MKL - Will Buffett's Berkshire Continue To Compound Money Robustly?

2023-08-15 11:40:21 ET

Summary

• Berkshire Hathaway is my largest holding and the one I know in the greatest detail, held for more than 25 years.
• The company is seen as a growth company that excels at compounding capital over the long term.
• The biggest challenge to Berkshire, especially in a post Buffett era, is adding major acquisitions or stock positions. It might choose to instigate a liberal program for stock buybacks.

Berkshire Hathaway ( BRK.A )( BRK.B ) is both my largest investment and the company I know best. It's also a very safe stock. Whatever you need to watch as a Berkshire owner, you don't need to worry about its survival during hard times. As Buffett himself has often said, nothing short of nuclear war could do critical damage to Berkshire. This is in part because it's a diversified conglomerate drawing earnings from disparate sources and partly because its pieces all focus on quality. Berkshire is ideally constructed to compound your money. In operational terms it's one of the most decentralized companies that exist, with its units interacting with the small headquarters in Omaha (about 30 people) only if something is going wrong. When it comes to capital allocation, however, it's highly centralized with all cash not needed in its various subsidiaries returned to Omaha to be allocated to other subsidiaries or new investments by Warren Buffett and his lieutenants.

I have owned a position in Berkshire through thick and thin for about 25 years. It has retained its sturdy performance during tough market declines, slow periods without acquisitions, and the periods when acquisitions like Burlington Northern and large stock positions like 5% of Apple ( AAPL ) were proving to be transformative. I also paid close attention to the way Berkshire performed during the dot.com and Mortgage Backed Securities crashes, the two major crises of the last three decades. Short answer: Berkshire did well and protected your capital as I wrote in this piece which amounted to a stress test for Berkshire. In the dot.com crash Berkshire stock went down briefly then turned up on the exact day the Nasdaq 100 topped out and kept going up until 2008. During the MBS crash it followed other financials down but rallied vigorously to new highs as the market realized that its operating earnings were holding up. Buffett, meanwhile, was doing lucrative deals that shored up various deeply troubled companies - Bank of America ( BAC ) was the one with which he exercised his options and built a large position. He also acquired the untroubled Burlington and Northern Railroad a year after the bottom of the crisis.

Berkshire does not pay a dividend. Instead it buys back its own stock over periods when the stock price makes it rational to do so. That makes Berkshire an ideal place to compound your money without the IRS raking its share off of the top. I'm one of the more than 95% of Berkshire shareholders who have no desire to receive dividends, my estimate supported by a 2014 vote in which 97% of Berkshire shareholders voted no to dividends. Shareholders can easily manufacture their own dividends by selling small amounts of stock, and they retain their share of Berkshire ownership up to the amount of cash buybacks done in a given year.

In 2020 and 2021 Berkshire bought back $24.7 billion and $27 billion in share value, a rate equivalent to a generous dividend around 4%-5% based on its market cap at the time. Buybacks haven't been on that scale every year because so far buyback limits have been very sensitive to the rising stock price. Those 2020 and 2022 numbers should be filed away in the back of your mind as they may well be part of a solution for rational use of cash in a future day when large acquisitions become more difficult. For now Berkshire's stock price continues to rule as it clearly did so far in 2023 as buybacks dropped from $4.4 billion in Q1 to $1.4 billion in Q2 as the share price rose.

