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Inside the mind of Warren Buffett

Berkshire Hathaway will soon face corporate life without one of the all-time greats of US business history. That's not a happy prospect
July 3, 2015

It's an odd feature, this. It's about Warren Buffett, the world's most successful investor, but it's not about Warren Buffett, the investor. It's about the way that Buffett works, but it's not about the way that he picks stocks. It's about Buffett the manager, but not about Buffett the fund manager.

It's about the side to Buffett that gets too little attention. We say 'side', but actually this part-forgotten side accounts for 80 per cent of the $525bn (£333.67bn) of assets that Buffett controls; while the stock market investments - the bit for which Buffett is lauded and famous - comprise just 20 per cent.

Whichever way you look at him, Buffett is an institution. So famous that somehow it seems right to refer to him as simply 'Buffett'. To the man on the street, he is best known as one of the world's two or three richest men, but who remains down to earth and avuncular despite vying with Croesus; as the brilliant stockpicker who spotted the hidden value in, say, American Express (US:AXP) when that company was on its knees; or as the man who loves shares in Coca-Cola (US:KO) as much as he loves the cherry-flavoured version of the famous soft drink.

But Buffett's greatest achievement is really the creation of Berkshire Hathaway, (BRK.B), the giant conglomerate of wholly-owned companies that began 50 years ago in May. In the intervening half century, Berkshire has gone from being a collection of troubled textile mills in New England to a vast conglomerate with a stock market value of $356bn. This makes it the third-biggest company in corporate America (see Table 1) and - to put its size into a more familiar context - makes it twice as valuable as the biggest component of the FTSE 100 index, HSBC (HSBA). Within Berkshire's sprawl there are eight companies that, if they were standalone, would be in the Fortune 500 list of the biggest US companies.

Yet if Berkshire Hathaway was the mega-corporation created by accident - which, in a sense, is the case - it is also the most successful conglomerate that the world has ever seen. So we want to do the following:

■ Explain why it was so successful, for which we will primarily use the testimony of Buffett himself and his vitally-important sidekick, Charlie Munger, the vice-chairman of Berkshire Hathaway.

■ Critically examine Berkshire's financial performance to see if it is as good as it's cracked up to be. Short answer - it's pretty darn good, but not in the way that you would expect from companies controlled by Buffett.

■ Explain why Berkshire may well decline rapidly after the departure of Messrs Buffett and Munger, who are 84 and 91, respectively, even though the two have convinced themselves that it can survive and continue to prosper.

To hear Philip Ryland discussing this feature in this week's free IC Companies & Markets podcast, click here.

 

The birth of Berkshire Hathaway

Let's start with that accidental birth. Like pretty well any stock picker in the world, the young Buffett could run his operation from a spare bedroom - all that's needed is a stack of annual reports and a clear brain. For some years, Buffett did just that, running his investment partnerships from the family home, an unpretentious five-bedroom house in uptown Omaha, Nebraska, which Buffett bought in 1957 and where - despite his wealth - he still lives. Later he moved his investment operation into an equally modest downtown office block in Omaha. When Buffett shifted most of his wealth from his partnerships to Berkshire, this address became the company's corporate headquarters and so it has remained even though the group now has 340,000 employees.

Morphing the young Buffett's operation from partnership into joint-stock corporate form began when he took control of publicly quoted Berkshire in May 1965 - a move that the great man has described as his dumbest ever. Buffett had planned to profit by selling a holding in Berkshire back to the company, as he had done more than once, but this time was narked when the company tendered marginally less than had been informally agreed. In response, Buffett began to bid for stock and his partnerships ended up controlling "a terrible business about which I knew very little", as he wrote earlier this year. "I became the dog who caught the car."

That said, it was always likely that Buffett would have (a) created some sort of conglomerate and (b) struggled to stick with a partnership form even if he had not taken over Berkshire. That's chiefly because a conglomerate is really just an extension of an investment portfolio; the chief difference being that, rather than own bits of various companies, the conglomerate owns 100 per cent of them.

