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Pete Yiu
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Pete is an ACA, CFA, CPA charterholder. He is the Chief Financial Officer at JMA Capital Limited based in Hong Kong.
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  • The Two Tenets To Berkshire's Success

    Summary

    -Operating cashflows are predictable and sustainable.
    -Price based on owner's earnings are still reasonable despite record high share price.
    -Corporate governance principles are the major contributors to Berkshire record high profit.

    At a record-high of US$130.90, Berkshire Hathaway, with a market value of $322.4 billion, is now the world's fifth largest enterprise. Berkshire published its interim statement on August 1, indicating an annual net profit increase of 41%. The owner's earnings, considered as highly important by the major shareholder and CEO Warren Buffett, rose to $234.005 billion, representing an annual increase of 15.83%.

    The operating cash flow of the first six months remained flat at $11.833 billion as compared with last year ($12.911 billion in 2013). As regards investment cash flow, due to the absence of large amount of capital outflow as with the $12.25 billion acquisition of the ketchup manufacturing giant H.J. Heinz. in 2013, the amount improved to being merely at $4.824 billion ($22.463 billion in 2013).

    The amount of till money made a record-high level at $55.455 billion (even when right before the largest acquisitions in the company's history of Heinz and BNSF, one of the biggest railroad companies in the North America, the amount of till money was only at $49 billion and $26.9 billion respectively). Berkshire would also be actively preparing itself for a greater return. Its plans of merging are much anticipated.

    While for profits, returns on investment, manufacturing, services, retail, and railroad accounted for 32.38%, 19.77%, 17.69%, and 14.32% of the$6.395 billion profits in the quarter respectively.

    The combined ratio (i.e. a total of loss ratio and expense ratio; the lower the combined ratio, the lower the proportion of expense, the higher the profits) of GEICO, a car insurance company is at 92.3%, outperforming other businesses in the industry (Progressive 92.6%; Allstate 95.4%). Its premium growth of 9.9% is also impressive.

    Regarding the reinsurance business, due to the absence of major natural disasters, General Re made some exceptionally lucrative profits with a 7.4% growth when compared with last year. Berkshire Hathaway Primary Group, which mainly provided insurance services to companies, benefited from the drop of combined ratio to 86.9%, thus making an eye-catching 2.1% increase in profit rate and a 28.55% swell in attributable profit.

    A significant return on investment is apparently reflective of poor quality of earnings. However, the amount of the two key items already account for 45.66% of the investment income of Berkshire (29.05% from investment and 16.61% from investment of the insurance business). How should one comprehend this? In fact, $1.1 billion out of the $2.064 billion investment income was from the swap of equity portfolio between Phillips 66 and Graham Holdings in order to acquire the petroleum pipeline company Philips Specialty Products Inc. and the Miami television station WPLG.

    Therefore, after subtracting this figure, the investment income is $964 million, which is close to that of last year at $622 million. The investment income from float is usually used on bonds by Buffett. Due to a rise in interests, the profits are relatively lower (-2%) with small fluctuation. The total value of float swelled to $78.5 billion on June 30, constituting an important support to the company's financing at low cost.

    Rapid growth of enterprise value

    A price-to-book ratio of 1.2:1 is a classic benchmark for Berkshire stocks, as Buffett once defined such a ratio as appropriate for the Berkshire stocks, and made share repurchase at this ratio.

    Assuming a company expands by $30 billion each year (as per previous record), it can reach the benchmark price-to-book ratio by mid-2015.

    From June 2009 to June 2014, shareholders equity increased from $114.527 billion to$234.005 billion, accounting for an annual compound growth rate of 15.36%. Even if this period involved piecemeal equity transactions and issuance of equity due to the BNSF transaction, the growth of corporate value was still rapid.

    When analysing the stock market, value investors should first understand the business model of the company. What the author has observed from the company performance is the two tenets that lead to Berkshire's good performance.

