It is quite staggering to imagine a holding company that generates 19.7% cumulative annual rate of return over 45 years. It's even more intriguing to comprehend its success considering the time-span, and the business cycles it has withstood. Yet Berkshire Hathaway (NYSE:BRK.B) has outsmarted the S&P 500 by a whopping 10.3% on annual compounded basis. The general perception in popular media is that Mr. Warren Buffett alone is the driving force behind the astronomical long-term success of the company. That has led to speculation with regards to the future of Berkshire Hathaway since he is 82 now (more on that later). But that is not necessarily the case, as Mr. Buffett himself pointed out of his own shortcoming in 2012 annual shareholder letter. Charlie Munger has been a wise advisor to Mr. Buffett for over 50 years, but that still does not quite explain the phenomenal performance. To associate the outstanding performance of a company to one or two individuals is quite naive. Instead, it is far more fruitful to understand the underlying philosophy driving the behavior of such incredible individuals.
Mr. Buffett and his co-pilot's investment philosophy have been greatly inspired by Benjamin Graham. The investment philosophy is primarily value based with a long-term perspective. Berkshire Hathaway, since its inception, has put great emphasis on the intrinsic value of the Business, not the stock per se. In 1995's shareholders annual letter Mr. Buffett pointed out that in terms of strategy with respect to acquisitions, their competitive advantage lies in the fact that they don't really have a framed strategy. Instead they (Buffett and Munger) are more inclined towards deciding whatever makes economic sense to the shareholders. This is done through mentally comparing dozens of other opportunities that are available instead of sticking to a strict 100% acquisition-only strategy.
Their investment decisions are firmly grounded in the belief (and rightly so) that business performance precedes stock performance. This entails a considerable amount of patience and conviction in one's decisions, but that is primarily the essence of value investing. Digging deeper, one would realize the consistency of investment policy over the years. In the recent annual shareholder letter (2012), Mr. Buffett pointed out that it is better to own a small share of a wonderful business than to hold 100% of a so-so company. The same (literally) words are echoed in a 1995 annual shareholder letter. An example of that are American Express (NYSE:AXP), Coca-Cola (NYSE:KO), International Business Machines (NYSE:IBM) and Wells Fargo (NYSE:WFC), of which Berkshire holds a relatively smaller fraction but intends to increase its stake in the future. The reason for holding such companies points towards an important criterion for choosing business: Management. Berkshire Hathaway has been very peculiar with respect to the acquiring business's management. The four companies highlighted above not only possess great business economics but also have a management team, which is self-motivated and shareholder-oriented.
Berkshire Hathaway's corporate structure is also unique and is a major source of its competitive advantage. In comparison to a traditional Private Equity firm, the holding period is much greater, reiterating the value investing philosophy of identifying Business with favorable economics and great management and holding them indefinitely.
Post-acquisition management interaction is also an interesting comparison. Berkshire Hathaway rarely interacts with its subsidiary companies' management. This gives confidence to managers in their ability to run the business without major supervision. It has been, ironically, a significant factor contributing to Berkshire's success. Cost cutting again is never really an option for Berkshire instead it has had a history of funding major capital expenditure in the past. In 2012, total capital expenditure increased by 19%, which is relatively higher considering the economic uncertainty surrounding the US economy. An example of that have been BNSF (transportation) and MidAmerican's electric utility (Energy). Major capital expenditure has been focused on the above two companies since Berkshire believes that society would forever need massive investment in both the sectors. An excerpt from the 2012 annual shareholder letter sums up the point: "Charlie and I love investing large sums in worthwhile projects … We will keep our foot to the floor and will almost certainly set still another record for capital expenditures in 2013. Opportunities abound in America." This is a statement in the midst of massive uncertainty, reasserts the long-term perspective that Berkshire has with regards to its investments. An added advantage is the breadth of Berkshire's investments providing benefit in terms of the options for capital intensive expenditure.
The company's plan with regards to its cash spending also hints towards the sort of strategy that it follows. Mr. Buffett pointed out that giving out dividends is not really a great idea; instead, he would rather invest in capital intensive projects that would yield better rate of return for the shareholders cumulatively in the long run. The second preferred use of cash is acquisitions, but he pointed out that adding value to the holding company through acquisitions would be tougher now, given the size of Berkshire. Third is repurchasing of shares at a lower price. Dividends don't cut it in Berkshire's corporate strategy and rightly so, given its reinvestment philosophy based on long-term growth.
Going forward, Mr. Buffett will be gone soon but that does not imply that the company is in jeopardy. Although no explicit mention of the next man in charge has been made. The annual shareholder letter from 2012 pointed towards Todd Combs who is young and has proven his worth in Berkshire by betting successfully in the last few years. Mr. Buffett has increased assets under his management showing increased confidence.
The strategy for Berkshire is more of a philosophy embedded firmly in value investing. The speculation of Berkshire fading after the demise of Mr. Buffett is not warranted since the investment behavior underlies a philosophy that would remain intact for years if not decades to come.