As a long time Berkshire Hathaway (BRK.A, BRK.B, or collectively BRK) shareholder who made the pilgrimage to Omaha 4 years ago to see and hear the Oracle(s), I put my BRK shares in buckets called Hold Forever and Don’t Need To Follow Too Closely. I was reminded when reading the 2018 Annual Report that Warren Buffett and Charlie Munger are 88 and 95, respectively. Their gene pool for memory, cognitive skills and good health are exceptional by any measure. However, recognizing that a generational leadership change is inevitable, I decided to examine BRK’s readiness for the post-Buffett/Munger era. In short, they were better prepared than most of the financial community gives them credit for. I’ll summarize that review for investors who may not follow BRK closely or worry about the same issue.
Berkshire’s evolution in the last 13 years culminates a remarkable 50+ year Buffett/Munger era
Since Warren Buffett and Charlie Munger acquired control in 1965, BRK has evolved from a struggling textile manufacturer founded 77 years earlier into a juggernaut business with the world’s 5th largest market cap. Its business model is a holding company using insurance underwriting profits and float to buy securities and strong operating companies. The variability and unpredictability of underwriting profits made this a necessary and virtuous goal.
The strength of BRK’s operating companies has nothing to do with strategic synergies that many high-profile CEOs point to in explaining M&A activities. Rather, it’s derived from their wide and long lasting economic “moats”. The result in BRK’s first four decades (1965-2005) of the Buffett era was a growing collection of small, diversified and exceptionally strong companies like See’s Candies, Dairy Queen, Fruit of the Loom, Nebraska Furniture Mart, and many more. Most businesses were acquired with the management team, often the founder or their descendents, remaining intact. There were no requirements from Warren other than to send excess cash flows back to Omaha for reinvestment. This allowed BRK to maintain a home office staff of only 14 people while creating a near-mythical, family-oriented corporate culture. When coupled with the Oracle of Omaha’s stock picking abilities and the use of float as interest-free capital, BRK more than flourished: it exploded. Warren’s folksy Annual Reports explained the business in simple terms and encouraged shareholders to think as long-term part-owners in the business. Decentralized operations and Buffett’s unwillingness to sell any business, regardless of its performance, became part of the company ethos.
With that extraordinary success came the question: are there limits to how large this model can scale to? To continue its growth, BRK needed to: 1) evolve into much larger operating companies, and 2) find methods or people to manage the sprawling set of businesses.
Warren whimsically described this intent to buy larger companies: “Our elephant gun has been loaded, and my trigger finger is itchy.” In the early 2000s, it began acquiring large infrastructure businesses in energy, utilities and railroads. Soon, stalwart American companies like BNSF Railway and MidAmerican Energy were part of the BRK fold. Later that decade, it starting adding much larger industrial manufacturing businesses like Lubrizol, Precision Castparts and Marmon. It’s become a slice of Americana comprised of a judicious selection of great businesses.
As importantly, the management processes are continuing to evolve. Shareholders were given “really good news" that Ajit Jain and Greg Able now run all daily operations. Charlie and Warren are free to concentrate solely on acquisitions while Ajit manages all insurance operations and Greg manages all non-insurance operations. These moves also position BRK for a smooth management succession. Buffett praises Ajit as having “made more money for BRK than I have”. Greg showed the same steely M&A discipline as Warren in refusing to raise his bid to acquire Oncor Electric in 2017, even though it meant losing a desirable asset. Also, poorly performing acquisitions were sold in 2017 and 2019, sending a message that management distractions won’t be tolerated.
The result has been a financial evolution where 76% of BRK’s $28.2B pre-tax operating income in 2018 came from operating companies unrelated to the original core insurance operations. This compares to only 31% of BRK’s $7.5B pre-tax operating income in 2005 coming from non-insurance operations. Industrial manufacturing and infrastructure businesses grew at rates nearly four times faster that other BRK businesses and segments. Despite this metamorphosis, financial reporters still write extensively about BRK’s stock portfolio composition and Warren’s more recent stock picking record. They are missing the point that short-term perturbations in stock holdings weigh far less in BRK’s long-term prospects than its strong operating companies.
This 13-year evolution is more fully detailed below and positions BRK well for the post-Buffett/Munger era.
Discipline in the M&A process has emerged as the real Berkshire secret sauce
Success in the M&A process stems from Warren and Charlie’s three simple principles: 1) never overpay for a business, 2) correctly judge the durability of the economic moat, and 3) only acquire businesses from high-integrity owners with the management teams intact. No one bats 1.000 in this arena, but Warren and Charlie have been uncanny in beating the averages with their insight and discipline. While BRK's business model is strong and Warren’s stock picking skills are legendary, this disciplined approach to capital allocation has emerged as BRK’s true secret sauce. Not surprisingly, Warren adopts the same philosophy in repurchasing BRK stock. He’ll do it almost reluctantly while ensuring BRK always maintains $40B or more in cash for acquisitions. By contrast, many of the premier US companies have loaded up on cheap debt in recent years to repurchase shares as a means to prop up EPS.
While M&A discipline is easy to espouse, it’s surprisingly difficult to achieve. History is full of blue chip companies with highly revered leaders that failed the test. Remember Time Warner’s (NYSE:TWX) 2003 AOL acquisition? or GE’s (NYSE:GE) 2015 Alstom acquisition? Hewlett Packard’s (NYSE:HPE) 2011 Autonomy acquisition, or IBM’s (NYSE:IBM) current Red Hat acquisition? To be fair, all of these acquisitions had the potential to become outstanding and transformative. But, disaster awaits CEOs with money (especially debt) burning a hole in their pockets… and Boards or activist investors pressing for immediate results. Warren frequently warns of these dangers in his Annual Reports. Strategic synergy and transformation are terms that often mask an inconvenient truth that businesses are frequently acquired at absurdly inflated prices. When coupled with the risk of technology obsolescence, volatile market demand or dishonest financial reporting, vast amounts of shareholder value may be destroyed. Time Warner, GE and HP are case studies in this phenomena. IBM’s results are still unknown.
