We trimmed our multidecade-long large weighting in Berkshire Hathaway (NYSE:BRK.B) to an average portfolio weighting based on our growing concern that Berkshire Hathaway has become too large, both in size ($525 billion in market cap) and in the size of the Company’s +$100 billion cash hoard. Simply put, the cash drag has become a stultifying impediment for the Company to achieve our hurdle rate of +10% growth. Now it must be said (admitted?) that we have long stated that Buffett’s fat-cash wallet is a high-class problem for any CEO. In the case of arguably one of the best capital allocators and investors extant in Buffett (and Munger too) the prospective strategic optionality of investing large sums of cash wherever Buffett finds opportunities to not only increase the ever-important diversity of the Company’s earnings streams (much to the delight of insurance regulators), but to also significantly increase the permanent earning power of said low-yielding cash has been acute during this bull market. That historic fact noted, the current and future prospects of Buffett & Co. deploying tens of billions in numerous gazelles, much less bagging that much vaunted elephant, both in terms of a truly attractive high return-on-asset business, plus at Buffett’s strict valuation criteria, have diminished significantly in the era of Quantitative Easing and of concomitant roaring bull markets.
Indeed, since Buffett Partnership time-immemorial Buffett and Munger have warned shareholders that size is the anchor of future performance. Relatedly, Buffett, given his wont, congenitally under promises, and given his delight has over delivered for decades. Except for the past decade – at least compared to earlier decades.
We would be less concerned (or more bullish) if Buffett reordered his preferred lineup of capital allocation targets. Buffett’s long-held preference is buying businesses outright first, followed by large, focused purchases of common stock and lastly, purchases of Berkshire Hathaway stock itself.
Take a look at the two graphics below. Buffett and Munger have long warned that they can’t compete in the bidding process of acquiring companies against private equity firms that have countless tens of billions at their disposal and who willingly will leverage such equity to pay top bidding-valuations in their respective hunt for acquisitions. In addition, Buffett & Co. refuse to compete in an acquisition if it involves an auction process, plus he refuses to go “hostile” in acquiring companies. Such conservatism, patience, and moral rectitude are no doubt admirable as Buffett & Co. wait for fat-pitch, multibillion-dollar opportunities to come knocking in Omaha. In addition, Buffett has little, if any, patience with investment bankers. Indeed, Buffett plays his singular game of acquisition by his invitation only. This game has turned into solitaire.
That said, for all intents and purposes, we have calibrated our expectation of successful gazelle and elephant hunting to literally zero in our near and longer-term operating earnings estimates for Berkshire. We hope our conservatism is wrong.
In addition, recent bagged gazelle in Lubrizol and elephant in Precision Castparts, which have thus far turned out to be turkeys. Precision stumbled right out of the gate after the acquisition in 2016 posting earnings declines, write -downs and impairment charges. Hopefully better results in 2018 portend to a long future of the rosy expectations at the time of the $37 billion acquisition.
Lubrizol too had high expectations after the $10 billion acquisition in 2011. Results early on were strong enough to impress Buffett so much that he “Sainted” Lubrizol, but the subsidiary has mostly struggled since. Operating earnings were flat in 2013, up a nice +10% in 2014, negative in both 2015 and 2016 and up slightly (+3%) in 2017. Pricing drove revenue growth of +6% in 2018, off of just +2% unit growth. Capital allocation at Lubrizol has been an admitted “big mistake” too. Lubrizol bought Weatherford’s oilfield chemical business in late 2014 for $750 million. The unit was disposed of shortly thereafter in late 2016, incurring a $365 million loss. Such results do not inspire one to assume too that “great multi-billion-dollar companies, at reasonable prices” are expected to be spotted in Omaha anytime soon.
Buffett has long taken great, and deserved, pride in his ability to make unconventional, fast decisions when the phone rings in Omaha when opportunities come calling. Buffett brags too that Berkshire’s checks will always clear. Fast multi-billion decisions are no doubt rare, but it must be stated, in the hunt for gazelles and elephants, private equity’s and most of large Corporate America’s checks are just as large and certainly clear just as swiftly as Berkshire’s. Unfortunately for shareholders, in a world flush with cash and where debt isn’t a four-letter pejorative, Buffett’s phone will likely continue to ring less than the Maytag repairman.
When we reflect on Buffett’s seminal acquisition of Burlington Northern Santa Fe back in late 2009, we have come to a new understanding that it may have been too good of an acquisition. At least “too good” for future elephantine acquisitions. To torture an analogy, we all know that elephants have prodigious memories. We suspect that prospective elephants on Buffett’s short hunting list, seared with decade-long bull market memories, may become ever more elusive targets.
Consider the fate of a BNSF shareholder on November 3, 2009: Buffett announced the acquisition of BNSF for $100 per share – a seemingly rich +30% premium to BNSF stock at the time. Tendering BNSF shareholders could elect to receive $100 in cash or a combination of cash and Berkshire stock. Let’s ask ourselves a hypothetical question about what might have been the fate for shareholders if BNSF had stayed independent. A very good proxy for BNSF is Union Pacific railroad. Both businesses have been of a similar size, growth, and profitability for more than a few years. Union Pacific has been a terrific operator, doubling its return on assets and net margin over the past decade. UNP stock – not surprisingly – has boomed over the great bull market. $10,000 invested in UNP stock on November 2, 2009 would have grown to just over $75,000 by June 30 this year. $10,000 in Berkshire Hathaway stock would have “only” grown to just over $32,000. If said BNSF shareholder would have heeded Buffett’s long-held advice and invested in a market index fund, $10,000 invested in the S&P 500 Index would have grown to almost $35,000. BNSF has turned out to be an elephant-home run for Berkshire shareholders. We’ll leave it to former BNSF shareholders to determine if Berkshire’s acquisition of BNSF was a home run for them, considering what they would prosectively leave on the table.
