Berkshire Hathaway: Shrinking Its Way to Higher Returns… The Most Underappreciated Retirement Stock in America
BD Capital (6/21/21)
Most media and investor attention towards Berkshire Hathaway focuses on the exceptional past track record or speculation about company actions in the present quarter or year. There have been strategic shifts at the company which I believe will allow Berkshire to maintain or increase its return on equity, and I expect investor perceptions of the stock to change in the coming years.
The 2021 shareholder meeting provided new perspectives about the company’s future. The new willingness to deploy significant capital towards buybacks has a two-fold effect of creating value that goes beyond share count reduction, and I will show why. I’ll also address common arguments made against Berkshire and evidence to why they are misguided. Finally, I’ll make the case that Berkshire is the ideal equivalent of an index fund that, for some reason, few people appear to want or talk about.
Buybacks Have a Two-Fold Effect of Creating Value: Forget About Hunting Elephants
As it relates to size and the cash build-up concerns, I think investors are only starting to give credit to the capital allocation shift taking place at Berkshire. This is evidenced by the new willingness to repurchase shares consistently and in scale. In the last four quarters, Berkshire used nearly $30 billion cash to buy back its stock. That was one of the biggest single deployments of capital in the company’s history, barely behind Precision Castparts, BNSF railroad, and Apple. That’s $5 billion more cash than Berkshire can generate in a good year and was a large reduction of cash on hand. This reduced shares outstanding and shareholders equity by over 6%. This is a big change. It’s an act of Berkshire significantly shrinking itself.
In my long-term view, buybacks like this have a two-fold effect towards increasing value. After a buyback, existing shareholders own a greater share of the company at an attractive entry price, as Buffett will only repurchase shares at a discount to conservatively estimated value. Two, this action actually makes it easier for Berkshire to operate its capital allocation model in the future. Here’s why.
Buybacks reduce the firm’s size and market cap because cash is leaving the building instead of adding to assets. Generally, the value of a share is little affected because there are fewer outstanding shares and the firm as a whole is worth less after the cash outflow. Relative to public and private assets that are constantly growing, and that Berkshire would be a potential acquirer of, each buyback makes Berkshire smaller. This creates opportunities on more assets that are material in size relative to a slower-growing market cap.
The numbers can be put into perspective by two slides Buffett presented at the annual meeting to show the growth of the world’s largest companies of the past three decades:
In 1989, the Bank of Japan was the largest at $104 billion. Today, it’s Apple at $2 trillion. Two different companies in the same spot, and the growth rate of the market cap in the top spot was 10% per annum. Since 1995, the market cap of the S&P 500 grew 9% annually from $4 trillion to $36 trillion. I don’t expect either of those growth rates to be as high in the future, but it still shows that the large assets in the economy are growing at a steady clip. For Berkshire to be able to make meaningful deals on these assets, Berkshire’s size can’t grow to be so big that the potential assets don’t move the needle. Will Berkshire grow its market cap at a 10% clip if it’s buying back 3% or 4% of its shares each year? Very unlikely.
With this put into perspective, Berkshire has now shown that it is willing to use the buyback tool which makes future capital allocation easier by shrinking and increasing the opportunity set. Berkshire’s market cap and cash pile will likely get smaller relative to public and private market deal sizes. I believe this creates a fair chance for Berkshire’s returns on equity to remain steady or slightly increase over time. A smaller Berkshire is a better Berkshire. It’s much easier to find good deals when you are worth $800 billion compared to $1.2 trillion. There are more options available that can make a difference. Given this, I’ve concluded that buybacks make the Berkshire business model more valuable going forward, with stable returns likely and higher returns possible. I expect we will see more buybacks in the future when the price is reasonable. They were on a $1.5 billion monthly pace at last disclosure at prices up to $260.
In addition to the buybacks, there is consistent ongoing capital deployment at existing businesses that is preventing the cash number from growing as quickly as many believe. Many will report that Berkshire generates $20 to $25 billion of operating earnings each year that it needs to find a deal for. In reality, the company spends more than its non-cash depreciation charge on capital expenditures to the tune of $5-10 billion a year depending on opportunities at the utility business, where all earnings are reinvested. Berkshire has massive plans for its utility business: in Buffett’s annual letter he suggested that they will be reinvesting all earnings for decades to come. That’s a lot of future cash that is already earmarked for a home.
