by negative interest rates, which have affected deposit margins, as well as intense competition for market share. On the positive side, costs remain under control and credit markets continue to improve. The bank is attempting to convince clients to move excess deposits elsewhere and is already charging certain large corporate clients to keep deposits on hand. However, the bank has made substantial progress in terms of wrapping up its noncore assets, and we think investors have sold off many European banks indiscriminately in 2016, providing undervalued opportunities.

Aegon (AEG)
Star Rating: 4 Stars
Economic Moat: None
Fair Value Estimate: $6.90
Fair Value Uncertainty: Very High
Consider Buying: $3.45

Aegon is struggling with a structurally difficult Netherlands market and poor U.S. execution. We believe that the focus on building a strong platform and asset management offering, despite the initially high integration expenses, is beginning to take shape. The focus, particularly in Europe, continues to be a reduction in costs from moving customers onto a platform that also enables customers to take advantage of a better service proposition. Despite lower solvency levels, we continue to believe the business can generate reasonable levels of profitability in the near term while maintaining leverage and reducing costs.

More Quarter-End Insights

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Basic Materials: China-Dependent Producers Largely Overvalued

Consumer Cyclical: Poised to Perform in the Second Half

Consumer Defensive: A Handful of Values in an Overheated Sector

Energy: Rally in the Works, but It Won't Last Long

Healthcare: We See Value in the Drug and Biotech Industries

Industrials: Weak Commodity Prices Weigh

Real Estate: Expect Some Choppy Waters Ahead

Tech & Telecom: Opportunities in Smartphones and IT Services

Utilities: How Long Can the Yield Paradox Survive?

Stephen Ellis does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.