The point of the hypothetical is to illustrate two new realities that Berkshire shareholders need to consider; Berkshire Hathaway stock as a desired currency in an acquisition has lost its former considerable luster. Truth be told, this is not new news to Berkshire faithful shareholders. Plus, would any CEO/corporate board – public or private – circa-2019 agree to put their respective company up for sale in today’s cash flush environment without a bidding/auction process? In our opinion, we think not. If it’s a “bagged” gazelle or elephant and earning the requisite Buffett-level returns on assets - we are doubtful that Buffett gets the sole call any longer. Even in a unique situation of a mastodon private Company such as Cargill or Mars whereby an all-stock acquisition (even at a “market discount”) by Buffett might be familial appealing for minimum capital gains tax, plus perhaps a heightened diversity desire (given Berkshire’s inherently diversified conglomerate), we would still be quite surprised that such a transaction could be pulled off absent an auction. We thank our lucky stars that Burlington Northern was willing to be sold (stolen?) in 2009. We don’t think BNSF could be bagged by Buffett circa-2019.
On the second preference of sizable common stock purchases, Buffett (and CIO’s Ted and Todd) have a tough task in size as well – a $200 billion common stock portfolio will see to that conundrum. We hope that in the next bear market, Buffett turns his two lieutenant portfolio managers loose to swing fat-sized bats. For that matter, Buffett too. Buffett’s “Buy American. I am.” slogan circa-2008 spawned numerous “bail-out” fixed income and fixed income/equity warrant spending sprees. (Mars-Wrigley, Goldman Sachs, Bank of America, General Electric, Harley-Davidson, Dow Chemical). Our hope is that during Buffett’s next “Buy American. I am. Redux.” spending spree is focused solely on great stocks, of great businesses, at great prices.
Lastly, on the matter of share buybacks, we, along with Berkshire shareholders who read and listen carefully to Buffett’s words on this matter, know full well Buffett’s share buyback philosophy, strategy, and intent. He has been more than transparent informing those shareholders-partners who may foolishly sell Berkshire shares back to Buffett himself. We have long wished that share buybacks would be a greater priority with Buffett. Alas, we now have carbureted our expectations of little meaningful share buybacks as long as Buffett is CEO (and alpha dog CIO). Share buybacks, executed at least at reasonable discounts to intrinsic value and in enough size, would be terrifically accretive to earnings per share growth. However, share buybacks are a reduction in capital. Again, in our view, the last thing Buffett wants to do is to reduce Berkshire’s capital base while he’s still in the captain’s chair.
Buffett and Munger have long lectured investors to stay within one’s “circle of competence.” Hindsight may not be fair (welcome to investing), but is it not fair to ask if the $50 billion acquiring these two companies would have served shareholders better if Buffett & Co. had stayed within their respective circle of competences and spent $50 billion buying back the stock of the company that Buffett knows better than anyone else?
We wish that Buffett would take to heart the share buyback wisdom that he has passed on to CIOs in the past – particularly to the last two CEOs of Apple. Steve Jobs listened intently to Buffett back in the day. But he never pulled the buyback trigger. Tim Cook on the other hand has turned out to be Professor Buffett’s A+ student.
Since 2012 Apple has returned an astonishing $364 billion in capital to Apple shareholders. $271 billion in share buybacks alone. All told, Apple’s share count has been shrunk by a none-to-small -27%. Given the net cash $135 billion on Apple’s balance, plus their ability to generate about $70 billion in operating cash flow per annum, multi-billion share buybacks should continue for years to come.
Share buybacks are new news for Berkshire’s $68 billion bank stock portfolio. In late June the Federal Reserve approved the stress test (CCAR) and the nation’s largest banks were approved to return billions in capital back to shareholders. Berkshire’s windfall is significant. In terms of Berkshire’s bank stock holdings Bank of America announced a $31 billion buyback over just the next 12 months. Over a similar time-frame Wells Fargo ($23 billion), U.S. Bancorp ($3 billion), J.P. Morgan (29 billion), Goldman Sachs ($7 billion) and Bank of New York ($ 4 billion).
To repeat our long-held view, the best elephant Buffett & Co. can bag is sitting in wide open fields at the Omaha Zoo – mastodon Berkshire Hathaway stock itself.
On the economic front, the U.S. Treasury slipping below 2.00% speaks to that not insignificant business cycle headwinds forming in Berkshire’s cyclical businesses. We expect the growth rates in Berkshire’s numerous cyclical businesses to continue to post decelerating earnings growth for the foreseeable future. Thus, another reason in our calculation to trim our holding.
All told, we are no doubt reluctant to sell any shares in Berkshire at valuations not much higher than at valuations where Buffett has been nibbling at buybacks himself. Our ongoing conviction in Berkshire Hathaway shares will closely mirror that of Buffett’s own conviction in Berkshire shares.
From David Rolfe (Trades, Portfolio)'s second-quarter 2019 Wedgewood Partners letter.
