Book Review: Warren Buffett’s Ground Rules

“So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.” 

— Warren Buffett, letter to partners, October 9, 1967

As Warren Buffett wrote these words to his partners in late 1967, he was writing from the perspective of a 37 year old man who was about to wrap up the eleventh year of his partnership having achieved gross returns of 1606.9%, which represents annualized returns in excess of 29 percent.  For a number of years, Mr. Buffett had been warning his partners that future results would not come close to his past track record.  However, in 1968, the partnership posted its highest ever gross return of 58.8 percent which exceeded the return of the Dow Jones Industrial Average by an amazing 45.6 percent.  Then in May 1969, with assets under management exceeding $100 million ($~650 million in 2016 dollars), Mr. Buffett announced plans to close the partnership and retire.

Warren Buffett's Ground RulesThe idea of closing up shop with an unparalleled thirteen year track record and assets under management growing at a tremendous clip probably seems crazy to most modern-day investment managers.  Although Mr. Buffett did not charge a fixed annual management fee like most other funds, he was entitled to 25 percent of all profits over a six percent hurdle rate.  Even if his performance was destined to fall to 10 percent, on average, he would have generated fees of at least $1 million per year in 1970s dollars.  However, by the late 1960s, he was securely rich and did not want to be “totally occupied with out-pacing an investment rabbit all my life.”  The only way to slow down, in his view, was to stop.  Jeremy Miller’s new book, Warren Buffett’s Ground Rules, does an excellent job of putting the Buffett Partnership letters into context.  Perhaps more significantly, Mr. Miller draws a number of lessons from the letters that are potentially just as actionable for investors today as they were for Mr. Buffett five decades ago.

The Buffett Partnership letters have been available for a number of years and many investors understandably pored over the details chronologically in an attempt to replay the amazing track record and come up with applicable lessons.  However, just as Lawrence Cunningham added significant value putting the Berkshire Hathaway annual letters into context, Mr. Miller’s efforts with the partnership letters have revealed valuable insights that a chronological reading might miss.

For practicing investors today, the most valuable section of the book is Part II where Mr. Miller goes through the three main categories of Buffett Partnership investments:  The Generals, Workouts, and Controls. All three represent fields where modern-day investors can look for bargains with an individual’s area of focus depending mostly on temperament, circle of competence, and assets under management.

The Generals

The Generals were companies that made up a concentrated portfolio of undervalued securities that represented the majority of overall partnership gains.  With only one exception, Mr. Buffett never discussed any of the Generals with his partners or even disclosed the names of the companies.  This strict secrecy might appear eccentric to investors today.  After all, we see famous hedge fund managers on television describing their favorite investments all the time.  Mr. Buffett’s desire for secrecy, even when he was relatively unknown, stemmed from his lack of interest in seeking out fame as well as his desire to continue accumulating shares of his favorite investments at low prices.  There was no incentive for him to reveal his portfolio and invite “coat-tailing”.  According to the book, the partnership would typically have 5-10 percent positions in five or six generals with a number of smaller positions adding another 10-15 percent in aggregate.

How did Warren Buffett go about selecting the Generals?

He was constantly appraising the value of as many stocks as he could find, looking for the ones where he felt he had a reasonable ability to understand the business and come up with and estimate for its worth.  With a prodigious memory and many years of intense study, he built up an expansive memory bank full of these appraisals and opinions on a huge number of  companies.  Then, when Mr. Market offered one at a sufficiently attractive discount to its appraised value, he bought it; he often concentrated heavily in a handful of the most attractive ones.

Imagine for a moment Warren Buffett sitting in his office in the late 1950s with The Wall Street Journal, a Moody’s Manual, a pile of printed annual reports, a notepad, and a pencil.  These were the tools of his trade at the time when he was coming up with these lists of investment candidates.  There was no SEC website, no access to spreadsheets like Microsoft Excel, no way to research companies except to send out for information, and he didn’t even have an HP-12C.  The idea of coming up with a list of hundreds of investment candidates and then keeping up with them and gauging their relative attractiveness is hardly an easy task with modern resources but it is certainly possible for diligent investors.  In the 1950s and 1960s, raw memory, intellect, and work ethic were probably greater competitive advantages than they are today, but the right temperament, which is timeless, is even more critical.

