Why I Own Berkshire Hathaway Shares

Berkshire Hathaway (NYSE: BRK-B) is one of the 50-plus companies that’s in my family’s portfolio. I first bought Berkshire shares for the portfolio in August 2011 at a price of US$70 and again in September 2015 at US$130. I’ve not sold any of the shares I’ve bought.

The first two purchases have performed well for my family’s portfolio, with Berkshire’s share price being around US$223 now. But it is always important to think about how a company’s business will evolve going forward. What follows is my thesis for why I still continue to hold Berkshire shares.

Company description

Berkshire is one of the most fascinating companies I have come across.

The story starts in 1965, when Warren Buffett took over the company because of anger. Back then, Buffett was a hedge fund manager. He had bought Berkshire shares a few years prior because they were cheap compared to the company’s assets.

In 1964, Berkshire’s then-leader, Seabury Stanton, offered to buy Buffett’s shares for US$11.50 each. Buffett agreed to sell. But Stanton’s official offer was slightly lower, at US$11.375 per share. Buffett was livid about being lied to, to the extent that he amassed a controlling stake in Berkshire to fire Stanton.

Berkshire was merely a struggling textile manufacturer when Buffett became its leader. But over the years, Buffett has thoroughly transformed the company through numerous inspired acquisitions and deft stock market investments.

Charlie Munger joined Berkshire in 1978. But for many years prior, he and Buffett were already collaborating. In fact, Munger helped Buffett to refine his already formidable investing prowess. 

Today the 88-year old Buffett and 95-year old Munger continue to lead Berkshire as chairman and vice-chairman, respectively. The company can also be rightfully described as a truly diversified conglomerate, with more than 60 subsidiaries across a wide range of industries. Here’s a sample of the companies under Berkshire’s umbrella:

• Berkshire Hathaway Reinsurance Group – provider of insurance products to other reinsurers and property, casualty, life, and health insurers globally
• GEICO – second largest insurer in the US auto insurance market (share of 13% at end-2018)
• Burlington Northern Santa Fe – one of the North American continent’s largest railroad companies
• Berkshire Hathaway Energy – one of the largest energy utilities in the US, and the second-largest residential real estate brokerage firm in the same country
• IMC International Metalworking Companies – among the top three manufacturers of consumable precision carbide metal cutting tools in the world 
• Precision Castparts – manufacturer of metal parts and components that go into aircraft
• Borsheim’s – fine-jewellery retailer
• Nebraska Furniture Mart –  furniture retailer (as its name suggests) 
• See’s Candies – chocolate and confectionary producer 

Berkshire’s reach extends beyond its subsidiaries. It also has a massive investment portfolio that is worth more than US$220 billion as of 30 September 2019. The portfolio consists of shares of more than 40 publicly traded companies that are mostly listed in the US. Some of them are also in my family’s portfolio, such as Apple, Amazon.com, and Mastercard. The investment portfolio is overseen by Buffett, Munger, Todd Combs, and Ted Weschler. 

Investment thesis

I had previously laid out my investment framework in The Good Investors. I will use the framework, which consists of six criteria, to describe my investment thesis for Berkshire.

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market

Berkshire is already a massive company, with US$247.8 billion in revenue in 2018. But I believe there’s still plenty of room to run for the conglomerate, although I’m not expecting rapid growth. 

I think a growth rate in the high single-digit or low double-digit percentage range for Berkshire is reasonable. This is because Berkshire’s diversified collection of US stocks and high-quality subsidiaries puts it in a great position to ride on the US’s long-term economic growth.

There are a few points I want to expand on. First is regarding the US economy. Over the years, Buffett has not been shy in sharing his enthusiasm about the US . In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“Charlie and I happily acknowledge that much of Berkshire’s success has simply been a product of what I think should be called The American Tailwind.

It is beyond arrogance for American businesses or individuals to boast that they have “done it alone.” The tidy rows of simple white crosses at Normandy should shame those who make such claims.

There are also many other countries around the world that have bright futures. About that, we should rejoice: Americans will be both more prosperous and safer if all nations thrive. At Berkshire, we hope to invest significant sums across borders.

Over the next 77 years, however, the major source of our gains will almost certainly be provided by The American Tailwind. We are lucky – gloriously lucky – to have that force at our back.”

(Do read the “The American Tailwind” section of Buffett’s 2018 letter.)

