Higher interest rates, Donald Trump's election and a massive pile of cash will fuel Berkshire Hathaway stock's rally in 2017.
Shares of Warren Buffett-led Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) delivered a blowout performance in 2016 by easily beating the S&P 500 (INDX:SPAL) and Dow Jones Industrial Average (INDX:INDU) and ending the year with a market cap of almost $400 billion for the first time in its history. And I believe the good times will continue in 2017.Rising interest rates
Berkshire Hathaway gets a significant portion of its earnings from its insurance businesses, which includes insurers like GEICO and General Re. In the first nine months of 2016, a little over 20% of the company’s net earnings came from its insurance business, which makes this the single largest contributor to Berkshire Hathaway’s bottom-line.
A large chunk of insurance income comes when the company invests the “float”, or funds generated by selling insurance policies, in liquid securities. But after the global financial crisis, the US Federal Reserve had slashed interest rates to near zero. That pushed yields on securities to historic lows dragging Berkshire Hathaway’s interest income. But things will likely begin to improve in 2017.
Last month, the US Federal Reserve increased interest rates for only the second time since the financial crisis to a range of 0.50% to 0.75%. Moreover, the US central bank has now predicted three interest rate hikes for 2017. If the Fed continues to increase rates by 25 basis points in 2017, then it could take the federal funds rate to as high as 1.25%-1.5% by the end of next year. The yields will likely move higher throughout 2017, which will have a positive impact on Berkshire Hathaway’s interest income, which will be a major growth driver for the company’s insurance earnings.
In addition to this, Warren Buffett has also built sizable positions in a number of major US banks. Wells Fargo (NYSE:WFC), U.S. Bancorp (NYSE:USB) and Goldman Sachs (NYSE:GS) have the leading positions in Berkshire Hathaway’s portfolio. In fact, Wells Fargo is Berkshire Hathaway's second largest stock holding. In addition to this, Berkshire Hathaway also owns $5 billion worth of Bank of America’s preferred shares and warrants to buy 700 million of the bank’s ordinary shares at just $7.14 (current price $22.10) anytime until September 2021. These banks are positioned to become the biggest beneficiaries of the increase in interest rates. To get an idea of how this might happen, consider Bank of America’s forecast in which it predicted a $7.5 billion boost to annual net interest income following a 1-percentage-point increase in interest rates.Economic Policies Of Donald Trump
In addition to this, Donald Trump could also turn out to be a big growth driver for Berkshire Hathaway. The President-elect has promised to take a number of measures, such as tax cuts, uptake in infrastructure spending and deregulation, which could stimulate economic growth. Mr. Market is optimistic about the future of the US economy under Trump, which is one of the reasons why the S&P-500 and the Dow Jones have climbed almost 5% and 8% respectively since the November 8 presidential elections. If Trump actually delivers, then it could work out well for Berkshire Hathaway.
The US recovery will lay the foundation for additional interest rate hikes in 2017, which is a big positive for Berkshire Hathaway’s insurance and banking businesses. Furthermore, Berkshire Hathaway’s other non-financial subsidiaries will also benefit from US growth.
The complex metal components maker Precision Castparts, for instance, which Berkshire Hathaway acquired a year earlier for $32.1 billion, could witness a surge in orders from aerospace, power and industrial customers. Berkshire Hathaway’s railroad subsidiary BNSF, which covers more than 32,500 route miles, could report an uptake in demand for transport of consumer and agricultural goods. The president-elect has also talked about reviving the flagging coal industry as well as the energy sector, which could also benefit BNSF, whose locomotives are used for transportation of commodities as well as industrial products used by the energy industry.
Also note that Berkshire Hathaway has direct exposure to the US energy sector through its subsidiary Berkshire Hathaway Energy, which is a power company that also owns two interstate natural gas pipelines. Besides, Berkshire Hathaway’s stock portfolio also has some exposure to the energy sector. The company owns 80.7 million shares of Phillips 66 (NYSE:PSX), a major US-based refiner that is also expanding in the midstream space, valued at almost $7 billion. Phillips 66 represents more than 5% of Berkshire Hathaway’s stock portfolio. The conglomerate also owns 20 million shares of the pipeline giant Kinder Morgan (NYSE:KMI), valued at $414.2 million. These energy companies are positioned to benefit from Donald Trump’s pro-energy policies and de-regulation.Huge Cash Reserves
What’s particularly unique about Berkshire Hathaway is that it has amassed an enormous cash pile of $84.8 billion. With the exception of a few large banks, no other publicly traded company in the US has a bigger cash hoard. This has put Berkshire Hathaway in a great position to use its cash reserves to boost shareholder value by making large acquisitions. Berkshire Hathaway has frequently said that it would keep at least $20 billion of cash reserves to meet any unforeseen insurance losses. This means that the conglomerate can use up to $64.8 billion for acquisitions.
There are dozens of major companies that could be on Warren Buffett’s radar, ranging from food company General Mills (NYSE:GIS) valued at $36 billion to discount retailer Dollar General (NYSE:DG) valued at $20.5 billion. Rumors are also abound that the Oracle of Omaha backed Kraft Heinz (NSDQ:KHC), which is Berkshire Hathaway’s largest stock position, could make a bid for snack giant Mondelez International (NSDQ:MDLZ) valued at almost $65 billion, although these might just be rumors since Buffett himself ruled out the possibility of a Mondelez deal in mid-2015.
In addition to this, Berkshire Hathaway can also deploy the cash reserves on expanding its stock portfolio. The company could, for instance, load up on additional shares of Apple (NSDQ:AAPL). The technology company became a part of Berkshire Hathaway’s stock portfolio last year, and it’s still a fairly small position, representing just 1.3% of the portfolio. Thanks to its large size, Apple can’t grow rapidly anymore. But Berkshire Hathaway might still like Apple since it generates strong and reliable levels of free cash flows, which are still growing at double-digit rates, and is expanding rapidly in the higher-margin services space. The company has recently said that it is eyeing record sales of $77 billion for the holiday quarter; and if the US economy expands under Trump, then Apple might witness an even better holiday season in 2017. Apple also pays a decent dividend yield of around 2% which will likely continue growing in the foreseeable future. Apple's shares are priced just 13-times this year’s earnings estimates, as per consensus data from Thomson Reuters.Bottom-line
Shares of Warren Buffett’s Berkshire Hathaway outperformed in 2016. The company’s performance will likely improve meaningfully in 2017 on the back of rising interest rates and Donald Trump’s pro-growth policies. On top of this, Berkshire Hathaway can also use its cash pile to boost shareholder value by making acquisitions or expanding its stock portfolio. therefore, I believe the conglomerate’s shares will continue to do well in 2017.