THE FUTURE OF BERKSHIRE HATHAWAY WITHOUT WARREN E. BUFFETT
Berkshire Hathaway remains our firm’s largest holding and, while we have discussed the company in the past, several clients have asked the question, "What is the future of Berkshire Hathaway should Mr. Buffett no longer be the CEO for a variety of reasons?" In response, we would like to share our thoughts on this unique enterprise and the irreplaceable and extraordinary Warren Buffett (Trades, Portfolio) who created and continues to guide the firm.
As many of our clients may know, I have followed Mr. Buffett and Berkshire Hathaway for over four decades, though with more insight over the past three decades. It has been an enormous privilege and pleasure watching him and Berkshire Hathaway evolve and grow in so many ways through the years. Today, Berkshire Hathaway represents the largest holding in our client portfolios, and we have never sold a share. As such a large holder on behalf of our clients, I have tried to think deeply about Berkshire Hathaway both in its current structure, but even more importantly, to when Mr. Buffett is no longer the CEO, for whatever reason. I have tried to summarize some of my key thoughts below without going into great detail, as to some of my concerns regarding Berkshire Hathaway without Mr. Buffett. Despite these concerns which I discuss, I strongly believe Berkshire Hathaway is well positioned overall for a future without him.
While I hope Mr. Buffett finds the Methuselah gene, which he has often referred to as it would provide him another 885.5 years to live, and, if I find it, I will split the years with him equally extending each of our lives for 484.5 years. Based upon actuarial tables he will likely live into his early to mid-90’s. I certainly hope it is even longer. I also believe a greater risk to Berkshire Hathaway than Mr. Buffett’s absence, would be a deterioration of his capabilities, rather than his passing. However, he has given the Board approval to "take away the keys" if he begins to lose his mental sharpness.
In Mr. Buffett there is embedded a broad and deep multi-dimensional set of skills that are simply not found in any other single individual. As the founder, builder and controlling shareholder of Berkshire Hathaway, his values and vision have been deeply integrated throughout the organization. Furthermore, his unique, set of multi-dimensional skills, along with his history with the firm, provide him with an unparalleled capability to evaluate and assess the many subsidiaries, management teams and acquisitions. There are some deals, from the purchase of entire companies, as well as one-off deals such as during the financial crisis, that come to Berkshire Hathaway exclusively because of Mr. Buffett’s integrity, track record, reputation and so on, that will be irreplaceable.
Berkshire Hathaway remains an extraordinary company, with a Rock of Gibraltar balance sheet, a collection of many world class businesses, stable and growing cash flows from diverse sources, and an outstanding team of managers leading many of its businesses. However, when Mr. Buffett (who is irreplaceable) is no longer the CEO, what will that mean for the future of Berkshire Hathaway?
In assessing the future, I have tried to consider the historical evolution of both Mr. Buffett and Berkshire Hathaway to gain some insights as to how best to prepare for that future without him. In Ralph Waldo Emerson’s words,
"Every institution is the lengthened shadow of one man." No organization better exemplifies that quote than Berkshire Hathaway. However, Mr. Buffett has done an outstanding job, fundamentally transforming the company over the years so that today the company is far less dependent upon him than ever before in preparation for when he is gone.
There are four areas of focus in my thoughts: corporate governance, leadership, operating structure, and valuation, each of which I will address.
Under Mr. Buffett’s leadership, corporate governance has been exemplary on every count as measured by evaluating the following four areas:
1. Rights and equitable treatment of shareholders and all stakeholders;
2. Role and responsibilities of the Board of Directors;
3. Integrity and ethical behavior;
4. Disclosure and transparency.
Given Mr. Buffett’s demonstrated track record of excellence in each of these areas, Berkshire Hathaway’s corporate governance, while non-traditional, has been relatively unchanged. Given BRK’s current corporate governance, it will be more difficult to prevent changes in the future under new leadership due to government regulators and external forces that will not be as forgiving as they have been under Mr. Buffett. For example, Berkshire Hathaway’s disclosure and transparency based upon the firm’s SEC filings, and annual reports actually offer very little information relative to the enormity of the organization.
