Tuesday, February 17, 2015

What would happen to Berkshire Hathaway after Warren Buffett is gone?

Warren Buffett is the super investor who is the hero of ordinary people and investors alike. While he has always been a ruthless businessman, he has also made plenty of people rich, has kept a very clean image of a successful yet folksy billionaire, and is liked and praised by many of his generous donations. Anyone who put $20/share in Berkshire Hathaway stock in the 1960s is now sitting on shares worth north of $200,000/each. We all know the story of Buffett however, and many are familiar with the way he turned around the ailing textile mill Berkshire Hathaway into a diversified conglomerate with interests in insurance, railroads, candy, utilities to name a few sectors. His company also holds a pretty impressive stock portfolio worth tens of billions of dollars. Now that Warren Buffett is about to turn 85 in August, many investors are asking themselves what would happen to Berkshire Hathaway after he is no longer in charge?

The answer of course lies in the way that Berkshire Hathaway was formed in the first place. Berkshire Hathaway was not formed in one single day. Rather, it was built brick by brick, over the course of 50 years. The basic idea has been to invest the excess cash from existing businesses and the float from insurance operations into more businesses, which generated even more cash to be invested. Buffett does not manage each one of those businesses. Instead, he has delegated those day to day management duties to the point of abdication. That doesn’t mean he doesn’t monitor the performance of those businesses. However, he has let the executives from each company under Berkshire’s umbrella to manage the operations in their own way. The only stipulation has been to send excess cash flows back to Omaha for Buffett to allocate. This similarity to what dividend investors do on a regular basis has led me to believe that Warren Buffett is essentially a dividend investor.

This is of course where the genius of Warren Buffett comes – he is trying to allocate that excess capital by purchasing more businesses or shares, and earn a high rate of return. Over the past 60 – 70 years, Buffett has proved his business and investing acumen in allocation of capital in a variety of assets and asset classes such as businesses, stocks in those businesses, and a range of derivatives, currencies, real estate to name a few. The reason for his success is his innate desire to keep learning, and keep a level head on what is actually happening in the world. Unfortunately, this is the one aspect that will be forever gone once Buffett steps down.

If he is no longer in charge of Berkshire, the underlying group of businesses will keep churning out record profits over time, since they are managed by experienced managers. The one drawback will be that capital will no longer be allocated by Buffett himself. As a result, it is very much possible that the future success of Berkshire will not be as good as the past. However, I believe that Buffett has certainly thought about putting systems and procedures in place, in order to address the capital allocation problem. He seems to be grooming Todd Combs and Ted Weschler to take on the role of managing billions of dollars of excess capital. Those two fellows have done very well managing money in the past. Chances are that over long periods of time, they will do well, even with short-term bumps on the road. Buffett’s other responsibilities will likely be split to one or two other persons.

I think that in the future, Berkshire will have to make more sizeable acquisitions, in order to deploy those growing cash piles to work for shareholders. The risk of course is that whoever is in charge, could do something stupid like engage in empire building. Of course, we all know that you cannot simply buy an ever bigger and bigger business every year, since those things take time to accomplish, you need agreement from others, and regulators would have to provide more input in order to prevent a monopoly forming in a certain industry. Plus, a company with $300+ billion in market capitalization has a big disadvantage in terms of size. There are only a few publicly traded companies in the world which are larger than Berkshire. Therefore, at some point in the next decade, it would be very difficult to grow even by acquisitions, since returns would be pulled down by forces of gravity. The important thing of course is that acquisitions never work out as expected, and thus one has to be very careful what they get themselves into. There are only so many good quality businesses in the world, and throwing hundreds of billions at the problem might create some nasty behavior that shareholders could pay for.

Excess cashflows could also be plowed into international acquisitions. Berkshire only has a few international businesses, which is obviously an opportunity for them. If they get more popular internationally, then it is highly likely that business owners who are thinking of disposing of their businesses, could consider selling to Berkshire only.

I think that excess cash could easily be taken out of Berkshire Hathaway by declaring a dividend to shareholders. If you no longer have a super investor handling the capital allocations, it might be wise to send the cash directly to shareholders. Given the depth of operations, I would consider that Berkshire Hathaway will be able to pay and grow its dividend for years into the future. I would not be surprised if Berkshire Hathaway eventually becomes a dividend achiever and even… a dividend champion one day. If General Electric (GE) could do it, or 3M (MMM) could do it, then so can Berkshire.

Even after paying a dividend, there will likely be more cashflow that is left to build up in corporate coffers. I think that Berkshire can use that cash to fund stock buybacks during the next stock market panic. Those usually happen once every 5 years or so, and are tough to predict.

Either way, the major competitive advantage of Berkshire Hathaway will be its massive size of operations. It could be the lender or investor of last resort to other businesses, particularly in times of trouble in the economy. This is due to the diverse streams of income coming from all businesses under the Berkshire Hathaway umbrella. Plus, keeping at least $20 billion in cash at all times will ensure the stability of the organization during the next recession or crisis.