But the thought process and the expertise that goes into selecting the acquisitions is much the same. Essentially, it is about allocating capital; putting capital into those projects that are likely to generate the highest dollar return; and whether that entails buying a chunk of a company or buying all of it really does not matter. As we shall see, Buffett's great expertise is as an allocator of capital. It is what has made him so successful. It explains both why Berkshire's structure is as it is - with a tiny HQ controlling a vast corporate empire - and why the conglomerate structure has been so advantageous for Berkshire.

 

From cigar-butt to Oliva Melanio Figurado

Starting in the early 1950s, Buffett had learned from Benjamin Graham, the founding father of investment analysis for whom he worked, that successful investment was simple in theory. It was just a matter of buying the opportunities where the gap between the value acquired and the price paid is the greatest. Graham's investment repertoire - like Buffett's to start with - boiled down to juxtaposing the value in a company's balance sheet with its stock market value, buying when the gap was sufficiently wide to ensure a margin of safety and waiting for the gap to close. Graham labelled this approach "cigar-butt investing". And, as Buffett explained in Berkshire Hathaway's latest annual report: "Most of my gains in those early years came from investments in mediocre companies that traded at bargain prices. Ben Graham had taught me that technique - and it worked."

Buffett's purchase of Berkshire itself was a typical piece of cigar-butt investing. He started buying the stock in 1962 at $7.50 per share against a book value of $20.20. The familiar pattern was that the company would tender to buy in stock somewhere between those two prices, Buffett would sell and pocket the difference.

However, there was a limit to what cigar-butt investing could do because, as Buffett added, it "was scalable only to a point. With large sums, it would never work well". The reason for its shortcomings was because it entailed buying shares in low-quality companies; companies - like Berkshire - that, for whatever reason, were in decline. The solution - as advocated by Charlie Munger - was to buy bits of, or all of, top-quality companies. As Buffett explained, Mr Munger's blueprint was: "Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."

If you like, the cigar butt was swapped for an Oliva Melanio Figurado cigar. Yet there was consistency at the core. In both approaches the aim was to capture the difference between the price at which the asset was offered and its underlying value. Only the methodology was different. Cigar-butt investing relied on a simple analysis of a company's balance sheet, while the high-quality approach relies on assessing 'intrinsic value', which is basically a guesstimate of a company's net present value. That's a fairly basic business-school concept, which is defined as all the future cash that will accrue to a company's shareholders expressed in today's money values. As such, it can only ever be an indicative figure. Yet to make an intelligent assessment of its value requires a thorough analysis of any company.

So Buffett got into buying whole companies partly because he was so successful at buying bits of them, but also because he had struck on a wonderful wheeze to get lots of investment capital for nothing. That wheeze was to buy insurance companies and use their 'float' - the pool of insurance-policy premiums - as interest-free capital with which to lever returns to the owners of equity. True, insurance-company float is only free when the insurer makes an underwriting profit (ie, in a given year, premiums exceed claims) and the insurance industry is so competitive that many insurers consistently record underwriting losses.

Buffett's solution was to buy the best insurance operations, with the leanest cost structure and be fussy about which risks are underwritten. Of course, the bosses of many insurance companies claim to do as much, but few practice what they preach. The proof of Berkshire's ability to walk the walk has been demonstrated by the size and the consistency of its underwriting profits. For example, in 2014 its insurance arm made an underwriting profit for the 12th year running. In large part because of that record, float has grown enormously. From $39m in 1970 soon after Berkshire made its first insurance-company acquisition - National Indemnity for $9m - float had grown to $28bn by 2000 and now stands at about $84bn.

And, in explaining Berkshire's origins, we have pretty well explained why the conglomerate structure suited it so well. It provided the best possible vehicle for Messrs Buffett and Munger to maximise their skills. Elsewhere in the corporate world, conglomerates were getting a bad name for the accounting shenanigans that their bosses uses to justify acquisitions. But, at Berkshire, the conglomerate form allowed the two to allocate capital efficiently and with minimal frictional costs. As Buffett said in the 2014 annual report: "At Berkshire we can - without incurring taxes or much in the way of other costs - move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise."

