The following article originally appeared in the May 2016 issue of The Manual of Ideas which was published on April 20.
Berkshire 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:
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:
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 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:
- Cash can be reinvested within the same operating company in which it is generated.
- Cash can be reallocated between operating companies.
- New partially or wholly-owned subsidiaries can be acquired (insurance or non-insurance).
- Marketable securities can be purchased.
- 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.
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.
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.