A short-ish note about Berkshire Hathaway

An accidentally well structured entity poised for resilience

In this post I am going to write about Berkshire Hathaway ($BRK.A, $BRK.B) - a very well written and analysed business - so there is very little new you are going to read below in terms of numbers or the business or Buffett’s investing skills. Instead, this note is going to focus on the big picture and why I think Berkshire is a good investment. Less numbers, more words.

A Brief History

Berkshire Hathaway was founded in 1839 and was a textile company for well over a hundred years. Sometime in 1962 Warren Buffett started building his position in this then-waning-textile company under his cigar butt approach, and was hoping that he would make more money from its eventual demise than continued operation. 

In 1964, a public tender for the shares was launched by then Chairman Seabury Stanton, and upon it being 1/8th of a dollar lower than where Buffett expected it to be, got angry, bought out as much stock as he could, toppled Stanton, and took control. At this point, even Buffett didn’t know what he wanted to do with the company. By his previous playbook, he would have likely shut it down. By some stroke of fortuitous events, Buffett used the capital remaining in the company to launch an expansion into fields way afar from textiles and turned this company into a conglomerate that we see today.

As we concern ourselves today about present day Berkshire, it is a conglomerate that is largely comprised of 3 sets of assets - 

• A set of insurance operations

• A set of wholly owned non-insurance subsidiaries that range from energy to railroads to timeshare aeroplanes to manufacturing.

• A collection of marketable securities - essentially shares of other public listed companies, including Apple, Coca Cola, American Express and so on.

Corporate Structure

Berkshire’s corporate structure is truly unique and I present this as a structural advantage for the company going forward. 

You will find Private Equity funds, but they don’t want to hold publicly traded stocks. You will find ETFs that trade in public stocks, but they can’t own wholly owned businesses. You will find conglomerates that thrive on expanding their brand far afield from where they started, but none want to hold large sums of marketable securities. You will find business with lots of cash generation and willing to invest, but they want to extend their empires through vertical or horizontal integrations, not just for the money making abilities of an acquiree. Berkshire can do all of the above.

If you find a great capital allocator today, you will see them all run it in a fund form, charging you fees either on a 2 & 20 basis, or as a fixed percentage or AUM. Fees alone then become a drag on your performance. Berkshire doesn’t charge you anything¹.

Berkshire Hathaway then is a truly unique company - one that is willing to let its capital go where it sees fit - sometimes it buys companies as a whole, often as bolt-on to some existing line of business, but regularly just to be left alone to make money, and at other times it buys stakes in publicly traded stocks. By not charging investors fees of any kind, Berkshire is also one of the most efficient investment vehicles you can find. This unique combination, done well, as Berkshire has, has produced outsized returns and is set to do so, so long as the people running it are doing the simple things right and being rational.

Leverage through Insurance Companies

In the world of insurance, premiums are collected first and paid out upon a claim later. This money, collected first, but waiting to be paid out, is called “float”. ²

The insurer’s profit comes from ensuring that they pay less out than what they received in premiums, taking in an “underwriting profit”. However, they are also free to invest the float in anything they deem appropriate, in the intervening period, resulting in an “investment profit or loss”. There are insurance companies that produce one or the other (the ones that do neither having been bankrupted out), but few companies can do both, with Berkshire having a collection of insurance companies that consistently achieve both. 

Berkshire’s float in 1967 was $17M, in 1977 $139M, in 1997 $7,093M, and will soon be a whopping $164Bn³! This money is available to the company, or us as shareholders, to enjoy the fruits of. This is a massive structural tailwind to the company. 

Taken together with all the other wholly owned subsidiaries that Berkshire has, the collection produces a solid stream of operating income, starting at $21.8Bn in 2017 to $30.8Bn in 2022. Along with this, the insurance companies collectively provide hundreds of billions of float that are at the disposal of the management to be invested on behalf of the shareholders. This collection of shares today, is available roughly at 16.6x P/E (after adjusting⁴ for cash at hand, and removing both marketable securities and its attached dividend income).

Marketable Securities

The other large part of Berkshire’s holdings are the marketable securities, valued at about $308Bn at the end of 2022. This collection, 75% of which was concentrated in five companies (Amex, Apple, Bank of America; Coca-Cola and Chevron), was bought for a mere $131Bn. Today, this collection of stocks produces $10Bn a year in dividends - roughly 3% yield - and otherwise just sits around waiting for these companies to grow and return their profits. 

Berkshire’s approach to investing in marketable securities is extremely well documented - and is based on a cautious approach of adding mature, well-run companies that have a prudent record of capital allocation, and stays away from speculative, short term positions. This approach is supported by a fear of “error of commission” - i.e. investing in the wrong things and happily trades off on “error of omission” - i.e. willingness to sit out on investments that might be doubtful in any way to the capital allocators at Berkshire. 

This collection of stocks will behave more or less like a subdued version of S&P 500 - i.e. it will go up and down in line with S&P, but will likely skip the excesses both on the upside and downside, purely because investors hardly get optimistic or pessimistic at extremes about mature companies. Today, back of the envelope calculation tells me that this trades at about 16-18x P/E.

