Warren Buffett Is One of a Kind. What That Will Mean for Berkshire Hathaway When He’s Gone.
When Warren Buffett turns 90 years old in August, it would be only natural for Berkshire Hathaway shareholders to celebrate his success—and worry about the future of the extraordinary company he built. In his 55 years at the helm as CEO, chairman, and investment chief, Buffett turned a struggling textile maker into a $555 billion conglomerate, using investment skills that became the envy of American business.
An investor who put $1,000—roughly 50 shares—in Berkshire in 1965 would now have $20 million, against $175,000 for a similar investment in the S&P 500 index. And that’s despite Berkshire’s underperformance in the past year and decade relative to the S&P 500.
With a record like this, who wouldn’t want Buffett to live forever?
Yet, investors who fear for the future of a Buffett-less Berkshire might be shortsighted—and shortchanging the company and its shares. Behind Berkshire’s recent subpar returns—the stock rose just 11% in 2019, compared with the S&P’s sizzling 31% total return—are a number of issues that could be resolved in a post-Buffett era.
Many investors think new leadership could break up the conglomerate to unlock value—or at least be more amenable to an idea that Buffett opposes. Given Berkshire’s $128 billion pile of cash, the initiation of dividends and bigger stock buybacks also seem likely. Berkshire also could take greater steps to improve the efficiency and profit margins in some of its operating businesses, which are underperforming peers.
Much will depend on who succeeds Buffett, whose job probably will be split in three, with a CEO, one or two investment chiefs, and a chairman, expected to be his elder son, Howard. But the quality of Berkshire’s operating companies and investment portfolio, and the opportunities for further shareholder enrichment, suggest Berkshire could reward investors for many years to come.
Even better, the stock currently looks cheap. The Class A shares, at about $340,000, trade for 1.3 times estimated year-end 2019 book value and 21 times projected 2020 earnings, a discount to their average in recent years. And, the price/earnings ratio overstates the valuation due in part to the large amount of low-yielding cash the company now holds. The more-liquid Berkshire Hathaway Class B shares (BRK.B) trade around $230. Each is worth 1/1,500th of an A share.
Buffett declined to speak with Barron’s for this story. But he has opined on the near-term future. At Berkshire’s 2017 annual meeting, he said, “If I died tonight, the stock would go up tomorrow.”
His rationale: Wall Street would immediately anticipate a corporate breakup.
Buffett may address some of these issues in his eagerly awaited annual shareholder letter, due on Feb. 22. The letter, coming about two months before the popular shareholder meeting, has become required reading for Buffettologists looking for insights into his thinking.
So far, Buffett has said little on succession other than that the next CEO will come from within the company. Barron’s and many investors have assumed that Greg Abel, 57, the chairman of Berkshire Hathaway Energy, the company’s big electric utility, is the likeliest choice to succeed Buffett, given his senior role at Berkshire and his experience in running the business.
Yet in a surprise move, Berkshire late last year named Berkshire investment manager Todd Combs, 49, as head of Geico, its auto-insurance unit. This may give Combs, a former hedge-fund manager who has spent the past nine years running part of Berkshire’s equity investment portfolio, valuable managerial experience that Berkshire’s board might want to see before considering him as a future CEO.
Berkshire is taking a chance because, aside from a few years at Geico rival Progressive (PGR) early in his career, Combs has no industry experience. He couldn’t be reached for comment.
The conventional wisdom had been that the younger Combs might follow Abel as CEO. But if the transition occurs in a few years, Abel will be about 60, and it’s possible the board might go straight to Combs.
Buffett has delegated more responsibilities in recent years, naming Abel and Ajit Jain, a brilliant insurance underwriter, as vice chairmen in 2018 with oversight of Berkshire’s noninsurance and insurance businesses, respectively. That positioned the pair as the most likely successors. Jain, however, probably is too old at 68.
The CEO handicapping remains theoretical, as there are no signs that Buffett plans to step aside soon. He is in good health and in the office every day doing a job he loves—one he has said he would pay to do. He still earns just $100,000 a year, making him one of the lowest-paid big company CEOs in the country. Buffett doesn’t get any stock compensation, and neither do any Berkshire executives.
