“The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” — Warren Buffett, Fortune, 1999
Capital allocation is a term that’s as important as it is poorly understood. Businesspeople love to chuck it around, but very few know what it means. As for investors, they may understand it in theory, but most are so obsessed with short-term earnings and growth rates that they give it almost no weight. This is unfortunate, because for both businesspeople and investors capital allocation is the key to building great wealth. Every financial data point emanates directly from the wellspring of capital allocation. Earnings, cashflow and growth rates are like the waves you see on the ocean’s surface; capital allocation is the deep-sea groundswell that produces them.
Capital allocation is in fact simple to define: It’s what managers decide to do with the cash available to them. If a company has good allocators, even a mediocre business will prosper. If a company has poor allocators, the best business in the world will eventually founder. No one understands and illustrates this better than Warren Buffett, who 55 years ago bought a struggling New England textile mill called Berkshire Hathaway, and later turned it into the world’s sixth-most valuable company simply by dint of capital allocation.
I own Berkshire for my clients, and the story of how Buffett transformed Berkshire is both a good case study in capital allocation and a good way to show why the stock is attractive today.
The birth of Berkshire as we know it
Buffett was a young and hungry stock picker running a series of small hedge funds from his hometown of Omaha when, in 1962, he stumbled upon a struggling, publicly traded New England textile mill called Berkshire Hathaway. Over the previous 15 years, Berkshire had been vitiated by lower-cost competition; it had lost all but two of its mills and 80% of its employees. However, it was cheap: Its stock was selling at a wide discount to both its net worth, or book value, and its current assets less its current liabilities, or net working capital.
Buffett began buying Berkshire shares on the open market and became so intrigued with the bargain that in 1964, he bought a controlling interest in the company through his investment partnership. Soon after, however, Buffett realized that he had made a poor capital-allocation decision—making Berkshire “the dumbest stock I ever bought,” he would later tell CNBC. Although Berkshire was cheap, it was cheap for a reason: It continued to be hammered by low-cost competition. While the inventory was indeed worth something, there was little hope that the business would ever be consistently profitable. It was a classic “cigar-butt” investment, the kind that Buffett’s Columbia Business School teacher, Ben Graham, favored. It was good for only a few puffs—there was no lasting value in it.
Showing the adaptability he remains famous for, instead of trying to sell Berkshire, Buffett installed new management and instructed them to squeeze the company hard for cash. No more would Berkshire’s capital be allocated to looms and mills. “I’d rather have a $10 million business making 15% than a $100 million business making 5%,” Buffett told his new managers, according to Roger Lowenstein’s masterful biography, Buffett. “I have other places I can put the money.”
Those “other places,” of course, were in fact one place: the stock market. Buffett didn’t close the last Berkshire mill until 1985, but by the late 1960s it was clear that the company’s future lay not in the textile business but in the capital-allocation game. In 1969, Buffett closed his various investment partnerships. Those who wanted to remain invested with him took Berkshire shares in lieu of cash, and the modern-day Berkshire Hathaway was born.
Buffett began using Berkshire’s assets to buy other cheap stocks, and the proceeds from those winners to buy still more. The Berkshire machine really got going, however, when Buffett began buying insurance companies—not as shares in the open market but as wholly owned Berkshire subsidiaries. As a pure profit proposition, an insurance company faces prospects no rosier than a textile company. Both industries are characterized by commoditization, low barriers to entry and high capital requirements. However, Buffett understood something important about the industry before nearly anyone else did: Until the claims come due, insurers can invest the premiums they’ve taken in. With so-called long-tailed business, there can be decades between taking in the cash and paying out the claims. The resulting “float,” as it’s called—the cash generated by premiums yet to be paid out—can prove exceedingly valuable in the hands of a good capital allocator. Every year an insurance company must pay out claims, but every year it takes in new premiums, thus ensuring a sort of perpetual-motion machine of cash flow.
For more than 50 years now, Buffett has invested this float with uncanny acumen, growing and changing as an investor in a remarkably fluid way. Although he began as a deep-value investor drawn to bargain-basement stocks like Berkshire Hathaway, under the influence of his partner Charlie Munger in the 1970s Buffett began to buy higher-quality businesses with long and durable economic futures. Coca-Cola with its global brand, for example, remains a core holding. More recently, Buffett has come to understand that technology franchises can possess similarly sustainable economic characteristics; Apple is now Berkshire’s largest publicly traded holding by a factor of two (see my “An Evolve-or-Die Moment for the World’s Greatest Investors” from the Dec. 1, 2018 issue of Fortune).
