Buffet Persists in Offloading Apple and Bank of America Shares, potentially driven by this significant threat
Buffet Persists in Offloading Apple and Bank of America Shares, potentially driven by this significant threat
Warren Buffett's corporation, Berkshire Hathaway (BRK.A 1.37%, BRK.B 0.86%), unveiled its third quarter results last Friday, surprising some with its strategic moves. Notably, Berkshire reduced its significant stakes in popular equities like Apple (AAPL 1.88%) and Bank of America (BAC 1.82%).
In fact, Berkshire shed approximately 25% more of its Apple shares, bringing its total sales for the year to about 600 million shares, translating to around two-thirds of its yearly stake. Moreover, it liquidated several billion dollars worth of Bank of America shares, which had previously held the second-largest position in Berkshire's portfolio.
In a curious turn of events, Berkshire also chose not to repurchase any of its own shares for the first time since mid-2018. As a result, its staggering cash reserve swelled to a whopping $325.2 billion, a notable increase from its $276.9 billion figure at the end of June.
While Buffett has consistently acknowledged his lack of predictive abilities regarding short-term market fluctuations, these decisions suggest at least a hint of caution. A multitude of possibilities, including taxes and succession, could be influencing these sales, but they could also indicate the presence of another significant concern.
Inflation and interest rates
These sales could potentially signal a warning sign. Back in 1969, Buffett dismantled his partnership that mostly held public equities and distributed cash to his partners, stating the lack of undervalued securities in the market. Instead, he poured his energy into growing Berkshire Hathaway (then a textile mill) into the vast corporation it is today.
Buffett's move in 1969 might have been prophetically insightful, as the 1970s proved to be one of the stock market's Achilles' heels. Returns were incredibly modest throughout the decade, despite growing earnings, as the market's price-to-earnings ratio (P/E ratio) dropped from around 20 times earnings to just 7 times during this period.
The culprit behind the stock market's decline in the 1970s? Inflation. Following the government's excess spending in the 1960s, inflation spiked dramatically in the 1970s. The Federal Funds rate ended 1970 at a relatively low 4%, but surged to as high as 20% in the early 1980s, after then-Fed Chairman Paul Volcker took decisive action to curb inflation, leading to broad economic downturns.
Could Buffett be bracing for another surge in inflation and long-term interest rates? Let's investigate why Berkshire's recent selloff of Apple and Bank of America shares may indicate this possible scenario.
Why higher rates may harm Apple
Buffett has a knack for identifying stocks that exhibit some level of resistance to inflation. Pricing power is an oh-so-desirable quality that Buffett seeks in his portfolio companies. This refers to the ability of a company to boost prices in response to inflation without losing customers.
Apple's loyal customer base undeniably gives it some pricing power over competitors. This is likely the reason why Buffett first invested in the stock in 2016. However, Apple's expensive products, such as iPhones and MacBooks, might limit its ability to further extract value from customers if inflation escalates.
Additionally, Apple stands as a large and mature company, growing revenues only 6.1% in its last quarter. Yet it also trades at a high valuation of around 36 times earnings. This is a stark contrast to 2016, when it traded around 12 times earnings at its lows.
While Apple's business does not seem to be in imminent danger, its stock could take a substantial hit if interest rates were to skyrocket and stock P/E ratios were to plummet. While Apple may fare better than other tech stocks in this scenario, its high valuation might not provide a sufficient safety margin.
Bank of America is vulnerable to rising rates, too
Some might question why Buffett would choose to sell his Bank of America shares given its relatively modest P/E ratio of 15, neither exceptionally high nor low for a bank. In theory, higher long-term interests rates Could boost Bank of America's loan yields and net interest margins.
However, there are also a couple of reasons that could negate this advantage. If a recession were to strike as a result of rising interest rates, underwriting results would suffer.
Furthermore, Bank of America has a potential risk lurking on its balance sheet. During times of low interest rates (e.g., the pandemic period), Bank of America purchased substantial quantities of long-term "risk-free" Treasuries and mortgage-backed securities at bargain prices. However, as interest rates shot up in the post-pandemic period, the value of these securities plummeted. In Q3 2021, Bank of America reported $85.7 billion in unrealized losses on these securities.
Since Bank of America has no intention of selling these securities prematurely, they may classify them as "held-to-maturity." Consequently, they are not required to account for these losses against their tangible common equity, which currently stands at $200 billion.
These unrealized losses constitute a significant portion of Bank of America's existing equity. And if long-term interest rates escalate further, these losses could grow significantly. Currently, the rules would safeguard Bank of America from seeing its equity dwindling. However, it's possible that Buffett is hesitant about this scenario, particularly if interest rates were to soar even higher.
Buffett and his team members Todd Combs and Ted Wechsler haven't just been offloading shares. One notable acquisition this year was Chubb (CB with a 0.01% increase), the leading publicly traded firm in the field of property and casualty insurance.
Chubb has traditionally served the affluent market with its "Masterpiece" homeowners insurance, providing it with market-leading pricing power.
Insurers have a unique position as they are more reliant on the insurance cycle rather than the economic cycle. When an insurer is in a positive position, it can adjust prices in line with inflation. Furthermore, the bonds that make up a significant portion of their net income are regularly expiring and being reinvested. Chubb's bond portfolio duration is relatively short, around five years, contrasting longer-term bonds like Treasuries or mortgage-backed securities. This means Chubb could potentially reinvest expiring bonds into higher-yielding securities quicker than banks like BofA, generating investment income at a faster pace.
Keep calm and stay informed
It's worth noting that Apple and Bank of America still represent larger assets for Berkshire than Chubb, with Chubb being a recent acquisition and the others being in the process of sale. This could suggest that Buffett is simply reducing risk in heavily-valued positions.
However, investors should be cognizant of the potential policy proposals from the new presidential administration that could escalate government deficits and inflation. Inflation could negatively impact several stocks, including Apple and Bank of America, as previously mentioned.
With the new president taking office and the Federal Reserve addressing post-pandemic inflation, investors should remain vigilant to these risks. Given Buffett's apparent concern, it seems prudent to remain alert.
Given Buffett's decision to significantly reduce Berkshire Hathaway's stakes in Apple and Bank of America, and the lack of share repurchases, it raises questions about potential concerns related to inflation and interest rates. Buffett's previous actions in the 1960s, such as dismantling his partnership and focusing on Berkshire Hathaway, suggest he may be preparing for a period of high inflation, which was indeed a challenge for the stock market in the 1970s.
The high valuations of Apple and Bank of America, coupled with their potential vulnerability to inflation and interest rate hikes, could be driving Buffett's decisions. Apple's expensive products and Bank of America's significant holdings of long-term Treasuries and mortgage-backed securities could be at risk in an environment of rising interest rates.
In such a scenario, Berkshire's investment in Chubb, a leading insurance firm with pricing power and a relatively short bond portfolio duration, could be a strategic move to mitigate these risks. Chubb's ability to adjust prices with the insurance cycle and reinvest expiring bonds into higher-yielding securities could provide better resilience against high inflation and interest rates.
As investors, it's crucial to stay informed and vigilant about these potential policy proposals and market trends. Buffett's actions seem to indicate a cautious approach, so it could be prudent for investors to do the same.