Berkshire's Simple Secrets to Success
In the firm's annual letter to shareholders, Warren Buffett and Charlie Munger reflect on Berkshire Hathaway's history and future prospects.
Berkshire Hathaway (BRK.B) released its fourth-quarter results and 2014 annual letter Saturday morning--required (and highly anticipated) reading for value investors and Warren Buffett acolytes the world over.
Morningstar's stock analysts will sort through the earnings release in a separate report. Beyond the business results, Buffett's annual letters also include ruminations on investing and more than a handful of insightful quotes to tide investors over until Berkshire's annual meeting--also known as the Woodstock for Capitalists--which happens the first weekend in May. (Morningstar's Berkshire analyst, Gregg Warren, will be one of the three analysts, in addition to three financial journalists, asking questions at this year's meeting.)
Fifty years ago, current management took over at Berkshire, and on the occasion of this year's letter, Buffett and his business partner, Charlie Munger, each recounted the ride, along with their expectations for the next 50 years. Their portions were written independently, the letter stated, and "neither changed a word of his commentary after reading what the other had written."
There was a good bit of overlap between the two accounts and several interesting points worth consideration for investors today--both Berkshire shareholders and any other fundamentals-based long-term-minded investors.
The Next CEO
Given the importance of thoughtful capital allocation to Berkshire's success over the years, much has been written about Berkshire's succession strategy and the possible effects on the firm when Buffett eventually steps down. Both Buffett and Munger addressed the issue, offering a few hints along the way.
"Both the board and I believe we now have the right person to succeed me as CEO," Buffett wrote, "a successor ready to assume the job the day after I die or step down. In certain important respects, this person will do a better job than I am doing."
Beyond confirming that the future CEO would come from internal candidates and would be "relatively young, so that he or she can have a long run in the job" Buffett didn't name any names. Munger, however, mentioned in his own forward-looking portion of the letter, "Ajit Jain [who heads several of Berkshire's reinsurance businesses] and Greg Abel [president and CEO of Berkshire Hathaway Energy] are proven performers who would probably be under-described as 'world-class.' 'World-leading' would be the description I would choose. In some important ways, each is a better business executive than Buffett."
Looking back at the ingredients of Berkshire's success, both Buffett and Munger interestingly noted the importance of keeping it simple and fending off bureaucracy, which will continue to be key for the firm's next CEO.
"At headquarters, we have never had a committee nor have we ever required our subsidiaries to submit budgets (though many use them as an important internal tool)," Buffett wrote. "We don't have a legal office nor departments that other companies take for granted: human relations, public relations, investor relations, strategy, acquisitions, you name it."
Munger touched on the same in describing the guiding tenets of Berkshire: "There would be almost nothing at conglomerate headquarters except a tiny office suite containing a Chairman, a CFO, and a few assistants who mostly helped the CFO with auditing, internal control, etc."
Moving Beyond Cigar Butts
Buffett also spent time recounting his evolution as an investor and the impact on Berkshire's philosophy. A student of Ben Graham, Buffett started his investing career in search of "cigar butts," ailing companies at ultra-cheap prices with one last "puff" in them, but he later realized the strategy wasn't scalable.
"My cigar-butt strategy worked very well while I was managing small sums," Buffett wrote. But it was "scalable only to a point. ... Though marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise."
Munger, whom Buffett met in 1957, began to lead him away from cigar butts and toward quality companies. Munger's blueprint for Berkshire, Buffett wrote, was "Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices."
This is a good tonic for today's investing environment, which features very few outright bargains after a years-long market rally. Looking at the opportunity set (which features few 5-star, high-quality stocks), we'd say investors who need exposure to the stock market can do far worse than buying wide-most names--those with highly durable competitive advantages--at fair prices (3 stars) when better bargains are hard to come by.
Focus on Moats
Such "wonderful business" tend to hold up better in downturns and provide meaningful long-term returns for investors to fund retirement or other big personal goals. In the case of Berkshire, they also meant cash flows to reinvest in even more wonderful businesses.