Given this, actual free cash flow that needs to be put to work is closer to $15-20 billion per year, less than 3% of the value of the firm. While still very important capital, with an open buyback program that can knock out $10 billion of repurchases in a few months at the right price, it is quite clear that cash build is not going to be a problem at Berkshire going forward. The urgency to find big deals in the future is nowhere near the level that has been suggested by many, and eventually more assets will grow into Berkshire’s deal size range.
“But Berkshire doesn’t pay a dividend…”
The common arguments against owning Berkshire Hathaway:
- The company is too big to allocate capital at scale going forward, evidenced by the $140 billion cash pile plus $25 billion annual cash flow, and returns will go down (disproven above).
- A Buffett-less future will lead to subpar performance. Current governance and succession planning is insufficient.
- Berkshire is not involved in tech, emerging economy trends, or ESG initiatives. It owns boring businesses.
- The company doesn’t pay a dividend.
Succession plans. I expect the loss of Buffett will have little effect on the firm other than his image and guidance for other executives. He has already delegated significant responsibility. There is a culture in the firm that embodies many of the principles that Buffett has preached for so many years, and he has put the people in place to be ready to man the ship now, if needed. Two “young” (in Berkshire context) portfolio managers are dealing with significant sums under Buffett and have proven themselves by opening the Apple position and a willingness to think independently through their investment in the Snowflake IPO, a cloud computing company. Buffett communicates and has lunch with them regularly, and I would expect they have soaked up wisdom, ideas, and the Berkshire culture.
The next CEO, Greg Abel, is already nearly as in charge as Buffett is. He has been with the company for two decades, running the $70 billion energy business, so clearly he has been part of Berkshire’s history of success. He has been available to shareholders at the annual meeting for two years now. The Berkshire operating businesses report to Abel and he provides guidance to subsidiary managers regularly. He is a straight-shooting, midwestern family man that oversees $350 billion worth of businesses while coaching his kids’ athletic teams. He has over $500 million personally invested in Berkshire’s energy business which dwarfs his annual salary. While not directly to Berkshire’s stock, his incentives are aligned and I expect they will find a way for him to build equity in Berkshire stock. Here is a great article on Abel that makes me believe that he may possibly be a better CEO than Buffett, just maybe not as good of a stock picker as the best ever:
Berkshire is very involved in tech, ESG, and emerging industry trends. 15% of Berkshire’s value resides in Apple, a company that spends $20 billion a year on research and development of consumer tech products. Berkshire owns 12% of Bank of America, who has made tremendous investments in technology to lower distribution costs and provide a high-end digital consumer offering in banking. The younger portfolio managers invested in a cloud computing company IPO last year. As far back as 2008, Berkshire invested $232 million in electric vehicle maker BYD, a stake worth several billions of dollars today. Lastly, but maybe most importantly, Berkshire Hathaway Energy has become a large player in renewable energy generation. 43% of the subsidiaries power generation is from renewables and they have invested $34 billion in wind, solar, geothermal, and biomass generation. Another $2.5 billion will be deployed for wind power generation by 2022. Any other questions?
The company clearly stays invested in the direction the world is moving to. There are also old-school operating businesses, like the railroad and manufacturing companies. Investors like to discount these boring businesses, however, they are very durable assets that provide goods and services in critical areas of our economy like housing and freight. The certainty and cash flow of these businesses provide an element of safety to Berkshire’s value.
The lack of a dividend is the most ridiculous reason for an individual investor to avoid Berkshire stock. First off, a dividend creates tax liabilities on income today for all shareholders. If the goal is to maximize long-term compounding, which includes minimizing taxes, then a dividend makes no sense. Buybacks do, as they generally lead to larger unrealized capital gains (tax-deferred) and uninterrupted wealth compounding.
Shareholders that want income from their stock can simply sell a small portion of their shares each year. If that amount is close to a typical low-dividend yield, then the value of the holding will still gradually rise over time. If the “share sale” dividend is a fixed percentage of the shares owned, then the annual sale-proceeds will gradually rise over time as well, resulting in a pay-raise for the shareholder that creates their own dividend. In some cases, the tax on the capital gain of the sale will be even less than the tax on dividends would be, even with the same pre-tax proceeds, because it is a partial return of capital from the investors cost basis. It’s not the lack of income, it’s the lack of creativity by the shareholder.