The financial results since 2005 shown in the tables below tell the story of BRK‘s remarkable evolution from a financial investment house into a strong operating company.
- Industrial manufacturing and infrastructure businesses grew nearly 4X faster than other BRK businesses. Industrial manufacturing pretax income grew at a 13-year CGR of 17.2% from $0.5B in 2005 to $5.8B in 2018. The infrastructure segment (railroads, utilities and energy) pretax income grew at a 13-year CGR of 19.9% from $523M in 2005 to $9.3B in 2018.
- The insurance business pretax income grew at a CGR of 4.7% from $3.5B in 2005 to $6.6B in 2018. The lumpy nature of underwriting losses clouds a clear view of income growth. It’s reasonable to say, though, that insurance pretax profits nearly doubled when smoothed out over a multiple-year period to see the trend.
- The Service, Retail and Financial Products pretax income grew at a CGR of 5.8% during this period. However, reporting differences in the Annual Reports slightly distort this result since the profits on financing mobile homes and certain other products were reported in the Building business results starting in 2018.
- The aggregate pretax income grew at a CGR of 9.7% from $7.5B in 2005 to $28.7B in 2018. This is a tremendous result for a company transforming its business mixes.
- BRK’s insurance float, that is, its interest-free capital, grew at a 13-year CGR of 6.8% from $49B to $122B.
- Liquid capital held for investment (that is, the sum of Cash & Cash Equiv, Equities, T-Bills and Fixed Maturity Securities minus Unpaid Insurance Losses) grew from $74B to $194B. Investors note: BRK’s unpaid insurance losses are typically paid out in loss-tails up to 10 years at values averaging 13% less than the amount carried on the balance sheet.
- Notes payable in the BHE and RR subsidiaries have grown from $18B in 2005 to $97B in 2018. They are not guaranteed by the BRK parent; do not threaten other operating businesses; and are easily serviceable by business unit operating profits.
- While investment gains are clearly important, Warren repeatedly cautions that they should not be counted on as part of BRK’s on-going income stream. The 2018 Investment Loss of $22.4B is a non-cash loss resulting predominantly from recent changes in the tax laws that require insurance companies to mark-to-market any stocks held and include those gains and losses in the income statement. The Kraft 2018 investment writedown was also included in this.
Buffett recently described a more relevant way for shareholders to understand the value of Berkshire and where it’s going
Historically, a significant portion of BRK's value has been tied to its formidable cash holdings and Warren’s oracle-like stock picks. Indeed, in December 2005, the liquid capital held for investment was $74B, or equal to 57% of the company’s market cap at that time. Furthermore, 65% of the $31B in market value of stocks held in 2005 was from unrealized stock gains. In that context, it was reasonable for shareholders to worry what would happen if BRK lost its revered stock picker.
By December 2018, the liquid capital held for investment had grown to $194B, but was now equal to only 41% of the company’s market cap. Similarly, unrealized stock gains decreased to 41% of the total stock's market value. Though cash holdings and stock selection remain a key part of the BRK value equation, they have been surpassed by the strength of the operating companies.
Warren reflected this for the first time in the 2018 Annual Report. Departing from the traditional beginning that compares BRK’s yearly changes in book value to corresponding S&P changes, he stated that BRK's book value has become an irrelevant method to describe the value of BRK. He went on to say: “Berkshire has gradually morphed from a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses”
Berkshire will face new challenges in the Post-Buffett/Munger era, but should continue to flourish
It is clear that BRK has evolved into a fortress-like base of strong operating companies with durable moats. Coupling the strength of BRK’s business model with a discipline acquisition process has diminished its dependence on the oracle-like stock picker. BRK is well positioned for the post-Buffett/Munger era.
The challenges confronting BRK in the post-Buffett/Munger era will undoubtedly be different from those of its past. As of December 2018, BRK is comprised of 79 operating companies and 389,393 employees. A home office staff of 26 people manages this behemoth. As each decade passes and the operating companies grow in size and number, new management systems will need to evolve along with them. Human capital is as essential as financial capital. Having strong operating executives like Ajit and Greg now in place, these challenges will be addressed.
Wrap up and summary
Compared to the relatively small list of companies with similar or greater market cap, that is Apple (NASDAQ:AAPL), Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Facebook (NASDAQ:FB), and Alibaba (NYSE:BABA), BRK is like a tortoise in the rabbit-versus-tortoise race story. Its business model is enviable; it has enshrined discipline into the M&A process; it has reduced its dependency on its key-man ‘Oracle'; it has a collection of durable operating companies with long lasting moats; and it has placed two exceptional operating executives into leadership roles for the next generation. New challenges always arise, but you can count on BRK’s many advantages to continue indefinitely. Slow and steady isn’t glamorous, but eventually wins the race.
This article is about BRK’s positioning and readiness for the future. With that now established, I will close with a last comment, however brief, on valuation. I will do this by referring the reader to Martin Sosnoff’s Forbes Feb. 29, 2019 contrarian article entitled "Berkshire Hathaway is History”. Martin is one of Wall Street’s first hedge fund managers, an author, a patron of the arts, and an occasional contributor to Forbes. His experiences offer unique insight based on a lifetime of valuing companies. While his rambling article criticizes the composition of BRK’s stock holdings, the author provides a $543B valuation estimate that is about 10% greater than today’s market cap. I generally share this point of view.
Disclosure: I am/we are long BRK.A. 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.