Workouts

Merger arbitrage was a major source of investment ideas and profit for the Buffett Partnership throughout its history.  As Mr. Buffett was wrapping up the partnership in 1969, he lamented that his performance in workouts that year had been “atrocious”.  Indeed, merger arbitrage was a hazardous activity in the 1960s and remains so today, except now there is far more information and efficiency which could make this field more challenging.

For the partnership, the overall experience in workouts was positive due to Mr. Buffett’s skill and insight into which deals to bet on.  When an acquisition is announced, the spread between the price the target company’s stock trades at and the offer price represents potential profit to an investor purchasing the stock.  The degree to which the investor can profit depends on the size of the spread, the amount of leverage used, the amount of time between buying the target’s stock and the transaction closing, and whether the deal actually does close or falls apart.  The situation becomes much more complex when an offer involves the acquiring company’s stock rather than cash.

Despite the risks, workouts represented an attractive field for the partnership both because of the profits they generated and due to the fact that these returns were uncorrelated to the overall stock market.  In most years, workouts made up 30-40 percent of partnership assets.  When the overall level of the stock market was rising, Mr. Buffett would tilt the partnership away from Generals and toward Workouts.  When the stock market was falling, he would allocate more capital toward Generals and less toward Workouts.

In contrast to the secrecy surrounding Generals, Mr. Buffett was more willing to discuss Workouts once they were fully … worked out.  Mr. Miller presents one such case study regarding Texas National Petroleum from the 1963 letter.  In considerable detail, Mr. Buffett describes how he came up with the idea, researched the matter in great detail, and profited from the spread that emerged.  One interesting item to note is that the company’s management was often available to comment on how the process was going.  While perfectly legal, ethical, and appropriate based on the rules in existence at the time, it isn’t clear whether managers today would be willing to discuss the progress of a transaction with an outside shareholder.

Modern-day investors can pursue workouts today but have to use a great deal of caution.  One potential field for consideration might involve looking at deals that involve Berkshire Hathaway.  For example, when Berkshire announced the Precision Castparts acquisition in August 2015, Precision Castparts shares did not trade up to the $235 offer price.  Shares jumped from around $193 on the day before the announcement to slightly over $230 on the day of the announcement.  One could purchase shares at $230 in mid-November and at a little over $231 just days before the acquisition closed in January 2016:

PCP August 2015-January 2016

Obviously buying shares during this period was not entirely risk free.  If the transaction fell through for any reason, shares would probably have fallen back to August levels or perhaps even further given the overall market environment in early 2016.  However, Berkshire is known for never backing out on acquisitions once announced.  The risk seemed quite low.  An investor who added leverage and waited until the transaction was about to close could have earned substantial returns.

Is this field risk free or for the faint of heart?  Not at all, but this was an important category for the Buffett Partnership and worth examining for those who believe that they have a suitable temperament.

Controls

Berkshire Hathaway’s policy is to never pursue hostile acquisitions and the company does not typically seek to influence the managers of investees.  Warren Buffett is not known as an “activist” investor today but that is precisely what he was at times during the 1960s.  The most famous example is Berkshire Hathaway itself where Mr. Buffett built up a stake in the company over several years before assuming control and forcing out management.  Berkshire started out as a General and morphed into a Control.

Although Berkshire Hathaway might be the most famous example of a Control, Mr. Miller’s coverage of the Sanborn Map Company is a classic that modern-day investors might find it easier to relate to.  Sanborn Map made up 35 percent of the partnership in 1959 and concluded successfully in 1960.