Variant Perception: Berkshire Hathaway is the ideal index fund in a tax-efficient corporate structure
Buffett has designed the structure and culture of Berkshire in a way that eliminates the undesirable aspects of indexing and corporate America, while still maintaining the fundamentals that make indexing work so well. He has eliminated common inefficiencies that slow down wealth compounding that are common in S&P 500 firms. This comes in the form of:
- Optimal capital allocation
- No dividend taxes, buybacks only at prices below intrinsic value (not at any price to offset stock compensation), and no stock-based comp issuance. S&P 500 firm buybacks are often executed in greater size at higher prices than lows (see chart). So much for buy-low, sell-high. It is simply destruction of shareholder wealth.
Additionally, in the last 11 years, only one-third of the capital S&P 500 firms used to buyback shares resulted in a net reduction in share count. A full 1.7% of shares per year went to stock based compensation or share issuances. That’s a significant number considering the S&P 500 buyback plus dividend yield is now around 4%. Of that 4% return, around 0.25% will be taken for dividend taxes, and well over 1% will be a “phantom buyback” that shareholders hardly benefit from due to stock-based compensation and other capital actions. The true net buyback and dividend yield of the S&P 500? Certainly much less than 4%. None of that happens at Berkshire.
More concentration in better businesses. Apple is possibly the best business in the world and makes up 15-20% of the value of Berkshire compared to 5.9% of the S&P 500 index. BNSF railroad is a critical U.S. infrastructure asset that earns durable 12-15% returns on invested capital (better than average business) and also comprises 15-20% of Berkshire’s value. Its largest peer, Union Pacific, makes up a puny 0.43% of the S&P 500. GEICO and the energy business together make up yet another 15% of Berkshire’s worth, with the former earning excellent returns on a growing equity base and the latter earning a durable, regulated-monopoly return of 8-10% on investments.
Collectively these four businesses are better than the average S&P 500 firm either measured by returns on capital, economic durability, or both. As a group they are half of Berkshire’s value. The rest of Berkshire contains smaller chunks of above and below average businesses (wholly owned subsidiaries and equities) that as a whole likely more or less reflect the economics of the S&P 500 index. Plus a large investable cash balance equal to 10% of Berkshire’s value that removes liquidity risk and destructive, poorly-timed equity issuances. The cash may also be opportunistically deployed into a better than average business, which may be Berkshire itself (buybacks), an acquisition, or a stock purchase.
The point here is that Berkshire concentrates more than the SPY fund in better businesses, has less risk, and the company’s value will be positively impacted to a greater degree by these big winners like Apple, GEICO, and BNSF railroad.
- More logical succession planning that leads to long-term thinking, actions, and value creation.
- Berkshire has no mandatory retirement age for executives or board members. Many S&P 500 firms have policies to remove insiders after a certain age or tenure to refresh and maintain diverse perspectives. For individuals that have been in the business for many years or decades and have developed an expertise to make quality business judgments, it makes zero sense to kick them to the curb just because they’ve made a trip around the sun x-amount of times. It’s detrimental to the leadership and long-term health of a company.
- The average CEO retirement age of S&P 500 firms is 60, and an average tenure of eight years. There is tremendous wisdom and expertise that comes after the age of 60 and after eight years with a company. Greg Abel is now assuming significant leadership at Berkshire at age 60, with hopes for a one to two decade run ahead. He has cumulative wisdom and experience in the business to make decisions that create long-term term value and enough time to see the results come to light down the road. Buffett told CNBC, “The likelihood of someone having a 20-year runway, though, makes a real difference.” It only makes sense that experience should be a desired trait for business leadership. S&P 500 firms put in place policies that prioritize refreshed diversity over experience.
- Index similarity: Let winners run (forever owners) and sufficient diversification
- Berkshire operates with a “never sell” framework. When they buy a core asset, it’s unlikely they will ever sell it regardless of overvaluation or through periods of significant underperformance. This is the same way index funds operate which allows Berkshire to catch the entire upside from the small number of investments that do extraordinarily well over time (GEICO, Coca-Cola, Washington Post, BNSF, Apple). This framework leads to the majority of index fund returns over time. Assets that don’t work out as well will be simply outgrown over time to the point they are immaterial or subsequently sold (Wells Fargo, Precision Cast Parts, newspaper business). Riding the major successes pays for several losers. The “never sell” framework also reduces taxes on capital gains and maximizes long-term compounding.
- Sufficient diversification. While Berkshire is certainly more concentrated than an index fund, it has optimal diversification. There is more exposure to upside from great businesses, yet there is also sufficient diversification so that one significant asset impairment or bad deal will result in, at an extreme, a one or two year setback in value appreciation. There is essentially no chance of significant capital loss at Berkshire. The assets are unrelated, uncorrelated and none comprise over 20% of Berkshire’s value.
