The Many Lessons from Berkshire Hathaway

 Introduction

Earlier this week I felt like I was accused. In a message from an investment committee colleague who is a retiring senior officer of an institution I was thanked for being a teacher to him. This upset me because I always wanted to be with the “good guys,” the students. For I believe I am a lifelong student of human behavior, particularly in terms of investments. In that search I am always looking for sources of knowledge and wisdom. One of the lessons I learned from my otherwise much too liberal education was that the Bible is more than an inspirational document about morality. Selective chapters and verses can provide lasting insights into economics, agriculture, military tactics and strategy, training, law, sociology, psychology, management development, and leadership among other lessons.

In a similar fashion, a continuing study of the ever changing Berkshire Hathaway can be very instructive as to how one should lead his or her investment life. As a long-term owner of the stock both in a private financial services as well as personal accounts, I attempt to read almost all that is published on the company. I am not totally successful as the amount published by the company is voluminous, including various commentaries by its twin leaders Warren Buffett and Charlie Munger. It is popular with some “arm chair” critics to cast doubt as to the current wisdom of various moves that the company is making on numerous multi-tiered chess boards.

The purpose of this post is to share with our community what I learned in reading just one document. Almost all of my comments come from reading and thinking about the 45 page 10-Q document filed with the US SEC addressing the third quarter of 2015. Please do not interpret this as a recommendation to buy the stock which would only be appropriate after a thorough understanding of one’s current portfolio, time horizons, and views. However, it is a recommendation to various colleges and graduate schools to use a study of certain aspects of the company including accounting, contracts, global economics, management approaches, personnel and personal development, insurance risk management, financial and economic history and developing a long-term, loyal shareholder base. 

Financial Services

While it is much more, Berkshire Hathaway is essentially a financial services holding and portfolio management company. For the quarter 80% of the revenues came from insurance and other related sources. This simple title covers many different activities. It is somewhat like celebrating a winning horse without recognizing the contribution made by the jockey, trainer, breeding and ownership elements including many whose names we do not know. Some may downplay its contribution, for in the quarter as insurance underwriting contributed only 9% of operating earnings. What they are missing is the generation of insurance float which at the end of the quarter stood at $86.2 Billion up $2.2 Billion from year-end. In many ways this is the single most important figure in the financial statement. The float was essentially the source along with operating cash flow that led to a $133 Billion investment portfolio housed within the insurance complexes. For those of us who grew up within the brokerage community, float represents margin debt without interest cost. If one applied all of the float to the total net assets of the company one could take a somewhat exaggerated position that the company is 33% leveraged. However, the key value of the float is as excess capital that can be applied in a matter of hours as part of, in essence, rescue missions for sound, high quality companies that need cash and Berkshire’s imprimatur and are willing to pay preferred dividends or interest way above markets rates plus equity “kickers.” These companies have included GE, Goldman Sachs*, Bank of America*, Dow Chemical, Mars, among others.

Insurance is not the only source of financial earnings for Berkshire Hathaway. If one looks through the activities of its railroad, utilities, and energy, the objective is to convert its own and others capital through operations into financial gains that are soundly leveraged. In the third quarter these activities produced 18% of total revenues. Finance and financial products represented the rest of the revenues even after a $764 million believed to temporary loss in derivatives

Messrs. Buffett and Munger clearly believe in the long-term attractiveness of financial services investing, which reinforces my personal biases. (Friday saw bank stocks rise sharply, with JP Morgan Chase* up 2 points on almost double the volume of Thursday, perhaps its timing is right) Berkshire has devoted some $ 48.9 Billion to financial services stocks with 74% in Wells Fargo and American Express. It believes in well chosen concentration; including the two mentioned above, some 58% of its equity investments are in just four stocks. The only one of which is showing a loss against purchase price is IBM which is down some $2 Billion from a cost base of $11.7 Billion.  Not being a registered investment company it is treating the decline as temporary and not writing down its value. (This option is available to private investors and not registered participants and could be a useful approach as long as the investor is highly confident of recovery to purchase price. While I might like to do this personally, I am afraid my clients’ financial people are more interested in immediate liquidating values to meet their funding obligations with money to spare.)

*Held personally and/or by the financial services fund I manage

In a somewhat different situation in terms of Tesco, Berkshire took a write down of $ 678 million, but did not sell the stock which shows that it lost faith in the ability to get back to purchase price but thought that this summer’s prices were unnecessarily depressed. Looking at fourth quarter UK prices Berkshire may be able to salvage some of its admitted loss.