    Little or big fortune - both by being thrifty

    The first thing is the habit of thrift. We can start with stories of Buffett. The young Buffet, to save on expenses, once converted the drawer of a dressing table into a baby cradle for his first child Susan Alice Buffett. More recently, when Buffett met Obama in the White House, Obama gave him a newly-designed tie from the White House as Buffett's was frayed (at the award ceremony of the Presidential Medal of Freedom, Obama jokingly mentioned in his speech that Buffett's good friend Bill Gates knew about the incident and also asked for a new tie). There are a lot more examples of Buffett being thrifty.

    As Buffett has always set an example of being thrifty and is always in the moral high ground, when the staff of the acquired companies are asked to reduce their expenses, they would not complain. Subsequent to the acquisition of H.J. Heinz by Berkshire and 3G Capital, it is rumoured that the monthly stationery expenses are limited to $15 per person. In order to cut down the electricity bill, mini-refrigerators for storing cold drinks in office are prohibited from use.

    However, people not only do not blame him for being thrifty, but appreciate it as his strength and as part of the corporate culture brought by him. Different from the traditional Chinese value of "accumulating small wealth by thrift, getting a big fortune by luck", to Buffett, both small wealth and big fortune are closely connected with the virtue of thrift.

    The thrifty character of Buffett also corresponds with the thrifty manner in diluting the equity of Berkshire. Buffett once said as a joke, "Charlie and I enjoy issuing Berkshire stock about as much as we relish prepping for a colonoscopy". As the acquisition of a 77% stake in BNSF in 2009 involved tremendous costs, Berkshire issued $10.6 billion worth of ordinary shares for the first time in a long while.

    However, since the rebound of global economy, the demand for energy has been strong. Railroad-related stocks have set records on share prices. The share price of the strongest rival Union Pacific has an increase of 220% to date.

    While for the BNSF transaction in 2009 with massive profits at $50 billion, the additional 6% stake issued due to the BNSF transaction not only was not a "colonoscopy", but a spa therapy abroad! The culture of being thrifty implemented by Buffett led to a drop in expenses and improved the operational efficiency continuously, with significant impact on its branches of services, retail, and manufacturing especially.

    Trust for profits

    Another tenet is trust. As what another CEO of Berkshire (Charlie Munger) said before, "we had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust". Whether it was about the previous investment in Nebraska Furniture Mart, or in GEICO by believing in Mrs. B and Tony Nicely to let them be in charge of the management, Buffett's practice of earning considerable profits with trust is a major feature in Berkshire.

    In the annual report this year, it is mentioned that the severe winter did affect the profits, and despite the increase in freight volumes of BNSF, the standard of service was below internal standard. Still, the much experienced management team of Berkshire continued to pursue their decentralisation policy and were expecting a good return.

    When Buffett found out that his colleagues made a serious mistake, he would point it out without reservation, and might even replace them upon impeachment (e.g. David Sokol, the Chairman of MidAmerican Energy, who was involved in insider trading).

    When the business dropped because of poor management, he would not hesitate to replace the management team (e.g. in Heinz, he replaced William Johnson by Bernardo Hees as the CEO).

    In summary, Berkshire's effective management model does not only embrace "economy" and "trust", but also flexibly makes use of the mechanism that restrains the drawbacks arising from "economy" and "trust". Even if Buffett and Munger later retire from Berkshire, it will not be difficult to replicate a performance-oriented management model. Calculated by owner's earnings and asset value per share, the growth of enterprise value of the flagship company is rapid. As Berkshire benefits from the huge amount of float from its four insurance subsidiaries, it is able to obtain financing at low cost (just like Hutchison Whampoa with Cheung Kong Holdings), and can expand across industries without attempting to be strategic but focus only on financial returns. Such is a distinctive feature of Berkshire.

    To get a glimpse of Buffettology, you may read The Essays of Warren Buffett: Lessons for corporate America, with essays adopted from annual reports. Buffett beyond value: Why Warren Buffett looks to growth and management when investing by Prem Jain is also a good read for buffettologists.

    The author is an analyst at JMA Capital Limited and a buffettologist.

    Disclosure: The author is long BRK.B.

    Tags: BRK.B, BRK.A
    Aug 14 2:17 PM | Link | Comment!
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