Since Buffett took control of Berkshire, its book value, or net worth, has increased 19% a year and its stock value 20% to 21% annually—but these numbers don’t begin to convey the enormous wealth Buffett has created. One thousand dollars invested in the S&P 500 in 1965 would be worth nearly $200,000 today, but that same $1,000 invested in Berkshire would be worth 130 times more—$26.4 million. Donald Othmer, a college professor originally from Omaha, invested $50,000 along with his wife in an early Buffett investment partnership and received Berkshire A shares worth $42 a share in 1970. When the Othmers died, they left an estate valued at $750 million—and that was 20 years ago. Assuming the estate had remained invested in Berkshire, that initial $50,000 would have grown 100,000 times over, to $5 billion.
Underperforming, and underpriced
For investors who want to make capital-allocation decisions today, however, this is ancient history. The pertinent question is: At their present price of $225 a share, are Berkshire Hathaway shares worth investing in today?
Yes, slow and steady Berkshire has as usual played tortoise to the market’s hare, so as the market has bounded ahead over the last three years, Berkshire’s stock has materially trailed. As a result, the excellent collection of businesses that Buffett has assembled are now essentially available on sale. I’m confident that double-digit share gains lie ahead for patient investors, even if we assume—as investors increasingly do—that Buffett will not be around much longer to make decisions.
To value Berkshire we must first understand it—and as an operating entity, Berkshire Hathaway is almost as misunderstood as the concept of capital allocation. Most people think of Berkshire as either a collection of publicly traded securities or as an insurance company. While both are partly true, over the last twenty years or so Buffett has concentrated his capital-allocation energies not on fractional shares in the open market but instead on buying entire businesses that Berkshire can own and operate outright. Today, it is ironic that Berkshire is primarily what it was when Buffett bought it in 1964—an old-line industrial company.
Wholly owned manufacturing companies are today Berkshire’s single-biggest reporting segment, accounting for 35% to 40% of the company’s operating profits. There is no single dominant business here: Berkshire owns companies that make aerospace components, metal-cutting tools, industrial lubricants, household paint, insulation and carpet. Unlike the legacy textile business, however, these companies have been purchased only after passing Buffett’s capital-allocation test as quoted atop this column: They all have a long-term sustainable advantage over their competition. For some, like aerospace company Precision Castparts, it is a dominant market position, which gives the company economies of scale and market power; for others, like Duracell, it is a brand that allows them to charge premium prices; for others, like carpet-maker Shaw, it’s status as a low-cost producer, which allows Shaw to sell commodity goods at a lower price.
Apart from manufacturing, the Burlington Northern Santa Fe railroad accounts for 25% of Berkshire’s operating profit and is the company’s single biggest profit generator. Talk about a business with sustainable competitive advantages: Bought in the wake of the financial crisis a decade ago, Burlington is the largest freight network in the nation, has a de facto monopoly position in much of its western corridors, and moves freight at a material cost advantage to trucks. The railroad falls into one of Buffett’s favorite investment categories: a “call,” or option, on an enduring trend. If you believe as Buffett does that the American economy will continue to grow, owning a railroad is the perfect way to play that growth—it’s a call on the growth of American business. (For a wonderful read on the changing dynamics of the railroad business around the time Buffett bought Burlington, see this 2013 Fortune article.)
Electrical utilities, which represent another 15% of Berkshire’s operating earnings, are another monopoly-based call on the slow, steady growth of electricity usage. At 89, Buffett remains intellectually vigorous and is no mossback when it comes to alternative energy; fueled by tax credits, Berkshire’s utility assets are rapidly moving to wind and solar generation.
Taken together, the railroad, utilities and manufacturing segments generate a full 75%-80% of Berkshire’s operating profits. The other 20%-25% of earnings come from service businesses—car dealerships, wholesale distributors like McLane, and furniture, candy and kitchenware retailers like the Pampered Chef. All have some sort of “moat,” or edge over their competition.
Ironically, Berkshire’s smallest segment in terms of operating earnings is the one that drives much of Berkshire’s value: Insurance, which accounts for only 10% of operating profit but generates $125 billion of float. This float underpins much of Berkshire’s publicly traded securities portfolio, which when added together with the company’s cash is worth roughly $320 billion today, net of all taxes and contingencies.