Sanborn was a successful publisher of very detailed maps used by insurance companies to assess various risks.  The company was a cash cow and management built up a large securities portfolio over a number of years.  By the late 1950s, the map business was in decline.  The market quotation of Sanborn implied that the map business had negative value, as Mr. Buffett described:

In the tremendously more vigorous climate of 1958 [in comparison to the late 1930s] the same map business was evaluated at a minus $20 [per share] with the buyer of the stock unwilling to pay more than 70 cents on the dollar for the investment portfolio with the map business thrown in for nothing.

The size of the investment portfolio had also made managers and directors complacent and there was a lack of urgency in rejuvenating the map business, which Mr. Buffett believed still had positive value.  Mr. Buffett joined the board but found that most of the other directors had nominal holdings of the stock and did not share his urgency.  In late 1958, an opportunity arose when several unhappy large shareholders decided to sell.  However, even in combination with unhappy continuing shareholders, Mr. Buffett lacked an outright majority.  Seeking to avoid a proxy fight, a solution was devised to take out all shareholders who wanted to exit:

About 72% of the Sanborn stock, involving 50% of the 1,600 stockholders, was exchanged for portfolio securities at fair value.  The map business was left with over $1.25 million in government and municipal bonds as a reserve fund, and a potential corporate capital gains tax of over $1 million was eliminated.  The remaining stockholders were left with a slightly improved asset value, substantially higher earnings per share, and an increased dividend rate.

In this example, we see an investor who was not yet thirty years old take effective control of a company founded in the late 1800s and devise a solution that not only resulted in significant gains for the partnership but also a positive outcome for continuing shareholders of Sanborn.  So, while Warren Buffett was an “activist” in his early years, the basic elements of fair dealing that he is known for today were already present.

George Risk Industries – A Modern Day Potential Control?

Are there still situations like Sanborn Map?  The situation at George Risk Industries in early 2010 was not identical to Sanborn Map but it “rhymed” in certain ways.  George Risk, founded in 1965, had an operating business but was massively overcapitalized with a large securities portfolio.  The son of the company’s founder served as CEO and had a controlling interest.  With a market capitalization of just over $20 million at the time, the company also traded below net current assets.

Fast forward to 2016 and not much has changed.  The founder’s son passed away and his daughter took over as CEO.  The family still has a majority interest in the company.  The valuation of the company has nearly doubled to around $37 million and shareholders have received meaningful dividends throughout the period.  The company is still massively overcapitalized.  Returns from owning George Risk have not equaled the return from S&P 500 or Berkshire Hathaway.

Would Warren Buffett, if he had been operating with very little capital in 2010, have attempted to purchase shares of this thinly traded stock?  Would he have taken an active role trying to persuade the Risk family to distribute securities to shareholders?  We cannot know the answer to these questions but would note that this field of endeavor is still very much open to small investors who have the appropriate temperament, and perhaps more importantly, a great deal of patience and ability to underperform for a long period of time while waiting for the investment thesis to play out.

Anyone who is interested in George Risk has the luxury of access to the SEC database covering almost 20 years of company history, something an investor operating in the 1950s could only dream about.

Closing the Partnership

As one reads the final chapters of the book, we know how the arc of Mr. Buffett’s life will proceed and view the story from that perspective.  However, in the late 1960s, it really did appear that Mr. Buffett wanted to slow down.  It was clear that he did not want to fully “retire” and intended to take at least an advisory role at Diversified Retailing and Berkshire Hathaway.

Some of you are going to ask, “What do you plan to do?”  I don’t have an answer to that question.  I do know that when I am 60, I should be attempting to achieve different personal goals than those which had priority at age 20.  Therefore, unless I now divorce myself from the activity that has consumed virtually all of my time and energies during the first eighteen years of my adult life, I am unlikely to develop activities that will be appropriate to new circumstances in subsequent years.

It is hard to not observe that Mr. Buffett closed the partnership shortly before reaching 40 years of age.  Was this part of a mid-life crisis?  Those of us on the far side of the big 4 – 0 might relate to the need to make some sort of reassessment upon the realization that we will soon be closer to receiving Social Security than to our college years.  It is obviously true that the environment of the late 1960s, described in detail in the book, was the main factor and Mr. Buffett really did feel like he was out of good ideas that could be implemented within the constructs of a $100 million portfolio.  However, it is interesting to get somewhat of a personal window into what went into the decision at this point in his life.