Buffett doesn’t need the income. His Berkshire stake is worth $88 billion, and that’s after giving away $34 billion of stock since 2006. In 2018, he took home half of his salary because he reimbursed Berkshire $50,000 for what the proxy called “minor” personal items like postage and phone calls.
Until the post-Buffett era opens the door to greater shareholder influence, don’t be surprised to see activist investors taking positions in Berkshire and gently offering suggestions while biding their time. Berkshire has many of the characteristics they seek: a top-notch company trading below the sum of its parts that ought to be distributing more cash to shareholders.
Some have already started buying in. Activist investor Bill Ackman, of Pershing Square Capital Management, sees opportunity in Berkshire and made it one of his largest holdings last year, telling investors that the stock trades at a “cheap valuation” and is “likely to increase substantially over the coming years.”
In the meantime, it is possible Buffett will find a long-sought elephant-size acquisition of $50 billion to $100 billion, in a deal that probably would be viewed favorably on Wall Street. Possible targets include airlines such as Delta Air Lines (DAL) or Southwest Airlines (LUV), where Berkshire already owns 10% stakes. Other possibilities include shippers FedEx (FDX) and UPS (UPS) or drugstore chain Walgreens Boots Alliance (WBA). In a 13F regulatory filing on Friday, Berkshire disclosed it had purchased 19 million shares of Kroger (KR), the grocery chain, in the fourth quarter, worth more than $500 million.
In pursuing deals, however, Buffett handicaps himself because he won’t participate in corporate auctions. He’s also price-conscious, which makes it tough to do deals now, given that valuations have gotten lofty during the nearly 11-year bull-market run.
David Rolfe of Wedgewood Partners in St. Louis, a longtime Berkshire investor who sold his position last year, leveled some criticism at Buffett about his recent record. Berkshire had missed investing in winning stocks such as Visa (V), Mastercard (MA), Microsoft (MSFT), and Costco Wholesale (COST) during the past decade, Rolfe wrote in his shareholder letter, and made few major deals—none of which appear to be big winners.
“Thumb-sucking has not cut the Heinz mustard during the Great Bull Market of 2009-19,” he wrote, a reference to Berkshire’s holding in Kraft Heinz (KHC). Rolfe makes a good point. Aside from Apple (AAPL), Berkshire’s largest holding, Buffett hasn’t come up with many big winners in the past 10 years—and that’s a big reason the stock has lagged the market in that span. The company’s Apple stake is now worth $81 billion, more than double its cost.
Conglomerates like Berkshire are an endangered species. Other public U.S. conglomerates, including General Electric (GE) and United Technologies (UTX), are breaking up or have done so. This reflects shareholder pressure and the view that more-focused companies fare better operationally. Many investors want to build their own portfolios of best-in-class companies and don’t need corporate managers to do so.
Buffett has long argued that Berkshire is better together, but that position may be tougher to maintain when he is no longer around. Berkshire carries the ultimate conglomerate discount in the stock market, a reference to the tendency of diversified companies to trade below the sum of their parts.
“If Buffett were a big owner of a company like Berkshire, he’d be knocking on the door and telling management that they’re way overcapitalized and should send some of that money back to shareholders,” says Bill Smead, manager of the Smead Value Fund (SMVLX), a Berkshire holder.
A bigger stock buyback and a meaningful dividend are likely once Buffett departs the scene—or even earlier.
It’s ironic that Buffett isn’t repurchasing more stock. Many of the companies in which Berkshire is invested—Apple, Bank of America (BAC), Wells Fargo (WFC), American Express (AXP)—are big buyers of their stock, and Buffett has cheered them on.
Buffett got expanded buyback authority in 2018, but the company is repurchasing stock at less than a 1% annual pace. Contrast this with Alphabet (GOOGL), another founder-run company that long had been cool to buybacks: Google’s parent stepped up the pace in recent quarters and is repurchasing 2% of its stock annually.
Smead thinks Berkshire should pay a regular dividend, consider a large special dividend of $50 billion, and buy back much more stock than the current sub-$4 billion annual pace. A bullish Smead says the stock is a good bet to top the S&P 500 in coming years by a margin of three to four percentage points annually.
For now, however, whatever Buffett premium once existed in the stock has vanished. Wall Street is giving the company little credit for its earnings power of more than $25 billion annually, its strength of its key businesses, and its gains in its $240 billion equity portfolio.