The other option behind Berkshire is that the operation becomes so gargantuan in the one or two decades after Buffett is no longer in charge, that the company is split into pieces. While Buffett and Munger have always said that Berkshire will stay intact, I am not so certain about it. I believe the seeds of a potential break-up of Berkshire Hathaway are planted in the separation of different businesses under different industries under the Berkshire Hathaway corporate umbrella. At some point, it might be more efficient to spin-off the Utility, Railroad, Manufacturing, Retail, Finance & Insurance into separate entities. A company that gets to be too large can become a bureaucracy, become slow to move, and might not allocate capital at best rates for shareholders. While size can be very helpful to weather cyclical storms in the economy, it could also mean that prioritizing investment might be very difficult when you have so many businesses and so many industries. Therefore, it might be better off to split into multiple separate companies, in order to focus effort in a more efficient way.

Of course, we will hear what Buffett and Munger have to say about the next 50 years of Berkshire Hathaway in the next letter to shareholders. I find this topic of interest, mostly because I think about succession planning for my own affairs. My goal is to organize my portfolio in a way that even a few decades after I go to hell, it will still generate a growing stream of dividend income to heirs or charities. In order to ensure that, I need to focus on businesses that are built to last, and therefore I could see doing what they are doing now with minimal changes to their operations and profitability. It is therefore of utmost importance to select only those businesses which are of very good quality, and which I believe will be able to compound earnings, dividends and wealth in the foreseeable future. The most important thing is to buy and hold those quality dividend stocks for the long run, and strive for a holding period of "forever".

Full Disclosure: I own 1 share of BRK.B

Relevant Articles:

Buy and hold dividend investing is not dead
Warren Buffett Investing Resource Page
Myths about Warren Buffett
How Warren Buffett built his fortune
Warren Buffett’s Dividend Stock Strategy

13 comments:

  1. Hello

    Berkshire is a bright star in terms of performance and inspiration for value investors. I guess, what Buffett builds over decades is not repeatable with the same company for the next 50 years. So a breakdown in single companies, with the chance to grow individually faster, might be an option. But up to now I think Berkshire shows a good growth in inner value, so this might not be a discussion for the next 10 years.

    Kind regards

    Marco

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    Replies
    1. Well, it is also quite possible that WB lives for another decade or more. What if he radically changes his diet, stops drinking Coke, starts eating organic Kale, and buys Whole Foods?

      Delete
  2. Dividend Growth Investor,
    I really enjoy your articles and have a "simple" question for you. Why do you own only one share of BRK.B? Warren Buffett is a classoc dividend growth investor, and in many ways you will be achieving some immediate diversification by holding a position in BRK.B. I understand owning one share in order to get his annual shareholder letters/ reports, bu why not buy a position in the company.

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    Replies
    1. DFG,

      Thanks for answering for me ;-)

      WG III - that's a tough question. I think DFG answered what I would have said. If BRK.A/B starts paying a dividend, and growing it,I will consider buying more. At such a high market cap however, the opportunities for total returns will be limited. The possibility of a major screw-up like in AIG are possible as well.

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  3. Excellent article DGI. I especially like "This similarity to what dividend investors do on a regular basis has led me to believe that Warren Buffett is essentially a dividend investor." Long BRK-B... :-) Regards, Rog

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    1. Most of the businesses he has purchased for Berkshire have tended to send excess money back to him to re-allocate. He is great at purchasing businesses and stocks - this is why Berkshire Hathaway has been such an amazing investment. As individual investors, we want to be sent that excess cash as well - if a company needs all cashflow then they better be in the start-up phase. Otherwise, a mature company should be generating and sending gobs of cash to shareholders.

      The other insurance companies have not done as well as BRK. So without WB, chances are that we need to see a dividend.

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  4. I'm looking forward to reading this year shareholder letter. I don't think BRK will change much after Buffett and Munger. It's too decentralized. Given BRK's size, they probably won't be able to compound capital at previous returns though.

    ReplyDelete
    Replies
    1. I am also looking forward to the letter. Unfortunately, I have not seen anything posted "early" on Fortune, like we saw last year. While BRK operations will be unchanged, all that excess cashflow building up in BRK coffers could be a risk in the wrong hands.

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  5. DGI,
    First, I hope you don't go to hell. :)

    Second, I personally think that a dividend is long overdue. BRK is way too big to grow in an efficient way, so paying cash to the owners makes a whole lot of sense.

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    Replies
    1. Ha, you can never be sure. Just wait till my article from tomorrow.

      As for going where I think I am going... I recently read this story:

      "Ben Graham told a story 40 years ago that illustrates why investment professionals behave as they do: An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. “You’re qualified for residence”, said St. Peter, “but, as you can see, the compound reserved for oil men is packed.

      There’s no way to squeeze you in.” After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, “Oil discovered in hell.” Immediately the gate to the compound opened and all of the oil men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. “No,” he said, “I think I’ll go along with the rest of the boys. There might be some truth to that rumor after all.”

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  6. It would be too sad to see them gone but there always be someone who will manage better than WB. Although I still think WB is the one out of billions.

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