Regardless of intentions, we know that any “slow down” did not last for long.  As Chairman and CEO of Berkshire Hathaway, Mr. Buffett took the underlying ground rules of his partnership into a corporate form.  As the Berkshire Owner’s Manual makes clear, the corporate form has not erased the partnership culture.

Most value investors are familiar with the history of Berkshire Hathaway and with the broad outlines of the Buffett Partnership as documented in excellent biographies such as The Snowball and The Making of an American Capitalist.
Thanks to Mr. Miller’s efforts, we now have the ability, in a concise and efficient format, to explore Warren Buffett’s early years as a professional investor.  Whether reading the book for actionable approaches to investing or just out of biographical curiosity, it is definitely time well spent.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

The Remarkable Iscar Story

“Follow your heart and invest your time and resources in a product that you love.  If you are excited about what you are making, it will hold your interest and you will be well equipped to interest your customers in it.”  — Stef Wertheimer

Contemporary business success stories often focus on entrepreneurs who come up with an idea, obtain funding, and score quickly by selling the business at an attractive valuation either via acquisition or through an offering of stock to the public.  There can be no doubt that a sub-set of these entrepreneurs have made real and lasting contributions to society in astonishingly short periods of time, but often we are left scratching our heads wondering about the valuations obtained by companies with no compelling business model or pathway to profitability.  In contrast, individuals who spend a lifetime building up a business do not typically receive the same attention.  Perhaps this is because the value of their creation is not recognized dramatically in a few years but snowballs over many decades.  However, if one seeks insight into how real and lasting value is created, reading the biographies and memoirs of entrepreneurs who have spent decades perfecting their craft is usually worthwhile.

The Habit of Labor:  Lessons from a Life of Struggle and Success

Habit of LaborStef Wertheimer’s formative years were spent in his native village of Kippenheim, Germany during the turbulent years leading up to the second world war.  Mr. Wertheimer’s prosperous family was deeply impacted by the Nazi persecution of Jews during the early-mid 1930s and the family decided to emigrate to British-controlled Palestine in 1937.  At the age of ten, Mr. Wertheimer found himself in an unfamiliar culture and had to grow up quickly as his family’s economic security deteriorated after his father’s business began to fail.  An early entrepreneurial aptitude coupled with a rebellious streak led Mr. Wertheimer to make important contributions to Israel’s early industrialization.  Iscar was founded in 1952 in a shack next to Mr. Wertheimer’s home.  It was valued at $5 billion 54 years later when Berkshire Hathaway acquired a majority interest.  The story of this extraordinary up-from-the-bootstraps business success is the main subject of Mr. Wertheimer’s book, The Habit of Labor:  Lessons from a Life of Struggle and Success.

Mr. Wertheimer did not complete his formal education and learned various crafts through experimentation, independent study, and apprenticeships as a young adult.  His subsequent experiences in the Palmach in the mid-late 1940s, particularly working in urgent situations requiring quick development of military supplies, clearly contributed to his leadership skills and aptitude for innovation under extreme pressure.  Nevertheless, in post-independence Israel, Iscar did not immediately prosper and the company faced five lean years with little monetary reserves.  Government policy did not recognize the importance of industrialization, offered little support, and there was very limited credit available for expansion.

Through the course of the narrative, Mr. Wertheimer provides many details regarding the rise of Iscar from these modest beginnings to the export powerhouse it became prior to Berkshire’s acquisition in 2006.  Additionally, readers who are interested in the economic development of Israel will find many aspects of the book interesting, particularly those related to Mr. Wertheimer’s lifelong focus on industrialization and the impediments that he faced.  There is much to learn regarding the benefits of vocational training coupled with attractive industrial parks focused on integrating education, manufacturing, arts, culture, and a high quality of life in communities that were previously agrarian, isolated, and undeveloped.