 

Table 1: Berkshire Hathaway: Big or what?
CompanyCodeShare price ($)Mkt cap ($bn)Assets ($bn)Revenues (Sbn)Pre-tax profit ($bn)Employees
AppleAAPL131.77759.1261.2212.264.992,600
ExxonMobilXOM85.27358.2349.5411.951.675,300
Berkshire HathawayBRK-B144.48356.1526.2194.728.1340,499
General ElectricGE27.51277.2648.3148.517.2305,000
Walmart StoresWMT75.35243.0203.7485.724.82,200,000
ChevronCVX103.11193.9269.6192.331.264,700

 

The cult of Buffett and Munger

Yet there is no getting away from the fact that Berkshire's success has more to do with Buffett and Mr Munger than with the conglomerate form. Indeed, Mr Munger has said as much. In explaining why Berkshire did so well once Buffett took control, Mr Munger has focused on four factors:

1. The "constructive peculiarities" of Buffett - which is a label for Buffett's genius and for his decision to focus his investment skills on a relatively small range of industries.

2. The "constructive peculiarities" of Berkshire - which is chiefly about Buffett's decision to build his conglomerate around insurance operations.

3. Good luck - which chiefly describes the wonderful tail wind provided by the performance of the US economy and its listed companies over much of Buffett's career. In the 50 years since Buffett took control of Berkshire, the total return on the S&P 500 index of US stocks has compounded at the rate of 9.9 per cent a year. Sure, the gain in Berkshire's share price has been at more than twice that rate. Even so, the effect of the push lent by the US economy should not be underrated and Mr Munger concluded that Berkshire's success was "so outstandingly large that Buffett would fail to recreate it if he returned to a small base while retaining his smarts and regaining his youth".

4. What Mr Munger describes as "the weirdly intense, contagious devotion of some shareholders and other admirers, including some of the press". He does not enlarge on this, but it seems to mean that at some point in Berkshire's rise a self-reinforcing mechanism kicked in and success bred success. Certainly for the past 20 years there has been something of the cult about Berkshire with Buffett as its high priest. That's more than time enough for a combination of contagious devotion and the magic of compounding to work miraculous effects on the wealth that Berkshire created.

Which is not to imply that Berkshire's success is down to smoke and mirrors. However, it may well have been fostered by factors that won't be able to be maintained once Buffett has gone. Chief among these would be what Mr Munger has described as "the seamless web of deserved trust" on which Berkshire is run. He explains: "Good character is very efficient. If you can trust people, your systems can be way simpler."

Simple enough that a staff of 25 at Berkshire's Omaha HQ can cope with a conglomerate employing 340,000. The point is that the boss may be at head office, but he and his staff don't run the show. The running is devolved to the operating subsidiaries, which are headed by people that Buffett likes and trusts. Or, as Mr Munger once told a meeting at Stanford University: "We want very good leaders who have a lot of power and we want to delegate a lot of power to those leaders."

Table 2: Berkshire's rating compared
CompanyPE ratioPrice/bookDiv yield (%)Beta
Apple14.26.31.40.9
ExxonMobil19.21.43.20.9
Berkshire Hathaway19.12.10.00.6
General Electric18.710.83.31.4
Walmart Stores15.44.12.60.4
Chevron22.81.34.21.2
Notes: PE based on forecast earnings for 2015; Price/Book for net tangible assets; beta - 5 yrs relative to S&P 500

Table 3: Berkshire's trading ratios compared
CompanyRoCE (%)RoE (%)Profit margin (%)
Apple25.838.430.2
ExxonMobil9.616.39.6
Berkshire Hathaway6.38.716.5
General Electric1.51.18.4
Walmart Stores12.620.75.5
Chevron5.011.38.5
Source: Capital IQ Latest full-year figures  

