Deconstructing Berkshire Hathaway
by Weston Wellington, Vice President, Dimensional Fund Advisors
Berkshire Hathaway released its 2010 annual report last weekend, including the letter to shareholders from Chairman Warren Buffett that is always eagerly awaited by the investment community. We are gratified to find that Mr. Buffett’s legendary ability to simplify complex issues remains undiminished and his trademark wit is as sharp as ever.
Financial journalists, eager for clues that might reveal Buffett’s thoughts on where markets are headed, focused on his optimistic outlook for the future (“America’s best days lie ahead”) and his appetite to make further large acquisitions (“my trigger finger is itchy”).
We prefer to focus on a number of issues touched on in the letter that offer investment wisdom that is equally useful today or ten years from now.
As of year-end 2010, Berkshire held positions in excess of $1 billion in fourteen common stocks. Five of these were non-US firms: BYD Company Ltd. (China), Munich Re (Germany), POSCO (South Korea), Sanofi-Aventis (France), and Tesco plc (UK). Five years ago a similar list of twelve companies contained just one non-US firm, and ten years ago there were none. In his comments about the future of America, Mr. Buffett remarked that “human potential is far from exhausted” and that, despite many setbacks, the American system “has worked wonders for over two centuries.” Judging by Berkshire’s portfolio, it appears this notion applies with equal force throughout the world.
Berkshire has willingly shouldered some unusual risks over the years. It acquired building products maker Johns Manville in 2000 despite the stigma of asbestos-related liabilities, invested over $15 billion in various financial firms in the tumultuous weeks following the Lehman Brothers bankruptcy in 2008, and once insured an internet firm against the possibility of awarding a $1 billion prize associated with a marketing promotion. Many investors might assume that such adventurous and unconventional thinking in equity assets would be matched by an equally unorthodox approach in fixed income. On the contrary, Buffett’s strategy for investing Berkshire’s cash ($38 billion at year end) is so conservative that some might accuse him of excessive caution. We suspect any institutional money manager with a balanced account mandate who maintained most of the fixed income assets in Treasury bills despite yields approaching zero would be fired for lack of imagination. Such an approach only makes sense if the role of fixed income is to preserve liquidity and limit the potential damage associated with riskier equities, rather than to generate satisfying returns. Mr. Buffett cites an observation from financial writer Raymond DeVoe that “more money has been lost reaching for yield than at the point of a gun.”
For those who ponder why it is that stocks are expected to provide a positive rate of return even if they pay no current dividend, one number cited in the letter offers a clue: $1 billion. That is the approximate amount of cash that shows up in Berkshire’s mailbox each month from its collection of seventy-six businesses. Mr. Buffett’s job is to invest that cash in new projects that carry an attractive rate of return, and history shows that these may come in a variety of shapes and sizes. Last year, for example, Berkshire spent $50 million to buy Alabama’s largest brick manufacturer and $22 billion to complete its acquisition of the nation’s largest freight railroad. Mr. Buffett reports that the rail acquisition is working out “even better than I expected,” and to the extent any chief executive can invest a firm’s profits more profitably than we can, dividends are not just unnecessary, they are undesirable.
Since taking control of a floundering Massachusetts textile mill in 1965, Warren Buffett has an extraordinary record of business success. While many have focused on his facility with numbers and ability to identify attractive business opportunities, it seems to us that the untold story is his astute judge of character and his ability to quickly identify individuals whose business acumen and character will make a good fit within the Berkshire organization.
What are the investment implications to this appealing story of long-run excellence? Mr. Buffett’s oft-stated goal is to grow Berkshire’s book value at a faster rate than the total return of the S&P 500 Index. He has succeeded in the past, and we think it probable that Berkshire will continue to do so in the future.
The more interesting question is to what extent Mr. Buffett’s skills are already reflected in Berkshire Hathaway’s stock price, and whether the S&P 500 Index is the most useful basis of comparison. Berkshire’s long-run price performance relative to the S&P 500 is sensational—over the last twenty-five years, it has compounded at 16.9% per year compared to 9.93% for the S&P 500 Index with reinvested dividends. The margin of superiority relative to the S&P 500 narrows for more recent time periods, however, and disappears altogether in comparison with broader-based equity strategies. Over the last fifteen years, for example, Berkshire shares have outperformed the S&P 500 by 276 basis points per year and are essentially even with a globally diversified Dimensional Balanced Equity Index (actually 16 basis points behind). Over the last ten years, Berkshire shares have underperformed the balanced index by 295 basis points per year.
Some might be tempted to conclude from these results that Mr. Buffett’s legendary skills are waning, but if markets are working properly, the numbers should come as no surprise. Berkshire’s book value has grown from $48 million in 1965 to $157 billion in 2010, making it larger by this measure than oil giant ExxonMobil. Mr. Buffett has gone from piloting a speedboat to commanding an aircraft carrier; the ever-increasing amount of capital Berkshire oversees makes it increasingly difficult to earn above-average returns. Moreover, Berkshire Hathaway is not a mutual fund, but a public company with a share price that reflects expectations for the future. Now that Mr. Buffet’s admirable qualities are understood and acknowledged by so many market participants, it seems likely that his perceived value is already reflected in Berkshire’s stock price, just as Apple’s current stock price reflects the genius of founder Steve Jobs.
We wish Mr. Buffett well and hope to be reading his letters for many years in the future. And investors who have a soft spot for Berkshire Hathaway shares can take comfort in the knowledge that if they own a truly diversified equity strategy, they own a piece of Berkshire.
Berkshire Hathaway Inc. 2010, 2005, and 2000 shareholder letters. Available at http://www.berkshirehathaway.com (accessed February 27, 2011).
Past performance is no guarantee of future results.
Dimensional Fund Advisors LP (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.
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