Berkshire Hathaway is in an interesting business. Of owning, investing, operating companies. One can look at it as a really large PE fund working with its own capital, an open-ended platform.
And yet, compared to a PE fund, the range of investments can be so much better. There is no limit on check size (which limits investment set for PE), and there is no constraint on holding period – which makes PE funds hold companies for a limited period and ensure maximization of value during that window. Instead, Berkshire Hathaway (BH) can hold perpetually. And thirdly, the stake owned. Normally PE funds prefer minority or buyouts, and mostly, private companies. The flexibility BH has is around stake sizes, listed, unlisted all kinds of businesses, and around sectors. Leaving them as a really large investor with little limits.
“Sometimes we can buy control of companies that meet our tests. Far more often, we find the attributes we seek in publicly-traded businesses, in which we normally acquire a 5% to 10% interest. Our two-pronged approach to huge-scale capital allocation is rare in corporate America and, at times, gives us an important advantage.”
An ideal way of operating. Limited constraints (very limited) on capital, term, sector, stake size. What one perhaps then needs is iron-clad discipline and clear investment thesis. Which, given Buffet and Munger’s playbook, the firm is amply provided with, and considering the number of shelves devoted to their investing philosophy in financial aisles of bookshops, is a source of wisdom for so many other investors.
Reading the 2018 Annual letter was a treat. Berkshire is another of those companies I am acquainted with, not well-versed in. To understand the company and its holdings a little bit better, I worked through the letter with a bit with discipline and made some notes. Here, following are excerpts from the letter reorganized the way I find it useful to get a sense of BH’s business. Yet to read through some of the other interesting sections of the annual report. Keeping this as an open post of sorts – to add more over time.
Notes and takeaways
On Berkshire’s business
“… let me remind you of our prime goal in the deployment of your capital: to buy ably-managed businesses, in whole or part, that possess favorable and durable economic characteristics. We also need to make these purchases at sensible prices.”
In the letter, he notes that the best way to look at the business is as a forest with different kind of trees in it. For ease, these trees can be broadly divided into 5 groves. One grove is around the insurance businesses, and the other 4 are around investments.
- Grove 1 – 80-100% controlled (e.g. BH Energy, BNSF Railway, Clayton Homes and lots others in several sectors ranging from manufacturing to retail)
- Grove 2 – 5-10% minority investments in several listed companies
- Grove 3 – Where control of companies is shared (sort of significant minority)
- Grove 4 – Cash equivalents
- Grove 5 – Insurance businesses (part of source of float)
A little bit of detail follows.
Grove 1 – the majority or 100% owned companies.
” the most valuable grove in Berkshire’s forest remains the many dozens of non-insurance businesses that Berkshire controls (usually with 100% ownership and never with less than 80%). Those subsidiaries earned $16.8 billion last year (after taxes).Viewed as a group, these businesses earned pre-tax income in 2018 of $20.8 billion, a 24% increase over 2017″
Here, the main companies are BNSF Railway and Berkshire Hathaway Energy (90.9% owned): Together $9.3 billion before tax (up 6% from 2017). The next 10 companies (Clayton Homes, International Metalworking, Lubrizol, Marmon,Precision Castparts, Forest River, Johns Manville, MiTek, Shaw and TTI) delivered $8.7 bllion pre-tax. And the rest $3.6 billion pre tax.
Grove 2 – Minority investments
“Berkshire’s runner-up grove by value is its collection of equities, typically involving a 5% to 10% ownership position in a very large company. As noted earlier, our equity investments were worth nearly $173 billion at year end, an amount far above their cost. Our investees paid us dividends of $3.8 billion last year”
A snapshot from the letter on the companies held: (Worth noting that they hold significant stakes in some of the world’s most profitable companies)
” What we see in our holdings, rather, is an assembly of companies that we partly own and that, on a weighted basis, are earning about 20% on the net tangible equity capital required to run their businesses. These companies, also, earn their profits without employing excessive levels of debt. Returns of that order by large, established and understandable businesses are remarkable under any circumstances. They are truly mind-blowing when compared against the return that many investors have accepted on bonds over the last decade – 3% or less on 30-year U.S. Treasury bonds, for example.”