In 1972, Berkshire acquired See's Candy, which, Buffett wrote, "had a huge asset that did not appear on its balance sheet: a broad and durable competitive advantage that gave it significant pricing power. That strength was virtually certain to give See's major gains in earnings over time. Better yet, these would materialize with only minor amounts of incremental investment. In other words, See's could be expected to gush cash for decades to come."
The "value of powerful brands" continued to permeate Berkshire's investments over the years, with wide-moat companies such as Coca-Cola (KO), American Express (AXP), and Wal-Mart (WMT) dominating its investment portfolio.
The notion of a "circle of competence" and its importance to Berkshire's success in investment and operational decisions was also noted. Wrote Munger, "In particular, Buffett's decision to limit his activities to a few kinds and to maximize his attention to them, and to keep doing so for 50 years, was a lollapalooza. Buffett succeeded for the same reason Roger Federer became good at tennis."
Buffett further quoted Tom Watson Sr. of IBM (IBM) (another of Berkshire's big investment holdings): "I'm no genius, but I'm smart in spots and I stay around those spots."
A Different Kind of Conglomerate
Buffett acknowledged the bad reputation of conglomerates, a lot of it earned due to past decades' "conglomerate mania," which was little more than accounting smoke and mirrors through which conglomerates would issue shares of overpriced stock to acquire mediocre firms trading a low multiples for good reasons.
But Berkshire's success as a conglomerate would seem to be the exception that proves the rule. Wrote Munger, "Did Berkshire suffer from being a diffuse conglomerate? No, its opportunities were usefully enlarged by a widened area for operation. And bad effects, common elsewhere, were prevented by Buffett's skills."
For instance, Buffett noted, Berkshire can "move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise" while avoiding all the related frictions that would otherwise accompany such moves--including taxes, egos ("if horses had controlled investment decisions, there would have been no auto industry"), and Wall Street bankers ("money-shufflers don't come cheap").
Referring again to See's cash flows, Buffett wrote, "We would have loved ... to intelligently use those funds to expand our candy operation. But our many attempts to do so were largely futile. So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See's to help purchase other businesses. If See's had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs."
Another benefit to Berkshire's conglomerate structure has been established over the years: The firm is "now the home of choice for the owners and managers of many outstanding businesses" who don't want to sell to a competitor or a private equity firm. Berkshire's approach to acquiring great businesses, and then letting them continue to run themselves, means potential acquisitions are knocking on their door--a good position for a conglomerate to be in.
But Mistakes Were Made
This is not to say that all of Berkshire's capital deployment went smoothly. For instance, Buffett recounted the ill-fated acquisition of Dexter Shoe, underestimating the effects of foreign competition and using stock rather than cash for the deal.
"The shares I used for the purchase are now worth about $5.7 billion. As a financial disaster, this one deserves a spot in the Guinness Book of World Records," Buffett wrote. "Trading shares of a wonderful business--which Berkshire most certainly is--for ownership of a so-so business irreparably destroys value."
But it's one thing to miscalculate the fundamental strength of a business, and another to acquire for acquisition's sake. "[Berkshire] never had the equivalent of a 'department of acquisitions' under pressure to buy," Munger noted.
"Patience" is another secret to success for the firm--waiting for the right opportunities and being content to sit on cash in their absence. But a patient approach also meant some so-called "fat pitches" sailed over the plate.
"While mistakes of commission were common," Munger wrote, "almost all huge errors were in not making a purchase, including not purchasing Walmart stock when that was sure to work out enormously well. The errors of omission were of much importance. Berkshire's net worth would now be at least $50 billion higher if it had seized several opportunities it was not quite smart enough to recognize as virtually sure things."
The Next 50 Years
Looking forward, both Buffett and Munger were optimistic about Berkshire's prospects.
"I believe that the chance of permanent capital loss for patient Berkshire shareholders is as low as can be found among single-company investments," Buffett wrote. "That's because our per-share intrinsic business value is almost certain to advance over time."
