Warren Buffett, the man, the legend, is now 87 years old, has some history with cancer and is well aware that his best days are behind him. Rumors are flying that he’s been negotiating with God himself to continue running Berkshire from the grave-at least that’s the word on the street but I can’t verify that. I suspect that the real plans involve mere mortals.
Warren Buffett is deservedly known as the greatest investor of all time. His track record with Berkshire Hathaway (BRK.B) (BRK.A) is remarkable. And yet, for investors, that track record isn’t necessarily enough to justify purchasing the stock. As everyone who has ever looked at a mutual fund knows, past performance is no guarantee of future results. As Buffett himself put it a bit more cheekily:
That may seem easy to do when one looks through an always-clean, rear-view mirror. Unfortunately, however, it’s the windshield through which investors must peer, and that glass is invariably fogged
Source: The Snowball, by Alice Schroeder
Why Would the Market Pay Extra for Buffett?
When trying to determine whether the value of the company (and thus the stock price) will drop after the death of Mr Buffett, it is worth inverting (as his partner Charlie Munger always says). The question then becomes, why is the market paying up for him to be running things.
Let’s think about the sources of value inside Berkshire Hathaway. There are insurance operations which earn money year in and year out on underwriting. He doesn’t do the underwriting but has created a great corporate culture. Probably Ajit Jain and Co. are adding the value here. The company has wholly owned subsidiaries in the utility, railroad, industrial, consumer product, financial, and media spaces. Given the size of the company, he isn’t actively running any of these businesses. There may be a bit of a halo effect, but I doubt it moves the needle. The final sources of value are investments and cash. Some of the investment have appreciated so much that it would be tough to sell them due to taxes owing (I’m looking at you Coca-Cola (NYSE:KO)), but new investments of cash are definitely the place where Buffett adds the most value.
More broadly, his value add is in capital allocation, which is basically the art of determining what to do with cash. He is objectively superior at that, which increases the likelihood of the company’s cash balances (and future cash income streams) being invested to earn a high return. That increases the present value of that cash to investors, and I believe is the primary source of any “Buffett premium.”
As someone who frequently writes on and invests in microcap net-nets, I am deeply aware that the market does not always value a dollar of cash at a dollar of market capitalisation. In Berkshire’s case, the huge cash pile is likely valued at a least a dollar for every dollar, because the market believes Warren Buffett will use the money effectively, as well as effectively allocate the significant cash flow that the business throws off each and every year.
Some of that Buffett premium is likely to disappear when Buffett passes away, and that day is inevitably getting closer. With Buffett now 87 and having had prostate cancer, he is certainly much closer to the end of his investing career than the beginning. Berkshire had the following to say about the matter in the Risks section of its most recent 10-k.
We are dependent on a few key people for our major investment and capital allocation decisions.
Major investment decisions and all major capital allocation decisions are made by Warren E. Buffett, Chairman of the Board of Directors and CEO, age 86, in consultation with Charles T. Munger, Vice Chairman of the Board of Directors, age 93. If for any reason the services of our key personnel, particularly Mr. Buffett, were to become unavailable, there could be a material adverse effect on our operations. However, Berkshire’s Board of Directors has identified certain current Berkshire subsidiary managers who, in their judgement, are capable of succeeding Mr. Buffett. Berkshire’s Board has agreed on a replacement for Mr. Buffett should a replacement be needed currently. The Board continually monitors this risk and could alter its current view regarding a replacement for Mr. Buffett in the future. We believe that the Board’s succession plan, together with the outstanding managers running our numerous and highly diversified operating units helps to mitigate this risk.
It has called out its succession plan as a mitigating factor to this risk, and when Buffett dies, I believe the successor(s) will be announced very shortly thereafter. However, there is one other big reason I am not very concerned about Mr Buffett’s eventual death, and that is I believe that capital allocation is actually getting easier at Berkshire Hathaway for a number of important reasons.
Reinvestment in Berkshire’s Owned Businesses
The simple fact is that he has, over the last 15 or so years, designed Berkshire to be able to reinvest a material portion of its excess capital internally. Capital-heavy acquisitions like Burlington Northern and its utility subsidiaries have a continual need for more capital and are a great way to reinvest the capital that comes from the other businesses and portfolio dividends without needing to make as many acquisitions.
The utility businesses especially are a great place to put new capital, because new capital investment in regulated utilities earns a regulated return. Thus, Buffett’s successor has a home from money that will earn a guaranteed rate of return that is generally around the cost of equity, or high single digits to low double digits. That will help take the pressure off.
The other thing that will help is that Berkshire has been acquiring companies that themselves grow by acquisition. The utility subsidiaries are the biggest example of this group, but there are a number of others. As a couple of examples, the Marmon group of companies regularly makes acquisitions, and Berkshire purchased Precision Castparts for a relatively full price, partially paying for its ability to grow its earnings using Berkshire’s capital. These (and many other) subsidiaries making tuck-in acquisitions will help Buffett’s successor effectively allocate capital by reducing the amount of money they need to allocate.
How Berkshire’s Buyback Plan Helps Allocate Capital
I believe the company’s buyback plan is also built to help Buffett’s successor allocate capital. If Berkshire’s stock falls on Buffett’s death and goes below the board’s buyback floor, the successor will have an easy way to accretively use Berkshire’s capital. There would be no reasonable way for anyone to criticise buying back Berkshire stock at a level previously endorsed by Warren Buffett himself.
The successor (and board) could also begin paying a dividend, although I think that is less likely. While a dividend has the attraction of being able to use an unlimited amount of capital in an intelligent way, it is also (at least indirectly) an admission by the successor of not being as savvy a capital allocator as Mr Buffett. Now, that is an admission that basically anyone should be happy to make, but for market confidence reasons, I can see why the board may not want to do so.
Filed under: Business
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