Berkshire’s Acquisition of Iscar

In late 2005, Eitan Wertheimer, who had taken over management of Iscar from his father, sent a brief letter to Warren Buffett describing Iscar and concluding that Berkshire Hathaway would be an ideal home for the company.  At the time, Mr. Buffett had never heard of Iscar and had never purchased a subsidiary outside the United States.  However, Mr. Buffett found Iscar’s primary business of developing consumable cutting tools attractive and was impressed with management, as he wrote in Berkshire’s 2006 annual letter to shareholders (pdf):

ISCAR’s products are small, consumable cutting tools that are used in conjunction with large and expensive machine tools. It’s a business without magic except for that imparted by the people who run it. But Eitan, Jacob and their associates are true managerial magicians who constantly develop tools that make their customers’ machines more productive. The result: ISCAR makes money because it enables its customers to make more money. There is no better recipe for continued success.

Stef Wertheimer provides an account of the deal in his book and states that the $4 billion price tag was not the primary factor that led his family to pursue the deal with Berkshire.  Mr. Wertheimer was primarily concerned with “the continued Israeli production, in the Galilee, by Israeli hands and with an Israeli brain, within an advanced and competitive world.” Obviously the Wertheimer family wanted a fair deal for the product of sixty years of effort but non-economic factors clearly played an enormous role.  We are reminded of the factors that led Bill Child to sell R.C. Willey to Berkshire Hathaway a decade earlier.  History doesn’t always repeat but it often rhymes.

As we noted recently, Berkshire was a very large company in 2006 but still relatively small compared to what it has become today.  With shareholders’ equity of $91 billion at the end of 2005, Berkshire’s purchase of 80 percent of Iscar for $4 billion represented a significant allocation of capital.  It is interesting to note that approximately half of the purchase transaction was accounted for by goodwill, representing the consideration paid in excess of identifiable assets:

Iscar

The Wertheimer family retained a 20 percent interest in the business until 2013 when they exercised a put option to sell their remaining interest (pdf) to Berkshire for $2.05 billion.  Based on this purchase, the implied value of Iscar was $10.25 billion in mid 2013, up from $5 billion seven years earlier, as Mr. Buffett noted at the time:

“Since the time IMC entered our lives, my partner, Charlie Munger, and I have enjoyed Berkshire’s association with the company, the Wertheimer family, and the company’s management team,” said Warren Buffett, Berkshire Hathaway Chairman and Chief Executive Officer. “As you can surmise from the price we’re paying for the remaining interest, IMC has enjoyed very significant growth over the last seven years, and we are delighted to acquire the portion of the company that was retained by the Wertheimer family when IMC first became a member of the Berkshire group of companies. We look forward to continuing our stewardship of this unique company founded by the Wertheimer family in Israel 60 years ago and nurtured into a truly global enterprise.”

Berkshire provides limited disclosure on Iscar in its annual reports so we do not have the information required to independently analyze Iscar’s value.  However, the valuation arrived at in 2013 was clearly set in 2006 at the time of the original acquisition.  The Wertheimer family negotiated a put option with Berkshire that specified the value of their remaining stake based on some kind of formula that clearly took into account the economic value of the company.  The model of acquiring a large majority stake from a family owned business and having the family retain significant ownership has been used before (Nebraska Furniture Mart is an example that comes to mind) and can align the interests of the family with Berkshire in the years immediately following an acquisition.  Ultimately, however, Mr. Buffett is relying on the management of these formerly family owned businesses to continue coming to work far past the point where there is any economic need to work.

After the 2013 transaction, Mr. Buffett noted that arcane accounting rules required Berkshire to substantially write down the value of the initial 80 percent ownership of Iscar due to the fact that the company acquired the remaining 20 percent.  This mystifying accounting rule also caused Berkshire to write down the value of Marmon when a similar series of transactions eventually resulted in full ownership.

