AAPL - Berkshire Hathaway: Buffett's Year Of Setting Things In Order

Summary

• This article follows up on a 2020 article on how Buffett dealt with a tough year; 2022 was a year of setting things in order to function without his authoritative presence.
• In 2022, Buffett got Berkshire's cash position down near $100B by buying large positions in Chevron and Occidental plus the $11.6B of Alleghany.
• Berkshire bought back Greg Abel's 1% of BHE for $87B, establishing a value of $87B, and reshaped his board with well qualified individuals who lowered its average age.
• Buffett's action called on his skills and knowledge but also his reputation and authority to take actions that others might find harder to take.
• Take notice of a great leader's determination to protect and improve the lives of others in a way that will outlast his individual presence.

It was a busy year for Warren Buffett and Berkshire Hathaway ( BRK.A )( BRK.B ). Buffett did plenty of buying and selling, although at first glance no overarching theme stands out. On the surface it looks like a normal year in which we can attempt to reverse engineer his actions, see what was behind them, and work out whether they may contain a message about things we should also be doing. This article will attempt to point them out. The most important message from Buffett's 2022 may not be obvious. One way to study Buffett's year is to search for the little Easter eggs that may offer hints of a more strategic course of action. I will attempt to point them out in order to present a whole picture which sums up the overall year. Not least is the portrait of a great leader who courageously defines a future designed to outlast his individual presence.

Normalcy Returned After Frenzied Pandemic Years

The pandemic year, 2020, was one period filled with Buffett actions which had wider implications. It was a year for hunkering down when it became instantly apparent to Buffett that the pandemic and lockdown had the potential to change everything. I wrote here summing up Buffett's 2020 actions. Two of the things that changed were Buffett's premise for buying airlines and the margin of safety surrounding his loan to Occidental Petroleum ( OXY ). The loan to OXY was provided to enable it to fight off the challenge by Chevron ( CVX ) to its purchase of Anadarko Petroleum. In addition to these actions, the events of 2020 also prompted a $10 billion write-down of 2016 acquisition of Precision Castparts as the large decline in commercial aircraft orders made it clear that Berkshire had overpaid for future growth. Buffett manned up and took full responsibility for the mistake.

Buffet also dumped Berkshire's entire airline position at a loss, saying at the Annual Meeting that there was risk of long term fundamental damage that could not be calculated. He also sold shares he received from the OXY Preferred near the bottom as the oil price collapsed. For both these actions he came in for heavy criticism. He had bought the airlines when they managed to get away from damaging price competition, and he made the OXY loan before oil prices crashed, briefly, to a negative number. How should we look at those actions? Critics were delighted to accuse him of panic. There were, however, sound principles behind both actions.

What Buffett had done in 2020 was to look at the larger picture and follow the sound trader principle of dumping the whole position when the basic premise is called into question. Was he right? That's the wrong question. The economic lock down threatened many of Berkshire's businesses, even BNSF railroad, whose trains had to run and employees had to be paid even as freight declined drastically. Berkshire's retail businesses were also earning very little. It was a time for building a firewall and making certain that the overall company could survive without crippling damage. Was it necessary to do this so quickly and completely? Again, wrong question. A business, an army, or an individual person must take action to defend against all things that might happen, not just the one thing which, with hindsight, actually happened.

In the meantime Buffett did find things to buy. He bought positions in a few pharma stocks and five Japanese trading companies with solid dividends, hedging the currency bet by borrowing Japanese yen in roughly the same amount. So far this Japan trade has worked out well. His other important move in 2020 was buying $10 billion worth of gas pipelines from Dominion Energy ( D ), which was in a hurry to get rid of them for cash. He also bought back $25 billion of Berkshire's shares. What the latter two purchases had in common was being in areas where he had a tremendous knowledge advantage. The share purchases were actually his most meaningful action in 2020 and, in retrospect, were done at a highly advantageous price. He bought back roughly the same dollar amount in 2021, once again his most meaningful action. All in all the two sets of buybacks reduced Berkshire's market cap by more than 9% so that each shareholders remaining emerged with 10% more of assets, earnings, and cash flow.

With the benefit of hindsight Buffett's major actions in 2020 assured survival in a difficult time and took advantage of opportunities which came up as a result of market conditions and the strong motivation of Dominion Energy to raise cash and wash its hands of gas pipelines. Were there better deals? Maybe. But these were actions with little or no risk at a time when survival was the first order of priority. The following year, 2021, presented more opportunities especially in the way of share repurchases. Which brings us to 2022, the year just ending.