Viewing Berkshire as a Source of Investment Inputs

I found the following nuggets useful to aid my broader investment thinking. I will be happy to expand upon any of these with our regular subscribers.

After a super-heated second quarter, I was not totally surprised that the summer proved to be slow for many of the operating activities. What did disappoint me is that in many of the financial activities sales slowed materially more than seasonally. This slow-down hit our financial services stocks particularly in the asset management business.

Luckily for Berkshire the big bet on Kraft Heinz paid off with the carrying value of this common stock, including additional investments, jumping to $15.8 Billion from $3.95 Billion at year-end. The characteristic boldness of the management is a hallmark of the way it understands the importance of moving decisively when opportunity knocks looking for massive capital deployment.

As predicted by Mr. Buffett, the reinsurance business has fundamentally become less attractive due to excess capital being deployed by new entrants into the business who are lowering premiums. For the nine months Berkshire Hathaway Reinsurance Group saw its underwriting gain drop to $247 million from $617 million for the prior nine month period. Once rates move back to attractive levels they are likely to return to the leadership of the big ticket business. The General Re subsidiary has analogous experience, dropping to $ 58 from $322 million operating gains in the same periods. The ability to tolerate these cyclical swings shows the benefit of the overall financial strength even with GEICO suffering a sharp increase in accident claims in the first half of the year ($213million vs. $746 million) before level results occurred in the summer driving quarter. One of the acknowledged skills of the company’s activities is risk management. In the long run it seems to know which risks the company should take. For example, it will undoubtedly turn the $130 million insurance property loss in China this year to higher revenues next year with substantial rate increases.

As part of its large diverse holdings of operating companies, managers are responsive to problems as shown below:

1. In response to a 37% decline in NetJets, it paid penalty fees for canceling aircraft purchase orders.

2. Sale of unprofitable operations within Fruit of the Loom.

3. One of the transportation companies is in the business of leasing cranes, the decline in the US business was being offset by gains in Australian infrastructure gains.

One of the reasons I believe that a study of Berkshire is appropriate for many MBAs is what they can learn from studying both the company’s mired accounting policies and capital development. In the first case the company made two $1.7 Billion acquisitions this year. In the first the Van Tuyl Group, now known as Berkshire Hathaway Automotive, will amortize the purchase goodwill. (The timing to participate in both the shrinking of the dealer community and getting close to peak annual auto sales seems good.) At the very same time it bought AltaLink a Canadian distributor of electricity which Berkshire will not amortize the purchased goodwill. By definition these two acquisitions will produce significantly different booked returns even though economically they perhaps should be similar.

The final revealed tool in Berkshire’s tool kit (which most investors are not aware of) is the ability of Berkshire to swap some of its security holdings which have appreciated in price, for some very specific operating subsidiaries of that company. This is a classic example of swapping investment assets for operating assets. I suspect that not only are these transactions tax free, but the new operating assets will be carried at the original costs of the transferred investments. This is another example that the stated book value of $151,083 for each “A” share is vastly understated under any reasonable liquidation program. To my mind the 20% premium that Mr. Buffett has suggested for buybacks would be a real bargain.

Bottom Line

I opened this post with an initial view of the Bible as a good teaching device for many subjects. However, in the end to be completely accepted it requires a good bit of faith. Because of the creativity and brilliance of Warren Buffett and Charlie Munger and the complexity of their structure and accounting, a somewhat similar level of faith may be required.

Question of the week: Will you share what lessons can be learned from a study of Berkshire Hathaway?  

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Lessons from Omaha and Louisville

Introduction

On Saturday there were two iconic events occurring in the heartland of America. In Louisville there was the 138th running of the Kentucky Derby, America's most famous horse race for three year olds. As regular readers of these blogs may remember, despite graduating from Columbia University, I count my two most important learning experiences the analysis of thoroughbred horses and my experience in the U.S. Marine Corps. One of the things that I learned from handicapping races was to select races that I could assess the critical elements of picking winning bets with some confidence. In terms of this year's Derby, the appropriate statement is, “I did not have a horse in that race.” There were 19 horses running. That the first two horses to finish had the smallest odds of 5 to 1 and 2 to 1, indicates that the betting crowds lacked confidence in their choices. (Often winning favorites have odds of 1 to 1 or lower.) The inability to pick winners and the lack of confidence shown by the crowd (or if you prefer, the market) are similar to the lessons learned at Berkshire Hathaway's (BRK-A),(BRK-B)annual meeting celebration.