What it’s worth
Because Berkshire has so many moving parts—more than 50 operating subsidiaries and hundreds of sub-subsidiaries—I try to keep it simple by dividing the company in half: Active, wholly owned operations like Burlington Northern on the one hand and the more passive cash and securities on the other. For the operating businesses, I assign what I consider to be fair-value multiples of earnings; I mark the cash and securities to market—that is, I simply take their market value.
As you can see in the accompanying two tables, Berkshire Hathaway is undervalued whether you look at it as a snapshot or (as I prefer) a motion picture that flows into the future. From the snapshot, you can see that when the cash and investment portfolio are backed out at market value, Berkshire is trading for only 12 times its operating businesses’ estimated 2019 cash earnings. That’s far too low a price: The S&P 500 average trades at 20 times 2019 earnings, and Berkshire’s collection of “moated” businesses are far above average.
Berkshire is also undervalued when analyzed as a dynamic, growing enterprise. Assuming the wholly owned businesses grow 6% to 7% a year, we can assign fair-value multiples to what the operating businesses should earn in 2023. I assume Berkshire’s railroad and utilities deserve the highest multiples because they are the best businesses: regulated monopolies immune to competition. The manufacturing and services segment deserve healthy but lower multiples—someone can always outcompete Duracell or the Pampered Chef—while the insurance business is not worth much as a profit-making concern. Its value resides in the float it generates for investment purposes, which is captured in the cash and securities lines.
Working through the math gets you to a fair value of $340 per class B share in 2023, about 50% above today’s quoted price of $225. Because it will take roughly three years to hit that price, the annualized gain should be in the mid-teens. That’s twice the broader market’s 7% to 8% historical return and thus highly attractive.
One of the reasons for the stock’s current underperformance is that many investors gripe that Buffett is not aggressively deploying Berkshire’s $120 billion in cash. As a longtime Buffett-watcher, I can tell you this complaint has been lodged many times, and every time Buffett either finds a large and lucrative acquisition, or prices come down and he finds several acquisitions at a cheaper price. He is being patient, in other words—another hallmark of a good capital allocator.
The other knock on Berkshire and its stock today is that, with Buffett turning 90 this summer, the master will not be around much longer. I am somewhat sympathetic to this argument: Although Buffett has appointed good understudies and has a (secret) succession plan, how do you replace Mozart? With Salieri, that’s how—an inferior musician. On the other hand, Buffett has been planning for Berkshire after Buffett for decades, precisely by buying durable, long-dated businesses that can outlive any single manager—even him. “We’re creating a Fort Knox here,” he said in 1998 when announcing yet another insurance acquisition. Brick by brick, business by business, he has made Berkshire a fortress with many, many moats.
It’s likely that nobody will duplicate Buffett’s capital-allocation skills, but that’s not necessarily a problem for Berkshire. Buffett has long resisted major stock buybacks at Berkshire because he’s confident in his ability to reinvest the cash, but his lieutenants will likely not be so sure. Buffett has raised the prospect that, after he’s gone, his successors may return massive amounts of capital to shareholders via both buybacks and dividends. This is no surprise: Buybacks are Capital Allocation for Dummies—you’re not doing anything particularly smart with the cash, but you’re not doing anything stupid, either. If Berkshire used all its available cash and equivalents to buy back stock, the share count would shrink by roughly 20%, and each share would in turn be 20% more valuable.
Who knows? His successors may even spin off Buffett’s many acquisitions, unraveling the great tapestry Buffett has woven over the last half century from a broken-down textile business. This collection of exceptional businesses may well be worth more on their own than as a complicated, somewhat opaque whole. Buffett has acknowledged this more than once, using as he often does equal parts intelligence, clarity and humor.
“If I die tonight, I think the stock would go up tomorrow,” he told shareholders at the Berkshire annual meeting in 2017. “There’d be speculation about breakups and all that sort of thing, so it would be a good Wall Street story.”
Adam Seessel is a portfolio manager at Gravity Capital Management LLC, a registered investment adviser. Certain of the securities mentioned in the article may be currently held, have been held or may be held in the future in a portfolio managed by Gravity. The article represents the views and belief of the author and does not purport to be complete. The information in this article is as of the publication date, and the data and facts presented in the article may change.
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