Alive – definitely alive.
This question – more than any other – dogs every discussion of Berkshire Hathaway (BRK.A) (BRK.B). It isn’t immediately visible to those arguing on either side (“Berkshire is overvalued”, “No! Berkshire is undervalued”) but it underlies their arguments all the same.
What do I mean when I say Berkshire Hathaway is worth more alive than dead? I mean that Berkshire as a continuing whole is more valuable than a Berkshire that is dismembered into its constituent parts this very day – a Berkshire that is cut up and dished out like a Christmas ham.
A lot of people value Berkshire as a closed-end investment fund. Peter Lynch wouldn’t make that mistake. He’d see that Berkshire fits the bill as one of his stalwarts:
Stalwarts are companies such as Coca-Cola, Bristol-Myers, Procter and Gamble…and Colgate-Palmolive. These multibillion-dollar hulks are not exactly agile climbers, but they’re faster than slow growers…When you traffic in stalwarts, you’re more or less in the foothills: 10 to 12 percent annual growth in earnings.
(From Lynch's One Up On Wall Street)
That’s what Berkshire is – not a lifeless closed-end investment fund, but a living, breathing stalwart – a mega-cap company that needs to be compared to (and valued like) other mega-caps.
I tried to make this point in the comments section of an earlier post, when I wrote:
So, now the question isn’t whether Berkshire can compete with its past (it can’t). But, whether Berkshire can compete with similarly sized public companies such as Nestle, Unilever, Google, Microsoft, General Electric, Johnson & Johnson, HSBC, AT&T, Wal-Mart, Bank of America, and the big oil companies. Can it? I think it can. So, relative to its peers (in terms of size) Berkshire isn’t overpriced. Is it overpriced compared to the Berkshire of twenty or thirty years ago? Yes. But, so is just about every asset on planet earth. So, that’s not the right yardstick to use. You have to compare Berkshire (the stock) to other stocks you can buy today – and Berkshire the company to other companies with similar size constraints. On both counts, I think a valuation of about $140,000 a share is appropriate and fair.
Berkshire’s value is every bit as dependent on growth as the value of those other corporate behemoths – more so, in fact, because Berkshire doesn’t pay out dividends. You need to value Berkshire based on its likely intrinsic value growth rate, because that rate will determine what the stock is worth in 3, 5, and 10 years’ time – just as it will at Microsoft and Bank of America and Wal-Mart and Google.
Berkshire is a growth stock. And how fast is it growing? Since 1995, I estimate intrinsic value has grown a little more than 15% a year. Of course, when I assign a value to Berkshire shares, I don’t assume it can keep up that kind of intrinsic value growth. Rather, I assume it could grow at a still stalwart like 10-12% annual rate with Buffett at the helm, and 8% a year without Buffett.
I may be (very) wrong about Berkshire’s growth prospects. But, I’m not wrong to see it as a living, growing integrated whole rather than a lifeless closed-end investment fund that needs to be parceled out soon and thus valued today as if it were already in liquidation.
That’s a pig-headed approach that runs contrary to everything we know about what Berkshire was in the past, is now, and likely will be in the future. It’s a compounding machine that will keep chugging along (at some pace) for many years to come.
How can I explain this simple truth in a way any investor can understand? How can I make people realize that Berkshire isn’t just the sum of its parts – but, rather an integrated whole that adds value that is not derived from the value of any particular part on its own, but rather comes from making those parts work in harmony towards a single goal?
I don’t know. So, I’ll try a simile.
The Berkshire model works. To some extent, it works with or without Buffett. It works a whole lot better with Buffett than without Buffett. But, a capital allocation conglomerate makes some sense even where Buffett isn’t at the helm.
Because businesses face capital allocation constraints very early – a lot earlier than we like to think.
An example of a good business in a smaller, narrower industry may help illustrate my point.
The following is total fiction – a complete hypothetical – however, I think it is oddly illustrative of the way the capital allocation conglomerate model can work (and does work at Berkshire).
There’s no doubt Berkshire benefits from Buffett’s “magic”; but there’s also some value adding alchemy in the capital allocation conglomerate model.
Berkshire is a combination of man and model.
The Strattec Simile
Strattec (STRT) is a small company with a market cap of just over $150 million and an enterprise value of much less.
Strattec is flush with cash and always has been. For background on Strattec’s spin-off, see Joel Greenblatt’s You Can Be a Stock Market Genius which includes a chapter outlining the case for buying Strattec when it was spun-off from Briggs & Stratton.
