“Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.”
— Warren Buffett, 2018 Annual Letter to Shareholders
Berkshire Hathaway has long been known for its culture of financial conservatism. Warren Buffett and Charlie Munger have, for decades, repeated the mantra of positioning Berkshire to always remain a financial fortress through all economic environments. Although some investors may consider a large cash position to be “trash” in light of microscopic returns on cash equivalents such as treasury bills, Buffett and Munger consider cash to be an indispensable ingredient in the recipe that built Berkshire Hathaway. While the cash has always primarily been there to ensure the safety of the corporation, many have also regarded cash to be “ammunition” available for Buffett and Munger to deploy opportunistically at times of stress when few others have the ability to deploy capital. As of December 31, 2019, Berkshire held $125 billion of cash equivalents.1
As Buffett likes to say, you can only tell who has been swimming naked when the tide goes out. Applied in a financial context, it is possible for businesses to operate in an unwise leveraged manner when times are good, credit is easy, and headlines about the death of the business cycle are appearing in respected newspapers. During such times, holding excess cash earning tiny returns is a lag on financial results. Doing nearly anything with excess cash, whether in the form of an acquisition or returning capital to shareholders, will boost return on equity in the short run.
During the nearly uninterrupted decade-long bull market that followed the financial crisis of 2008-09, Berkshire built up a formidable cash hoard while less far sighted managers decided to go skinny dipping in the ocean in the misguided belief that the tide would never go out and leave them exposed. Far from maintaining excess cash, many companies took on cheap debt for acquisitions or to finance a return of capital to shareholders leaving balance sheets in a leveraged state. For a while, actually for a long while, this type of approach worked wonders. Those who pursued leveraged strategies saw their stock prices rise and their equity-linked compensation enhanced. Holding excess cash was punished since, after all, the business cycle might be dead and the cash represented nothing but an anchor holding down return on equity.
It is unlikely that the business cycle will ever die, regardless of how stable a given period of history might seem to those living through it. The end of the long expansion of the 2010s came abruptly with the arrival of the coronavirus pandemic in early 2020. Much like when the tide goes out before an enormous tsunami comes ashore, executives found themselves exposed on an expanded beach with the surf well out in the distance. Suddenly, all of that leverage and risk taking appeared obviously unsustainable. Within weeks, many large businesses were in financial distress.
Berkshire Hathaway is in no way immune from the effects of the coronavirus pandemic. It is too broadly involved in the United States economy to escape unscathed. However, the presence of $125 billion of cash on the balance sheet at the end of 2019 makes it obvious that nothing that the virus can throw at the company will remotely threaten its solvency. Buffett’s fortress will not be exposed to the indignity of going to the government begging for bailouts.
However, the question that remains is whether the cash will position Berkshire to benefit from the current environment by making opportunistic investments. This has long been the hope of Buffett himself and many shareholders who have accepted the inherent lag of a large cash position in exchange for the optionality that it would provide when the tide goes out on everyone else.
Buffett’s fortress is like a lighthouse high above the ocean looking down on the naked executives exposed by the receding tide and looking for a lifeline. That’s a wonderful image for shareholders to hold in their thoughts but is it correct? Is the $125 billion of cash truly available for deployment at this time or has the economic situation deteriorated to the point where Berkshire’s risk aversion requires a large portion of these funds to be held in reserve?
To answer these questions, one must take a look at the history of Berkshire’s cash position and put it into the context of other investments held by the company. Then the resources on the asset side of the balance sheet must be weighed against the insurance claims on the liability side of the balance sheet.
Cash and Investments
Unlike most insurance companies which tend to invest in fixed income securities designed to match the duration of their expected insurance liabilities, Berkshire does not attempt to duration match and pursues policies that are much more flexible. Berkshire Hathaway has maintained a large portfolio of cash and equity securities for decades. In recent years, cash and equities have increased in importance while fixed income has shrunk both in absolute and percentage terms.