The warm up

My wife Ruth and I were privileged to attend the Friday night dinner hosted by Charlie Munger for his large family and his friends, (mostly from his days of living in Omaha) and other well wishers. For those who don't know Munger, he has been Warren Buffett's business partner for at least 47 years. His training as a leading attorney combined with a wonderful laconic delivery of encapsulated logic has been something of a control rod to Warren Buffett's natural enthusiasm. Keeping with his tradition of few words, his remarks were brief and to the point and can be summarized as follows:

1. The decision as to the successor to Buffett is probably the most important decision of Warren’s life and probably will be one of his best.
   
   
2. For Berkshire-Hathaway, making the second $200 billion will be easier than making the first $200 billion.
   
   
3. The managers of BRK’s subsidiaries are an unusual circle of trusted associates unlikely to be found at any other company.

The main event

What one takes out of the six hours of questions and answers is very much dependent on what one expected. The media used the estimate that 35,000 attended the meeting, which is possible including the exhibition space with its closed circuit television. However, I am told that the main arena has only 18,300 seats. Early in the day almost every seat was filled. As the day wore on, particularly after the lunch break, there were many empty seats. Either the lack of significant news or the distraction of buying, at a discount, merchandise from Berkshire’s subsidiaries, partially emptied the main arena. Nevertheless, my son Steve and I found some of the afternoon answers to the questions of interest. In summarizing the lessons of the day, it may be useful to respond to particular types of attendees. For example:

• Those primarily interested in valuing the stock
  
  
• Analysts trying to model near-term results
  
  
• People who are interested in business principles
  
  
• Those who have political considerations

Valuing Berkshire Hathaway's stock price

There is a belief that the stock should sell at a price equal to an unidentified intrinsic value. A poor substitute for this would be book value. Currently the company has announced a policy of buying back the stock at 110% of book value, (it believes the stock is undervalued by book value). For instance, BRK’s auto insurance company, GEICO, is being valued at $1 billion over its historic cost. The intrinsic value for that company is the firm's current book value plus the size of its float. Management stated that it would not accept a bid with a $15 billion premium over GEICO’s carrying value .

Analysts trying to model near-term results

With the exception of the housing-related operations, operating earnings are up at Berkshire-Hathaway. The current level of float is approximately $70 billion. Buffett and Munger are warning that the float is unlikely to rise further. Over the next ten years, it is possible that Berkshire’s utility operations and probably the railroad (Burlington Northern) will need additional capital of $100 billion combined. Creation and management of float has been one of the keys to the firm's success. These concerns led to a decision not to go forward with a possible $22 billion acquisition. If they did do this particular deal, the transaction would have forced Berkshire to sell some securities, either owned or to be issued, which management did not want to do. There is a desire to maintain a reserve of at least $20 billion for all possible opportunities and contingencies.

Todd Combs and Ted Weschler, the two internal investment managers had $2.75 billion each to manage as of the end of March. Each has a base salary of $1 million and an incentive on the excess return in which he would get 10%; 80% based on his own performance and 20% based on the other manager's results. This is similar to the arrangement BRK had with the former CIO of GEICO. (The company does not use compensation consultants or have a standard compensation plan for their operating executives.)

Business principles

There is a recognized risk of getting too big to manage effectively. Buffett and Munger believe they are pioneering with an uncoordinated holding company approach. Even with their various insurance companies, they do not attempt to coordinate their risks. The use of mathematical measures of market price risks is not believed to be prudent or realistic. Barriers to entry are critical for them in their acquisition and business planning. They do not believe in erecting barriers, but buying them. In their mind, a brand is a promise.

National (political) policies

Judging by the sound of applause, a large number of the audience were opposed to the popular understanding of the so-called "Buffet Rule." Some believed that his pronouncements have hurt the stock and are causing the stock's price to be below where it would normally trade.

Because of the current US interest rate repression that is likely to lead to inflation and higher interest rates, it was suggested that investing in medium and long-term bonds should be avoided. Instead of investing in developing more US-based oil and gas, the United States should import as much as possible, just the opposite of energy independence.

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When Warren Buffett Speaks About Investing, the Wealthy Should Listen

Is this you?

The really wealthy are those that have liquid investment capital in excess of their perceived needs. All the rest are enslaved to their circumstances and lack the flexibility to be the masters of their investment future. This blog is directed to the wealthy; whether they are ultra high net worth counting their portfolios in the tens of millions or those that are merely wealthy, who have a spare few dollars to invest.