Strattec has been a good business; but, it’s also been a small business. Today, it carries about $60 million on its balance sheet – which is just over 40% of total assets and just under 60% of total equity. That’s way too much cash for a public company to carry.
Strattec has been both blessed and cursed. It’s been blessed with a good, narrow business that produces plenty of free cash flow and it’s been cursed with a good, narrow business that produces plenty of free cash flow.
The cash kept coming; the growth never did. Over the last ten years, Strattec has tried to sop up some of that cash – and has succeeded to the tune of about $95 million in 10 years, or nearly $10 million a year in share buybacks.
Strattec is part operating business and part investment company. The market treats the operating business as the more valuable component, but there’s no denying capital allocation (or misallocation) has been a key determinant of the company’s stock price performance.
Strattec has $60 million in cash today, and has (indirectly) plowed $95 million back into the lock business through stock buybacks made over the last ten years.
Strattec could have really used a Buffett like capital allocator over the past decade.
Or, it could have just paid a nice, fat dividend. Either way would have worked.
You can see the conundrum. It’s natural for businesses (even publicly traded businesses) to find themselves producing more cash than they ought to reinvest in their established field of expertise.
Now, I’m not really saying that Strattec has too much cash today (though it very well might) and needs to do something about this problem. That’s a much narrower argument that only matters if you’re looking at Strattec as an investment.
I’m not doing that here. Rather, I’m saying that Strattec has had too much cash for a decade – and a decade is a very long time in investing – so, Strattec doesn’t just have a sub-optimal operating model today; it’s had one for ten years and its owners have suffered for that (“suffer” is a relative term; the stock has done fine versus the S&P – but, it hasn’t done fine versus the actual business).
The math is simple. Over the past ten years, Strattec had $155 million in cash ($95 million in buybacks + $60 million in cash now held) fall to the ultimate bottom line, the balance sheet.
Last I checked, the company had a market cap of – drum roll please….$155 million!
Investors who held the stock for ten years saw the business they owned generate $155 million in completely free cash flow – and yet the business they own is now worth merely the sum of that $155 million. Had all $155 million been paid out in annual dividends, the future value of the business as of today would not now be valued by the market at $0/share; so, it seems we’ve had some sub-optimal capital allocation over the past 10 years at Strattec.
The stock may be cheap too. I’m not ruling that out. But, even if it is very, very cheap today, if some investor had taken over Strattec ten years ago and set out to emulate Buffett’s capital allocation adventures at Berkshire Hathaway, shareholders of Strattec would be better off today.
For the past ten years, Strattec was a cash flow machine. To create value at a cash flow machine you can do one of three things 1) turn it into a compounding machine (like Buffett did at Berkshire) 2) turn it into a dividend paying machine, or 3) turn it into a EPS growth machine, either by growing the business, or buying back shares at low prices (relative to earnings).
Growing the business was out of the question at Strattec. It’s a big player in a small industry, and it was dependent on its key customers (GM, Ford, and Chrysler) growing their business. They didn’t. As a result, Strattec was starved for growth. It was (through no fault of its own) a cash rich, growth poor – highly profitable but hopelessly stagnant company.
Creating an EPS growth machine through stock buybacks was also a difficult proposition as Strattec had an average P/E of over 13 during the last ten years. While a P/E of 13 isn’t especially rich; it isn’t an especially low multiple for a no-growth business either. Therefore, buyback fueled EPS growth would have been costly.
If an investor took control of Strattec ten years ago with Buffett’s mindset (but not necessarily his skills), he would have richly rewarded shareholders over that ten year period.
How would this work? And why would it work?
Intelligent capital allocation provides some value in this kind of situation even if capital isn’t allocated to investments that produce above-market returns, because something is being done with the cash.
If Strattec hadn’t bought back its own stock, and had instead created a stock portfolio into which it put all its free cash flow, that portfolio would now be worth over $150 million even if it achieved nothing in the way of returns. This would have resulted in Strattec being worth much more today, because Strattec would be valued as a $150 million closed-end investment fund with an automotive lock business thrown in.
Instead, the company has a higher EPS than it otherwise would as a result of spending $95 million buying back shares; it also has about $60 million in cash sitting on the balance sheet – unfortunately, the market tends to value that $60 million less optimistically than it would if it believed the cash would be invested (at the holding company level) in a basket of stocks that would be held for many, many years.
Capital reallocation would not have weakened Strattec’s financial condition in the least. In fact, it would have strengthened the company’s financial condition, because by now the holding company would have close to $100 million more that the lock business could tap in times of trouble. Strattec would be even more ridiculously overcapitalized than it is today – since, the $95 million in cash spent on share buybacks would still be on the balance sheet (rather than in the pockets of former shareholders).