Addressing The Problem Of Too Much Cash

If you want to know what a person can do if working the nineties you should think about what Warren Buffett accomplished in 2022. In many respects Buffett's active life at age 92 is unique. Other great investors have been successful well into their 90s but guiding one of the world's great corporations is another task altogether. Making investments is only a part of it. What makes it more challenging is the fact that Berkshire Hathaway is a conglomerate with close to 400,000 employees. Its almost 100 businesses operate in different industries with altogether different business models.

With Berkshire Hathaway what Buffett provides is a combination of leadership for the operating subsidiaries and capital allocation, with an eye on the level of cash and T Bills. The amount of cash is the point where the operational task and the investment task meet. Too much cash drags down return on equity. Too little means not having enough in the event of a crisis. At the end of 2021 the cash level was $146.72 billion. At the end of 2020, despite $25 billion employed in share buybacks, it had been $138.3 billion. That was clearly too much. The root problem was the hyper-low interest rates over the previous decade which had driven the prices of assets far beyond fair value. This hardly bothered hedge funds which used low rates to borrow, enabling them to top Berkshire's sensible bids on two major utility assets and one tech company.

In 2021 rates remained low and asset prices presented few options while Berkshire's cash position continued to grow at a rate of at least a couple of billion a month. During the Q and A portion of the 2017 Annual Meeting Buffett had focused specifically on the problem of Berkshire's cash hoard, saying

At a point, the burden of proof really shifts to us, big time. There's no way I can come back here three years from now and tell you that we hold US $150 billion or so in cash."

With the cash position having risen to almost $147 billion despite a second year of $25 billion in buybacks, that $150 billion number was in sight. To make matters worse, Berkshire's stock price had led the market's shift toward value, taking it close to the limit Buffett was willing to pay. At the right price share repurchases reward sellers, who can artificially create a dividend while retaining their percentage of ownership up to the percentage of shares repurchased, the cash realized was in the vicinity of 4-5% over 2020 and 2021. The deal was even better for shareholders who don't sell as their percentage of ownership went up by a little more than the percentage of share repurchased. The entire company also benefits as Return on Equity goes up as the denominator shrinks (common equity reduced by cash expended). Overpaying, however, harms these results so that Buffett had a firm though unstated limit to the price he would pay. Entering 2022 Buffett needed a whole new approach.

And The Solution Was... Energy

So why energy? The prospects for energy changed radically with the events in the early days of 2022. Buffett had written in his 2020 Shareholder Letter about the difficulties in building a grid to deliver wind and solar energy from remote sources to the cities where most energy was needed. Back in 2006 Berkshire Hathaway Energy had been among the first to undertake this task of building a grid, deferring all cash return until 2030 when the $18 billion project was scheduled to be completed. In short, Buffett understood the energy problem from both perspectives and knew that the solution was not going to achieved nearly as quickly as enthusiastic activists had assumed. The withdrawal of Russian energy in the course of the war in Ukraine put this into focus for the rest of the world. Their estimates for transition to green energy had been far too optimistic. Having abandoned nuclear energy as well as coal, Germany found itself using more coal than ever in its history.

My sense of the process by which Buffett came to buy both OXY and CVX derives from the detailed knowledge he built upon when making the $10 billion loan to OXY. With control of Anadarko's Permian Basin assets OXY became a very interesting investment possibility. His close look at Chevron led him to decide that it might be a great investment as well. At the low point in 2020 energy had shrunk to less than 2% of the S&P 500. Even after tripling and leading the market for over a year the energy sector was around 6%. The market was nevertheless far from keeping up with the improvement in energy earnings. Without help from energy the S&P 500 earnings would have had a negative rate of change for the year. Because the price of the energy sector has tripled, many pundits now say it is expensive. By the best broad measures it continues to be cheap.

It's not that Buffett had any expectation to that oil and gas prices would rise as astronomically as a few analysts projected. They didn't have to. What Buffett saw was the simple fact that OXY and CVX were gushing cash flow. It was clearly enough for OXY to clean up its balance sheet and begin with small dividends and buybacks which could be sustained even if oil and gas prices declined. Moreover, CVX and OXY were integrated energy companies which would be supported by downstream profits from refining and marketing. The one major risk was political but it was well known. OXY and CVX didn't have to operate brilliantly to work out as investments. They just had to perform fairly well under fairly decent conditions for their returns to continue rising. Very few analysts managed to see it that way.