To build on Buffett’s American Tailwind idea, I want to highlight that the working-age population in the US is estimated to increase by 13% from today to 2050. That’s one of the brightest demographics among developed economies across the world. Here’s a chart from Morgan Housel showing this:

The second point I want to expand on is the quality of Berkshire’s subsidiaries. If you’re a long-time observer of Berkshire, you’ll know that a durable competitive advantage is one of the key qualities that Buffett seeks when making acquisitions. 

There are numbers to prove this point: Berkshire’s manufacturing, service, and retailing businesses earn healthy after-tax returns on net tangible assets while holding plenty of cash and using very little debt. The table illustrates this from 2012 to 2016 (the last year that Buffett reported the after-tax return on net tangible assets employed by this group of businesses).

A last note from me on Berkshire’s room for growth: Buffett and Munger are, in my eyes, two of the best investors in the world today, and they’re still constantly looking for bargains in the stock market and private businesses to acquire to strengthen Berkshire’s portfolio. 

2. A strong balance sheet with minimal or a reasonable amount of debt

As of 30 September 2019, Berkshire’s balance sheet has US$102.2 billion in borrowings – that’s a fair amount of debt. 

But Berkshire also has a massive cash hoard of US$128.2 billion, including US$53.4 billion in short-term investments in US Treasury bills, which can be considered as cash for liquidity purposes. So Berkshire does have tremendous resources to invest for growth as well as withstand shocks.

There are huge insurance businesses within Berkshire. So I think it’s also important for me to watch the company’s ability to payout huge insurance claims from time to time. 

Buffett believes that “the annual probability of a US mega-catastrophe causing [US]$400 billion or more of insured losses is about 2%.” For perspective, a US$400 billion insured-loss is nearly four times the highest amount that the US has seen since 1980. This is illustrated in the chart below (the dark blue bars indicate insured losses in each year):

In the event that US$400 billion of insured losses happen in a year, Berkshire’s share would be just US$12 billion or so. This is a huge sum of money. But it is far less than the annual earnings the company expects from its non-insurance businesses. For context, Berkshire’s non-insurance businesses generated US$20.8 billion in pre-tax income in 2018, up 24% from 2017. Although Berkshire will be bruised by a US$400 billion mega-catastrophe event in the insurance industry, most other insurers would go bust according to Buffett. 

The diversification present in Berkshire adds another layer of financial resilience. I mentioned earlier that the conglomerate controls over 60 subsidiaries across many industries. This is also true of Berkshire’s investment portfolio. The 40-odd stocks in the portfolio belong to technology, banking, media, consumer products, and more.

3. A management team with integrity, capability, and an innovative mindset

On integrity

Buffett’s overall reputation, in business and in life, is pristine. The excerpt below, taken from Berkshire’s latest official proxy statement released in March 2019, will also shine tremendous light on the integrity of Buffett and Munger (emphases are mine):

“Due to Mr. Buffett’s and Mr. Munger’s desire that their compensation remain unchanged, the Committee has not proposed an increase in Mr. Buffett’s or Mr. Munger’s compensation since the Committee was created in 2004. Prior to that time, Mr. Buffett recommended to the Board of Directors the amount of his compensation and Mr. Munger’s.

Mr. Buffett’s annual compensation and Mr. Munger’s annual compensation have been [US]$100,000 for more than 25 years and Mr. Buffett has advised the Committee that he would not expect or desire such compensation to increase in the future…

...Mr. Buffett will on occasion utilize Berkshire personnel and/or have Berkshire pay for minor items such as postage or phone calls that are personal. Mr. Buffett reimburses Berkshire for these costs by making an annual payment to Berkshire in an amount that is equal to or greater than the costs that Berkshire has incurred on his behalf.

During 2018, Mr. Buffett reimbursed Berkshire [US]$50,000. Berkshire provides personal and home security services for Mr. Buffett. The cost for these services was approximately [US]$290,000 in 2018. Berkshire’s Board of Directors believe that in light of Mr. Buffett’s critical role as Berkshire’s CEO and given that Mr. Buffett spends a significant amount of his time while at home on Berkshire business matters that such costs represent bona fide business expenses.

None of Berkshire’s named executive officers use Company cars or belong to clubs to which the Company pays dues. It should also be noted that neither Mr. Buffett nor Mr. Munger utilizes corporate-owned aircraft for personal use.”

Buffett and Munger earn their riches predominantly from their ownership of Berkshire shares. As of 6 March 2019, Buffett controlled Berkshire shares that are worth around US$90 billion at the current price; Munger’s stake also makes him a billionaire (around US$1.5 billion). These high ownership stakes give me comfort that their interests are aligned with mine.