In terms of size, the portfolio has grown from $122 billion at the end of 2008 to $409 billion twelve years later at the end of 2019. Berkshire has added over $100 billion of cash, increasing the cash position from 20 to 31 percent of the portfolio. Fixed income declined from 22 percent of the portfolio at the end of 2008 to under 5 percent at the end of 2019. Allocation to equities rose from 40 to 61 percent of the overall portfolio. The exhibit below shows the evolution of Berkshire’s cash and investments over the past twelve years:
Of course, Berkshire’s large equity portfolio has declined in value significantly since the end of 2019 due to the decline in stocks so far this year, but the overall trend that has prevailed in recent years is quite clear.2 Warren Buffett has clearly preferred to invest in equity securities compared to the paltry yields offered for fixed income investments, and he has allowed cash to build up on the balance sheet despite minuscule yields on cash.
In his 2018 annual letter to shareholders, Buffett made a number of comments regarding how he thinks about the cash on Berkshire’s balance sheet, and it is worth quoting from that letter at some length:
“In our fourth grove, Berkshire held $112 billion at yearend in U.S. Treasury bills and other cash equivalents, and another $20 billion in miscellaneous fixed-income instruments. We consider a portion of that stash to be untouchable, having pledged to always hold at least $20 billion in cash equivalents to guard against external calamities. We have also promised to avoid any activities that could threaten our maintaining that buffer.
Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.
In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.
That disappointing reality means that 2019 will likely see us again expanding our holdings of marketable equities. We continue, nevertheless, to hope for an elephant-sized acquisition. Even at our ages of 88 and 95 – I’m the young one – that prospect is what causes my heart and Charlie’s to beat faster. (Just writing about the possibility of a huge purchase has caused my pulse rate to soar.)”
Warren Buffett’s 2018 annual letter to shareholders
These comments will sound familiar to anyone who has followed Berkshire for a long time because Buffett has repeated the same wish to deploy excess liquidity into acquisitions multiple times. However, the environment of the 2010s rarely afforded him the opportunity to acquire businesses in full at attractive prices so he instead increased Berkshire’s holdings of marketable equity securities. This accounts for the massive rise in the equity portfolio over the years, both in absolute terms and as a percentage of invested assets.
It is also worth pointing out Buffett’s reference to holding a minimum of $20 billion in cash equivalents in case of “external calamities”, a pledge that he has made repeatedly and one that is again included in the 2019 annual report. We will return to the question of the $20 billion minimum cash level later in this article.
Insurance Liabilities
One cannot properly evaluate Berkshire’s investment portfolio without understanding that the company has significant insurance liabilities. The business of any insurance company is to take in premiums from customers in exchange for covering losses in the future. Depending on the line of insurance in question, claims can arise soon after the payment of premiums or not for years or decades. For example, Berkshire’s GEICO unit insures automobiles and coverage is “short-tail” in nature, meaning that almost all claims are paid within a few months of an insured loss. In contrast, Berkshire’s reinsurance group often writes coverage for risks that might not result in payouts for many years or even decades.
Insurance companies attempt to make money on their underwriting but often fail to do so. An underwriting profit occurs if the premiums that are collected end up exceeding the losses that are incurred. However, even if an insurance company fails to make money on underwriting, they can achieve overall profitability by investing the “float” they hold between the time premiums are collected and payments on claims are made. The following exhibit, from the 2019 annual letter to shareholders, shows the growth of Berkshire’s float over the years:
One of the main engines behind Berkshire’s growth over the years has been its massive growth of float coupled with management’s ability to achieve underwriting profits. Over the past seventeen years, Berkshire has achieved underwriting profitability in sixteen years and has earned a cumulative total of $27.5 billion of underwriting profits.3 In addition to earning underwriting profits, the float has been available for Berkshire to invest in order to earn additional returns.
How long can Berkshire rely on having this float available for investment? According to Warren Buffett, any decline in float should be very gradual:
“We may in time experience a decline in float. If so, the decline will be very gradual – at the outside no more than 3% in any year. The nature of our insurance contracts is such that we can never be subject to immediate or near- term demands for sums that are of significance to our cash resources. That structure is by design and is a key component in the unequaled financial strength of our insurance companies. That strength will never be compromised.”
Source: 2019 annual letter to shareholders
In theory, and so far in practice, the stability and quasi-permanence of the float has allowed Berkshire to invest opportunistically and venture beyond the fixed income investments that most insurers restrict themselves to. It is useful to compare Berkshire’s total float to its investment portfolio to get a sense of the scale of both. The following exhibit shows Berkshire’s cash and fixed income investments and compares the total to insurance float (click on the image for a larger view):
What’s interesting about this data set is that Berkshire seems to maintain cash plus fixed income securities at a level that roughly approximates float. While cash and fixed income were roughly balanced in 2010, Buffett has obviously favored cash in recent years while fixed income declined both in absolute terms and as a percentage of the portfolio.