Berkshire has paid a total of approximately $6 billion in aggregate for full ownership of Iscar which had a valuation in excess of $10 billion in mid 2013, and part of the $6 billion (the amount was not specifically enumerated) has been written down due to accounting requirements.  We do not know whether Iscar has remitted any cash to Berkshire over the years, or the precise amount if it has.  However, based on the information we do have, it is quite clear that Berkshire’s acquisition of Iscar worked out very well.  The Wertheimer family no longer has an ownership interest in Iscar but Eitan Wertheimer continues to be involved in the business along with the management team that he assembled over the past three decades.

Given Berkshire’s current shareholders’ equity, it would take a deal almost three times the size of the initial Iscar acquisition in 2006 to have a similar impact today.  The number of family owned businesses like Iscar of a size required to “move the needle” at Berkshire is smaller today than it was in 2006.  Nevertheless, this acquisition model can still be useful for Berkshire as well as for aspiring “mini Berkshires”.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

Berkshire Hathaway in 2026

The following article originally appeared in the May 2016 issue of The Manual of Ideas which was published on April 20.

Introduction

Berkshire Hathaway Mill - New Bedford, MABerkshire Hathaway’s long history dates back to the nineteenth century but the company was effectively “founded” by Warren Buffett when he assumed control in 1965.  The story of Berkshire’s evolution from a struggling textile manufacturer to the sprawling conglomerate we know today has been well documented and will be scrutinized by students of business for decades to come.  Berkshire is also still a work in progress.  Mr. Buffett remains firmly in charge of the company at age 85 and shareholders could very well continue to benefit from his leadership well into the 2020s.

Over the past 51 years, Berkshire has compounded book value per share at a stunning annualized rate of 19.2 percent and has retained all earnings except for a ten cent per share dividend paid in 1967 and minor repurchases made in recent years.  With a market capitalization of approximately $350 billion, Berkshire is currently the fifth largest company in the United States.  Berkshire was already a very large company ten years ago.  Over the past decade, shareholders’ equity has increased from $91 billion to $256 billion which has been mostly attributable to retention of nearly all earnings.  Net income was over $24 billion in 2015, up from $8.5 billion in 2005.  From 2006 to 2015, book value per share compounded at an annualized rate of 10.1 percent while the stock price compounded at 8.4 percent due to a modest contraction in the price-to-book ratio.

As Berkshire’s capital base continues to grow, it will become increasingly difficult for Mr. Buffett or his successors to redeploy earnings at acceptable rates of return.  If Berkshire compounds book value at 10.1 percent over the next ten years, shareholders’ equity would stand at approximately $670 billion by early 2026 and market capitalization is likely to exceed $1 trillion.  How likely is such an outcome?  In his 2014 letter to shareholders, Mr. Buffett warned that “eventually – 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.”  At that point, Berkshire will have to return cash to shareholders in the form of dividends or share repurchases.

Berkshire Over the Past Decade

Before considering Berkshire’s prospects over the next decade, it is worth examining the evolution of the company over the past ten years.  How did Berkshire compound book value per share at an annualized rate of over 10 percent starting with a capital base that was already very large in 2006?

The property and casualty insurance business has been a major source of Berkshire’s growth since National Indemnity was acquired in 1967.  Through its insurance subsidiaries, Berkshire has been able to benefit from underwriting profits in addition to harvesting returns from investing policyholder “float”. Berkshire’s large holdings of marketable securities have been funded with both shareholders’ equity and policyholder float.  However, Berkshire has never restricted its non-insurance investments to marketable securities.  Starting with the acquisition of See’s Candies in 1973, Berkshire began moving into high quality non-insurance subsidiaries.   As Berkshire grew over the years, Mr. Buffett began a more significant realignment of Berkshire with an emphasis on adding a diverse stream of non-insurance profits.  This trend has accelerated over the past decade as the table below illustrates:

Berkshire EBIT 2006-2015

We can clearly see that pre-tax operating income has shifted dramatically toward non-insurance businesses.  Most obviously, Burlington Northern Santa Fe provided more pre-tax income in 2015 than the consolidated insurance business (underwriting profits and investment income).  In 2006, Berkshire was still four years away from acquiring BNSF.  Berkshire’s collection of operating businesses that are not enumerated in the table also provided more pre-tax income than the insurance group in 2015.

