Berkshire's Rationale Will Fade After Buffett

 | Mar 03, 2014 | 11:30 AM EST  | Comments
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This was a big weekend for those with a passion for investing. Berkshire Hathaway's (BRK.A) (BRK.B) CEO Warren Buffett released his highly anticipated annual letter to shareholders. One of the most interesting sections, that of the investment advice and tales of the Nebraska farm and RTC deal, was already published as a preview in Fortune Magazine. It is, however, certainly worth a re-read.

WEB's advice is useful, although he is becoming more John Bogle-like in recommending the use of index funds That is an irony considering he accumulated his fortune in the early years in a classic "1+20" vehicle.

(As an aside, we do wonder how WEB funds his not-so-extravagant lifestyle. He has never sold a share of BRK, supposedly, the stock doesn't pay a dividend and his salary is only $100,000. That does raise the question of how he funds daily life. Clearly, he must live off his separate personal account, which is reputed to be worth several hundred million.

That capital grew over the years from the remains of the original partnership, and has probably compounded faster than BRK itself. He apparently speculates in smaller ideas in that account, things he cannot do with BRK anymore. What he does in the account is the information that would really be interesting to investors, but alas, the world will never know.)

Because we all will be deluged with media analysis of the letter, I am not going to review it in any detail. Rather, I want to get to the key macro-point that in my mind confirms that Berkshire simply cannot continue to be the great investment it was over the years. Like the S&P 500 Index funds WEB now advocates, BRK will be a great vehicle for those investors looking for modest, market-like gains at low risk: wealth preservation. For those still looking to build wealth, it is time to look elsewhere.

The reason is simple and well-known. Berkshire is now so large, and must compound against such a gigantic base of capital, that future gains must by necessity converge with the overall market and economy. There is simply no way Warren or his successors can continue to purchase the sorts of "elephants" that could realistically contribute to better-than-market earnings growth. (In the letter WEB jokes about buying up the Fortune 500 but he may just have to do that -- which would then assure market-like performance!)

The analysis of BRK that Warren offers in the letter confirms the problem. In the letter, he discusses their "Powerhouse Five" operating businesses, which contributed one third of the total earnings of BRK. The Five are all relatively recent purchases: BNSF, Iscar, Lubrizol (evidently Sokol was right about the attractiveness of that business), Marmon, and MidAmerican Energy. Similarly, the insurance segment is highly concentrated in a few large operations, mainly GEICO and General Re, and produced an underwriting profit that was 10% of earnings. He boils down the investment portfolio to the  

"Big Four" of American Express (AXP), Coca-Cola (KO), IBM (IBM), and Wells Fargo (WFC). A fifth, Bank of America (BAC) sits off-balance sheet in a call option position. All of these gigantic "elephant" positions are the main contributors to BRK's annual profit.

In contrast, all the great acquisitions that BRK made over the years that people love to talk about, such as See's Candies, simply don't matter individually. The Retail/Manufacturing segment had revenue of $95 billion in the year, yet contributed only 12% to earnings. WEB and his successors could work 24 hours a day but would not find enough deals to move the needle in that group.

The reality for BRK now is that it is 100% dependent on the performance of the elephants, which are generally mature, slow growth businesses. They also must find new elephants, which are by definition rare, and the sellers will be quite aware that BRK needs those deals to maintain its performance. So how many great deals will magically appear? Ted and Todd seem to be doing okay so far but they are running all of $7 billion, so their ability to source single deals that are multiples of that size is still unknown.

In the years ahead, I think we will see BRK's focus on the elephant operating businesses increase even more. This is inevitable and no criticism of Warren nor his successors. It is mathematical necessity and anyone long BRK must embrace the fact that it has grown into a large, conservative, wealth-preservation fund.

Over the past five years BRK has underperformed the S&P 500. I wouldn't short it like our own Doug Kass, but I wouldn't own it either. There is simply no longer a compelling case to place your bets on a wonderful money manager in his 80s running a $200 billion mutual fund.

A couple other BRK thoughts:

  • Warren advertises that they use leverage conservatively, if at all, but part of his success is built on using "other people's money". In this case it is insurance float. That is money that he rents, and must be paid back eventually. Is no different than debt; it just has different maturity and for them, a negative interest rate. But the result is the same whether your funding is float or debt. The rate of compounding was far higher than it would have been if Warren had no access to any capital other than his own cash flow. Bully to him for running a levered investment fund quite soundly, but there is no denying what it really was/is.
  • Warren still deludes himself by thinking there is some sort of synergy to Berkshire, which he again notes when he says "...though there are important and enduring advantages to having them all under one roof...". There is no synergy. Berkshire is simply the portfolio of one very good portfolio manager, and it has some brand cache because of the man himself.

When he is gone, the rationale for Berkshire will fade. It will probably take 20 years, but eventually it will be broken up. All his great first generation managers will retire, and the next generation will realize they are in a giant conglomerate with no upside potential for their skills. The conglomeration/de-conglomeration cycle is as old as business itself, and will most probably happen again here.

By the way, I will be in Omaha again this year with some members of my cabal, as I have for the past two decades. It is still a great fun weekend. I highly recommend it as an event you will enjoy immensely, even if the stock itself is not that interesting.

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