Berkshire Hathaway’s (NYSE:BRKB) latest letter to investors is out, and Aleph Blog has provided an interesting critical analysis of Warren Buffett fan’s orthodoxy.
Here are 10 items Aleph Blog highlights about Berkshire, with some extended commentary from me on why they are important:
- Measuring Performance: Berkshire’s practice of measuring performance by the change in book value per share year over year is good. The change in book value per share is less susceptible to accounting manipulations than is the change in earnings per share. Book value per share is calculated as (Stockholders’ equity – Preferred Equity) / average number of common shares outstanding. When book value per share increases year over year, it suggests that earnings are increasing at a faster rate than is the issue of new equity. Recall that earnings flow to the balance sheet in the form of assets. As long as that increase in assets is not matched by the same increase in liabilities, equity increases. (Recall that Assets = Liabilities + Equity). Therefore, book value per share provides some insightful knowledge about managements’ efficacy. On that score, Buffett has performed very well.
- Capital Management: Berkshire’s structure allows it to take the free cash that its varied businesses generate and reinvest that cash in other businesses and acquisitions. To some very limited extent it has done this in public equities, such as Coca-Cola (NYSE:KO) and Washington Post Company (NYSE:WPO), among others, but the majority of its acquisitions have been in privately held companies, which companies then generate more cash for Berkshire to use for further investments. Berkshire’s largest recent acquisition was that of Burlington Northern Santa Fe Railway, a large train operator.
- Culture: A company’s culture is impossible to quantify but it has definite quantitative effects. The bankruptcies of Bear Stearns and Lehman Brothers can be attributed in large part to those companies’ malignant cultures; Berkshire is a conservatively managed company with a surprisingly small amount of excess expenses for a company of its size. (Warren Buffet has even wryly named his personal jet “The Indefensible“.)
- Insurance: Successful insurance companies are run on the basis of writing well-priced policies. This implies that well-run insurance companies have to turn down certain business. Theirs is not a sales culture. Further, the float that insurance companies generate is part of the free cash that Berkshire can use to make investments elsewhere. Insurance float is carried as a liability on Berkshire’s balance sheet, in that its various insurance companies may need to pay out claims. But if an insurance company is well-run, not all of its insurance contracts will result in payment, and that cash that is not claimed becomes an asset on Berkshire’s balance sheet. That is cold, hard cash that Berkshire can use to invest elsewhere. Again, assuming a well-run insurance company, float that is retained on the balance sheet becomes a gold mine for future investment opportunity.
- Manufacturing, Service and Retailing Operations: These various divisions of Berkshire provide it with some much-needed diversification. Examples of investments in this sector of the economy are its investments in NetJets and Marmon.
- Regulated, Capital-Intensive Businesses: Despite a general aversion to regulation among investors, regulation of a particular company can be advantageous for the investor if the company that is being regulated knows how to manage both the regulations and the regulators. Cynics will call this regulatory arbitrage or regulatory capture; a more charitable interpretation would be that these are well-managed companies. Companies that fall into this category include the aforementioned Burlington Northern Santa Fe Railway and Mid-American Energy Company.
- What Matters Least at Berkshire: Berkshire’s well-known investments in public equity actually comprise the minority of its overall portfolio.
- Todd Combs: Todd Combs is the investment manager that Buffett has appointed to manage the public equity investments that Berkshire makes.
- Derivatives: Despite Buffett’s famous claim that derivatives are financial weapons of mass destruction, he has used them to his advantage and has generated positive returns with them
- Debt: Buffett’s famous avoidance of debt, in both his management of Berkshire and in his personal life has meant that whatever cash he has on hand can be used for productive purposes rather than to reduce loan balances.