Although Buffett and Munger’s philanthropic actions are not directly-related to investing, I think they speak volumes about the characters of the two elder statesmen of business. The actions also inspire me, so I want to include a brief discussion. In 2006, Buffett pledged to donate more than 99% of his wealth to charitable causes during his lifetime or at his death. Since then, Buffett has already given more than US$34.5 billion to charities. Munger, meanwhile, has given hundreds of millions of dollars over the past 30 years toward the building of school facilities.

On capability

On the topic of capability, Berkshire’s track record of growth since 1965 has been nothing short of stunning. More on this soon.

On innovation

For a long time, Buffett was averse to technology stocks because he couldn’t understand them (he first broke the duck by investing in IBM in 2011, and of course Berkshire now has a big stake in Apple). So it’s no surprise that Berkshire is not the first name that comes to mind if we mention the word “innovation.”

But what Berkshire lacks in technological innovation, it makes up for with a unique mindset in business.

Let’s first talk about Buffett’s view toward acquiring companies. I want to discuss this because acquisitions will be one of Berkshire’s key growth drivers in the years ahead. The excerpts below from Berkshire’s 2008 shareholders’ letter are instructive (emphases are mine):

“Our long-avowed goal is to be the “buyer of choice” for businesses – particularly those built and owned by families. The way to achieve this goal is to deserve it. That means we must keep our promises; avoid leveraging up acquired businesses; grant unusual autonomy to our managers; and hold the purchased companies through thick and thin (though we prefer thick and thicker).

Our record matches our rhetoric. Most buyers competing against us, however, follow a different path. For them, acquisitions are “merchandise.” Before the ink dries on their purchase contracts, these operators are contemplating “exit strategies.” We have a decided advantage, therefore, when we encounter sellers who truly care about the future of their businesses.

Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing.

A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.”

I believe that Buffett’s mindset of wanting to be long-term (eternal?) owners when acquiring companies, alone, is a competitive advantage in the private markets that is not easily replicable. Berkshire has walked the talk of being a responsible long-term owner of businesses and implementing decentralised management – these traits have made the conglomerate a preferred buyer when owners of good private family-built businesses are looking to sell. In his 2018 shareholders’ letter, Buffett again emphasised that Berkshire wants to be a long-term owner of the businesses that it acquires:

“You may ask whether an allowance should not also be made for the major tax costs Berkshire would incur if we were to sell certain of our wholly-owned businesses. Forget that thought: It would be foolish for us to sell any of our wonderful companies even if no tax would be payable on its sale. Truly good businesses are exceptionally hard to find. Selling any you are lucky enough to own makes no sense at all.” 

Some of you reading this may be wondering, “Is Buffett’s competitive advantage in acquiring companies really so simple? Isn’t that easy to replicate?” My response will be something Munger once said: “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”

Next, Buffett also does not push for short-term gains at the expense of Berkshire’s long-term business health. A great example can be seen in Berkshire’s excellent track record in the insurance industry: Its property and casualty (P/C) insurance business has recorded an underwriting profit for 15 of the past 16 years through to 2018. In contrast, the P/C industry as a whole often operates at a significant underwriting loss; in the decade ended 2018, the industry suffered an underwriting loss in five separate years.

4. Revenue streams that are recurring in nature, either through contracts or customor-behaviour

There are two main components to Berkshire’s operating businesses: Insurance, and non-insurance companies.

The insurance part consists primarily of GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. Insurance is a service that organisations and individuals require on an ongoing basis, so there’s high levels of recurring activity there. GEICO, in particular, focuses on auto insurance, and that’s something drivers need every year.

For the non-insurance portion, two big entities are Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy. The former runs railroads in North America and the latter is an energy utility. Physical products will regularly need to be transported across the continent while energy (such as natural gas and electricity) is something that organisations and individuals require daily.

5. A proven ability to grow

Buffett is quite possibly the best capital allocator the world has seen to-date. The table below is taken from Berkshire’s 2018 annual report, and it shows the incredible 18.7% annual growth in the company’s book value per share since 1965, the year Buffett assumed control. ‘Nuff said.

In my explanation of this criterion, I mentioned that I’m looking for “big jumps in revenue, net profit, and free cash flow over time.” So why the focus on Berkshire’s book value per share? That’s because Berkshire’s main assets for many decades were public-listed stocks. Although, it’s worth pointing out that the company’s book value per share is increasingly losing its relevance as a measure of the company’s intrinsic economic worth  – Berkshire’s main value now resides in its subsidiaries.