Most of Buffett's buying was done in Q1 but by the Q3 Report in September Berkshire's CVX holding was around $33 billion and his OXY holding was just under $12.5 billion and had passed the 20% hurdle. That enabled Berkshire to consolidate its earnings and enjoy the improved tax rate that comes with that status. Berkshire's Chevron position had reached 8.55%, making it the largest Chevron holder including index funds. Best of all, the heavy buying of OXY and CVX had played the major role in pulling Berkshire's cash position down to $109 billion by the end of Q3, a number close to the hinted-at ideal $100 billion.

At this point Buffett has invested about twice as much in the two integrated oil companies as in Apple ( AAPL ). The energy companies are unlikely to take off and nearly quadruple as Apple did, but they are fairly likely to exceed Apple in dividends and dividend growth. The similarity with Apple is that after a halting start Buffett put the pedal to the meddle, backing an opinion with risks and prospects he had grown to understand. The result is less pressure to build another huge position, at least for a while. For those who may still wonder, by the way, I believe Buffett is unlikely to go all the way to an acquisition of OXY. Going over 20% provided many of the advantages that would come with an outright acquisition, and I suspect Vicki Hollub prefers being CEO of a large integrated oil and gas company to running a subsidiary. What might make her think twice is the possibility of running all of Berkshire Hathaway Energy, and possibly some or all of Berkshire's non-insurance businesses, when Greg Abel eventually takes over as CEO. That would require serious thinking on both sides.

Alleghany: You Can Never Have Too Much Insurance

As a youngster fresh out of school I filled out a questionnaire to apply for a job in the insurance industry, and one large part of it was a series of multiple choice questions describing various fictional individuals and asking how much life insurance they needed to carry. I personally have never bought life insurance except for the $10,000 I bought from the Army before leaving for Vietnam. I made a pair an with an Army buddy but fortunately neither of us collected. I did my best to estimate what level the various fictional personages might actually need but I needn't have bothered. The answer was simple: YOU CAN NEVER HAVE TOO MUCH INSURANCE!! The right answer in each case was the highest number.

Berkshire's acquisition of Alleghany (Y) puzzled me ever so slightly until I remembered that Berkshire's insurance unit was built on the same principle. As an investor, you can never own enough insurance companies. Buffett made them a take-it-or-leave-it offer with a 25-day period to shop themselves. Alleghany came cheap at a 1.25 price to book, and it was cheaper yet if you factored in the wholly owned and growing toy and steel fabrication businesses. A less tangible but perhaps important addition was that it brought back CEO Joe Brandon who had worked at Berkshire as CEO at Gen Re until compelled to resign under pressure from the SEC when wrongly associated with the AIG sham transaction scandal. Now that he is back in the fold some have speculated that he might one day be Ajit Jain's successor. Jain is ten years older.

In short, the Alleghany acquisition was a good deal. There was one more aspect that caught my attention. Buffett stipulated that he was opposed to paying investment banks and the final amount he would pay would be $848.02 per share, reduced from $850 to reflect the $27 million Alleghany spent as an investment banking fee to Goldman Sachs ( GS ). Buffett has been stubborn about this kind of thing from his early days. He was ready to accept a tender offer selling all his shares in Berkshire until the paperwork was 1/8 of a point lower than his verbal agreement. Instead of selling he began buying, gained control of Berkshire, and replaced the CEO with himself. It wasn't the $27 million Alleghany paid to Goldman Sachs - well, not entirely - but like the quick flip on Berkshire back in 1965 it was a matter of principle. With Alleghany a great deal in any case, he couldn't resist underscoring a basic principle involving his distaste for the investment banking industry. The $11.6 billion in cash paid for Alleghany rounded out the purchases which dropped Berkshire's cash position to $109 billion.

Buying Greg Abel's 1% Of Berkshire Hathaway Energy

In June Buffett moved to buy back Greg Abel's 1% personal stake in Berkshire Hathaway Energy which dated back to its acquisition. It had been Berkshire's fastest growing unit, growing organically and by astute bolt-on additions in which Abel has played an important part. The rate of compounding at BHE has benefited from the fact that unlike other utilities it pays no dividend and is able to reinvest its entire cash flow in projects virtually certain to produce a solid return. Berkshire originally invested $2 billion in MidAmerican Energy, the core business, and has seen after-tax earnings grow from $122 million to $4 billion.