Today: Significant valuation dispersion to other assets
At $278 per share, Berkshire sells at a 6.5% earnings yield with the ability to reinvest at 9 to 11% returns for many years to come. With all earnings retained and compounded at these rates, this can lead to a 14-18% earnings yield on today’s cost, ten years from now. There are quite possibly no assets available of Berkshire’s certainty, quality, and durability that will match that yield on cost in the next ten years, assuming all distributions are reinvested. I predict Berkshire Hathaway will be one of the top performing large cap stocks and outperform the S&P 500 index over the next decade.
You can compare Berkshire’s durable 6.5% earnings yield to long-term government bonds near 2%, below investment grade corporate bonds at 4.3% and the S&P 500 earnings yield near 4%. The bonds have nowhere near the reinvestment opportunity that Berkshire does and the S&P 500 has suboptimal capital allocation while trading at a 50% premium to earnings.
Berkshire’s total operating earnings per B-share (including look-through of equity portfolio) is slightly more than that of a share of the S&P 500 index fund (SPY). A Berkshire B share is $278 whereas a share of SPY is $420. The index fund is a 50% premium for equal earnings that are of lesser quality, I believe, based on the assets that comprise Berkshire’s earnings power.
Public comparables also point to mispricing. Berkshire’s equity holdings are marked to market at $300 billion. Their BNSF railroad is a nearly identical asset to Union Pacific (in the S&P 500) which is publicly traded at $145 billion. The S&P 500 utilities sector trades at 19 times forward earnings which would imply $75 billion for Berkshire Hathaway Energy which is set to earn around $4 billion annually when including renewable energy tax credits. The utility of the cash pile is often a mystery at $140 billion, but it is clear that at least $75 billion is investable for the right opportunity.
Putting the above values together is $595 billion compared to Berkshire’s actual market cap of $637 billion. What wasn’t included above was manufacturing, service, and retail businesses earning $10 billion pre-tax, GEICO insurance earning cyclically-adjusted $2 billion pre-tax on underwriting, plus nearly $4 billion of pre-tax earnings from other insurance, equity-method investments, and preferred stock. You can try to put a precise value on these businesses, but it doesn’t really matter. These $16 billion of annual operating profits are worth more than the $42 billion difference that the market cap and public comps imply. I would reckon to say those earnings are worth around $170 – $220 billion. This would put Berkshire at a value of $770 – $820 billion if it were more appropriately comped to public S&P 500 assets. That would be $340 to $360 per B share.
Secondary evidence of this valuation and quality dispersion comes from the Vice Chairman of Berkshire, Charlie Munger. At the 2021 annual meeting, he said he prefers Berkshire over the market and thinks it will do better. Additionally, Buffett and Munger have engaged in substantial share repurchases at prices up to $260 per B share. Historically, Buffett is unwilling to invest capital without a significant discount to a conservatively estimated intrinsic value or an expectation of at least a 10% return, which would imply a value well over $300 per share at his repurchase prices. The fact that the shares traded from $175 to $230 for the majority of the last year is absurd. The large repurchases created substantial value for shareholders.
The Next 50 Years
At the annual meeting, both Buffett and Munger said they believe the Berkshire business model can go on for a very long time, at least 50 years. Munger said the runway might amaze everyone. I agree with their statements based on the facts we are seeing today, notably the flexible capital allocation and succession plans.
The Berkshire model will become more valuable over time as the Berkshire team continues the tax-efficient compounding of capital year after year, which will get easier with a flexible buyback and growing energy business capital expenditures. These simple, low-risk capital deployment tools will reduce the need to do big deals to create value. Deal sizes will continue to grow along with the economy and markets while Berkshire is able to profitably slow its growth in size to open up more investment opportunities.
Investors may continue to disregard Berkshire due to the misguided concerns I addressed. If so, the price will remain fair and buybacks will likely continue. That is very good for long-term shareholders that see the direction the company is headed. Every share repurchased has the two-fold effect of increasing shareholder ownership at a discount and also making it easier to execute the Berkshire business model.
I expect one day that Berkshire Hathaway will be a very popular stock for many different investor types. The company is in a period of transition, which it is executing flawlessly, that investors won’t appreciate until there are established financial and stock returns. The longer it takes, the better for current owners and investors with funds to deploy. Berkshire represents one of the few high-quality retirement assets available today that sells at or below fair value with the prospect for a fair long-term equity return. If Berkshire were valued to reflect the level of interest rates and comparable assets it would be priced 25% to 50% higher than current levels.
BD Capital 