If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that. Warren E. Buffett
Quoted in Amy Stone, Homespun Wisdom from the "Oracle of Omaha" (June 5, 1999), BusinessWeek
There was a lot of talk about Berkshire Hathaway (NYSE:BRK.A) last week and its 200,000 USD price per share milestone. Ironically there wasn't that much fanfare for the much more significant landmark that the shares also recently attained of one million percent return.
When Buffett took control of Berkshire on May 10, 1965 shares traded at $18 a piece. So when shares surpassed $180,000 for the first time in March of this year investors that have been with Buffett from the very beginning attained a one million percent return on their Berkshire Hathaway investment. In Peter Lynch's parlance, a ten-thousand bagger.
After such an amazing performance for so many years it is reasonable to ask if market outperformance can continue. As can been seen in the table below, outperformance has decreased significantly, although there was a small recent bounce (resulting from attractive investments made during the great recession).
*As of August 16, 2014
One evident conclusion from the chart above is what Buffett has been warning for quite some time now. As Berkshire (NYSE:BRK.B) becomes bigger it is more difficult for the company to outperform the market by a significant margin.
At present, the places where Berkshire can invest most of the incremental capital have high single digit after tax returns.
Manufacturing Service and Retailing had a ROE last year of 7.8%, Railroad, Utilities and Energy a ROE of 6.3%. Excluding goodwill, the returns on tangible capital are a little higher at 15% for the former and 8.6% for the latter. Since growth will be a combination of organic and inorganic, returns will likely fall between the ROE and the return on tangible capital. The key takeaway being that it will be very difficult for all this capital to earn >10% after tax returns. If Berkshire has been able to grow book value at a higher rate in recent years, it has been thanks to some "turbochargers". These include the Goldman Sachs (NYSE:GS), GE (NYSE:GE), Dow Chemical (NYSE:DOW), and Bank of America (NYSE:BAC) investments, as well as the index put options sold.
Going forward there are some tailwinds that will help outperformance, and some headwinds that will make it difficult.
- The BAC Warrants are one of the "turbochargers" that still has several years remaining, and is likely to boost returns going forward. These warrants were received as part of a 5B investment in Bank of America, where Berkshire received 5B of preferred shares yielding 6%, plus approximately 700M warrants with a strike of $7.14 and expiration in 2021. It is difficult to know the precise carrying value (since they are bundled in the "Other investments" section, but it can be deduced that they are carried at about 6B, about the amount by which they are in the money). The notional amount is almost 2x the carrying value, therefore even if BAC only provides market returns from now till 2021, Berkshire will enjoy ~2X the gain thanks to the implicit leverage.
- The Heinz deal is very likely to provide attractive double digit returns for Berkshire. There are two factors at play here. One is the way the deal was structured. A very significant part of the Heinz acquisition (about 30%) was financed with low cost debt, therefore providing the partners with ~1.4X leverage. Roughly two thirds of the investment by Berkshire were in the form of 9% preferreds that include warrants, and one third for half the common equity. Given the leverage and the history of 3G as a very efficient operator, it is easy to see solid double-digit returns from this investment.
- Rising interest rates will give more value to the 55B dollars in cash. The way I like to think about Berkshire is that most of the equity in the insurance subsidiaries is invested in the stock portfolio, and the float is invested in cash and high quality bonds. Since the float has had a negative cost for some time now, and it leverages the equity in the company, any amount that the cash and these high grade bonds generate is almost a "free" turbocharger to the returns on equity of the company.
- Some renewable energy electric generation assets are providing mid-double-digit returns (see Solar 15% Returns Lure Investments From Google to Buffett). At a recent convention Buffett remarked that Berkshire has so far committed approximately 15B to these types of solar and wind projects, and he'll be happy to double the amount in the next few years.
- Exhaustion of several powerful turbochargers (index put options, high-yielding convertible preferred shares, high-yielding bonds). All these were extremely profitable, but several are now gone (GS and GE are now portfolio investments and not convertible preferred shares, Swiss Re was repaid, etc.) and others have mostly ran its course and won't be contributing much going forward. The index put options now represent only a 4.7B liability for a 32B notional amount (therefore if all these put options expire worthless, Berkshire can still benefit by 4.7B when the last contract expires in January 2026).
- Some big stock investments likely to continue to be a drag, or if sold would cause big capital gains taxes (e.g. P&G and Coke that together make approximately 20% of the portfolio). Despite triggering significant capital gains, Buffett reduced the P&G position from more than 105M shares, to about 52M currently, which shows he probably is not that optimistic about the company (this article describes some of P&G's problems). With respect to Coke, Warren does not sound as bullish as he once did, and has not added to the position in a very long time (despite adding to bigger positions like Wells Fargo, so it does not seem to be a matter of avoiding concentration).
- Size. In Berkshire's annual report, the risk section makes it very clear that size will be a drag on returns (note the emphasis the company added to the word "not" and how it made clear that it won't even get close to past returns):
- Culture that shuns investing in disruptive technology companies (in a world where everything is increasingly disrupted by technology). This one is admittedly more subjective, still I wish Berkshire had at least one or two investment managers with very deep technology understanding and some background in the tech industry.
A lot of capital will go to electricity generation assets and BNSF. Berkshire will need additional turbochargers (high-yielding special Buffett deals) to be able to maintain >10% p.a. growth in book value going forward. Outperformance for the next decade is still possible, but likely to come at just a few percentage points above the S&P500. Therefore BRK can still be seen as a very good alternative (or complement) to index funds, just don't expect spectacular returns.
Disclosure: The author is long BRK.B. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.