Has this overall strategy been successful in compounding investor capital? Short answer: Yes. As of its 2022 Annual Report Berkshire exactly doubled the performance of the S&P 500 Index including dividends since 1965, the exact annualized returns being 23.6% for Berkshire compared to 11.8% for the S&P 500. Does much of the return come from the distant past? Yes and no. The way to test this is to use a more recent start date. Starting in 2000 both Berkshire and the index saw annualized returns drop exactly 4%, largely because of the two mega bear markets within 23 years, but Berkshire held on to its exact relative advantage. You can confirm this by checking the table on the first page of the 2000 Annual Report. Just to be sure, I compared the numbers for 2000 to 2022 to the numbers for 1965 to 2022 and it was the same exact double, 19.8% to 9.9% with both Berk and the S&P 500 down about 4% from the annualized compounding rate in 2000. Here's how that 2000-2022 comparison looks on a graph:

How Berkshire And The S&P 500 Got To These Numbers

Berkshire and the S&P 500 index used very different approaches to achieve those numbers. Neither of them compounds money as smoothly as my bank savings account did in the 1950s. A handful of rapid growth companies do that kind of smooth compounding at a high annual rate of return for a while, but their compounding rate tends to slip over time as they mature. Berkshire and the S&P 500 index also have slowed a bit but not very much compared to all comparable competitors. Both hit the same speed bump in 2007-2009 although Berkshire escaped the dot-com crisis of 2000-2003. The S&P 500 index benefits from the automatic increase in cap weightings of its rising growth companies while Berkshire, more bumpily, benefits whenever Buffett is able to make a huge acquisition or build a huge stock position at what usually turns out to be a bargain price.

Those large irregular purchases of a whole company or single stock are likely to be the biggest challenges in Berkshire's future. Few if any other CEOs or CIOs have the wealth of experience, the good judgment, and the decisiveness to do what Buffett with Charlie Munger's assistance can do in this area. Even with the Buffett/Munger skill set the results aren't always perfect. For one thing, the focus has shifted over decades from capital light businesses like See's Candy and Coca-Cola ( KO ) to the General Re purchase. Gen Re raised the level of bond holdings in Berkshire's portfolio to counteract high stock prices but was overly concentrated in areas which proved to be vulnerable to 9/11. Heavily regulated businesses like BNSF and much of Berkshire Hathaway Energy require huge amounts of capital but are virtually assured by the regulators of getting a solid return on it. The challenge to Warren and Charlie has been to figure out the right way to evaluate these very different business models including the most recent departure, the very large position in Apple ( AAPL ) which introduced Berkshire to technology as used in a dominant consumer brand.

The one major failure of such a purchase was the acquisition of Precision Castparts in 2016. In the 2020 Annual Report Buffett admitted that he overpaid and as a result wrote down PCP by $10 billion of its $37 billion purchase price. The write down was prompted by a truly horrible year in which the pandemic led to a shut down of air travel which led to a suspension of new orders for airplanes which led to a huge reduction of demand for aircraft parts. I had some doubts about Buffett's purchase of Precision Castparts (having just sold it at a price below Buffett's purchase price) and my reason had the same broad contours as what eventually happened. My concern was that the business of Precision Castparts was sort of a third derivative requiring a good economy fostering a lot of air travel, enough airline profits to produce more orders for airplanes, and enough parts ordered from PCP to make it a growth story. There were too many links in the chain where things could go wrong and disappoint. Was Buffett feeling pressure to do an acquisition? Was it simply a matter of trying too hard? Possibly, but Buffett had always been immune to all external pressure to make a deal.

I ask these questions not to criticize Buffett but to point up how extremely difficult to it is to hit home runs when faced with the necessity to add large publicly-traded stock positions or major acquisitions every seven or eight years at a minimum. Where both Buffett and his lieutenants have batted 1000 is in bolt-on acquisitions in areas where Berkshire has deep understanding of the industry and a long history of success. Examples include the pipelines purchased from Dominion Energy ( D ) and the purchase of the moderately large insurance company Alleghany. In smaller individual stock positions Buffett has had roughly the same degree of success as his two investment lieutenants with the two lieutenants perhaps ahead because of growth positions like Visa ( V ) and Mastercard ( MA ). The real message here may be that 1950s style value investing no longer works very well and Buffett and his understudies are really doing two different things which are hard to compare.