Indeed, investors often view Berkshire as a play on the company’s portfolio of stocks, led by Apple, Bank of America, Wells Fargo, Kraft Heinz, Coca-Cola (KO), and American Express. The equity portfolio had a strong 2019, driven by Apple and the banks, but it trailed the market in prior years, hurt by the weak showing of Kraft Heinz and Wells Fargo.
Despite the focus on the investment portfolio, it’s a relatively thin slice of profit. Berkshire gets 80% of its earnings from its operating units and 20% from investments.
Berkshire has built what is probably the most valuable insurance business in the world, with a focus on property-and-casualty policies. The jewel is Geico, which Buffett discovered in the 1950s. It now is the No. 2 auto insurer in the country, behind State Farm. Geico’s low-cost direct-sales approach has helped it steadily take market share by offering lower rates than broker-sold insurance.
One of Buffett’s favorite attributes of the insurance business is its $127 billion of “float,” or premiums invested prior to being paid out in claims. Most P&C insurers lose money on operations, resulting in an effective cost to that float. But Berkshire has been consistently profitable, earning an underwriting profit in 15 of the past 16 years. This results in a negative cost of float.
Burlington Northern Santa Fe, one of the country’s top railroads, is Berkshire’s largest and most profitable division. Another important business is Berkshire Hathaway Energy, a diversified utility with operations in the Midwest, Pacific coast, and United Kingdom. Burlington Northern, Geico, and Bershire Hathaway Energy are probably worth more than $200 billion.
Pershing Square’s Ackman has highlighted a little-noticed opportunity for Berkshire to boost profits at Burlington Northern and Geico. Both have lower profit margins than key rivals.
This may reflect Buffett’s hands-off approach to Berkshire’s dozens of operating units. “Charlie and I are the managing partners of Berkshire. But we subcontract all of the heavy lifting in this business to the managers of our subsidiaries. In fact, we delegate almost to the point of abdication,” Buffett has written.
Charlie Munger is Berkshire’s 96-year-old vice chairman and Buffett’s longtime sounding board and friend.
If Burlington Northern were public, it probably would face pressure to adopt precision scheduling railroading, an efficiency technique that has angered customers but boosted margins throughout the industry. Burlington Northern’s management hasn’t embraced that idea, and Buffett has supported them. Without Buffett, it may be difficult for its management to resist implementing the technique. This could lead to higher margins.
In moving Combs to Geico, where margins are below that of Progressive, Berkshire may be looking to bring in a new perspective to boost results. Buffett lauded former CEO Tony Nicely, who retired in 2018, in an annual report. However, Geico’s results arguably could be better.
Progressive has been a pioneer in segmenting potential customers by risk and using real-time driving information to price individual policies. Meyer Shields, an insurance analyst at Keefe, Bruyette & Woods, says that Combs will have his hands full, noting that “Progressive is the undisputed analytics leader in personal auto insurance. Competing with geniuses at Progressive is not a part-time job.”
Geico has said that Combs will continue to manage a portion of the Berkshire equity portfolio—about $15 billion—while running the company.
Berkshire ought to provide greater financial transparency about many businesses such as Precision Castparts and hold its first-ever investor day so that the investment community can better understand the company, which has minimal analyst coverage. Buffett should identify his potential successors and include them onstage with Munger and him at Berkshire’s annual meeting in May.
Shields has a Market Perform rating on Berkshire partly because of what he views as inadequate financial disclosure. While Berkshire provides revenue and profit information for its top businesses, it doesn’t offer complete information for most of its smaller ones. “The amount we know about the individual businesses is remarkably poor,” he says.
Berkshire stock crushed the S&P 500 during Buffett’s first 40 years as boss, and looks like a better bet over the next decade. The S&P 500 contains most of the world’s best companies, but it is at a record high and trades for a near-record 20 times forward earnings.
Berkshire, on the other hand, is a sleeper that offers investors many ways to win, including a bigger buyback and a dividend, a large accretive acquisition, better profitability, and a potential corporate breakup. While Buffett has come to personify Berkshire, there’s reason to believe that the company will be a market beater when he’s gone.
In the meantime, happy 90th.