Like many other value investors and Buffett followers I paid passing attention to the headlines and summary articles on "Buffett's Alpha" by Andrea Frazzini, David Kabiller, and Lasse H. Pederson. The summaries were all roughly the same: Buffett achieved smashing success, trouncing the market, but he did so by a simple strategy of buying cheap, low-beta, high-quality stocks and levering his portfolio up by a 1.6 ratio. A secondary observation was that the public holdings of Berkshire Hathaway (NYSE:BRK.B) had outperformed its private holdings (companies owned outright).
I paid a couple of aspects of the paper far too little attention. I already knew the kind of public companies Buffett generally buys, and the authors were right about that - no news there. I also knew what they meant by portfolio leverage - mainly cash from insurance float, for accepting runoff positions like asbestos liability, and for selling long term puts on various markets. The characterization of these positions as leverage is fine, in a literal sense, but it's obviously quite a bit different from what leverage means when you do it in a margin account. The authors note this in passing, but I'm not sure the difference is clear to the average investor.
It is important to note that most of Buffett's "leverage" has an extremely high probability of running off to zero or to an infinitely receding horizon, including both insurance float and the cash received from his (often wrongly maligned) put writes. Berkshire's leverage differs from that of other large insurers like Chubb and Travelers only in its greater use of equity/ownership investments (in combination with a cash reserve currently not less than $20 billion) to offset potential future claims. Scale, diversification, and a history of successful underwriting (nine consecutive profitable years and counting) support the use of this approach.
It was the part about public versus private holdings that I passed over without thinking. I knew that Buffett has often expressed a preference for buying whole businesses over buying parts of businesses (public holdings). Buffett understands very well that control has enormous advantages when it comes to reallocation of capital and avoidance of double taxation of earnings.
Buffett's investment in publicly traded stocks may appear virtually random after factoring out value, quality, and low-beta, but it is not random with respect to time. Buffett entered many of his public stock positions when they were individually unpopular. It is interesting, then, that in the aftermath of the 2009 financial crisis he did not primarily add to his public equity positions.
Well aware that the market was on sale, as he had observed in a New York Times op-ed, he continued to ramp up his public holding of Wells Fargo but added nothing to his position in Coca-Cola and made modest new purchases in general. Instead he generally favored highly profitable specially structured deals such as the Mars-Wrigley financing. Even more interesting were his outright purchases of Marmon, and then Burlington Northern. Some were puzzled or critical at the time, but I doubt that they are now. These latter two purchases are already demonstrating a transformative power and leading a major transition from the Old Berkshire Hathaway to a New Berkshire Hathaway. They also provide a key commentary on the public-holdings-versus-private-holdings argument.
When glancing at public articles on the "Buffett's Alpha" paper I had lazily let the public-versus-private-holdings assertion pass unexamined until a comment by X.L on my recent article The Big Five: Which Would You Be Willing to Own If They Closed The Market for 20 Years raised the question. Let me thank him for prompting a train of thought which led to this article. I responded by saying that the researchers must be in some way mixed up in their efforts to evaluate returns on private holdings. I suggested that the commenter on my article might look at Buffett's 2012 Annual Letter for his comment on the understatement of Marmon's value on the Berkshire books. Then I kept on thinking about it: how the heck did the authors come up with their pricing of the private holdings anyway? The whole public-versus-private-holdings issue is very, very interesting
Public Holdings Versus Private Holdings
The "Buffett's Alpha" authors have a simple equation for the value of Berkshire's private holdings: at any given point in time it is Total Assets (Berkshire market value) less Public Holdings (at market value) less Cash. They added this:
"We note that the estimate of Berkshire's private companies includes the value that the market attaches to Buffett himself (since it is based on the overall value of Berkshire Hathaway). To the extent that there is randomness or mispricing in Berkshire's stock price (e.g., due to the Buffett-specific element), the estimated value and return of the private companies may be noisy."
"We cannot directly observe the value and performance of Buffett's private companies, but we can back them out based on what we know."
I must confess that I have some reservations about this "backing out" methodology for valuing Berkshire's private holdings, largely because it is based upon a peculiar stretch of an assumption using the efficient market hypothesis. By that assumption Berkshire is worth whatever Mr. Market says it is worth at any given moment (except maybe for a little Buffett-specific noise). If you back out everything with a hard value - cash and assets priced daily by Mr. Market - what remains is a hard value for what remains: the private businesses. I am not prepared to accept that daily stock quotes of Berkshire and its public holdings suffice to determine a hard value for the purpose of valuing private holdings.
Mr. Market, bear in mind, decided to cut the value of Berkshire in half between June of 1998 and March of 2000 while Mr. Market himself was going absolutely insane over dot-com companies. It then doubled Berkshire's price from that point to May 2002 while the market as a whole fell apart. Five years later it basically repeated the 50% drop during the interval of the housing meltdown while Berkshire's book value and earnings had a single year of modest decline then repeated a recovery of 150%. In the latter instance Berkshire stock closely (and wrongly, in terms of earnings and book value) correlated to Mr. Market as a whole.