The closest things to a current large scale action with Buffett's signature on it are energy and the five Japanese trading companies. Buffett's edge with energy comes from more than two decades analyzing and reflecting upon the many stages of energy production and transportation to its consumers. What he sees is the unpopular fact that while carbon energy must ultimately be replaced it cannot be replaced entirely for decades. What he sees with Japan is that it is a cheap market with legal protection of capital and human rights similar to that in the United States. The Japanese market hasn't made a new high in more than two decades and the trading companies bought with a currency hedge were a one-stop vehicle for playing it.

Berkshire's combined positions in Occidental ( OXY ) and Chevron ( CVX ) sum up to the price paid for major industrial acquisitions although there's some evidence, including recent reduction of the CVX holding and the measured buying level with OXY, that Buffett's intention is to keep a tight limit on both price and position size. The position in Japanese trading companies (now about 8.5% of total combined market cap and limited to 10%) is about twice the size of major bolt-on additions but smaller than the size required to make it a truly major position like Apple or Bank of America. The energy and Japan positions in sum may meet the hurdle for moving the needle, for now, but neither seems likely to have the future long-term growth of most major acquisitions and stock positions. That leaves a major question.

Who will take over the task of macro-premise investing as Buffett's successor? I suspect that the answer is that nobody can quite replicate the successes of Warren and Charlie unless there's a plan in place that a person a lot smarter than me has quietly come up with. A possible approach is the one put in place by Apple's Tim Cook which is to innovate with new products as much as possible and use excess cash to buy back shares as long as the return on buybacks exceeds the return on cash. In other words, never mind valuation based on Apple's stock price unless it is obviously extreme. Berkshire would then slide toward being a slower growth company with more focus on annual shareholder return in the form of buybacks but still without value-destroying dividends.

Questions Updated In Interim Reports

By this point you are probably saying, Whoah! wait a minute! I assumed this was going to be the sixth or seventh article drilling down on the details of Berkshire's quarterly earnings report. There were a couple of really good ones, by the way, and if you have a particular appetite for well assembled details and their implications I especially enjoyed this one by Gary Gambino and this one by Daniel Jones.

Generally, to be honest, I don't look closely at the details of quarterly earnings. The main reason is that the details are boring and damage brain cells. A "beat" or a "miss" at low single-digit percentage scale means nothing at all in most cases and the reasons for a beat or miss are generally obvious or random. Analysts have to say something, however, and they attempt to rile up owners, potential buyers, and potential short sellers with energized headlines.

Quarterly reported earnings are interesting mainly when something jumps off the page at you suggesting or reinforcing your view of a long-term change. The business school term is Management By Exception and it often comes to you unconsciously as when a tennis pro thinks "Something is not quite right with that kid's backhand take-back." With Berkshire those little unconscious jabs matter a lot because Berkshire's many holdings are generally well understood and also somewhat unpredictable. As to overall results they're held hostage by gyrations in the value of Berkshire's stock portfolio.

When the Accounting Standards Board changed the rules in 2016 so that unrealized gains and losses in a corporate portfolio had to be reported regularly Buffett cautioned that this would lead to wacky results of no real significance. He recommended disregarding the effect of price change in the stock portfolio and focusing on operating results. The trouble is that it's hard to do this and most earnings reports don't try. Unrealized gains from Berkshire's stock portfolio made for a considerable pop in Q2 after a decent pop in Q1. The two great quarters, however, almost exactly equaled the negative impact of quarters 3 and 4 of 2022, so you should maybe just shrug.