It must also be said that Berkshire’s no slouch when it comes to free cash flow. The table below shows the record of the conglomerate’s annual growth in free cash flow of 11% going back to 2007. I picked 2007 as the starting point to show that Berkshire was still gushing out cash even during the Great Financial Crisis of 2008-2009.

6. A high likelihood of generating a strong and growing stream of free cash flow in the future

Berkshire has excelled in producing free cash flow from its businesses for a long time and has The American Tailwind on its back. So, I don’t see any reason to believe that Berkshire’s ability to generate cash from its businesses will change any time soon.

Valuation

In Berkshire’s 2018 shareholders’ letter, Buffett wrote:

“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.”

The four groves Buffett mentioned refers to Berkshire’s (1) insurance operations, (2) non-insurance businesses, (3) ownership stakes in a quartet of companies – Kraft Heinz, Berkadia, Electric Transmission Texas, and Pilot Flying J – that it shares control with other parties, and (4) treasury bills, cash, and fixed-income investments.

I like to keep things simple in the valuation process, so I’m going to use an even simpler but sound heuristic to value Berkshire: Its price-to-book (P/B) ratio.

Earlier, I mentioned that Berkshire’s book value per share is losing relevance in being a proxy for the company’s true economic worth, so there’s a contradiction. I believe the contradiction can be resolved by simply allowing Berkshire to be seen as a bargain even if its PB ratio is significantly higher than 1. Buffett’s recent actions suggest this makes sense too.

For several years, Buffett had a standing order for Berkshire to repurchase shares if its P/B ratio fell below 1.2. But the order was amended by Buffett in July 2018: Now Berkshire can repurchase its shares at any time when he and Munger believe that the share price is “below Berkshire’s intrinsic value.”

Buffett publicly stated in his 2018 shareholders’ letter that over time, Berkshire is likely “to be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value.” From the third quarter of 2018 to the third quarter of 2019, Berkshire has spent a total of US$3.48 billion to repurchase 2,744 Class A shares and 12.04 million Class B shares. These buybacks have happened when the company’s PB ratio was clearly higher than 1.2 and averaging around 1.4.

The risks involved

Succession is the biggest risk I’m watching with Berkshire. Buffett and Munger are both getting on in years – I will be truly sad the day they are no longer around.

Berkshire has very capable senior leaders who are supporting Buffett and Munger, including Ajit Jain (head of all insurance operations), Greg Abel (head of all non-insurance operations), and the investing duo of Todd Combs and Ted Weschler. All four are much younger too, with ages ranging from 46 to 67. Buffett has also tasked his son, Howard Buffett, to assume a non-executive chairman role in Berkshire when Buffett-senior eventually departs. The younger Buffett would be responsible for protecting and nurturing Berkshire’s culture.

I am confident in Buffett and Munger’s succession plan. But it remains to be seen whether Berkshire’s dealmaking prowess, competitive advantages, and culture will diminish when the octogenarian and nonagenarian leave the scene.

A massive catastrophe is another key risk I’m watching. I mentioned earlier that Berkshire is able to brush off a US$400 billion industry-wide catastrophe event in the US. It will take a huge disaster to result in insured losses of US$400 billion. For context, the sum is nearly four times the highest amount that the US has suffered since 1980, as I already mentioned. But there’s no upper limit to Mother Nature’s wrath, especially given the alarm bells that scientists have been ringing in recent years on climate change.

The Good Investors’ conclusion 

Berkshire is not the fastest-growing company around, and its rapid-growth days are clearly over. But what it lacks in pace, it makes up for in stability. The conglomerate excels against my investment framework by having (1) the American Tailwind behind its back; (2) a diverse collection of excellent businesses; (3) a robust balance sheet and finances; (4) strong recurring revenues; (5) a great track record of growth; and (6) two brilliant leaders at its helm who have been there for decades – Warren Buffett and Charlie Munger – and who are as safe a pair of business-hands as anyone can find.

Every investment has risks, and so does Berkshire. Succession (because of the advanced age of Buffett and Munger) and major disasters (because a big part of Berkshire’s business is in insurance) are two big risks for the conglomerate that I’m watching.

But on balance, I believe that Berkshire is one of the lowest risk stocks there are in the world for producing a long-term annual return in the low-teens range. 

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.