I think it likely that 1st quarter earnings at Berkshire will again offer a positive surprise. Emboldened buy lucky guesses last year and being too stupid to quit while ahead, I will attempt the impossible (predict Berkshire’s first quarter)

Since Berkshire does not choose to break out fourth quarter results, I will start by doing this for them (by subtracting the nine month totals for operating earnings from those for the full year). This yields the following figures for the 4^th quarter of 2006

Underwriting Gain = $1,323 million
Investment Income = $1,093 million
Operating Businesses = $1,761 million

Total 4th QTR 2006 Operating Earnings = $4,177 million

Pre-tax Investment and derivative gains = $1,104 million

Total Pre-tax income 4^th Qtr $5,281 million

The most surprising thing about Berkshire's fourth-quarter earnings was the strength in the operating businesses. Everyone had expected underwriting profits to be strong because of quiet storm season, and they were at $1.3 billion; but as it turned out the biggest story was the operating companies. While underwriting profits were up $543 million in the fourth quarter, profits of the wholly owned subsidiaries were up $697 million. This is an increase of 66% from 2005. Part of this gain can be explained by acquisitions, but probably only about $250 million. That leaves us with something like $450 million that can only be classified as systemic growth within these operating companies.

This was indeed, a pretty good quarter, but while most people gave the credit to the hard insurance market, profit growth at our wholly-owned companies is a bigger story. This is because while the underwriting profit will be difficult to sustain, profits at the subs are likely to continue to grow. To maintain the 60% growth rate from the last year Berkshire is going to have to make big acquisitions, something they have not been able to do for the last six months, but the $450 million extra gain in the four quarter indicates that Berkshire may be able to maintain a reasonable rate of growth even without acquisitions.

To estimate underwriting gain for this years 1^st quarter I also want to look at the first quarter of last year. For the first quarter of 2006 we have the following figures.

Underwriting Gain = $511 million
Investment Income = $1,018 million
Operating Businesses = $1,309 million

Total 1st Qtr 2006 Operating Earnings = $2,838 million.  

Underwriting profits in the first quarter of the year are always down from the fourth quarter of the previous year because of the way Berkshire books the profit from its Cat coverage. In the first quarter of 2006 underwriting profits were down 35% compared to the previous quarter. So we can start our estimate by knocking 35% off underwriting profits for the fourth quarter (plus some extra for expected premium weakness in the Cat business). Investment income should be about flat, but income from operating businesses should remain strong and show about the same rate of quarter to quarter growth that it established in 2006. These assumptions yield the following figures.

Underwriting Gain = $700 million
Investment income = $1,100 million
Operating Businesses = $1,900 million

Estimated Total Operating Earnings 1st Qtr 2007 = $3,700.00

This would be an increase of 30% from last year, but seems to me a reasonable guess. At 35%, taxes would take about $1,295 million and that would leave $2,405 after tax, plus whatever investment gains there are. This will come as a shock to Mr. Market, who, it appears, doesn't expect much from Berkshire's first-quarter because of the weakening in the insurance market.

Part 2 - Investment and derivative gains

Operating business income may not be the only surprise in Berkshire's first-quarter report. Last year, the big story, coming in, was the hard market in the Insurance business, but it turned out in the end, that the strongest growth in earnings came from the operating business.

This year I think the underwriting gain will flatten and then decline, operating companies will remain strong but not as strong as last year, and that the story this year may be derivatives. In last year's first quarter Berkshire listed $354 million in derivative gains, and $447 million in investment gains, but this Year there is the potential for larger gains in derivatives. The annual report listed Warren’s derivative positions on page 40, and one of those was described as credit default obligations with the notational value of $2.5 billion. Warren’s explanation;