To be fair, it is devilishly hard to get a reasonable estimate of private market value. I do, however, believe that there are better methods to extrapolate than this one. One commonly used method is to pick a similar company in the same industry, compare for various qualitative and quantitative factors, and then use that company's market cap as a basis for estimate. Even so the market cap of the company used for comparison may create distortions of its own by bouncing around somewhat randomly and irrationally. Some sort of average valuation must be used. In any case it is safe to say that the value of privately held companies is actually the least "noisy" of Berkshire's holdings in real world terms. It is more stable than the market value of publicly traded companies because the focus of private owners is firmly grounded in longer term streams of earnings and cash flow. I'm pretty sure Buffett looks at it this way, having described the long term cash generation for owners of companies as an "equity bond," which more or less disregards market pricing except for cost at purchase.
Even if one accepts this more realistic methodology for the valuation of privately held companies, it is very hard to get a meaningful time series of returns for the private holdings of Berkshire Hathaway. The acquisitions have taken place at different times, and thus produce a series that is lumpy and hard to reduce to smooth return calculations. The best approach is probably to get a back-of-the-envelope estimate by simply looking at the earnings series.
Taking the two most recent major Berkshire acquisitions with more than a single year of earnings - Marmon and Burlington Northern - the rate of increase in earnings since purchase has trounced the earnings growth of the overall market. If one assumes change in PE multiple similar to that of the market (I have to admit that this is hypothecation with which I am not perfectly comfortable), they would have outperformed the market. Using this methodology, a back-of-the-envelope estimate suggests that Buffett's private holdings have in fact outperformed his public holdings at least from the moment of these acquisitions.
There are two sources that potential Berkshire investors might find useful in confirming and elaborating upon this argument. The most detailed data is the readily available series of Berkshire annual reports and SEC filings. An excellent compressed form with convenient presentations of time series is contained in this work done by noted Berkshire enthusiast Whitney Tilson. But statistical estimate of the growth rate of wholly owned Berkshire subsidiaries stops well short of the more important story.
The New Berkshire Hathaway
One of the tables in the Tilson report on Berkshire points up an important change in its overall architecture. The compounded annual increase in per share public investment (appreciation plus new purchases) by decade was 27.5% for the 1970s, 26.3% for the 1980s, 20.5% for the 1990s, but only 6.6% for the 2000s. The per share increase in operating earnings of Berkshire's private holdings was 20.8% for the 1970s, 18.4% for the 1980s, 24.5% for the 1990s, and 20.5% for the 2000s. In other words, Berkshire's operating companies as a whole are gaining in importance relative to his portfolio of publicly trade companies.
Not only are Berkshire's privately held companies gaining on its public portfolio, they are likely to gain at an increasing rate in the next decade as earnings for Burlington, Marmon, Lubrizol, Iscar, and others are included for the entire period. This in itself does not say that these companies are outperforming the market (although their earnings comparisons suggest that they are), but it says something even more interesting. Berkshire is undergoing a major transformation. It is morphing from an investment company into an operating company. This New Berkshire Hathaway is very different in its overall architecture, its risks, and its opportunities for growth from the Berkshire Hathaway with which we are familiar. It is better!
There is another very important element in this transformation. After emerging from his early Ben Graham stage Buffett sought out high ROIC companies which required little capital. This was true both in his public portfolio (companies like American Express, Coca-Cola, Gillette, and The Washington Post) and privately held companies like See's Candies. High ROIC is one of the measures of quality companies, but it does sometimes generate a problem. At a certain point such companies often encounter a shortage of investment opportunities to employ free cash flow. Faced with this problem, some pay out more in dividends, some buy back shares and reduce their float, some overreach by poorly considered acquisitions, and many come under attack from vultures who want to get their hands on the cash. Growth, in any case, often slows down.
It's clear that Buffett has not missed the implications of this problem. Dividends and stock buybacks have never been primary uses of cash for Buffett. It is obviously hard to put $25 billion or so (and increasing) into the public market for stocks with high expectations of market-beating return. Buffett has come up with an ingenious solution to this problem.
To my knowledge Buffett has never described himself as a stock picker anyway. When describing what he does Buffett uses the term "capital allocator." The unique architecture of Berkshire makes the fullest use of this broader skill. Berkshire functions as a collection of independently run companies which return excess cash to the home office. This structure has permitted Buffett to put his skill as capital allocator to the optimal use. The fruit of these efforts is the New Berkshire Hathaway.
Burlington Northern, Marmon, MidAmerican, Lubrizol, Iscar, and Tungaloy all have one thing in common: they require capital and are able to employ that capital profitably. The insurance companies which were the center of the Old Berkshire generate cash of which only a small fraction is needed for an immediate ready reserve. The rest can be reallocated internally to businesses positioned to employ capital or externally to seek further acquisitions. Thus the New Berkshire operates like a giant piston-like piece of machinery which take inputs of capital from one side and employs it profitably in the other. Companies like Philip Morris, Johnson and Johnson, and, yes, even Microsoft and Apple, must feel pangs of jealousy. As long as Buffett can grow these new subsidiaries and find new ones from time to time the New Berkshire has found an ideal place to put free cash with a safe and above-market rate of return. There is one central takeaway for Berkshire investors: continued, reliable growth.
Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.