The headline was that Buffett paid $870 million for Abel's 1%, thus establishing a value for BHE at $87 billion, a number which may set a price for buying back the remaining 8% in the estate of former Berkshire director Walter Scott who died in 2021. Among publicly traded utilities BHE would rank second to NextEra Energy ( NEE ) followed by #2 Duke Energy ( DUK ) and #3 Southern Co. ( SO ). The $87 billion is just under 22 times the $4 billion earnings.

Those are the headlines, but as with Alleghany there is a hidden nugget suggesting the process into which the Abel buyout fit. Abel's stake in a Berkshire subsidiary came up at the Annual Meeting along with the observation that he owned very little of Berkshire itself. It's hard to criticize Abel's commitment after 23 years of running Berkshire's fastest growing unit, and it's easy to forget Buffett's previous casual mention that Abel as CEO might be partially compensated with Berkshire shares. At the Annual Meeting Buffett replied that it would be easier to address Abel's BHE holdings while he was still "alive and around." He went on to say that the board gave him wide latitude after 57 year as CEO when it came to making deals and investments The board's attitude, he said, was, "'Well, Warren thinks the deal is okay, it must be okay,' which is true. So I could make a deal with anybody, and it doesn't get all messed up with process." He explained:

If I'm not around the pressures are on the directors to do whatever the lawyers tell them to do and the lawyers tell them to do this and that, and then they want to bring in investment bankers to make a value," Buffett said. "And the whole thing is a game from that point forward."

This fits nicely with the stand Buffett took against the waste of time and money on investment bankers in the Alleghany transaction. It comes down to putting the focus on getting important things done, using his strong position and personal authority when necessary to produce the right outcome. In explaining his action in the Abel buyout Buffett provided a succinct statement of his ambitions for the entire year: get the house in order while I'm here to do it.

Reshaping The Board Of Directors

On December 19 Berkshire undoubtedly raised the hackles of those who would impose their notions on boards by naming Tom Murphy, Jr., co-founder of Crestview Capital, to the Berkshire board. Murphy thus follows in the footsteps of his late father, Thomas Murphy, Sr., former CEO of Cap Cities/ABC, who resigned from the Berkshire board this year a few months before his death at age 96. The appointment added an individual with a lifetime of business success and clear understanding of the workings of Berkshire Hathaway built over the fifty years in which his father was a friend and confidant of Buffett.

Critics of Berkshire's governance probably didn't care for this appointment. From Buffett's perspective it was perfect. providing a vital, committed, and well versed board member while dropping the average age of the total 14=person board by more than two years. At the same time the average age of board members was reduced by more than two years.

Berkshire has no diversity goal although the fact that four of fourteen board members are women and two are people of color demonstrates that board membership is open to all those who qualify. Berkshire is a complex company which few outsiders fully understand, and it shouldn't be a surprise that board members are generally individuals Buffett knows and respects. Here are the qualifications described in the proxy statement:

In identifying director nominees, the Governance Committee does not seek diversity, however defined. Instead, as previously discussed, the Governance Committee looks for individuals who have very high integrity, business savvy, an owner-oriented attitude and a deep genuine interest in the Company."

Investment research firm MSCI put its objection this way:

Berkshire Hathaway continues to lag peers in corporate governance. The concerns include board entrenchment (over 42% board members are over 70 years old and 57% have served on the board for over 15 years), lack of board independence and diversity (57% not independent of management and less than 30% women on the board), combined CEO-chairman functions, and high voting power of the controlling shareholder."

Artificial and nominal qualifications are clearly not so easy to find in conjunction with the things that matter at Berkshire Hathaway. Four women and two men of color isn't all that far from the ideal of most outside judges, and the important thing to remember is that none of them are token representatives of any particular group. members. All got there on solid qualifications. All understand the important principles which stand behind Berkshire and need to be preserved.