The chart below excludes the impact of realized investment gains, eliminations, and unallocated interest and provides another view of the shift toward non-insurance operations since 2006:Berkshire Pre-Tax Operating Income

We can see that based on this measure, the insurance group’s contribution has fallen from 57 percent of pre-tax income in 2006 to 26 percent in 2015.  The overall trend, although irregular, is quite clear.  The pie chart below illustrates Berkshire’s diverse sources of operating income for 2015.  Berkshire is often referred to as an insurance focused conglomerate.  While this characterization was arguably true in 2006, insurance plays a much less prominent role today.

Berkshire 2015 Pre-Tax Operating Income

Berkshire has added numerous non-insurance operating businesses since 2005 including PacifiCorp, Business Wire, Marmon, Burlington Northern Santa Fe, Lubrizol, NV Energy, Van Tuyl Automotive, and several others including a number of “bolt-on” acquisitions made by Berkshire subsidiaries.  Berkshire’s acquisition of Precision Castparts closed in early 2016.

How did Berkshire go about funding these acquisitions which collectively have transformed the earnings power of the company?  With the notable exception of the Burlington Northern Santa Fe acquisition, which was made partially through the issuance common stock, Berkshire has avoided diluting existing shareholders and has leveraged its free cash flow to fund acquisitions.

Over the past decade, Berkshire posted cumulative net income of $140 billion, cash flow from operations of $200 billion, and free cash flow of $113 billion, which we define as operating cash flow less capital expenditures.  Berkshire invested $62 billion in businesses acquisitions over this period.  In addition, the company allocated $35 billion toward net purchases of equity securities and $34 billion toward the purchase of other investments including financial crisis-era investments in Goldman Sachs and General Electric, as well as more recent investments in Bank of America, Restaurant Brands International, and the Kraft Heinz Company.

It is clear that Berkshire has grown over the past decade primarily through the successful acquisition of several non-insurance subsidiaries utilizing strong cash flow.  These non-insurance subsidiaries will continue to generate significant free cash flow over the next ten years.  It is very likely that the insurance subsidiaries will remain major contributors as well through generation of underwriting profits and investment income.  Insurance results are likely to be quite volatile but, barring a major insurance acquisition, will represent a much less important part of Berkshire ten years from now.

The Next Decade

Berkshire Hathaway has a “high class” problem:  The powerful cash generation capability of the company tends to snowball which makes the task of deploying cash flow more difficult over time.  Berkshire had over $61 billion of cash equivalents at the end of 2015, excluding cash held in the railroad, utility, and financial products groups.  Operating cash flow has averaged over $30 billion during the past three years.  Berkshire can deploy cash in any of the following ways:

  1. Cash can be reinvested within the same operating company in which it is generated.
  2. Cash can be reallocated between operating companies.
  3. New partially or wholly-owned subsidiaries can be acquired (insurance or non-insurance).
  4. Marketable securities can be purchased.
  5. Cash can be returned to shareholders via dividends, repurchases, or both.

If none of the options listed above are taken, cash will continue to build up on the balance sheet over time.  Historically, shareholders have been content to see Berkshire’s cash balance build up since this has provided Mr. Buffett with “ammunition” to opportunistically deploy when the right opportunity presents itself.  Cash flow generated in a given year need not be deployed within the same year but could instead collect on the balance sheet awaiting the emergence of a huge “elephant” sized acquisition that will consume the free cash flow generated over multiple years.  However, until an attractive “elephant” emerges, large amounts of cash on the balance sheet will dampen Berkshire’s overall return on equity and depress the growth of book value per share.

The exhibit below gives a sense of the scale of Berkshire’s “high class problem”.  We can see that retained earnings have ballooned over time.  Berkshire’s retained earnings account stood at $47.7 billion at the end of 2005 and grew to $187.7 billion at the end of 2015.  Another way of looking at this statistic is to note that nearly 75 percent of all earnings Berkshire has retained throughout its long history have come from earnings over the past decade and over 47 percent have been earned over just the past five years.