There's a back story, however. The reported stock fluctuation gains for Q2 almost exactly matched the $26 billion as Apple value rose from $151 billion to $177.6 billion. You may remember that Apple is one of the Magnificent Seven which led the roaring tech rally in the first six months of 2023. The rally basically reversed tech losses in 2022. You can't just ignore fluctuations in an investment area valued at $353 billion and constituting about 45% of Berk's market cap of $786 billion This is especially true when its total volatility was in one stock. The way to think about this, in my opinion, is to think about Apple as a mature company which is rather highly valued at 30 times earnings and ask how much its market cap might be reduced in a bear market accompanied by some disappointment in Apple's results. Maybe 40%-50%? Then, of course, knock the total of the remaining stocks down by a lesser amount, maybe 10%-20% per cent, and see what it does to those estimates of Berkshire's value arrived at by adding up its separate pieces. The value of most other pieces won't change much, but the value of publicly traded investments sure will.

A Few More Continuing Questions To Think About

A company as large and diversified as Berkshire inevitably has a few things going on in two or three of its divisions which should be revisited regularly to see if there are long term implications. There are two kinds of things that require examination - external changes beyond Berkshire's control but possibly requiring a response and internal problems which need to be addressed. It's sometimes hard to know which kind of problem you have when it first appears. Here are three long-term thought questions Berkshire leadership must be presently engaging:

• What's going on with revenues and earnings at BNSF which saw a drop in revenues of 11.6%, 11.1% from total volume and the rest from revenue per car. This would be quite large for a one time event but it also comes as revenues have leveled off in recent years suggesting a larger context. Several years ago observers brought up the concern that declining coal volumes might be hard to replace. The most likely explanation is that BNSF has reached a level where growth in volume is hard to come by and may be flattish in the future. This doesn't mean that there will be zero growth with BNSF, just behind Apple in Berkshire's Big Four Family Jewels, or that it will cease to contribute to Berkshire's compounding. It continues to throw off plenty of cash. The point is that Q2's 11.6% decline in revenue is likely part of a longer term slow down resulting from events and trends beyond Berkshire's control.
• All insurance units looked good on the surface led by GEICO. The real question is whether GEICO is in the process of a true turnaround after years of losing market share to Progressive ( PGR ) which had a head start in the use of telematics to evaluate driver behavior. A fairly blunt element of GEICO's response has been sacrificing volume for higher profit margins which you may have noticed in the reduced frequency of its ads. It also was a good year for GEICO thanks to it being a pure vehicle insurance company much less exposed than its competitors to weather catastrophes. It's important to remember that one year isn't enough to declare victory. The competitive story will need to play out over several years of reports to determine whether the 2023 improvement was due to external events or a big fix of GEICO's internal competitive problems. Something of the sort is true generally of the insurance business including property and casualty and reinsurance. Berkshire's insurance side must certainly be looking at a variety of ways to reduce the risks deriving from climate change whether through higher pricing or a strategy for reducing the importance of vulnerable areas in its total potential liabilities. This year was fine but helped by the fact that nothing much happened with huge impact on Berkshire.
• Berkshire's PacificCorp, which was found liable for alleged harm coming from the California/Oregon fires two years ago, will now have to pay $18 million in punitive damages. According to some analysts the amount may reach a billion as complainants are added to the list and the most extreme projections run an order of magnitude higher at $28 billion. Was PacificCorp allegedly "reckless" and "negligent" so as to be responsible for that degree of alleged physical harm and mental suffering? An Oregon jury apparently is saying yes. That's the version of the argument involving internal past actions which if true would call for an internal shake-up to fix things. The external problem beyond Berkshire's control is the political climate in Oregon and California and its status as a target with deep pockets. Has it ceased to be worth the trouble and risk of doing business there? A little over two years ago a close examination made me take that position on China and so far it has been right and right and right. Are the businesses now leaving California the beginning of a necessary migration similar to that of businesses which have left China?

There may be other areas like the three above which are sneaking up on elements of Berkshire. If you have spotted one let me know in the comment section.

