Many investors may not realize this, but Berkshire Hathaway (BRK.A) (BRK.B) is among the 10 largest companies in the S&P 500. It has over $200B market cap, $50B in cash, and is traded at 18x trailing P/E. Berkshire owns ~50 companies, spanning business operations as diverse as selling insurance, candy, mobile homes, furniture, machinery, private jet services, and railroad transportation. If an investor had invested $10,000 in BRK.A back in 1965, the investment would be worth $50 million today. This translates to 19.8% compounded annual return. A key question for an investor is whether BRK.A can continue to outperform the market going forward as the company has become so large.
As we began to research the company, we were surprised to find that only a handful of analysts cover this stock. Since Berkshire Hathaway owns over 50 companies with diverse businesses, it would be nearly impossible to dissect each company's P/L and derive a composite financial projection for the parent company, BRK.A. We also wonder if the sum of parts is worth more than the whole with a conglomerate like Berkshire. One day, after Warren Buffett steps down as the CEO, what will the new management do with the company? Will it spin-off parts of the company to unleash their hidden value? In other words, what makes the Berkshire model unique?
To analyze Berkshire Hathaway, we decide to focus on the key drivers for Berkshire's revenue growth in the future. These issues center on its core business, conglomerate business model, its recent largest acquisitions such as Burlington Northern Santa Fe Railroad, as well as its derivatives position.
What is Berkshire's core business?
Berkshire Hathaway was a failing textile company when Warren Buffett acquired it in 1964. However, Buffett turned around the company after he acquired National Indemnity Company and then Geico, the car insurance company. Since then, the company has taken off. Subsequently, Berkshire acquired General Re and the Berkshire Hathaway Reinsurance Group, two of the largest reinsurers in the world. In essence, Berkshire's core business is insurance.
One thing unique about the insurance business is its "float": the premium paid by clients every month that the company keeps. It is essentially "free money" for the company to invest until it pays claims. Traditionally, an insurance company invests float in fixed-income assets that generate a steady return. Those returns are usually lower. Buffett, however, was able to invest the "float" in business that generated 5% excess returns compared to fixed income assets. Over time, the compounded excess returns amount to significant profits for shareholders. Currently, Berkshire's float stands at $70B. That explains BRK.A's superb performance over the last five decades.
What's the advantage of conglomerate business model?
Buffett prefers to buy the entire company than owning its stock. There are several advantages to owning a whole company. The earnings of the subsidiary companies flow directly through to the parent company (Berkshire), thereby avoiding double taxation. If you own a stock that pays dividends, the income is essentially taxed twice: once at the corporation level (in the form of income tax for the corporation) and once more at the investor level (in the form of dividend taxes). An article in Seeking Alpha specifically discussed this issue (What is the true P/E multiple for Berkshire Hathaway). Buffett has been deliberately avoiding unnecessary taxation in his business decisions. That's one of the reasons Berkshire has never issued dividends.
By owning a company, you can choose the management team and consequently have much greater control over business operations. In addition, a privately-owned subsidiary does not have to file quarterly earnings reports as required by the SEC for publicly-traded companies. It allows them to really focus on their core business.
Another very important advantage is that liquidity is of less concern for subsidiary companies. An independent company usually holds a certain amount of cash to meet liquidity requirements. In contrast, Berkshire subsidiary companies require very little liquidity, and could even run with a "negative" working capital. As such, this business model frees up a lot of cash that ultimately flows to Berkshire and Buffett to invest in more profitable businesses or investment opportunities. At present, Berkshire has $50B cash to deploy. In a recent interview with CNBC, Buffett said that he was "salivating" to deploy the cash in good business or investment opportunities.
So, there is significant synergy among the subsidiary companies and the parent, Berkshire. The subsidiaries are essentially cash machines that generate cash for Berkshire to invest in assets with higher returns.
In the next series, we will analyze its largest recent acquisitions, such as the Burlington Northern Santa Fe Railroad and the Lubrizol Corporation. We will also discuss Berkshire's derivative position because it has contributed a lot of volatility to the BRK.A stock price in recent years. We are wondering if Buffett may have taken too much risk in its derivatives business. Finally, we decide that a Discounted Cash Flow model will be suitable to value a company like BRK.A.
Disclosure: I am long BRK.A.