Berkshire's Shareholders' Equity 1994-2015

The implications of Berkshire continuing to retain all earnings over the next decade while growing book value per share at a compound rate of approximately 10 percent are staggering.  If we take Berkshire’s 2015 net earnings of $24 billion as a baseline, reinvestment of all earnings would need to result in enough incremental earnings power to generate approximately $62 billion of net income for Berkshire by 2025.  We would expect retained earnings to increase by about $420 billion over the next decade.  Berkshire’s shareholders’ equity would approximate $675 billion by the end of 2025 based on these assumptions.  With this kind of track record, the market would most likely value Berkshire in excess of $1 trillion.

Is it possible for Berkshire to redeploy over $400 billion within its existing businesses, through acquisitions, or toward marketable securities over the next decade?  Even allowing for the fact that the assumptions made here are necessarily imprecise, it is clear that the capital allocation task at hand over the next ten years will be far more difficult than it has been over the past decade.  Very few publicly traded companies are large enough for Berkshire to purchase a meaningful stake in the stock market.  While there are many companies in the $5-20 billion range that Berkshire states is its preferred acquisition target size, it is likely that much larger acquisitions will be necessary to fully allocate Berkshire’s cash flow in the future.

There is no doubt that Berkshire could deploy over $400 billion over the next decade.  There are always deals to be done, at a sufficiently high price.  However, elevated valuations in public and private markets would make it difficult for Berkshire to acquire businesses that offer incremental returns that will make it possible for Berkshire itself to compound book value at 10 percent going forward.  Opportunistic investments could be made during periods of stress in the financial markets, but perhaps not at a size necessary to absorb all of Berkshire’s available cash.

Conclusion

Berkshire’s management will eventually fail to find enough attractive investment opportunities to intelligently deploy all of the company’s free cash flow.  It is obvious that Berkshire will look like a radically different company in 2026 if it is able to find enough reinvestment opportunities to continue compounding book value at approximately 10 percent annually.  Berkshire would have shareholders equity approaching $700 billion and a market capitalization very likely to exceed $1 trillion.  The composition of Berkshire at that point would look nothing like the company we observe today and even less like the Berkshire of ten years ago.

Achieving this outcome would be a remarkable management accomplishment.  Given Mr. Buffett’s history, if he is able to continue running Berkshire for a majority of the next decade, it would be unwise to rule out this rosy outcome.    However, it seems more likely that Berkshire will begin returning cash to shareholders at some point within the next decade even with Mr. Buffett in charge.  If private and public markets for businesses remain elevated, the probability of cash return over the next several years will be very high.  If valuations plummet, cash return is less likely although still possible.

Mr. Buffett has indicated that Berkshire’s board of directors will consider repurchases as a means of returning cash to shareholders.  Repurchases, if made at levels at or below intrinsic value, can be more efficient than dividends because only shareholders who are voluntarily departing will face tax consequences.  If repurchases cannot be made at prices that make sense, cash dividends will have to be initiated and all shareholders would face the tax consequences.

Berkshire’s current repurchase limit of 120 percent of book value would have to be increased substantially in order to make repurchases of any significant size possible.  Since 120 percent of book value is far below any reasonable assessment of Berkshire’s intrinsic value, it follows that Mr. Buffett and the board of directors would have to agree to increase the repurchase limit in order to return material amounts of cash to shareholders.

Up to this point, the goal of repurchases has been to increase the per-share intrinsic value for continuing shareholders so a low limit makes sense.  Berkshire has not been in a position where it had to return capital to shareholders.  Bargain repurchases will always make sense but when Berkshire has no choice but to return capital, it will have to decide between dividends and repurchases.  At that point, even repurchases at intrinsic value would serve continuing shareholders well because it would spare them from undesirable tax consequences.  Whether an increase in the repurchase limit is something under consideration is perhaps one of the most important questions facing Berkshire shareholders today and a topic worthy of discussion at the upcoming annual meeting.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.