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Berkshire Hathaway: The One Stock Portfolio

Summary

I use a modified Kelly Formula to position size Berkshire.

Berkshire is a collection of Wide Moat Companies.

Berkshire Hathaway has capable leaders throughout the organization.

Berkshire Hathaway stock trades at a discount, when it should trade at a premium.

Last week I wrote an article playing Devil's Advocate against Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) which can be found here. In this article I would like to explain the major reasons why I own shares in Berkshire. If you were forced to own just one company and you had to hold it over the next ten years what would that one company be? For me the answer is easy, Berkshire Hathaway. It is not that I think Berkshire will be the best performing stock over the next ten years; that would be highly improbable. However, what other company provides the same level of safety, diversification, and return potential. Thankfully, we are not forced to own just one company for the next decade and can create a portfolio of companies we think can outperform. Still, I think for most investors Berkshire belongs in their portfolio.

Diversified Wide Moats

Berkshire doesn't just have a wide moat, but a collection of companies that have wide moats. Considering how innovative the world has become it is very easy to understand how a wide moat company could see their moat deteriorate due to innovation and disruption. However, with Berkshire Hathaway they have numerous moats and a variety of different kinds of moats. The reinsurance business has a quality reputation, scale, and safety moat; GEICO is a low cost operator; the utilities are regulated; BNSF is hard to copy due to the capital needed to build a network of rail lines; Wells Fargo (NYSE:WFC) is well-managed & has a culture of strong management, and Coca-Cola (NYSE:KO) has a strong brand. The diversity and number of moats provide both safety against disruption and above average return generation which should benefit Berkshire over the next 10 years and beyond. There are always going to be several Berkshire subsidiaries that are facing headwinds such as the ones suggested in the last write-up. However, there will be other subsidiaries with tailwinds which is one of the benefits as the diversification creates greater stability.

Capable Leaders

The company is filled with intelligent, hard working leaders that want to work for Berkshire Hathaway. Charlie Munger and Warren Buffett are irreplaceable and when they depart from Berkshire they will be missed. Berkshire will not be the same without them. However, they are leaving the company in good hands. Whether you are talking about Ajit Jain, Matt Rose, Ted Weschler, Todd Combs, or the Blumkin family the vast majority of companies within Berkshire have strong leadership. Berkshire has such a strong reputation for how its subsidiaries are led that even when a small subsidiary has been poorly managed it generates headlines. Out of all the names rumored to replace Buffett I am happy with all of them, but I expect that Ajit Jain will become the next CEO. I have been satisfied with both Ted and Todd and believe they will do a good job allocating capital. At first, I was a little concerned about nepotism when Warren recommended his son Howard Buffett become the next Chairman. His rational was that Howard would protect the companies culture. The more I have thought about this the more I agree with Warren's rational. I think most people underestimate the importance of a company's culture and the necessity to protect it.

Strong Cash Flow Generation and Cash

Berkshire has a high class problem, they generate so much cash they don't always know what to do with it. In the near term this is not much of a problem due to their recent acquisitions, but cash will build up again. Also, it is widely known that Berkshire wants to hold at least $20 billion in cash in case of emergency. This cash cushion not only provides safety, but also can be used if a great opportunity were to arise. The cash flow, cash, and quality balance sheet are another reason why Berkshire would be my first choice if I had to own one company over the next ten years. Investor can be confident that there is very low risk of bankruptcy and a very high potential of generating decent returns. Eventually, Berkshire will either start paying a dividend, repurchasing shares or both.

Deal Flow Will Still Come to Berkshire

The recently announced acquisition of Precision Castparts (NYSE:PCP) exemplifies that Berkshire is likely to continue to be offered good deals going forward. The management of PCP is well aware of the need to replace Buffett and Munger in the future, yet they sold the company to Berkshire anyways. This tells me that the reputation of Berkshire Hathaway goes beyond Buffett and that many companies still want to be a part of Berkshire. As stated above Berkshire generates strong cash flows and always holds at least $20 billion in cash, for those reasons alone Berkshire will be seen as an emergency investor.

Valuation

While Berkshire will be affected by its size that does not mean it cannot outperform the S&P 500, it just means that it won't beat the market by as large of margin as it has in the past. If they can outperform the market by 3% annualized over the next ten years I would consider that a success; I don't consider it an unreasonable assumption either. The issues discussed in the Devil's Advocate article are already reflected in the stock price. There have been numerous write-ups on how to value Berkshire from sum-of-the-parts to operating earnings plus the investment portfolio. I agree with the vast majority of them; Berkshire is undervalued in my opinion. In the current market environment most wide moat companies are trading at premiums, but I think that Berkshire is trading at a slight discount.

Position Sizing

I use a modified Kelly approach to determine the max buy-in position size. The modified Kelly Formula that I use takes into account excess returns, not total returns, and uses a 1/5th Kelly Factor to reduce the position size. For Berkshire I have used the high level of confidence as my percentage input into the formula. I did not use the Very High level, because I do not have that high of certainty that Berkshire will generate excess returns versus the S&P 500. However, they are well managed, stable, and have wide moats which increased my certainty to High. The excess return assumption was 3%.

Level of Confidence

%

Very High

60.00%

High

57.50%

Moderate

55.00%

Low

52.50%

Very Low

50.00%

The modified Kelly Formula set a max buy-in allocation at 3.3%. If Berkshire's stock price were to decline relative to the market than the buy-in allocation would increase all else equal. If you are a more aggressive investor you can increase the Kelly Factor to 1/4th, 1/3rd, or 1/2 from the 1/5th factor I am using. The allocation is also a max buy-in so if you are more conservative you can lower this allocation. Remember this is a buy-in allocation, so it is the max allocation I am willing to buy into the position, not the max I am willing to hold. If I were to buy it a 3.3% allocation and Berkshire did really well it may hit 4-5% of my total portfolio before I trimmed or sold it.

Conclusion

With Berkshire Hathaway an investor can look forward to owning a diversified wide moat company, with capable leaders, conservative balance sheet, strong cash flow generation, that if offered deals others don't at a valuation that looks attractive. I would say that is a recipe for success and deserves an allocation in many investors portfolios.


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