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Buffett Missed Out on Crisis, Revealing Berkshire’s Big Weakness

Bloomberg logoBloomberg 6/25/2020 Katherine Chiglinsky

(Bloomberg Businessweek) -- Warren Buffett has likened it to a forest, laid out its building blocks, and even tried to break it down into different groups to explain the setup. But his Berkshire Hathaway Inc. has always defied neat categorization.

Constructed from the remains of a New England textile company, Berkshire is a mashup of businesses from the railroad BNSF to auto insurer Geico to Dairy Queen to party goods supplier Oriental Trading. It also holds a portfolio of substantial investments in public companies such as Apple Inc. and Wells Fargo & Co. The sheer diversity of the businesses has caused investors to consider the company similar to a mutual fund. Individual investors who might not otherwise consider themselves stockpickers sometimes plunge a significant chunk of their net worth into this one company. Hordes of them show up to Berkshire’s celebrated annual meeting in Omaha each year to find out what the greatest investor of his generation is planning to do with their money.

From 1965 through the end of last year, the annualized return on Berkshire stock was 20.3%, compared with 10% for the S&P 500 index. It now has a total market value of $441 billion and is the only company among the six largest in the S&P 500 that wouldn’t be classified as a technology giant. Berkshire’s size is Buffett’s achievement but also a bit of a problem. While Buffett can drop large sums of money on a deal, he also needs bigger buyouts or larger stock purchases to move the needle for Berkshire. His failure to find those “elephant-sized” deals, as he’s called them, recently has contributed to Berkshire’s underperformance vs. the S&P 500 in the last five years.

a close up of a logo: Berkshire Hathaway’s Operating Businesses © Bloomberg Berkshire Hathaway’s Operating Businesses  

Even during the tumultuous market in March that started chipping away at stock valuations, Buffett was relatively quiet. That’s fueled questions about what shareholders actually get when they invest in Berkshire. If they aren’t reaping the benefit of Buffett’s ability to strike unique and complicated deals similar to ones he’s pulled off in the past—such as the BNSF buyout and the preferred stock investments with companies including Goldman Sachs Group Inc.—are they simply getting an oversize conglomerate chock-full of old-fashioned industrial businesses and retailers?

It’s shifting to “being a conglomerate, and that’s OK, but it does have a different value proposition for people,” says Meyer Shields, an analyst at Keefe Bruyette & Woods. “It’s a conglomerate that certainly in the past was able to achieve unrivaled returns, and it’s much harder to see that materializing again. So you’ve got a bunch of very good businesses—probably some below-average, too—but you’ve got a bunch of very good businesses.”

That’s not so exciting, but it has its advantages. Buffett held a record $137 billion in cash at the end of the first quarter and has said he’ll keep Berkshire as a “financial fortress.” When the S&P 500 plummeted more than 38% in 2008, Berkshire was down just 32%. “What Warren offers investors and has offered them is the assurance that once the money’s inside Berkshire, they’re going to do what’s right with it,” says Tom Russo, who oversees a portfolio including Berkshire at investment adviser Gardner Russo & Gardner.

Buffett’s critics wonder if his strategy has run its course. Longtime shareholder David Rolfe at Wedgewood Partners Inc. ended up getting out of the stock last year, saying that Buffett’s successful deployment of his cash would be “paramount” if Berkshire wants to regain its ability to deliver outsize growth. “We know the conglomerate isn’t growing anywhere near what it has in the past,” he says. But investing such a large sum of money is a feat that few have tried.

And the conditions for investing are challenging. Low interest rates and bond yields have pushed investors into stocks in search of better returns, so equity valuations are high. Buffett has had to compete with an army of private equity funds in the hunt for attractive investments. It’s a tough environment for a bargain hunter—one that’s “literally shut down the capital allocation machine at Berkshire,” Rolfe says.

Berkshire didn’t respond to requests for comment, but Buffett is acutely aware of the drag of size on its performance. He acknowledged it at the 2019 annual meeting and warned of it long before. “Warren has said for decades that, as we grow, our rate of return will go down,” says James Armstrong, president of Henry H. Armstrong Associates, an asset manager that invests in Berkshire.

Berkshire’s makeup has also shifted in recent decades. Buffett said in his 2018 annual letter that it had morphed from a business “whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses.”

Over the decades, Buffett took the textile operations, which eventually closed, and added companies such as insurers, which generated premiums he could use to make other investments. This is essentially a cheap way to borrow money, and was an important part of the Buffett recipe. In 2000 he snapped up MidAmerican Energy, the key building block in his now sprawling energy operation. He added the railroad BNSF in 2010 in a famous crisis-era deal. With the additional purchase of Precision Castparts in a deal valued at $37.2 billion more than four years ago, Berkshire became a company with a huge concentration of its operations in industrial sectors.

“Berkshire is obviously much larger, therefore it will grow more slowly, but it is also much more defensive than it used to be, and that has value to many investors,” Armstrong says. “I can’t think of a better-positioned company to own if you believe that bear markets and recessions have not been permanently eliminated by some magic force.”

They certainly haven’t been. But the latest episode of market volatility was curiously unfriendly to Buffett’s opportunistic style. In the 2008 financial crisis, companies such as Goldman Sachs turned to Berkshire because of its huge amount of capital and Buffett’s reputation as a white knight investor. This time, the window for him to swoop in and do deals on the cheap slammed shut almost as soon as it opened, thanks to strong intervention by the Federal Reserve to keep interest rates low and ensure that companies could continue to borrow.

“There was a period right before the Fed acted, we were starting to get calls,” Buffett said at Berkshire’s meeting in May. “The companies we were getting calls from, after the Fed acted, a number of them were able to get money in the public market frankly at terms we wouldn’t have given.”

Berkshire still has advantages few other companies or investment portfolios can replicate. It can take the cash generated by any business it controls and redeploy it to other operations. Take See’s Candies, a confectionery maker that Buffett bought in 1972 for $25 million. Since the purchase, the company had earned $1.9 billion pretax and required just $40 million in additional investments, Buffett outlined in his annual letter released in 2015. Berkshire ended up putting that leftover money to use by buying other businesses. “Envision rabbits breeding,” Buffett said in the letter.

Berkshire also has unique risks, such as the question of who will eventually succeed the 89-year-old Buffett. Given that, skeptics such as Rolfe argue that investors who want exposure to some of the businesses that make up Berkshire, like Geico or BNSF, can invest in their publicly traded competitors.

Buffett’s many remaining fans still see an opportunity to own, in one stock, a collection of businesses that’s hard to match. “They are in completely different industries, they are affected by different forces to a large extent,” Armstrong says. Along with that comes “a group of stocks, plus a big amount of cash, and that cash is allocated by people who have a demonstrated track record in doing it well.”

(Updates chart to include that Berkshire Hathaway owns 91.1% of Berkshire Hathaway Energy.)

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