"Intrinsic value" is the key phrase, as we know market price and intrinsic value don't always go hand in hand. Investors must mind valuation, even for the best of companies. "A sound investment can morph into a rash speculation if it is bought at an elevated price," Buffett noted. "Berkshire is not exempt from this truth."
(For the record, Morningstar estimates Berkshire's intrinsic, or fair value, at $157 per B share today, just a touch above its current trading price of $147 and change, meaning the shares look essentially fairly valued.)
Backing that intrinsic value growth, Buffett wrote, is the firm's solid financial strength and diversified earnings stream. "We will always be prepared for the thousand-year flood," Buffett wrote, pointing to Berkshire's role as "first responder" during the market crisis. The firm's cash on hand ("at least $20 billion--and usually far more") plays a major role not only in its ability to pounce on opportunities, but also in riding through the inevitable market panic. "Cash is to a business as oxygen is to an individual: never thought about when it is present, the only thing in mind when it is absent," Buffett noted.
In the short term, the stock's market performance, Buffett admitted, is anyone's guess. "Movements of the general stock market during such abbreviated periods will likely be far more important in determining your results than the concomitant change in the intrinsic value of your Berkshire shares," he wrote, recommending at least a five-year holding period time.
As for the long term, Buffett echoed past comments in advising shareholders to moderate expectations. "The bad news is that Berkshire's long-term gains--measured by percentages, not by dollars--cannot be dramatic and will not come close to those achieved in the past 50 years," he noted. "Probably between ten and twenty years from now, Berkshire's earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company's earnings."
For Berkshire's shareholders, that could mean dividends or buybacks, but for now the firm sees plenty of use for its cash flow.
Munger noted, for instance, that Berkshire's railroad and utility subsidiaries provide sizable opportunity to invest in new fixed assets and that the environment for acquisitions could improve. "With Berkshire now so large and the age of activism upon us, I think some desirable acquisition opportunities will come and that Berkshire's $60 billion in cash will constructively decrease," he wrote.
A few other interesting quotes from Buffett's 2014 roundup that are worth a read:
"Charlie and I encourage bolt-ons, if they are sensibly-priced. (Most deals offered us aren't.) They deploy capital in activities that fit with our existing businesses and that will be managed by our corps of expert managers. This means no more work for us, yet more earnings, a combination we find particularly appealing. We will make many more of these bolt-on deals in future years."
"With the acquisition of Van Tuyl Automotive [in October], Berkshire now owns 9 1⁄2 companies that would be listed on the Fortune 500 were they independent (Heinz is the 1⁄2). That leaves 490 1⁄2 fish in the sea. Our lines are out."
"At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business. It's better to have a partial interest in the Hope Diamond than to own all of a rhinestone."
"Our flexibility in capital allocation--our willingness to invest large sums passively in non-controlled businesses--gives us a significant advantage over companies that limit themselves to acquisitions they can operate. Our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire's endless gusher of cash."
"Who has ever benefited during the past 238 years by betting against America? If you compare our country's present condition to that existing in 1776, you have to rub your eyes in wonder. In my lifetime alone, real per-capita U.S. output has sextupled. My parents could not have dreamed in 1930 of the world their son would see. Though the preachers of pessimism prattle endlessly about America's problems, I've never seen one who wishes to emigrate (though I can think of a few for whom I would happily buy a one-way ticket)."
"A sound insurance operation needs to adhere to four disciplines. It must (1) understand all exposures that might cause a policy to incur losses; (2) conservatively assess the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) set a premium that, on average, will deliver a profit after both prospective loss costs and operating expenses are covered; and (4) be willing to walk away if the appropriate premium can't be obtained. Many insurers pass the first three tests and flunk the fourth."
"In the world of business, bad news often surfaces serially: You see a cockroach in your kitchen; as the days go by, you meet his relatives."
"Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments--far riskier investments--than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk."
"Investors can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to 'time' market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy."
"Borrowed money has no place in the investor's tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator--and definitely not Charlie nor I--can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet."
Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.