Questions Continue to Linger Over Berkshire Succession
Although the top candidate remains veiled in secrecy, signs abound about the preferred successor.
With more than a year having passed since the David Sokol affair raised some serious questions about succession planning at Berkshire Hathaway (BRK.A) (BRK.B), we feel as though we still don't have a complete picture of what the firm will look like in a post-Warren Buffett world.
The Oracle of Omaha moved to quell some of the concerns that have arisen about succession planning in his annual letter to shareholders this year, noting that Berkshire's board of directors has a candidate in mind to replace him as chief executive, and that this person is "an individual to whom they have had a great deal of exposure and whose managerial and human qualities they admire." Buffett also noted that the board has "two superb backup candidates" in mind, in the event that the first pick for the CEO role was not available.
Although these statements were meant to reassure shareholders, many of whom have concerns about who will replace Buffett longer term, we think that the veil of secrecy that Berkshire insists on maintaining around the board's choice has only raised more questions about the potential candidates. Considering the critical role that the Oracle of Omaha plays as capital-allocator-in-chief at Berkshire, we believe that this will not only be a big topic of conversation at this year's annual meeting, but in subsequent periods, as well, especially with Buffett recently announcing that he has stage-1 prostate cancer--not quite the "excellent health" he portrayed himself as having in this year's annual letter.
As many investors may recall, succession was not formally addressed by Buffett until his 2005 annual letter to shareholders, where he noted that his three main jobs--chairman, chief executive, and chief investment officer--would likely be handled by one chairman, one CEO, and three or more external hires (reporting to directly to the CEO) that would manage the investment portfolio, once he retired.
While the Oracle of Omaha's son, Howard Buffett, has been identified by Buffett as his choice for nonexecutive chairman, ultimately serving as a guardian of the company's values, and adding "one extra layer of protection" for shareholders, the decision ultimately rests with the board of directors. Buffett feels that the firm would be better-served longer term if someone with a vested interest in the company takes on the role of nonexecutive chairman, envisioning an individual that would act to counter-balance whoever ends up in the CEO role. That is the main reason why we continue to believe that Bill Gates, co-founder of Microsoft (MSFT) and director at Berkshire since 2005, has to be the second (if not first) candidate for this role. Given the breadth of his business knowledge and experience, and the fact that the Bill & Melinda Gates Foundation has a vested interest in seeing Berkshire transition as smoothly as it can into a post-Buffett era, we would expect Gates to spend just as much time looking over the shoulders of future capital allocators at Berkshire than any nonexecutive chairman would.
'The Brains, Judgment, and Character'
Looking more closely at the efforts aimed at filling the role of chief investment officer, Berkshire continues to make strides toward hiring three or more external managers to oversee the firm's investment portfolio, which includes not only the $140 billion in cash, equities, fixed income, and other investments held in its insurance operations at the end of 2011, but the ongoing float that is created by the business. Following up on the hiring of Todd Combs in late 2010, Berkshire announced in the third quarter of last year that it had hired Ted Weschler, bringing the total number of outside managers up to two.
Much like Combs, who was a little-known hedge fund manager running around $400 million worth of assets at Castle Point Capital Management, Weschler comes to Berkshire as a relatively unknown commodity, having run about $2 billion with Peninsula Capital Advisors prior to coming on board. One of his claims to fame, though, was that he bid $2.6 million not once, but twice (in both 2010 and 2011), to win the annual auction of a private lunch with Warren Buffett. Both of these outside managers have, however, racked up solid investment track records with their funds, with Combs generating an annualized return of 8% during the four full years that he was running his fund (compared to a negative 1% total return for the S&P 500 Index) and Weschler producing an annualized return of nearly 30% for his investors during the last decade (compared with a 1% return for the benchmark index).
Similar to Buffett, both men have run fairly concentrated stock portfolios, with Combs holding a total of 24 securities at the end of September 2010, with his top five holdings accounting for 35% of his portfolio. Weschler, meanwhile, held just nine securities at the end of June 2011, with its top five holdings accounting for 90% of his portfolio. With Combs' appetite leaning more toward financial-services names, and Weschler focused a bit more on consumer-oriented firms, they should dovetail nicely with Berkshire's current holdings, which is more heavily weighted toward consumer and financial-services companies.
Although Buffett has not provided explicit details about the responsibilities of each of his lieutenants, he did note in this year's annual letter that each "will be handling a few billion dollars in 2012," and that both "have the brains, judgment, and character" to manage the entire portfolio when he and Charlie Munger are no longer running the show. A sign of this trust is the fact that Buffett allowed his two lieutenants to build up a nearly $1 billion stake in DirecTV (DTV) during the fourth quarter of last year--a much larger bet than we would have expected to have seen this early in their tenure at Berkshire. It is also interesting to note that Buffett has said he expects both men to help him (and the future CEO) with acquisitions, an indication that he expects Berkshire's managers to work much more closely together than they may have in the past.