My Saturday Chore

Approximately 60 days before the annual meeting of Berkshire Hathaway (BRK.A), Warren Buffett publishes his letter to shareholders. He times the release for a Saturday morning. I have two reasons for reading this year’s nineteen page letter. First, thankfully I have been a shareholder personally for many years and the stock is also in the hedge fund I manage. The second reason I read the letter intently is that it is an excellent investment primer, particularly for those who can think of themselves as wealthy as described above. This year, with one of my sons, I plan to attend the annual meeting, known to some as “the Woodstock of Capitalism.”

THE LESSONS:

Liquidity is a good defense

The first lesson is to lose less on the inevitable downturns. Buffett’s direct quote is, “Our defense has been better than our offense.” When you examine the Berkshire portfolio, you can see that in many years there is an excess of short term cash instruments (wealthy people have cash). Part of Buffett’s business strategy is to use a large amount of cash generation owned by others (float). He uses this float to replenish the cash he uses for investment. Wealthy people also have a positive cash flow which allows them to have spare ammunition to be able to shoot at attractive targets during down turns. Perhaps more importantly, with a pile of cash on the sideline, the wealthy don’t panic and sell at depressed prices. Liquidity is a good thing to own or control at all times, but particularly in rough periods. The low return on liquidity in ebullient periods is a tolerable insurance premium.

Invest in what you know

Warren Buffett at age 79 and Charlie Munger at 86 only invest in those companies that they think they understand and whose future they can predict with some degree of certainty. They are not comfortable investing on the basis of new products, no matter how exciting they may be. (Remember that Bill Gates of Microsoft is not only a director of the company, but he and his wife will direct the vast bulk of Buffett’s charitable estate.) Berkshire’s caution on new products did not prevent them from investing $3 billion in wind generation for a controlled utility in a monopoly position.

Investors bring their own needs to an investment

With its long term need to find productive places to invest its continuous cash flow, Berkshire has found that Burlington Northern Santa Fe (BNSF), a railroad serving many of its customers, will continually need cash for capital investments. Berkshire views positively the railroad’s need for additional capital every year. Berkshire’s willingness to supply long-term capital trumped a price that an ordinary buyer would pay for this stock. The lesson here is that a particular need of an investor leads to an investment decision that others do not perceive when one is buying the whole company. This is similar to a property owner buying adjacent land to prevent any construction on the site.

We can all make investment mistakes

Over the last forty years, one of the attributes of all the great investment managers that I have known is that they admit their mistakes. Privately, they are like fishermen: they talk about the one that got away. With Berkshire Hathaway, Mr. Buffett dwells on mistakes of commission. Buffett publicly admits it was his personal mistake that drove GEICO, one of their owned companies, into the sub prime credit card business.

In their publicly traded portfolio, Berkshire Hathaway has thirteen positions each with a market value of $1 billion or more. Many of these have been great long term successes: American Express (AXP), Coca Cola (KO) and Procter & Gamble (PG). One of the thirteen is ConocoPhilips (COP), which they have been selling, but still have a book loss remaining of some $ 800 million. The reason that I find this holding so interesting is that I have noted a similar position in a number of value-oriented funds with great long term records. This stock has been a great value trap. As good as Warren Buffet is, it shows even he can make a mistake, particularly when a position in the larger Exxon (XOM) would have produced better results.

Think Global, even in US Investments

An additional insight from looking at the baker’s dozen billion dollar holdings is that there are two foreign stocks; BYD,the Chinese battery manufacturer and Tesco, a British retailer. But when you look further into the other companies one can speculate that at least half of their underlying earnings power comes from overseas. Thus, in truth Berkshire is increasingly becoming a global investment vehicle despite the high profile railroad investment (which also has some foreign trade elements).

Berkshire’s Liquidity Advantage

The final lesson that I choose to highlight relates back to the first, but in this case pertains to good companies when they have a need for liquidity. Taking advantage of those needs, Berkshire purchased the non-traded securities of Dow Chemical, GE, Goldman Sachs, Swiss Re and Wrigley. All these holdings produce dividends and interest which pay Berkshire roughly 10% on its investment plus an additional equity kicker. From time to time good companies have poor liquidity and are willing to pay a big price for it. Thus, one can use one’s own liquidity to help others for an outsized return. But like a good US Marine Corps Division, as soon as one commits a reserve, one needs to reestablish a new reserve so that one can fight another day.

What are your lessons that you would like to pass on?
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