This is a very conservative picture of what would have happened if an investor took over the capital allocation job at Strattec ten years ago, and left the management of the lock business in place.
One, because Strattec really did produce $155 million in completely free cash flow – so, even if a stock portfolio at the holding company level did absolutely nothing over that time period, it would still have approximately that much in cash (invested outside the lock business). Returns in excess of zero over that time period would have grown the value of the company’s investments.
Two – and this point is of tremendous importance – the capital allocator at Strattec would have been ideally situated to make extremely intelligent investments (just as Buffett was at Berkshire).
Because the capital allocator at Strattec would have been in the same position as a mutual fund manager – except he’d have no fear of redemptions, no need to produce market beating returns within any single year or quarter, and fresh cash coming in each and every year.
What did Buffett do under similar circumstances? A lot of things. But, one of the most important things he did was buy big chunks of businesses he believed in at deep discounts to intrinsic value. Could a capital allocator at Strattec have done this?
The lock business would have been producing both earnings and free cash flow each and every year. Let’s assume the amount of free cash flow produced by the lock business was $15 million per year.
If the capital allocator had $15 million a year in cash to invest, he would have needed to find one good opportunity a year in public companies with market caps in the $100 - $150 million range. This would have given Strattec Berkshire like 10-15% stakes in public companies.
The capital allocator at Strattec could have lessened his work load even further if he limited himself to bigger companies – say those trading in the $200 - $300 million range.
Then, he’d need only one good idea every two years. As you move up the market cap ladder, great ideas tend to become scarcer. On the other hand, you can certainly wait for a perfect pitch if you only need to swing once every two years.
Why does this capital allocation conglomerate model work?
It provides several benefits. Among the most important are:
1) A way to put cash to work
2) A rock-solid financial position
3) Extreme focus at every level – especially the top
The first point is obvious. The second point is easier to overlook. Berkshire can achieve good returns while overcapitalized, because it’s a capital allocation conglomerate.
Financial strength isn’t a trait peculiar to Berkshire. Any holding company modeled on Berkshire would naturally tend towards a rock-solid financial position, because that’s the nature of the beast.
Management could intentionally undermine this rock-solid financial position by using leverage, but unless they did, such a holding company would tend towards financial strength as a result of the holding company’s capital reallocation activities.
Think about it.
How do slow growth, cash flow machines create value for shareholders?
Two ways: dividends or share buybacks. Both ways weaken a company’s financial position by returning cash to shareholders. Share buybacks can increase earnings per share, but they still take cash from the company.
Now, how does a compounding machine create value for shareholders?
It buys stocks or businesses. Both of these actions strengthen a company’s financial condition. The company’s assets are not distributed, they are invested. Diversification increases in either case. Stocks are highly liquid, but they are also solid long-term investments that offer capital appreciation and some inflation protection. Operating businesses can also offer capital appreciation and inflation protection – but more importantly they offer additional free cash flow from a different source.
The process of building a compounding machine naturally leads toward extreme financial strength– not because the capital allocator seeks to maximize the conglomerate’s financial condition, but rather because he seeks to maximize shareholder wealth without buying back shares or paying out dividends (which are normally the only options available to a high free cash flow, low growth business).
This is exactly what would have happened at Strattec if a capital allocator with a Buffett like mindset had taken control of the company ten years ago.
Look at the company’s results for those ten years and try to imagine what the company would look like today. Even if the capital allocator wasn’t especially skilled, shares of Strattec would almost certainly have a higher market value today than they do now – and the company would have an even stronger financial position.
That’s the natural progression for a capital allocation conglomerate built on a high free cash flow, low growth business. Businesses like Strattec become more valuable when they are part of a capital allocation conglomerate than they are on their own.
Likewise, the private businesses Berkshire buys become more valuable when they are part of Berkshire than they were on their own.
As separate businesses, they can harvest their profits – but they can’t plant new acreage. As a result, next year’s yield will look a lot like this year’s yield. But, at Berkshire, Buffett can plant new fields using harvests from prior years.
This allows Berkshire to grow faster than the sum of its parts. Buffett harvests the old fields and plants new fields.
Of course, at Berkshire, there’s also the small matter of insurance (and the float it provides). But, that’s not worth talking about, because no one will argue that an insurance company isn’t worth more when it can invest its float than when it can’t. That’s already a generally recognized truth.When you combine both elements – cash flow from operating businesses and float from insurance businesses – you have the fuel that propels Berkshire’s growth.