The ultimate departure of Warren Buffett and Charlie Munger will have less of an impact on Berkshire than many believe it will. For much of the past five decades, Buffett and Munger have focused on building and acquiring businesses that would fit seamlessly into their organisation.
A big part of Berkshire's success has been due to the company's operating subsidiaries being managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility down to the subsidiary level. We don't expect much to change in that regard once Buffett and Munger depart the scene.
Where the company will be lacking is in having capital allocators of their calibre, with the knowledge and connections that they have acquired over the years, running that part of the business. That said, we are encouraged to see Buffett's two lieutenants Todd Combs and Ted Weschler getting far more involved in the operating subsidiaries, as opposed to just focusing on stocks in the insurer's equity portfolio. We like the fact that the two front-runners for the CEO job Ajit Jain, head of Berkshire's reinsurance and specialty insurance operations, and Greg Abel, head of the company's utilities and energy subsidiary, have bountiful amounts of capital allocation experience.
Regardless of who succeeds Buffett and Munger longer term, the next managers will not need to do anything too heroic as long as they continue to earn more than the company's cost of capital, which is extremely low. We're remain encouraged by the fact that Berkshire has plenty of cash on hand and a disciplined share-repurchase program in place, allowing it to step in and buy back meaningful levels of stock in the event that something does happen to drive the value of Berkshire's shares below 1.2 times book value, which is the threshold that Buffett has established for share repurchases.
How is Berkshire Performing?
The big news during the first quarter of 2017 for Berkshire Hathaway Reinsurance Group (BHRG) was the deal that it put together with American International Group, which threw a wrench into our negative earned premium growth forecast for the business. We expect things to look more normal in the second quarter, with earned premiums declining for both General Re and BHRG and the two companies squarely focused on keeping their combined ratios below 100%.
The same could not be said for BHPG, which has generated double-digit earned premium growth in each of the past 12 quarters. As for the investment portfolio attached to the insurance operations, we expect rising interest rates and favourable market conditions to have a positive impact.
With respect to Berkshire's noninsurance operations, our fair value estimate assumes significantly better near-term coal volume, as well as improved operating income and returns on invested capital and a decrease in the company's tax rate longer term. The railroad has been beset by a shortfall in coal volume that started in the first quarter of 2016 with volume falling 21% last year, as well as a falloff in industrial products. Things looked better in the first quarter of 2017, with coal and industrial products volumes increasing 19% and 1%.
Berkshire's regulated utility and energy business, has always been the least volatile of the insurer's operating companies, given that the regulated utilities operate in an environment where in exchange for their service territory monopolies, state and federal regulators set rates that aim to keep customer costs low while providing adequate returns for capital providers.
As for Berkshire's manufacturing, service, and retail operations, which now account for one fourth of the company's pre-tax earnings, we expect mid-single-digit revenue growth with pre-tax margins of around 7% for the second quarter. The same could be said for the company's finance and financial products division, with our forecast calling for mid-single-digit revenue growth and pre-tax margins above 25%.
When we added Berkshire to our Best Ideas list at the end of July, the shares were trading at a 10% discount to our current fair value estimate and 16% above Berkshire's own threshold for buying back stock of 1.2 times book. While not the biggest discount we've seen in the shares, we like that there is the potential for book value per share expansion beyond our own projections, especially with regard to tax reform.
Dividend Payment Looks Likely
We also expect the company, which had $96.5 billion in cash and cash equivalents on the books at the end of the first quarter to pay out a one-time special dividend of around $20 billion midway through our five-year forecast. This will only come to fruition, though, if cash balances continue to grow and the company lacks identifiable investment options.
Buffett said at the annual meeting this year that it would become untenable for the company to sit on more than $150 billion in cash and equivalents in the near to medium term, which is where things would go without any meaningful additions to the portfolio the next several years.
Our main assumption here is that any dividend paid before Buffett departs would be one-off in nature as opposed to a regular quarterly dividend. This would then leave the managers that follow him with an arrow in their quiver; the ability to start paying a regular dividend, that should provide them with time to prove themselves to shareholders while also admitting that, as they are unlikely to ever come close to matching the record Buffett put together, excess capital should be returned to shareholders more regularly.