Finding That Chief Capital Allocator
Running an investment portfolio, however, is a much different task than being a capital-allocator-in-chief, which is the role that we feel the next CEO will have to fill. With all of Berkshire's operating businesses managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility for each business down to the subsidiary level, Buffett has had the freedom to focus on managing the investments in the firm's portfolio and making capital-allocation decisions.
By insisting that the outside managers Berkshire hires to run the investment portfolio report directly to the CEO, he is signaling, in our view, that the primary job of any incoming CEO will be one of chief capital allocator. Although one could argue that Buffett has already laid claim to some of the firm's future cash flows, by buying up capital-intensive businesses such as MidAmerican Energy and Burlington Northern, the company generates a substantial amount of cash each year, the excess of which (after all capital projects are funded) will either need to be invested in other opportunities or returned to shareholders in the form of share repurchases or dividends--decisions that will need to be made by this capital-allocator-in-chief.
With Buffett noting on countless occasions that his successor must also be "genetically programmed to recognize and avoid risk, including those never before encountered," we continue to believe that his top choice for the CEO job is Ajit Jain, who heads up Berkshire Hathaway Reinsurance Group. Not only does Jain understand risk (across a wide range of industries) better than just about anyone else at Berkshire, but in the words of Buffett himself, he has "probably made a lot more money" for the firm than Buffet has during the period that Jain has been with Berkshire. Buffett has even joked that if he, Munger, and Jain were all adrift in a rowboat in a dangerous storm that shareholders should focus on saving Jain's life. Although Jain's experience has primarily been on the underwriting side of the business, his success there has been built on his ability to avoid making "dumb decisions" rather than making "brilliant" ones--attributes that have kept him in good stead with Buffett during the last three decades.
If the firm's next CEO is expected to do nothing more than act as a caretaker for the business, tending to the needs of the managers that run all of the different subsidiaries, overseeing the actions of the investment managers that handle the company's investment portfolio, and dealing with the capital-allocation decisions that need to be made in any given year, then we could not think of a better candidate within Berkshire than Jain.
That last point is an important one because Buffett has said on more than a few occasions that it would be highly unlikely for the next CEO at Berkshire to come from outside of the firm. He has also noted that the board of directors would gladly support Jain as the company's next chief executive if he decided to seek the post. The problem is that Jain has been on the record several times saying that he does not want the job, which is the main reason why there continues to be ongoing speculation about other potential candidates for the CEO role at Berkshire.
Looking back to last year's annual meeting, we had the chance during the press junket to ask Buffett and Munger what they were looking for in a CEO candidate, and Buffett responded that he would prefer to have someone who understands business and can work with the wide array of operations and managers that Berkshire has under its umbrella. Both he and Munger did note, however, that Berkshire does not need to have a management system like the U.S. Army or
ExxonMobil (XOM)--where managers are rotated around and learn the different operations, with the goal being to eventually run the entire organization--believing that this would be disruptive for the firm as well as for the individual businesses that would see their top managers switching every couple of years.
The Next CEO Will Be...
Considering the breadth of Berkshire's operations, we continue to believe that the list of potential CEO candidates includes (at the very least) these five names--Ajit Jain (chairman, president, and CEO of Berkshire Hathaway Reinsurance Group), Tony Nicely (chairman, president, and CEO of GEICO), Tad Montross (chairman, president, and CEO of General Re), Matt Rose (chairman, president, and CEO of Burlington Northern), and Greg Abel (chairman, president, and CEO of MidAmerican Energy). That's not to say that the managers of other large operations--such as James Hambrick (chairman, president, and CEO of Lubrizol), Frank Ptak (president and CEO of The Marmon Group), and Grady Rosier (president and CEO of McLane)--those who have received positive mentions in Berkshire's annual letter to shareholders, or those who Buffett has spoken highly of in interviews are off the map. We also wouldn't be surprised to see any one of them emerge as the top candidate, given that Buffett has close relationships with many of them and has also had a heavy hand in guiding the board to the best possible replacement for CEO.
It should be remembered, however, that whoever steps into Buffett's role as chief executive is going to feel a lot more pressure from shareholders and analysts than Buffett has ever been subjected to, which means that the board will have to work all that much harder to ensure that the potential candidates are thoroughly prepared for the scrutiny that will be laid on them (perhaps the main reason why Jain has shown such a disinterest in the job over the years). Ultimately, the real question for investors is whether any one of these candidates, let alone the collection of managers that will be assuming Buffett's three main roles at the firm once he has departed, can ever replace the significant advantages that have come from having an investor of Buffett's caliber, with the knowledge and connections he has acquired over the years, running the show. We think that the short answer to that question is still "no."
Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.