Mr. Buffett has often indicated that his role will be broken into two separate functions: a CEO (management) and a CIO (investment). The Chief Investment Officer team will include Todd Combs and Ted Weschler, both recruited over the past few years. Todd and Ted have demonstrated outstanding investment skills combined with the personal characteristics that Berkshire Hathaway seeks. Tracy Britt Cool joined the firm a few years ago and has helped oversee several of the smaller companies in the Berkshire family. I believe that the investment segment should consist of both an investment team (Ted, Todd, perhaps a 3rd investor) and an operating team (Tracy Britt Cool and another individual) that work closely together but have distinct roles as required by Berkshire Hathaway. The investment team would focus on investing Berkshire Hathaway’s prodigious cash flows into equities, debt securities, the purchase of entire companies, both public and private, and assisting the subsidiaries in making bolt-on acquisitions. The operating team will be more internally focused on working closely with the top management teams of many subsidiaries. The investment and operating teams will work collaboratively to enhance the collective knowledge and improve Berkshire Hathaway’s investment and operating performance. Furthermore, working together they may find new ways to enhance Berkshire Hathaway’s future cash flows and management depth. Having both a talented investment team (externally focused) and operating team (internally focused) with some overlap will provide Berkshire Hathaway with a fuller complement of skills to better serve the company in various ways.
The new leadership of Berkshire Hathaway and the many operating companies will present challenges going forward that cannot be understated. The new CEO will simply not have the historical background, extraordinary set of skills, and broad freedom that Mr. Buffett has appropriately gained from a multitude of experiences and constituencies over the years. However, with the collective synergies of a very talented group of leaders working together, Berkshire Hathaway can be expected to prosper and grow.
The operating structure of Berkshire Hathaway should be more formalized, while maintaining the unique corporate culture, decentralized operating subsidiaries and centralized corporate resources and cash allocation (above defined levels).
Finally, Berkshire Hathaway’s valuation remains below its intrinsic value as measured in a variety of different ways: float based model, two column approach, multiple of book value, or combinations of these valuation methods. On September 26, 2011 Mr. Buffett instituted the first repurchase program in the company’s history to buy back stock when it trades for a 10% or lower premium to stated book value. On December 12, 2012 this price limit was increased to 1.2x book value and the company repurchased $1.2 billion of stock in one transaction. This has effectively placed a floor on Berkshire Hathaway’s stock price which we believe remains far below intrinsic value. While I have mentioned several approaches above, my preferred approach would be to value the float and then value each individual company within the Berkshire Hathaway family based on their individual financials, and the qualitative characteristics of each to determine their likely value to a rational private buyer. The result would be a much higher price for Berkshire Hathaway than the current price or any of the values generated from the earlier methods discussed above or in the example illustrated below.
A sum of the parts valuation done by Keefe, Bruyette & Woods which utilizes a valuation for the float and combines it with a valuation for the various operating companies using price earnings multiples follows.
With regard to Berkshire Hathaway’s valuation, we believe the company is clearly worth significantly more than its 1.3x stated book value or the valuation above. Both understate the value of many of Berkshire’s outstanding businesses as they are lumped together in segments. Furthermore, should acquiring companies be either strategic or private equity, the valuations could be much higher given cost cutting and other synergies that could be achieved leading to higher individual company valuations. Accordingly, we believe that Berkshire Hathaway’s valuation is significantly greater than the current stock price.
Let’s assume that Mr. Buffett is no longer the CEO. Several changes will be made over the ensuing year or so, with some immediately and others taking longer, but which will inevitably take place.
First, a new CEO will be appointed. I believe that will be Ajit Jain with two backup candidates. Second, the Board of Directors will be reconfigured over time. Third, several of the CEO’s of subsidiaries will retire. Fourth, new CEO’s and leaders will need to be chosen to replace the departing CEO’s. Fifth, a dividend will most likely be instituted to reduce the need to invest the prodigious cash flow coming into headquarters. Sixth, while historically, divisions were managed to generate excess free cash flow to send back to Omaha, going forward some of that free cash flow will be redirected toward building the enterprise via bolt-on acquisitions and internal growth. Seventh, the stock price will probably decline 10-20% or more, which, in my view, will present an extraordinary buying opportunity.
The new CEO will be managing more with a dividend focus and improving operations internally within Berkshire while also focused upon buying entire companies along with Todd and Ted. Mr. Buffett often states that his job is to allocate capital and determine the compensation of the top management teams at the subsidiary level. I believe the new CEO will also do both but in a more collaborative way with Todd, Ted and even other executives.
