The massive, hidden problem at Berkshire Hathaway, part I
From Porter Stansberry, Editor, The Stansberry Digest:
Today’s Digest is extraordinarily controversial
Much of what I am going to share with you below has never been discussed publicly before – anywhere. And there’s a good chance that almost everyone who reads this letter – even fans of my work – will completely dismiss my conclusions.
“Porter has really gone too far this time,” they’ll say.
Critics, meanwhile, will surely label this research “irresponsible”… or even fraudulent.
But before you rush to judgment, please at least read to the end of this essay. Even if you find it deeply offense (and many of you will), I urge you to please think carefully about the facts you’ll find below. That’s especially true if you strongly disagree with me.
And as always, please don’t hesitate to send me feedback on today’s Digest at firstname.lastname@example.org.
Warren Buffett is the ultimate American business icon
His firm, Berkshire Hathaway (BRK), has made a tremendous amount of money for an incredibly long time. America loves a winner. And even more than that, Buffett has turned his plain-spoken, “folksy” public persona into a bulletproof public brand… a brand that nothing can stain. As good as Buffett is at investing, he’s even better at PR.
And that’s why no one has noticed…
Berkshire Hathaway is being badly mismanaged.
The strategies, structure, and brilliance that created capitalism’s most perfect business have been abandoned, forgotten, or lost. Worse, Buffett has led the company into what could become a massive trap, a problem that has already cost the company its competitiveness with the S&P 500 and will eventually lead the company to be broken apart.
The heart of Berkshire still beats – it owns a collection of the world’s best insurance companies. But this incredible asset is being overwhelmed by a series of disastrous investments, the damage from something which is being hidden from shareholders.
These results and Buffett’s efforts to cover them up should lead shareholders to ask for him to step down as CEO. Berkshire should be split between its insurance companies and its wholly owned industrial firms, and most of the latter should be sold. Unless these steps are taken, Berkshire Hathaway will no longer beat a S&P 500 index fund.
It won’t come close.
To understand what has gone wrong at Berkshire, you must first understand what powered its incredible results
For decades, Berkshire followed a simple but incredibly powerful formula.
The first step was to gain access to huge amounts of capital. Buffett did this by acquiring property and casualty (P&C) insurance companies, starting with National Indemnity in 1967. He paid $8.6 million in cash for the business. But the company came with $19.4 million in “float.” That’s the cash the firm was holding from premiums on insurance policies that had not yet been paid out in claims.
As long as the insurance underwriters were disciplined and charged enough in premiums to pay all claims, P&C insurance would allow Buffett to amass a massive amount of capital for free. Actually, he would be paid billions and billions just for holding the capital. By 1980, Buffett had amassed $237 million in float. By 1990, the size of his investment capital had grown to $1.6 billion. By 2000, Buffett was managing $27 billion. Today, he holds $114 billion in float.
And all of the earnings from this capital are Berkshire’s to keep – as long as his underwriters do their jobs. And for the 14 years prior to 2017, Berkshire recorded underwriting profits of $28 billion. That is, in addition to all of the investment income produced by the $114 billion in float, Berkshire also earned $28 billion just for holding the money.
You can’t understand Berkshire’s incredible performance until you understand how insurance powers all of its profits
Berkshire isn’t running the same kind of race as everyone else. Virtually every other company in the S&P 500 has to pay for capital or slowly retain it from earnings. Berkshire, meanwhile, has billions and billions coming in the door from its insurance subsidiaries. All Buffett has to do is invest it wisely.
For decades, Buffett chose to invest most of Berkshire’s capital in high-quality, publicly traded companies
The stock market enabled Buffett to buy valuable parts (minority stakes) of great businesses. These companies required zero additional capital or management energy from Berkshire. This formula of gaining access to capital via insurance company float and investing it wisely (and cheaply) created capitalism’s most perfect compounding machine. Berkshire was an investment “snowball” rolling down a mountain, getting bigger and bigger through a force as powerful as gravity.
Buffett described the approach in his 1996 letter to shareholders…
Companies such as Coca-Cola and Gillette might well be labeled “The Inevitables.” Forecasters may differ a bit in their predictions of exactly how much soft drink or shaving-equipment business these companies will be doing in ten or twenty years. Nor is our talk of inevitability meant to play down the vital work that these companies must continue to carry out, in such areas as manufacturing, distribution, packaging and product innovation.
In the end, however, no sensible observer – not even these companies’ most vigorous competitors, assuming they are assessing the matter honestly – questions that Coke and Gillette will dominate their fields worldwide for an investment lifetime. Indeed, their dominance will probably strengthen.
In 1996, Berkshire’s $30 billion portfolio was a virtual capitalism “hall of fame.” Buffett owned American Express (AXP), Coca-Cola (KO), Gillette, Walt Disney (DIS), McDonald’s (MCD), Washington Post (GHC), and Wells Fargo (WFC). More than half of the portfolio was invested in American Express, Coca-Cola, and Gillette.
When Buffett bought entire businesses instead of portions of great companies, he went shopping for the same traits
He looked for companies that didn’t need much capital to grow, had management in place, and were extremely unlikely to fail… like See’s Candy, Nebraska Furniture Mart, Kirby, and Berkshire’s high-end jewelry businesses.
The compounding machine didn’t need companies that were going to grow fast. With the size of Berkshire’s capital pool growing fast (via huge increases to insurance-company float), all Buffett needed to do was find companies that could grow their cash distributions reliably, year after year. The most important thing was simply not to make mistakes. After all, if you knew your portfolio was going to grow by double-digit amounts every year simply because of additional capital, why would you take any risk?
But in 2003, Buffett began to radically move away from this winning strategy
It started with the acquisition of MidAmerican Energy…
Rather than focusing on owning parts of the best businesses in America or buying all of world-class smaller companies, Berkshire began to invest in firms that required enormous amounts of capital, were highly regulated, and that featured “commodity” economics. These investments broke the formula. They’ve resulted in a tremendous decrease in Berkshire’s ability to compound wealth. As a result, for the first time in Buffett’s career, he no longer routinely beats the S&P 500…
Crux note: Look for the second part of Porter’s controversial essay on Warren Buffett’s Berkshire Hathaway in tomorrow’s Crux newsletter.