The massive, hidden problem at Berkshire Hathaway, part II
Crux note: You can find part one of Porter Stansberry’s controversial essay on Warren Buffett’s Berkshire Hathaway right here.
From Porter Stansberry, Editor, The Stansberry Digest:
Berkshire Hathaway is a huge company
But to simplify it enough to understand how it has changed, you can view the business in three parts.
First is the insurance companies. My team of analysts knows as much about the P&C insurance business as anyone in the world. We study every company in the sector and our investment model for this industry produces annualized returns of 20%. We know that Berkshire Hathaway’s insurance operations are the best in the world, bar none. We estimate that over the past 10 years, the book value of Berkshire’s insurance companies has grown by around 140%. Today, we peg the value of Berkshire’s insurance companies at about $250 billion to $300 billion.
You should know that substantially, all of Berkshire’s investments in publicly traded stocks are held in these insurance subsidiaries. Buffett’s stock investments are led by a $28 billion investment in iPhone maker Apple (AAPL). Currently, his portfolio is worth $170 billion. So roughly half of the value of his insurance companies are in the form of publicly traded stocks. Dividends from Buffett’s stock portfolio totaled $3.7 billion last year alone.
But these investments just aren’t what they used to be. Beyond Buffett’s obvious plunders and big investment losses – IBM (IBM), for example – the entire quality of the portfolio has degraded over the years.
Far from being a capitalism hall of fame, most of the public companies Buffett now owns feature extremely low returns on assets. Most of the return on equity in his portfolio depends on leverage – not one-of-a-kind assets or consumer franchises. We took his portfolio and combined Berkshire’s share of each company into a virtual business so that we could analyze the quality of the entire portfolio. Buffett used to offer a similar analysis of his portfolio, by showing the “look through” earnings of his holdings.
Doing the same kind of analysis, we’ve built a model we call Berkshire Investments, Inc. This shows us exactly what Berkshire’s interests in these businesses would look like if they were a stand-alone company. Berkshire Investments, Inc. produces $63 billion in revenue, $11.6 billion in operating earnings, and $8.4 billion in free cash flow. Profit margins are good – 18%. But almost all of this margin is the result of leverage. Return on assets is only 2%. In terms of capital efficiency, the portfolio is middle of the road.
Buffett moved away from great consumer businesses that were extremely capital-efficient and moved into banking. He invested around $20 billion in four banks – Wells Fargo, U.S. Bancorp (USB), Bank of New York (BK), and Bank of America (BAC). That’s about 20 times more money than he invested in American Express or Coke.
Except for the Bank of America stock that he bought during the crisis of 2008, these investments have been marginal. They’re unlikely to produce superior results going forward because they can’t grow without retaining a lot of their earnings.
In no way do these investments match the kind of investments that Buffett routinely made prior to the early 2000s. And that’s not to mention the $15 billion worth of airlines he bought recently, or the other choices that just don’t match any of his previous investments, like $3.2 billion in General Motors (GM).
Regardless of whether these other choices end up becoming great investments, they do not match the kind of capital-efficient, high-margin, low-leverage, growing businesses that Buffett used to favor. There’s nothing inevitable about any of these firms – except that they will eventually fail because that’s the track record of both Delta (DAL) and GM.
The second part is that Berkshire owns approximately 45 other major businesses
There are manufacturers (like Marmon), service companies (like Flight Services), and retailers (like See’s Candies). For the most part, these are excellent businesses. In 2016, on $24 billion in net tangible assets, Buffett reported that they earned an after-tax return of 24%.
While there are probably a fair number of mistakes in this group (most of the newspapers Buffett bought recently are struggling), these firms individually don’t require much capital and aren’t big enough to make much difference to Berkshire as a whole. Unfortunately, Buffett no longer details any of their performance figures in his letter, so we really don’t know which of these groups is shining and which is struggling.
The third part of Berkshire is where I think was the major mistake
Since 2003, Buffett has invested an incredible amount of capital into two highly regulated utilities. Most investors don’t understand how big these investments have become or how much more capital will be sucked into them. These two companies – Berkshire Hathaway Energy and the Burlington Northern Santa Fe (“BNSF”) railroad – truly threaten both Berkshire’s business and Buffett’s legacy.
These two regulated utilities contributed 44% of Berkshire’s earnings last year (excluding investment income). That’s almost half of Berkshire Hathaway’s after-tax operating income, a statistic that has steadily grown as these firms continue to require more and more capital. And that’s the concern… As Berkshire continues to invest heavily in these businesses, more and more of its earnings will become locked in highly regulated, capital-intensive utilities.