Structurally, while currently many of the CEO’s report directly to Mr. Buffett, the new CEO will need a more formalized structure to facilitate his (her?) ability to lead Berkshire. The large subsidiaries such as BNSF, Iscar, Lubrizol, Marmon, Mid-American and Geico will continue to report directly to the new CEO. I have outlined a structure at the end of this letter as to how this might appear. The remaining companies need to be segregated and placed under a separate group president. Segregated areas might be housing related companies, manufacturing and service firms, and retail operations, to name three. Some of this is already being implemented by Tracy Britt Cool, but going forward I believe this would help the new CEO in dealing with the managers that oversee many of those businesses, rather than as with the current structure where they all report to Mr. Buffett. The role of each group president will be having several subsidiaries reporting to them, creating very little bureaucracy, yet still providing the subsidiaries with a thoughtful executive from the outside to bounce ideas off of and to enhance their leadership. Each group president would have several of the 60 operating subsidiaries reporting to them and they will in turn report to the new Berkshire Hathaway CEO. This will enable Ajit, or whomever, to remain focused on the insurance operations, by simplifying his responsibilities with a minimal number of direct reports-the fewer the better.
My biggest concern relates to the new generation of operating subsidiary management teams and keeping them in place. Many of the original managers that sold their companies to Berkshire Hathaway were in unique positions, very different from those the next generation of leaders will face. These original managers sold their firms to Berkshire Hathaway for many reasons: avoid going public, avoid private equity which would need a liquidity event in the years ahead (going public or sale), liquefying their wealth from the firm for cash to diversify and for estate tax planning purposes, maintaining autonomy, finding a permanent home, and being "knighted" by Mr. Buffett an enormous honor. These original managers love Mr. Buffett for these as well as other reasons. However, the new generation of managers will likely not feel the same loyalty or, frankly, love for the new CEO that their predecessors felt for Mr. Buffett. We are concerned as to whether the new management teams will remain as loyal to the new Berkshire Hathaway as the prior leadership.
Despite Mr. Buffett being unquestionably the greatest investor who has ever lived and given his excellent track record in choosing people, I believe that Todd and Ted were excellent choices and will do a terrific job allocating capital in the years ahead. Certainly, they cannot replicate Mr. Buffett’s success given the anchor of size and the unlikely probability that, while they may be outstanding, they will not be as extraordinary as Mr. Buffett. I also think their role should include visiting potential Berkshire-like companies that fit into the Berkshire Hathaway profile to learn about the respective businesses and also to build relationships with management teams/owners of both public and private firms keeping their names at the top of the list should that company decide to sell. Berkshire Hathaway is unique in many ways, including its financial strength and quasi-permanent capital, providing the company with the capacity to do deals of enormous size while still providing a unique blessing available to few investors -- the great option of doing nothing unless potential investments meet all of their parameters.
Todd and Ted along with the new CEO will work together on large acquisitions for Berkshire Hathaway of both private and public companies, while also assisting in searching for appropriate subsidiary bolt-on acquisitions. Historically, Berkshire Hathaway typically acquired 100% ownership of companies. A few exceptions were Mid-American, Iscar and Fechheimer, where a portion of the equity was left in the business to incentivize management teams going forward. I believe that it will be more common in the future without Mr. Buffett and I believe it will be prudent for BRK to structure more deals this way so great leaders and management teams can financially participate in what they are helping to build beyond just earning a salary, albeit a very generous one. I believe that the investment team would benefit from traveling to meet companies both public and private to learn more about their businesses and to meet management teams always building relationships in the process, which could yield solid acquisition opportunities over time. There is nothing like meeting people in person to build upon relationships and to learn about businesses, and Berkshire Hathaway should place a greater emphasis on this kind of ongoing focus. Major banks and brokers structurally define such activities as an important means of staying in touch and generating new prospects. BRK could and should implement some sort of similar ongoing program.
Historically, many of the Berkshire subsidiaries were managed to maximize free cash flow to send to headquarters. Going forward they will be more focused upon using that free cash flow to invest in internal capital projects and bolt-on acquisitions before sending excess free cash to headquarters. This represents a meaningful change for many of the management teams requiring a broader set of skills in building and growing an enterprise rather than just managing for free cash flow to send to Omaha.