Berkshire's shareholders have a high level of sophistication and do not feel the necessity of guidance from poorly informed outsiders be they journalists or professional do-gooders. Will they grasp why Berkshire doesn't pay dividends? They are unlikely to understand the burden taxes on dividends would place upon the majority of Berkshire shareholders. Do they see the way dividends would reduce overall compounding of wealth. What about the horrible idea of breaking up Berkshire? Do journalists and other outsiders recognize that Berkshire's parts have a synergy in which its insurance side generates funds float which provides funds for it acquisitions and investment portfolio? Even journalists at high-status publications often just don't get it about these factors. Why should they? It sounds good to suggest that Berkshire be broken up as soon as Buffett is no longer in control. If it were a good idea, why wouldn't Buffett, one of the best and most successful business leaders, be doing it himself.

Buffett took the necessary action while it was within his power. He rounded out a board which would ignore badly founded criticism and knock down bad ideas because they understood the exact reason the ideas were bad. Unlike "independent" directors who often make most of their income as board member, they will understand the principles and culture which make Berkshire Hathaway unique.

Continuity And Change

For Warren Buffett at 92, as Frank Sinatra put it, it was a very good year. All of his major actions had behind them the goal of setting his world in good order while he had the opportunity to do so. In the process he continued displaying his extraordinary capacity for combining continuity and change. In the years after shutting down his Partnership, he shifted from Ben Graham close analysis of value stocks to adopting Charlie Munger's solution of value stocks which also have strong growth. After profiting from the See's Candy capital light model to buying whole businesses which required a lot of capital but had assured returns on investment. He broadened his past experience with brand power to see Apple as an inimitable company with consumer brand power which also just happened to use technology.

In 2022 he continued to repurchases Berkshire shares, though at a more modest rate than the past two years (about $6 billion as of October), an expression of the fact that he sees Berkshire shares as worth buying even after pulling ground on the market as a whole.

All major actions of 2022 involved not just immediate opportunity but a chance to take care of future needs. He drew upon years of experience and his personal authority to act decisively, taking large positions in energy and adding to an already large insurance side. With these actions he whittled down Berkshire's cash position to $109 billion (as of Q3), thus reducing the unthinking calls for a dividend. He used detailed info picked up while deciding to finance Occidental Petroleum's victory over Chevron in the fight to buy Anadarko and bought both OXY and DVX in what amounted to a rare macro judgment. His acquisition of Alleghany drew from the same insurance business that had begun with National Indemnity in 1967 and has continued timelessly as a very good business. He took the opportunity to buy back Greg Abel's 1% of Berkshire Hathaway Energy for $870 billion, thus putting a price for one final buyout. Finally, he added a board member who lowered the age of the board while meeting his criteria for an engaged and well informed board.

Berkshire stock, almost incidentally, led a market shift to value and so with a few days remaining in the year has soundly beaten the S&P 500 by 20% while trading currently up 2% in a down year for almost everything else. Here's that chart:

In the course of 2022 Buffett set Berkshire's affairs in order insofar as it was within his power to do so. Some aspects of Buffett's leadership will be hard to duplicate, including his extraordinary detailed command of business and investing and the courage to weigh risks against rewards for large investments such as his Apple and energy positions. This must certainly have been a source of discussion within top management, but the most Buffett can actually do is to buy time for successors by keeping the cash balance under control and leading by example while providing investment to which successors might add. Chief among these is the option of buying back Berkshire shares using criteria which Buffett and Munger can provide.

Fortunately, there's a good chance that Berkshire will be around to manage things into a new era of higher interest rates which may present more opportunities to buy cheaper shares and businesses. Not the least of his lessons is that diet and exercise are fine but don't be too quick to reject hamburgers, steaks, cherry Coke, and the occasional whiskey, if you happen to like these. What actually matters, obviously, is never retiring and tap dancing to work every day. It also helps if you behave honorably. If you do so, you need not worry about the opinions of your critics.

Is Berkshire Hathaway a buy? It's a company to hold for the long term and there are only a few times in its history when it was expensive. One was the years just before 2000 when it sold at 200% of book value and Buffett told investors not to buy at that price. Another was last March when its price went vertical and ran up to $360. At that price there was no margin of safety. Buffett himself may have bought a few shares not far from its present price around $300 but the numbers suggest that he had little enthusiasm. It was probably good value in June and again in October when it traded close to $270, a number I mentioned as a good buying point in an earlier article. If a continuing bear market caused it to trade at or below that price again, it would be a Strong Buy. The present price may be an OK price. It's never a sell, especially now that Buffett has taken such pains to shape its future.

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