Nonsense About Rates And U.S. Credit Ratings

Berkshire continues to hold a lot of Treasury Bills. It's hard to see how that could be controversial but it generated two silly controversies:

• On Aug. 4 Barron's did an article by Carleton English entitled "Warren Buffett and Bill Ackman Face Off Over Bonds." (Sorry I can't link it but I dropped my Barron's subscription a few months ago on the grounds that the headlines suffice 99% of the time.) Somebody please send a note to Carleton English that Buffett owns 3 and 6 month Treasury Bills which are not Bonds. They are essentially cash. Ackman shorted 30-Year Bonds . Ackman and Buffett didn't face off over anything.
• CNBC asked Buffett about the Fitch downgrade of U.S. debt. Buffett's response was (as quoted by CNN) "There are some things people shouldn't worry about. This is one." Buffett was much too polite.

There are a few things to think about that make some sense, however. Buffett loves getting 5% with zero risk. It really drops the risk premium for stocks and maybe pulls some stock P/Es down to a comfortable level. You don't suppose Buffett might extend his Treasury maturities? There's a chance that the Bill rates start to slide as it becomes clear the Fed is done raising so it becomes a game of getting the best deal on longer maturities in which rates won't likely slide as far or as fast. Meanwhile I have been loading up higher rates every time a Treasury Note or CD rolls over but that's an area where Buffett and I diverge. He and I are both getting older but my portfolio isn't Berkshire. Berkshire never ages so Buffett's role for fixed income is purely to be a parking place or pay insurance claims in case there's a sudden catastrophe. Or might Buffett be willing to cover at least a portion of potential insurance liabilities with a bond ladder? Don't laugh. Ancient annual reports reveal that he did that in the 1970s. His portfolio at that time had a mix of bonds and stocks similar to the current portfolio of Markel ( MKL ) today.

The Bottom Line On Berkshire

What started out to be an analysis of the numbers in Berkshire Hathaway's recent Q2 Report turned into a full discussion of what I actually do with interim reports. To start with I skim over "beats" or "misses" of a few percent because they are not significant unless they suggest a new trend. I then update my picture of the company in question asking if anything derived from the report has altered my basic view of the company. The tough calls come from the almost invisible evolution which comes only with the passage of time. For the most part a sudden change or crisis does not come without warning in small but persistent changes. That's what you look for. This article has been an interim picture of Berkshire discussing trends which may fly under the radar but are potentially important.

Berkshire Hathaway continues to be a wonderful company. It has no real risks in the sense of risks to its basic survival. Its most vulnerable parts continue to be in fairly good shape. There are questions, as with any large conglomerate, but they have to do with how to fix parts of the company which have internal problems or a need to come to grips with issues beyond Berkshire's control. It gets an A+ for Profitability on Seeking Alpha's Quantitative system thanks in part to its five year return on equity over 10% and a one year return of 17% thanks largely to strong unrealized capital gains. All other measures are in A territory except Valuation which rose on the recent earnings report. It is ranked #2 of 703 stocks in Financials and #28 among all 4686 stocks covered.

The major question is whether Berkshire can keep up its growth and maintain its excellence in compounding value. Operating companies should continue to do their share, but without Buffett, who has clearly made the call on all acquisitions and stock positions of size, it's eventually going to be difficult to make the kind of growth jumps which have come along once or twice a decade. There may be a partial solution in an arrangement in which Berkshire commits to more regular buybacks perhaps linked to something like the five-year Treasury yield.

Substantial buybacks are a great way to provide cash at a favorable rate of taxation for shareholders who want cash while providing a tax-free reward for shareholders who don't want cash. It's worth remembering that buying back shares up to 4% of market cap can currently be done for $32 billion in cash, something Berkshire has approached a couple of times in recent years. Retiring that cash amount of Berkshire shares is, obviously, the same as making an acquisition on that scale with the confidence of knowing exactly what you are getting. A math quirk deriving from the fact that it produces a reduction of common equity rather than an increases in total earnings means that shareholders who keep their shares do a little better than they would have in the event of an acquisition with Berkshire's quality and numbers.

I agree entirely with SA's Quant System. Berkshire is a Strong Buy.

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