Table 4: Berkshire: the major activities
SubsidiaryActivityRevenuePre-tax profitGross assets
GEICOCasualty insurance20.51.1645.4
Re-insurance op'sRe-insurance16.40.8828.7
BNSFFreight trains23.26.1762.9
BH EnergyPower gener'n & supply17.62.7171.5
MclaneGroceries wholesaler46.60.445.4
Data for year to end Dec 2014; all figures $bn  

 

Berkshire's performance

As to how good Berkshire's performance has been, let's start with a table familiar to IC readers - Table 5, which shows Berkshire as we would report any company's full-year profits. This shows turnover, profits and earnings all growing at a fair pace, even if profits and earnings faltered in 2014. This growth was achieved with relatively little debt (net debt was just 7 per cent of end-2014 net assets), but it seems to be well rewarded by the market - the 'B' shares trade on 18 times 2014's earnings. Of course, there is no dividend yield on which to make an assessment because Berkshire does not pay a dividend (and hasn't since 1969). Famously, Buffett says that Berkshire won't do so while he is confident that, in the long run, each dollar of retained profits will generate more than a dollar of additional market value.

Table 5: Berkshire Hathaway (BRK.B)
ORD PRICE$142.98 MARKET VALUE: $352bn
TOUCH:$142.97-142.9912-MONTH HIGH:$152.94LOW: $122.72
DIVIDEND YIELD:nilPE RATIO:18
NET ASSET VALUE:$97.46NET DEBT:7%

Year to 31 DecTurnover ($bn)Pre-tax profit ($bn)Earnings per share ($)Dividend per share ($)
201013619.15.29nil
201114415.34.14nil
201216222.25.98nil
201318228.87.90nil
201419528.18.06nil
% change+7-2+2
Beta: 0.6 £1 = $1.55

Meanwhile, those looking especially closely will note that in 2014 Berkshire only generated $8 of earnings for every $97.5 of equity capital (net asset value) that it used. That may help explain why the ratio of market value to net asset value - about 1.5 times - is comparatively ordinary. Arguably, a higher conversion rate of equity employed to market value might be expected for a company run by a master of capital allocation such as Buffett. But if equity capital only generates a modest amount of net profit, there is a limit to how far the price-to-book multiple (the ratio of market value to net asset value) can go.

Let's develop that point with Table 6. This is extracted from comprehensive data for Berkshire Hathaway over the period 2000-1. The table shows the results of a typical year for Berkshire; 'typical' meaning the average returns of the past 15 years - the average year-on-year growth rates and the average profits ratios. What's remarkable is those growth rates because, even at the base date 15 years ago, Berkshire was a big conglomerate, employing gross assets of £136bn and generating revenue of $30bn and operating profits of almost $6bn. To start from that base and, on average each year, to produce 15 per cent sales growth, 35 per cent growth in operating profits and 44 per cent for earnings per share is something else.

Table 6: Berkshire: a typical year
Sales growth (% pa)14.7
Profit margin (%)15.1
Operating profits growth (% pa)35.4
Free cash flow growth (% pa)21.7
EPS growth (% pa)43.8
Return on equity (%)8.2
Free cash return on equity (%)8.3
Capital turnover0.25
Average of years 2000-15; Source: Berkshire Hathaway accounts 

Maybe it's doubly remarkable that Berkshire did this without any so-called 'bootstrapping' - acquiring growth by issuing its own highly rated shares to buy companies trading on lower profit multiples. Such a tactic - much loved by bosses of many acquisitive companies - ensures that earnings grow. But it almost equally ensures that the quality of a group declines as dross is bought in and eventually that will be reflected in a falling share price. Although Berkshire is a keen acquirer of businesses, almost exclusively it uses its own cash to make payment - it has laid out $74bn in cash acquisitions in the past 15 years - and has issued next to nothing in the way of new shares.

True, revenue growth may now be on a downward trend. In four of the past seven years, percentage growth has been in single figures. In operating profits, year-to-year changes are too volatile to discern a trend. However, profit margins have been extremely steady, within two percentage points of the 15 per cent average in all but four of the 15 years. With tax rates trending downwards on a growing quantum of profit, the effect has been to give a huge kicker to growth in earnings per share, even though that growth has come with the volatility that is consistent with a residual number.