In 2022 this collection of companies declined by about $53Bn or about 15% of its starting value at the beginning of the year. This is roughly, a subdued version of the 18.11% loss in S&P500.

Since 2017, GAAP accounting rules require Berkshire to book any decline or gains in the value of this investments into their P&L. Berkshire doesn’t like this⁵ but they have to comply. So, the reported profit and loss numbers wildly fluctuate, in line with the market movements. Investors are provided information on this breakdown and it behooves us to separate operating income from changes in valuation of marketable securities. In 2022, operating income was $30.8Bn whereas unrealised losses were $53Bn⁶.

Putting it all together

Right, so Berkshire is a company that has a unique corporate structure, with no investment fees, with a large collection of wholly owned subsidiaries valued reasonably, producing cash both through profits and through insurance float, which in turn funds the purchase of more companies, both in the universe of private companies, and public companies, and where applicable, such capital allocation is made with a focus on avoiding errors of commission, and which in turn is expected to produce about S&P 500 returns. 

I am willing to posit here that the outsized returns Berkshire has achieved over the past 58 years (19.8% vs 9.9% of S&P) is not just because of Buffett or Munger’s  superior stock picking skills, but because the structure (leverage from float, focus on capital allocation etc) put together lends itself to that kind of outcome.

Risks

First obvious risk is that this company is today run by two nonagenarians and at some point not long in the future, management is going to change hands, and everything that we know about Berkshire today can be uprooted by a new management with different focus. The management has made their succession plan clear and I am less worried about this in the short term, but worth keeping an eye on in the medium to long term.

Second risk is the performance of the insurance companies, with insurance collectively producing wild swings in underwriting profit from year to year (2022 was a $90M loss, whereas 2021 was $728M profit), and GEICO seeming to be struggling a bit, with underwriting profits declining from +$3.4Bn in 2020 to -$1.8Bn in 2022. Worth keeping an eye on.

False Narratives

While talking about Berkshire to my investors friends, I have heard a bunch of questions & narratives, that are almost always tangential to the core Berkshire offering. I am producing a selection here and commenting on why these are false narratives:

• Why did Berkshire lose money in 2022 - if they are that legendary, shouldn’t they never lose money? Balderdash! For large part, Berkshire is a long-term buy-and-hold investor and hence, their marketable securities will decline in line with the market⁷.

• Why didn’t Buffett invest in Amazon? Because it didn’t fall into his circle of competency for a long time.

• Why didn’t Buffett beat S&P in such & such year? Because he has promised that he doesn’t care about beating the index, and so the result shouldn’t be expected.

• Was Buffett right in selecting Coke over Pepsi? Who cares - investment in Coca Cola has been hugely profitable as it is.

• Why didn’t Buffett beat Gold in the 2000s? Because he never promised he would.

• Why doesn’t Buffett own Gold/Crypto/Your-favourite-stock? Because he is not your personal financial advisor. He will invest in what he thinks is right. It has worked for 58 years and will likely work for a while in future.

Those who bring up these narratives are, paraphrasing Buffett’s words, either Berkshire illiterates or silver tongued demagogues. Don’t get into the trap of false narratives - they can very often distract you from the core thesis. In Berkshire’s case, the core thesis is rather simple and if you don’t buy into it, don’t buy into the business, but if you do, then the investment case becomes rather straight forward.

(This is the business I understand most of, and hence have read the most of, and could write the most on. I have attempted what I thought was the bare minimum commentary on the company but realise it has gone on for over 2000+ words. My apologies.

While I hope you find this note interesting for the sake of the content itself, if it helps, Berkshire is my largest holding by a long long margin, and is the oldest contribution to the current coffee can portfolio - starting my holding as far back as 2017. I have never reduced my position, or even thought of it.

Disclaimer: I hold positions in some of the tickers mentioned in this post. I am not your financial advisor and bear no fiduciary responsibility. This post is only for educational and entertainment purposes. Do your own due diligence before investing in any securities.)

1. Buffett himself admits that making the decision to buy the prized insurance assets under Berkshire was a mistake, and he would have been better off buying it on his own. Furthermore, he had already run a partnership till then, under some form of performance based fees, so he wasn’t new to that structure. 

2. In case of a policy taken on a single travel trip, this is only of the order of a few weeks, but in many other kinds of insurance, such as life insurance, or casualty insurance, this can be of the order of decades.

3. It grew from $147Bn to $164Bn upon completion of the Alleghany acquisition.

4. These adjustments were purely my own handiwork. Any omissions and commisions are purely mine. Berkshire reports GAAP numbers and provides the breakdown - any adjustments are left as homework for the reader. I find this a superior form of reporting.

5. Buffett talks about it in the 2017 Annual Report. In the past, gains or losses in marketable securities had to be booked only on the Balance Sheet, which makes sense. The new rule changed it to require these to be booked on the Income Statement too, which frankly as a reader of financial statements, I have found no use of.

6. The $53Bn of change in valuation is only for 2022. This is based on whatever was the closing price taken in at year end 2021. On acquisition cost basis, almost all of Berkshire’s marketable securities are wildly profitable.

7. Also “legendary” is a title media gave to Buffett and Munger, not a title they suppose anywhere. You should invest in what you find value in, not based on media labels.