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Some Caveats On Berkshire Hathaway

Summary

Berkshire Hathaway is indisputably a phenomenal company, which has greatly outperformed the market throughout its history.

However, it has underperformed the market in 5 out of the 6 last years and is likely to continue to underperform in the future.

The article discusses some factors that limit the potential growth of the stock.

Berkshire Hathaway (NYSE:BRK.B) is indisputably a phenomenal company, which has greatly outperformed the market throughout its history. To be sure, the stock has grown its book value at a compounded 19.4% annual rate during the last 50 years while S&P (NYSEARCA:SPY) has returned 9.9% per year including its dividends. Nevertheless, the big question is whether Berkshire is likely to keep outperforming the market in the future. In this article, I will detail some caveats on this exceptional stock.

Size

While the stock has pronouncedly outperformed the market since 1965, it has underperformed the market in 5 out of the 6 last years. The main reason is that it has now become a stock with market cap $320 B and hence it cannot keep growing at its historical pace. This is not just my opinion; it is Warren Buffett's view, which was clearly stated in his annual shareholder letter (page 35). It is also self-evident, as the market cap of the stock would exceed the current US GDP in about 22 years if the company kept growing at its average historical rate. Therefore, the size of the company has become a key factor that has limited its growth potential in the last few years and will certainly continue to do so.

The premium of Buffett

As Warren Buffett and Charlie Munger are 85 and 91 years old, respectively, it is very likely that someone else will be running the company after some years. This will be a game changer for the stock, as the "Buffett" premium will disappear. Some investors claim that the two junior managers of Berkshire, Todd Combs and Ted Weschler, who were hired 5 years ago, have outperformed Buffett most of the time and hence the retirement of Buffett will not have an impact on the stock. However, while it is true that these two managers are exceptionally skilled, they have only been tested during the current bull market and hence they should also be tested in a bear market.

Moreover, while I believe that their record will probably be good even in a bear market, I also believe that there is no replacement for Buffett. More specifically, after he retires, the management of the company will start diverging from his principles, slowly but steadily. In addition, it is critical to realize that it is not only Buffett's principles that have made the company such a stalwart but mostly his judgment. To be sure, millions of investors have read up to a dozen of books that fully detail Buffett's investing strategy but very few have accomplished his results. The judgment of Buffett is what the company will miss after his departure and, unfortunately for the shareholders, it is a priceless asset.

Major holdings

The top 5 holdings of the US portfolio of Berkshire are Wells Fargo (NYSE:WFC), Coca-Cola (NYSE:KO), International Business Machines (NYSE:IBM), American Express (NYSE:AXP), and Wal-Mart (NYSE:WMT). As these 5 positions account for 70.4% of the total US portfolio, it is evident that their future growth will be crucial to the performance of Berkshire. Unfortunately, while these stalwarts have historically provided exceptional returns to their shareholders, most of them have greatly underperformed the market in the last few years and are likely to keep underperforming the market, each one for its own reasons.

Coca-Cola has spent $21.0 B in share repurchases during the last 5 years but has reduced the share count by just 4.5%, from 4.658 to 4.450 B shares. Doing the math, one realizes that the company spent almost half (46.4%) of its earnings on share repurchases but the management rewarded itself with 2/3 of the shares it repurchased. Therefore, the management essentially distributed about 31% (2/3 of 46.4%) of the total earnings to itself. To make a long story short, the management has been excessively rewarding itself at the expense of the shareholders even though it has failed to grow the earnings during the last 4 years. When there is no growth and the company spends half of its earnings on dividends and the other half on totally inefficient share buybacks, the prospects for future growth are gloomy.

Apart from Coca-Cola, which is likely to keep underperforming the market due to its prodigal management, most of the other major holdings of Berkshire have prudent managements but are facing their own headwinds, namely intense competition. IBM is facing heated competition in its cloud and data analytics segments, while American Express lost its business with Costco (NASDAQ:COST), as the competition drove the potential profit from this business to unreasonably low levels. Finally, Wal-Mart is facing increasing competition, has failed to grow in the last 4 years and, even worse, its earnings are expected to fall to the 2010 level this year. All in all, it is hard to see how the above mentioned 4 of the 5 major holdings of the US portfolio of Berkshire will outperform the market in the future.

It is also worth noting that Buffett stated in the annual meeting that the peak of the reinsurance business was already history and its prospects had turned for the worse, with very little the company could do about it.

Systematically important financial institution

Another factor that may further limit the growth potential of Berkshire is that it may soon be characterized by government regulators as a systematically important financial institution [SIFI]. Such a nomination would enhance its capital restrictions and liquidity requirements, thus posing additional obstacles to its growth. Fortunately for the shareholders, Berkshire has not been characterized as SIFI yet but the Bank of England asked the US regulators why Berkshire had not been included in the list this year. Therefore, this is an additional risk for the growth potential of Berkshire, though the probability of materializing is low as Berkshire generates a significant portion of its revenue from non-financing activities, such as the 3 of the 5 major holdings mentioned above.

Conclusion

To sum up, Berkshire has an unparalleled record of performance and returns throughout its 50-year history. However, it has grown so large that it has become extremely hard to keep outperforming the market in the future. That's why it has underperformed the market in 5 out of the 6 last years. Moreover, when Buffett departs, the company will lose its most valuable asset, his judgment. Finally, most of the major holdings of Berkshire are facing pronouncedly heated competition, which makes it hard for them to keep growing at their historical rates while they are also facing the same size problem as Berkshire. Therefore, Berkshire will find it increasingly hard to outperform the market in the future.


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