Grove 3: Shared control
“A third category of Berkshire’s business ownership is a quartet of companies in which we share control with other parties. Our portion of the after-tax operating earnings of these businesses – 26.7% of Kraft Heinz, 50% of Berkadia and Electric Transmission Texas, and 38.6% of Pilot Flying J – totaled about $1.3 billion in 2018″
Grove 4: Cash Equivalents
“Berkshire held $112 billion at year end in U.S. Treasury bills and other cash equivalents,and another $20 billion in miscellaneous fixed-income instruments. We consider a portion of that stash to be untouchable, having pledged to always hold at least $20 billion in cash equivalents to guard against external calamities. We have also promised to avoid any activities that could threaten our maintaining that buffer.”
Grove 5: Insurance businesses
A few selected excerpts from the letter. This highlights the business model of the insurance business and how the float in insurance serves as one of the key funding sources for the rest of the investment activities.
“Our property/casualty (“P/C”) insurance business – our fifth grove – has been the engine propelling Berkshire’s growth since 1967, the year we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, National Indemnity is the largest property/casualty company in the world as measured by net worth.
One reason we were attracted to the P/C business was the industry’s business model: P/C insurers receive premiums upfront and pay claims later. In extreme cases, such as claims arising from exposure to asbestos, or severe workplace accidents, payments can stretch over many decades.
This collect-now, pay-later model leaves P/C companies holding large sums – money we call “float” – that will eventually go to others. Meanwhile, insurers get to invest this float for their own benefit. Though individual policies and claims come and go, the amount of float an insurer holds usually remains fairly stable in relation to premium volume. Consequently, as our business grows, so does our float. And how it has grown, as the following table shows:
If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it.
Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. That loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses.
Nevertheless, I like our own prospects. Berkshire’s unrivaled financial strength allows us far more flexibility in investing our float than that generally available to P/C companies. The many alternatives available to us are always an advantage and occasionally offer major opportunities. When other insurers are constrained, our choices expand.
Moreover, our P/C companies have an excellent underwriting record. Berkshire has now operated at an underwriting profit for 15 of the past 16 years, the exception being 2017, when our pre-tax loss was $3.2 billion. For the entire 16-year span, our pre-tax gain totaled $27 billion, of which $2 billion was recorded in 2018.”
The success of the model is Disciplined risk evaluation.
A summary of results of operations and related caveat:
“We believe that investment and derivative gains/losses, whether realized from dispositions or unrealized from changes in market prices of equity securities, are generally meaningless in understanding our reported results or evaluating the economic performance of our businesses. These gains and losses have caused and will continue to cause significant volatility in our periodic earnings.”
The value of business is much greater than sum of the parts.
” I believe Berkshire’s intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.”
“Finally, a point of key and lasting importance: Berkshire’s value is maximized by our having assembled the five groves into a single entity. This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead.”
On Funding Sources
Four main buckets detailed. Berkshire Hathaway has a $707 billion balance sheet (see image of liabilities side below)
” Much of our ownership of the first four groves is financed by funds generated from Berkshire’s fifth grove – a collection of exceptional insurance companies. We call those funds “float,” a source of financing that we expect to be cost-free – or maybe even better than that – over time. “
Debt: Sparingly used. Mainly asset backed. No BH guarantees. Notes on debt are worth noting
Equity: “Berkshire’s $349 billion is unmatched in corporate America. By retaining all earnings for a very long time, and allowing compound interest to work its magic, we have amassed funds that have enabled us to purchase and develop the valuable groves earlier described. Had we instead followed a 100% payout policy, we would still be working with the $22 million with which we began fiscal 1965.”
Float: “Beyond using debt and equity, Berkshire has benefitted in a major way from two less-common sources of corporate funding. The larger is the float I have described. So far, those funds, though they are recorded as a huge net liability on our balance sheet, have been of more utility to us than an equivalent amount of equity. That’s because they have usually been accompanied by underwriting earnings. In effect, we have been paid in most years for holding and using other people’s money. As I have often done before, I will emphasize that this happy outcome is far from a sure thing: Mistakes in assessing insurance risks can be huge and can take many years to surface. (Think asbestos.)” ” Unlike many other insurers, however, we will be looking to add business the next day.”
The float in case of Berkshire has grown significantly.From $39 million in 1970, to $1.6 billion in 1990, to $65 billion in 2010 and to $122.7 billion in 2018.
Deferred Income Taxes: “The final funding source – which again Berkshire possesses to an unusual degree – is deferred income taxes. These are liabilities that we will eventually pay but that are meanwhile interest-free. About $14.7 billion of our $50.5 billion of deferred taxes arises from the unrealized gains in our equity holdings. These liabilities are accrued in our financial statements at the current 21% corporate tax rate but will be paid at the rates prevailing when our investments are sold. Between now and then, we in effect have an interest-free “loan” that allows us to have more money working for us in equities than would otherwise be the case.”