Perhaps most impressive of all is Berkshire's ability to generate free cash (the cash that's left for shareholders after all operating expenses - including capital spending - have been paid). Granted, there is a lot of variation around the average growth in free cash of almost 22 per cent. But what stands out is that not once in the past 15 years has Berkshire failed to generate free cash. As might be expected for a group that's identity has shifted towards running utilities - power and railways - free cash has been trending upwards. Only once in the period 2000-08 did it top $10bn, but in the six years since then it has been above that level every year. In aggregate over the 15 years Berkshire generated $138bn of free cash even after laying out $76bn on capital spending.

However, the unexpected - and disappointing - feature of Berkshire's accounts is the low rates of return on capital that the group makes. As Table 6 shows, the average return of both net profits and free cash to equity has been almost the same - 8.2 per cent and 8.3 per cent, respectively. The odd thing is that this does not tally with a company whose average year-on-year change in net assets over the past 50 years is 20 per cent. Over the long run there should be a convergence between the average change in per-share net asset value (book value) and return on equity.

True - as would be expected from such a large group - Berkshire's pace of growth in book value is trending downwards. For the period 1977 to 2004, the 10-year moving average of annual growth in book value was always at least 20 per cent (with the exception of 2002). But since 2004 the 10-year trend has dropped considerably and is now running at just over 10 per cent. As well as being a function of Berkshire's enormous size, that drop in the pace of growth is also a comment on the fading tailwind offered by the stock market. Yet Berkshire's comparatively ordinary return on equity (RoE) is not a new phenomenon. In the 14 years that we have monitored - 2001 to 2014 - RoE has never been higher than 11.6 per cent and has been in single figures for all but three of those years. Interestingly, cash flow RoE has been more consistent than the net-profits ratio, although its trend is more clearly downwards - it is 11 years since it was in double figures.

Sure, Berkshire employs an awful lot of capital - $526bn-worth at the end of 2014, of which $243bn was equity. But, by the nature of its activities, it is a capital-intensive operation, what with all the fixed assets of its utilities operations, the capital requirements of its insurance businesses and its famed long-term investments (the likes of American Express, Coca-Cola and Wells Fargo), whose values are 'marked to market' in the accounts. That helps explain why the group's ratio of turnover to capital employed is so low - on average, Berkshire's 'capital turnover' is just 0.25. Arithmetically, that explains why RoE is low - to the extent that RoE is simply a function of capital turnover multiplied by profit margins. But it does not explain why RoE is low in the first place.

 

The future, without Buffett and Munger

Still, we could quip that Berkshire's shareholders have a far more important thing to worry about than the group's oddly low return on equity - specifically, the future without Messrs Buffett and Munger in charge. That day will arrive sooner than they wish - as we said earlier, Buffett is 84 and Mr Munger is 91. And whatever those two may protest about Berkshire's sound long-term prospects without them, it is easy to imagine a process unfolding after their exit that will change Berkshire irrevocably and undermine its share price. Let's imagine it, step by step.

■ One - there will be a shake-up in Berkshire's corporate governance. That's partly because Buffett and Mr Munger are by no means the only really old people on the board. At the start of 2015 the 13-person board included at least six who were on the wrong side of 80. Three of those were older than Buffett, although one of them - Donald Keough - died in February.

Those old ones are there because they are long-term business friends of Buffett or Munger. As they leave they will be replaced by new directors who will have a different relationship with whoever is Berkshire's new chief. Those dynamics will lead to Berkshire adopting a more conventional board structure. Mr Munger's "seamless web of trust" will be replaced by the more familiar corporate-governance model of "agents watching agents". Even if it works satisfactorily, it won't be better than Berkshire's current minimalist approach.