Can the new leadership at Berkshire Hathaway continue to maintain the delicate balance of decentralized operations at the subsidiary level and yet have companies work together in certain areas where there are mutual benefits? For example, will the furniture companies work together to gain advantages by leveraging their collective buying power in advertising, or buying products-Jordan in the northeast, Nebraska Furniture Mart in the mid-west, RC Willey in the west? Will they discuss operating capabilities that they can share in the form of best practices with their sister companies? For example, say a Berkshire company has installed SAP software which has resulted in better inventory control, expense management, and other strengths. See’s Candies has developed unique knowledge on handling part-time work forces. Is this being shared with other sister companies? Will the various companies within Berkshire benefit from these best practices and utilize those to enhance each of their own operations? However, this is a very delicate balance that needs a few unique individuals to assure that the decentralized culture is not adversely impacted in any way, being that this has been an important aspect to sustaining the magical Berkshire Hathaway culture. My sense is there are many areas, where money could be saved if companies shared best practices and leveraged their buying power in certain areas, which would result in the creation of significantly increased excess cash flows. Surely there will be important benefits from a greater emphasis on cross company collaboration.
I also believe that many of Berkshire’s strengths are not fully utilized by the operating subsidiaries as much as they could be, leveraging Berkshire Hathaway’s competitive advantages to the benefit of subsidiaries could present opportunities on several fronts from its balance sheet to issues raised above with sister companies learning and helping one another to improve in various areas. What are the true benefits of being part of the Berkshire Hathaway family, and how will these be more fully utilized?
I remember interviewing Ed Schollmaier, the former CEO of Alcon Laboratories. In that interview Ed repeatedly mentioned the enormous benefits of being owned by Nestle, whose deep pockets provided Alcon with the luxury of a long-term horizon, enabling the firm, to grow and build its businesses without the short-term requirements of dealing with Wall Street. Today, Alcon is the dominant player in the eye care industry and leads in virtually every area in that field. Ed attributes their success to many factors, but among the most important has been the many benefits of Nestle’s ownership. How can Berkshire better exploit these types of benefits for its own subsidiaries? Certainly a great deal of this may already be in place, but I am sure it could always be enhanced and improved.
I should mention Bill Gates (Trades, Portfolio) as a member of the Board being one of the only individuals in the world with the global stature, reputation and intellect likely to play a key role as a potential chairman of Berkshire Hathaway working along with the non-executive chairman Howard Buffett. I expect Bill Gates (Trades, Portfolio) will continue to play such a role in the BRK hierarchy given his age, love for Mr. Buffett and his desire to sustain Mr. Buffett’s long term goals for the company helping to assure that Berkshire remains well managed, and presumably reflect a continuing escalation in the stock price. The higher the BRK stock price the greater the value of charitable contributions of Berkshire Hathaway stock donated to the Bill and Melinda Gates Foundation which, in turn, will lead to positively impacting many more lives around the world.
Berkshire will announce the payment of a dividend after Mr. Buffett is gone, with an immediate and meaningful rise in the stock price given that many large institutional investors and other investors that have mandates forbidding the purchase of non-dividend paying stocks will then be able to purchase the most solid dividend payer in the world. BRK’s diverse set of revenue streams and Rock of Gibraltar balance sheet promise continued ability to sustain a major dividend flow.
Berkshire Hathaway’s unique culture is unlike any other business that I can recall over the past 50 years. It remains to be seen if this incredible institution built by Mr. Buffett can survive him, and if so for how long, given that few if any past conglomerates have survived, including Teledyne, Gulf & Western, ITT and several others. While Berkshire is far different and unlike any of these earlier conglomerates, there are many forces both internal and primarily external that could lead to the potential possibility of a total or partial break-up of the company. While the probability remains low in the short term after Mr. Buffett’s passing, the possibility rises years later for various primarily external reasons such as losing the controlling shareholder and many other large current stockholders that have remained very loyal in the past. A new and large short-term focused shareholder could be one example that could potentially present future challenges to Berkshire Hathaway, particularly if the firm is not performing as expected.
In the chart below, I briefly list a simple possible breakout of segments reporting directly to Ajit Jain. This certainly has many variations for example the smaller companies area is currently or could be run by Tracy Britt Cool while the other three larger groupings could be combined into two rather than three. Nevertheless, I think the operating structure needs to be simplified for the new CEO as no individual can operate Berkshire Hathaway as Mr. Buffett has.
In conclusion, BRK remains, in our view, perhaps the most compelling and deserving holding in almost any long-term portfolio, with or without the extraordinary leadership it has enjoyed throughout the reign of Warren E. Buffett.