What The Recession Tells Us About A Buffett-Less Berskhire

| About: Berkshire Hathaway (BRK.B)

Summary

Many parts of Berkshire are set up to continue running as well as they do now after Buffett leaves.

There are some deals which will be hard to duplicate without Buffett, however.

The recession offers a sample of some of these unique deals.

For many years now, and possibly for many more to come, investors have speculated about Berkshire Hathaway (BRK.A, BRK.B) post-Buffett. Exactly what Buffett benefits are going to be hard or impossible to duplicate? It seems clear that some aspects of Berkshire should continue on without a hitch. The extreme decentralization in place means that with or without Buffett the excellent group of operating managers will be running their business almost entirely free of interference.

Back when Buffett had to take control over Salomon for 10 months during 1991-1992, to protect a $700 million purchase of preferred stock made in 1987, Berkshire still achieved excellent results. As Buffett stated of this time period:

My decision to take the job carried with it an implicit but important message: Berkshire's operating managers are so outstanding that I knew I could materially reduce the time I was spending at the company and yet remain confident that its economic progress would not skip a beat...My job is merely to treat them right and to allocate the capital they generate.

A ten month hiatus is of course not the same as losing Buffett forever, and "merely" is obviously understating how important a job and how skillful one must be to allocate capital wisely. But this illustrates how Buffett has for a long time set up Berkshire to run very independently from himself in many respects.

Very positive signs for the future are Todd Combs and Ted Weschler, investment managers hired about five years ago, who by all accounts have been a success. Todd Combs even had a significant influence on the Precision Castparts acquisition. In fact Buffett had never even heard of the company before Combs brought it to his attention.

But it's not simply high skill levels with allocating capital that is unique with Buffett, as he is famous for completing complex deals on, or with not much more than a single sheet of paper. Everything from compensation arrangements to acquisitions can be done very quickly.

That's a great skill to possess, because in times of intense turmoil he often finds himself approached, and deals need to be reached fast. Everyone knows what stockpiles of cash Berkshire always keeps on hand. When credit markets tighten Berkshire is often thought of as a lender of last resort. While this is true to some extent, there is more to the situation than this. To have Warren Buffett's vote of confidence during hard times, to be able to put it on public display, is a great way to stop the bleeding.

To be in possession of this stamp of approval from Buffett comes with a steep asking price from Buffett, but cheaper access for capital in other places. Take for example the deal struck with Goldman Sachs (NYSE:GS) in September of 2008. Berkshire announced a purchase of $5 billion in preferred shares paying a 10% annual dividend, with a 10% premium to be paid if the preferreds are redeemed. There were also warrants to buy $5 billion in common stock with a $115 strike price.

A few days later Goldman would seek to raise billions in capital by completing a public offering of common stock. Would Goldman have been able to have done so at such advantageous terms without Buffett's support? It's highly unlikely. Buffett's involvement with Goldman helped stabilize the stock price of Goldman leading up to the issuance of equity to the public. The endorsement let people know the long-term prospects of Goldman were intact.

Would a Berkshire-without-Buffett vote of confidence be worth a Warren Buffett vote of confidence in the future? This isn't likely, at least not for many years - possibly decades - after Buffett's departure, when any successor may finally achieve the prestige and reputation currently enjoyed by Buffett.

The Goldman deal was modified in the future, making it a net share settlement, meaning Berkshire would simply receive stock worth as much as Berkshire would have realized by exercising the warrants and immediately selling the shares. In October of 2013 Berkshire received more than 13 million shares of Goldman Sachs common stock, which had a market value of $2.1 billion. This comes on top of the preferred shares which were redeemed in March 2011, which netted Berkshire $1.75 billion. Berkshire has since sold around 2 million of the Goldman shares.

In addition to Goldman Sachs there were five main other crisis-era deals of a similar nature - $6.5 billion with Mars/Wrigley and $3 billion with General Electric (NYSE:GE) in October of 2008, $2.7 billion with Swiss RE (OTCPK:SSREY) in February 2009, $3 billion with Dow Chemical (NYSE:DOW) in April 2009, and $5 billion with Bank of America (NYSE:BAC) in August 2011.

It will be quite some time before the final results of this more than $25 billion in deals can be tallied, but some, like Goldman, have reached an end:

  • $2.7 billion of 12% preferred stock from Swiss Re, January 2011
  • $3 billion of 10% preferred stock from GE, October 2011
  • $4.4 billion of 11.45% notes from Mars, October 2013

Dividend and premium income totaled $5.7 billion from this $10.1 billion in investments.

Like Goldman Sachs, General Electric had warrants which were switched to a net share settlement, although the results were less stellar - 10.7 million shares worth $260 million were received in October of 2013. As of the last filing Berkshire maintained nearly all these shares.

The $3 billion investment in Dow Chemical 8.5% preferreds, $2.1 billion in Mars 5% preferreds, and $5 billion in Bank of America 6% preferreds remained heading into 2016. Provisions could see Dow converted to common stock by year end, and calls and puts take away up to 50% of Mars. Buffett has stated he is unlikely to hold on to Dow common stock. The Bank of America preferreds cannot be redeemed until 2019. Warrants also exist allowing Berkshire to purchase 700 million shares of Bank of America for $5 billion before September 2021. The warrants are likely to be purchased shortly before expiration. They are currently worth $9.5 billion, down from around $12.5 billion year end 2015, as shares have slumped in 2016.

As considerably lower yields are available in this present environment, the loss of these investments has created investment income growth that is inconsistent and rather stale over the last 5 years.

Buffett has claimed that a simply average investor could have done as well in the crisis in terms of profitability, if only they made purchases during the panic period. While it is true that hindsight shows there were plenty of opportunities, average investors will simply never jump in to such an environment the way Buffett did, and will fail to capitalize on it. Having the discipline to remain awash in cash and wait for such rare opportunities is not often seen.

At the start of 2008 Berkshire had cash-equivalents of $44.3 billion. By the end of 2009 this figure was down to $30.6 billion, with $8 billion of this set aside for the acquisition of Burlington Northern Santa Fe. This is with retained operating earnings of $17 billion over the same period. As Berkshire desired to have at least $20 billion of cash maintained, not only were these investments a success in terms of profit on what was invested, but also in putting to work such a large sum that otherwise would be earning a pittance for Berkshire.

Long-time investors may remember the compliments always directed towards Rose Blumkin of Nebraska Furniture Mart, who worked until she was 103. Berkshire's annual reports often contain compliments of older managers. Buffett has sometimes joked that individuals in their 70's are of an age only appropriate for trainees at Berkshire. Buffett himself is 7 years the junior of Charlie Munger, still with Berkshire. So while discussions of Berkshire without Buffett are of course understandable, it is always important to keep in mind that this is something which still may not exist for quite a long time.

Disclosure: I am/we are 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.