■ Two - Berkshire's shareholder base will change. That's partly because many of those shareholders - especially those who own the original 'A' stock - are also very old and partly because who knows how many own Berkshire stock simply because of Buffett. Without the Sage of Omaha running the show, they will want to reduce their exposure to Berkshire.

■ Three - the 'B' shareholders will get restive. They are the second-class citizens anyway. Their rights to Berkshire's net assets are 1,500th the rights of the 'A' stock, yet each 'B' share only has one 10,000th the voting rights of an 'A' share. Sooner or later the cry will go out that this is intrinsically unfair. But equalising voting rights between the two classes of share will give more power to investors whose commitment to Berkshire may not be that strong.

■ Four - linked to the dynamic of 'Three', there will be pressure for Berkshire to pay dividends. This issue has arisen before and - amazingly for a listed company - Berkshire has twice polled shareholders to ask if they wanted dividends, in 1984 and 2014. On both occasions the answer was a resounding 'No'. Without Buffett at the helm, however, and with the shareholder base in flux and anxious, the response next time may be very different.

■ Five - a power struggle will develop. Picture this: the new chief executive is appointed - apparently his or her identity is already known and the appointment will be from within - but the pressures already mentioned mount, as do problems in Berkshire's vast conglomerate. Soon, unhappy investors want to replace the new boss with someone with "the appropriate stature" from the outside. To whom do they appeal? In theory, they go to the new non-executive chairman, who will be Howard Buffett, son of the great man. But the farmer, photographer and philanthropist with his father's money is likely to be loyal to his father's wishes. The alternative is to go to the only big gun on Berkshire's board - Bill Gates, founder of Microsoft, friend and bridge partner of Buffett snr who is famous for not suffering fools gladly. One-third of the board is too infirm to understand what's going on, the other two-thirds are split between Howard and Bill. It's a mess.

■ Six - anxious to respond to unhappy shareholders, the new boss does what all chiefs do when they want to impress - he (or she) will reorganise Berkshire; no matter whether there is logic behind the proposals, the important thing is to dress up the change as progress. Into Berkshire's head office will come a range of hitherto-unknown functions - personnel, legal and, of course, M&A. Berkshire will appoint advisers they never had before. Management consultants will move bits of Berkshire around like children playing chequers. The size of Berkshire's board will expand enormously. Committees will be formed to monitor corporate governance, corporate social responsibility, board nominations and remuneration. The buzz of activity will be humming. Wall Street analysts will be deeply impressed. Nothing will actually improve.

■ Seven - Operational issues within Berkshire's subsidiaries multiply. Laying out $6bn in 2014 to improve performance at BNSF, the freight-train operator that is Berkshire's biggest non-insurance subsidiary - "a truly extraordinary amount", according to Buffett - proves to be just what some analysts fear: too much spent too quickly. Benjamin Moore, a paint maker which is on its third chief executive in three years, continues to be troubled, as does NetJets, a timeshare provider of aircraft for the well-heeled. The new boss has little choice but to get involved with too many operational problems in more industries than it is possible for one person to understand intimately. Berkshire increasingly looks like a conglomerate that is too complex to hold together.

True, it does not have to come to that and Berkshire's decline - for it surely will decline - may be gentler. As Messrs Buffett and Munger point out, Berkshire has subsidiaries that will continue to churn out cash year after year. Buffett himself says that "Berkshire is ideally positioned for life after Charlie and I leave the scene". That, he reckons, is in large part due to Berkshire's corporate culture. "Our system is also regenerative," he says. "To a large degree both good and bad cultures self select to perpetuate themselves. For very good reasons, business owners and operating managers with values similar to ours will continue to be attracted to Berkshire as a one-of-a-kind and permanent home."

Maybe. Yet as Mr Munger also acknowledges, Berkshire has a corporate culture that is "nearly unique" and that owes much to "Buffett's constructive peculiarities". It would be nearer the truth to say "Buffett's genius". He ranks alongside the greats of US business history and his longevity is, indeed, unique. Take away Buffett and Berkshire just won't be the same - and it won't be better. When the great man goes, just watch the short sellers gather.