On Stock Repurchase
In a couple of places in the letter, he discusses stock repurchase
“All of our major holdings enjoy excellent economics, and most use a portion of their retained earnings to repurchase their shares. We very much like that: If Charlie and I think an investee’s stock is underpriced, we rejoice when management employs some of its earnings to increase Berkshire’s ownership percentage.
Here’s one example drawn from the table above: Berkshire’s holdings of American Express have remained unchanged over the past eight years. Meanwhile, our ownership increased from 12.6% to 17.9% because of repurchases made by the company. Last year, Berkshire’s portion of the $6.9 billion earned by American Express was $1.2 billion, about 96% of the $1.3 billion we paid for our stake in the company. When earnings increase and shares outstanding decrease, owners – over time – usually do well.
True, the upside from repurchases is very slight for those who are leaving. That’s because careful buying by us will minimize any impact on Berkshire’s stock price. Nevertheless, there is some benefit to sellers in having an extra buyer in the market.
For continuing shareholders, the advantage is obvious: If the market prices a departing partner’s interest at, say, 90¢ on the dollar, continuing shareholders reap an increase in per-share intrinsic value with every repurchase by the company. Obviously, repurchases should be price-sensitive: Blindly buying an overpriced stock is value destructive, a fact lost on many promotional or ever-optimistic CEOs.
Some sellers, however, may disagree with our calculation of value and others may have found investments that they consider more attractive than Berkshire shares. Some of that second group will be right: There are unquestionably many stocks that will deliver far greater gains than ours.
For 54 years our managerial decisions at Berkshire have been made from the viewpoint of the shareholders who are staying, not those who are leaving. Consequently, Charlie and I have never focused on current-quarter results.”
A few other notes and insights
Since letters (like autobiographies) can reveal how people think about stuff, and when it is coming from that level of insights and experience, it is worth noting and giving space in your own thoughts, and turning it over now and then. Saving it here for my future reference:
On price and value
“On occasion, a ridiculously-high purchase price for a given stock will cause a splendid business to become a poor investment – if not permanently, at least for a painfully long period. Over time, however, investment performance converges with business performance.”
” We use debt sparingly. Many managers, it should be noted, will disagree with this policy, arguing that significant debt juices the returns for equity owners. And these more venturesome CEOs will be right most of the time. At rare and unpredictable intervals, however, credit vanishes and debt becomes financially fatal.
Russian roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company’s upside but does not share in its downside. But that strategy would be madness for Berkshire.”
On mistakes of omission
” In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.”
On reporting and expenses
“For example, managements sometimes assert that their company’s stock-based compensation shouldn’t be counted as an expense. (What else could it be – a gift from shareholders?) And restructuring expenses? Well, maybe last year’s exact rearrangement won’t recur. But restructurings of one sort or another are common in business – Berkshire has gone down that road dozens of times, and our shareholders have always borne the costs of doing so.”
Related note – Two classes of shares
Berkshire’s market cap is $497 billion. And each Class A stock is around $303k. One can buy a house in some suburb or buy one Class A share.
Since Berkshire Hathaway is one of the companies with two classes of shares, and given my personal discomfort with these (explored further here), I did a bit of looking up on why and how. And there is a lot on the internet. One of the links here.
The point is the whole idea behind Class B was to provide an investment opportunity to small investors (believing that otherwise they would have paid advisor fees to participate in Berkshire gains.
Trying to look for the letter briefing the launch of Class B shares, I came across the acquisition criteria listed on their website from 1995 or so. A quarter of a century ago. Pretty much loops back to the comparison with PE firms.
"We are eager to hear from principals or their representatives about businesses that meet all of the following criteria: (1) Large purchases (at least $25 million of before-tax earnings), (2) Demonstrated consistent earning power (future projections are of no interest to us, nor are "turnaround" situations), (3) Businesses earning good returns on equity while employing little or no debt, (4) Management in place (we can't supply it), (5) Simple businesses (if there's lots of technology, we won't understand it), (6) An offering price (we don't want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown). The larger the company, the greater will be our interest: We would like to make an acquisition in the $3-5 billion range. We are not interested, however, in receiving suggestions about purchases we might make in the general stock market. We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me."