Deployable Cash
How should shareholders think about how much of Berkshire’s $125 billion of cash is truly deployable today? Is Buffett holding this cash in order to provide himself with optionality to make a major acquisition or simply as a substitute for fixed income investments that he would make if interest rates were not at rock bottom levels?
The answer to this question is important in terms of thinking about Berkshire’s overall valuation. If one views the $125 billion of cash as a fixed income substitute rather than as a pool of funds that could provide Buffett with optionality, then such cash is not really available to deploy during times of financial market stress and opportunities, such as the period we are currently in. However, if one views the $125 billion as ammunition for Buffett to make wise investments, then we have a reasonable chance of significant incremental value creation.
The fact that Buffett wants to deploy the cash is obvious from his annual letters, including the excerpts cited above. It is quite obvious that he does not regard the cash as “off limits” or destined for fixed income investments if and when interest rates finally normalize. Taking him at his word, the cash is available for deployment, subject to his minimum $20 billion reserve.
Is this a prudent course for Berkshire? Has Buffett’s view of the minimum level of cash increased in light of the Coronavirus pandemic? Jason Zweig’s recent article covering his interview of Charlie Munger suggests that Berkshire’s level of risk aversion could have increased in response to the pandemic. Munger is not at all afraid of saying he doesn’t know how the current economic situation will turn out and says that Buffett’s phone has not been “ringing off the hook”.
Could the minimum have increased from $20 billion to $40 billion?
It is certainly possible, but that leaves Buffett with $80 billion of cash still available for deployment. It is quite unlikely that risk aversion has suddenly increased to the point where the entire cash balance is deemed untouchable. Given that Berkshire’s float is unlikely to decline much in any given year, there would be no reason to suddenly maintain more cash in anticipation of imminent loss payouts.
Could Buffett and Munger have increased the minimum cash level even further anticipating negative cash flow in the operating subsidiaries?
This is also possible due to the unprecedented nature of the current pandemic shutdowns and uncertainty regarding when business conditions will return to some level of normalcy. However, again, it is not plausible to think that Berkshire would suddenly have to reserve many tens of billions of dollars for this purpose. Even if one supposes that the minimum to be held against insurance losses has risen from $20 to $40 billion and an additional $20 billion will be held in reserve due to economic uncertainty, that would still leave $65 billion available for deployment.
Conclusion
Taking Warren Buffett at his word, his clear intent at the time the 2019 annual letter was released in February was to find opportunities to deploy Berkshire’s large cash hoard. Much has obviously changed over the past two months and it will be interesting to see what he has to say at the annual meeting on May 2.
The lack of any deals during the pandemic so far could have more to do with the rescue packages passed by Congress and the Federal Reserve’s actions to provide liquidity to the overall system and to specific companies and industries that are in severe financial distress. Berkshire might be a fortress far above the beach with a lighthouse offering refuge to companies caught swimming naked, but executives who are bombarded with easy cash being dropped on the boardwalk by the government have fewer reasons to call Warren Buffett.
We are still in the midst of the most severe economic downturn since the Great Depression and Buffett could still find attractive opportunities that offer a reasonable margin of safety and prospects for attractive returns. This type of environment would normally present numerous opportunities, but we cannot ignore the fact that the pandemic itself and the government’s response are both unprecedented. If Charlie Munger, in his recent interview, was willing to repeat “I don’t know” numerous times with respect to the current situation, we should not fool ourselves into thinking we can predict what Buffett will do with Berkshire’s $125 billion of cash.
Disclosure: Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.
- Throughout this article, I have excluded cash held within the railroad and utility subsidiaries which totaled $3 billion as of December 31, 2019. All references to cash is inclusive of Berkshire’s holding of United States treasury bills. [↩]
- For an estimate of Berkshire’s equity portfolio decline as of March 22, 2020, see Berkshire Hathaway and the Coronavirus Crash [↩]
- See Warren Buffett’s 2019 annual letter to shareholders and the company’s annual reports. [↩]