Mauro Tibone, EBX Columnist

Buffett’s Berkshire Hathaway, Victim Of Its Own Success?

Mauro Tibone, EBX Columnist

Berkshire Hathaway is the well-known holding company run by its famed CEO Warren Buffett, regarded by many as the most successful investor of all time. Buffett is also famous for holding court with his many aphorisms about money and investing, such as ‘investing is easy but not simple’ or ‘Wall Street is the only place where people ride to in a Rolls Royce to get advice from those who take the subway’.

A philanthropist and a pragmatist, despite his enormous wealth accumulated over the past 50 years, Buffett is also humble enough to admit that he’s been lucky to be born at the right place and the right time in history.

Testament to his lucky star, here stands Berkshire Hathaway, a humongous financial behemoth, whose market capitalization is north of $270 billion, surpassed only by three public companies in the USA such as Exxon-Mobil, Apple and Microsoft.

Buffett and his somewhat under-appreciated partner Charlie Munger have managed to turn a small flailing textile business acquired in 1965 into a large diversified financial conglomerate. Berkshire operates in a wide array of businesses (confectionery, food, retail, railroad, banks, electric and gas utilities, home furnishings, manufacturing, jewellery, publishing…) around his core insurance operations.

Buffett built his empire using the ‘float’ provided by his insurance business (that is paid premiums which are not held in reserves for reported claims and that may be invested) to finance his investments, a practice that he referred to as ‘having one’s cake and eating it too’.

In the early stage of his career Buffett mainly focused on long term investments in listed public companies. Recently, given the size of his company, he has shifted his focus to buying whole companies.

Since 1965, Berkshire Hathaway has never paid out a dividend to shareholders, but has reportedly grown its book value by about 19,7% compounded annually, versus 9,4% for the S&P500 index (calculated accounting for reinvested dividends).

This outstanding performance looks a little less impressive, if we look at the most recent years. In fact, Buffett himself in the last annual letter to shareholders admitted that unfortunately his holding company has underperformed the S&P 500 Index in 3 of the last 4 years, with a negative absolute return in 2008 and 2011.

Moreover, this could actually mark the first year during which Berkshire has underperformed the broad market over a 5-year stretch, raising doubts from Buffett’s critics on his legendary magic touch at making money.

I would note that Berkshire’s difficulty to beat the market consistently has actually already been noticeable for quite some time. If we calculate a simple moving average of the 10-year relative performance versus the S&P 500 index, it is easy to plot a chart, which clearly shows a declining trend, from about 18% in the 1985 down to about only 2% last year.

This would suggest that Doug Kass’s criticism at investing nowadays in Buffett’s Berkshire could bear some validity.

Doug Kass, head of hedge fund Seabreeze Partners, has been a long time Buffett admirer and always revered his common sense investing approach.

However, about 5 years ago Kass started calling into question a number of issues related to Buffett and his company. Eventually he put his money where his mouth was… by short-selling Berkshire Hathaway stock (that is betting Berkshire’s stock price would fall or would return below market average)!

Since then, Buffett has been questioned on several other issues, starting from the intensity of his work at Berkshire and the role of his succession at the helm of Berkshire Hathaway.

Buffett’s son’s role as non-executive Chairman, to preserve the values that distinguish Berkshire, left many investors at odds with his decision. Likewise, the fact that the role of executive CEO has been selected by Buffett in total agreement with Berkshire’s board but has not yet been revealed to the public.

In the meantime, fund managers Todd Coombs and Ted Weschler are gradually assuming a bigger role in terms of actively managing his portfolio of stock holdings, while Buffett and Munger still maintain their role of key decision makers when it comes to new acquisitions or large capital investments at its subsidiaries.

Some detractors of the Sage of Omaha point out that his unfortunate response to the Sokol’s affair in 2009 was far from optimal. In that instance, reports highlighted that David Sokol, than Berkshire’s CFO and apparent heir to the throne, had front-run a major Berkshire’s investment in Lubrizol, raking up millions on his personal account. Buffett initially said he saw nothing wrong with Sokol’s dealings, only to change his mind later on acknowledging the impropriety of those trades when pressed by criticism from the investment community.

That certainly took some shine off his clean image that Buffett has cultivated over decades, trying to stay away from Wall Street shenanigans.

On the other hand, I believe it would be wrong to criticize Buffett on the grounds of his opportunistic investment in Goldman Sachs during the financial crisis in 2008 or because of its stake in Moody’s (both institutions had questionable roles in the collapse of the financial markets as contributors to the housing bubble were involved in unethical practices).

Warren Buffett pragmatist as he is, always stuck to his golden rule that all investors should keep in mind: do your homework when it comes to money.

Buffett has also always avoided common practices in Wall Street, such as short-selling (another popular criticism often remarked upon during bear markets), or at times following the crowd (still memorable the tech bubble he missed by not investing in technology in the mid 1990s).

As far as short-selling is concerned, I believe that his optimistic view of America and life in general would not be suitable to such an investment strategy and I would promptly dismiss this criticism altogether. Buffett is at his best when he identifies an investment and pursues it aggressively, with the view to hold it over the long term, not speculating in order to make a quick buck.

As per not following the crowd during the tech bubble, he followed his tenet of not investing in any business you do not understand (he partly backtracked by investing in IBM only a few years later). Frankly, I don’t see anything wrong with that either, looking at the outcome he produced.

Despite his (or his successors’) talent at spotting sound investment opportunities, the law of big numbers is probably working against Berkshire, though.
Declining returns in the future (especially when compared to Geico, his insurance crown jewel) are a distinct possibility.

The recently announced 1st quarter results at Berkshire seem to prove this point.
In spite of a 50% jump in profits, well ahead of market expectations due to a very favourable performance of its insurance operations, Berkshire book value increase still lagged the broad market performance in the same period.

Given all the above arguments, what’s the investment case in Berkshire Hathaway?

I would contend that at this stage it is unlikely that Berkshire will generate significant above average market returns.

Berkshire insurance operations require a lot of capital, as rating agency S&P highlighted with Berkshire’s recent downgrade by one notch. The agency noted that Berkshire’s holdings make the company risky and its practice of maintaining less capital to hedge against losses than its competitors could be an issue, should the economy fare worse or take a hit in the reinsurance business.

Some financial analysts believe that Berkshire Hathaway’s intrinsic value is still higher than its current market capitalization. Regardless, in light of Berkshire’s recent price appreciation and the many issues the company will have to face going forward, I would be more inclined to participate in the market with low cost efficient ETFs rather than owning Berkshire’s high priced stock (one share of class A stock is worth almost 170k dollars).

The Sage of Omaha may well be with us for many more years to come, but the odds he will be able to outsmart the market going forward are probably less than his adoring fans would have us believe.

On the other hand, there is great scope in following Berkshire’s management choices in terms of portfolio selection, with new additions or sales. This is an insightful exercise, very helpful to identify interesting investment themes and to provide valuable clues on the US economy from some of the most brilliant investment minds in the world.
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