The way Berkshire used to work was as a compounding machine
Money comes in the door via insurance float. It gets put to work in highly capital-efficient companies that are completely reliable. It circulates back to the parent company in the form of dividends or, in the case of wholly owned firms, in the form of retained earnings. It goes back out again to buy another insurance company and garner more capital via the firm’s float.
The trouble now is that because Buffett has put so much capital into his massive, regulated utility bets, the machine is essentially broken.
When measured by the cash, the current value of the stock, and the assumed debt that Buffett paid to acquire BNSF, Berkshire spent $52 billion to get its railroad. We estimate that Berkshire has spent a total of $20 billion (including assumed debt) to build its energy company. But the purchase price is just the beginning of the problem. These are enormously capital-intensive businesses. Last year, Berkshire spent almost $10 billion in cash on capital improvements on the railroad and its energy company.
But the energy company retains 100% of earnings. It pays no dividends to Berkshire. Yes, the value of the energy company continues to grow, but Berkshire can’t circulate this capital back through its compounding machine. The company’s huge advantage is broken.
Even worse, the railroad is a terrible investment. Capital expenditures continue to grow, but the railroad’s profits don’t. In 2016, BNSF earned $3.5 billion in net income – about the same amount of money it made in 2012. Since then, Berkshire has invested more than $30 billion in the railroad.
The problem with BNSF isn’t just the nature of its business. Compared with its peers, the company requires far more capital and produces far worse earnings. Here’s how Buffett himself described these problems (in 2014), back when he was still willing to include a discussion about its results in his annual letter…
This problem [a decline in earnings] occurred despite the record capital expenditures that BNSF has made in recent years, with those having far exceeded the outlays made by Union Pacific, our principal competitor. The two railroads are of roughly equal size measured by revenues… but our service problems exceeded Union Pacific’s last year, and we lost market share as a result. Moreover, U.P.’s earnings beat ours by a record amount.
Clearly, we have a lot of work to do. We are wasting no time: As I also mentioned earlier, we will spend $6 billion in 2015 on improving our railroad’s operation. That will amount to about 26% of estimated revenues (a calculation that serves as the industry’s yardstick).
Outlays of this magnitude are largely unheard of among railroads. For us, this percentage compares to our average of 18% in 2009-2013 and to U.P.’s projection for the near future of 16-17%. Our huge investments will soon lead to a system with greater capacity and much better service. Improved profits should follow.
But did they? Buffett doesn’t make it easy to find out. We dug through the 10-K to figure out what has happened. It’s ugly.
Based on the total cost to acquire BNSF and judging returns based on cash flows available to Berkshire Hathaway (retained earnings minus capital expenditures), we estimate Buffett has made approximately 2.6% a year on this investment.
As I mentioned earlier, regulated utilities made up about 40% of Berkshire’s total earnings last year
But none of the earnings from the power company are available to Berkshire. And the railroad earns virtually nothing, compared to the amount of capital invested. Worse, more and more of Berkshire’s capital must be used to continually feed these regulated machines. Why would Buffett continue to make these investments? In his own words, he says…
Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. It is concomitantly in our self-interest to conduct our operations in a way that earns the approval of our regulators and the people they represent.
In short, over the past 20 years, Buffett has gone from powering his incredible compounding machine with “inevitables” – the greatest businesses ever built – to powering his empire with cash-eating, regulated utilities. And the future value of these investments, assuming he can actually turn the railroad around, rely on the honesty and integrity of our elected officials.
Buffett has gone from investing with the “inevitables” to investing at the mercy of the “incorrigibles.“
That’s not a great bet, in my view.
But a bigger problem looms for investors today
As these investments continue to consume more and more of Berkshire’s capital, relatively smaller amounts of money can be recycled through the compounding machine. On a relative basis, more and more of Berkshire’s capital is becoming trapped in these low-margin, capital-intensive, regulated businesses.
That means beating the S&P 500 has gone from being something that happens practically every year to something that happens about half the time. If this trend continues, it will become progressively more difficult for Berkshire to beat the S&P 500, and in another five years or so, it will be virtually impossible.
Buffett made a huge mistake buying BNSF
His power company might turn out to be a good investment, but the capital intensity of the asset base isn’t right for Berkshire’s business model. It doesn’t allow for cash to returned to the parent company. As a result, Berkshire’s magic is fading. The compound machine is broken.
For decades, Buffett has maintained the same stance
He has said that if Berkshire’s book value didn’t grow faster than the S&P 500 for any five-year period, he should relinquish control of the firm’s capital and begin paying a dividend. But when that happened in 2014, Buffett simply “moved the goalposts.” He ignored all of his previous statements and changed the measuring period to six years or longer. He has long criticized other CEOs for this type of behavior. Worse, he has made the decision to stop discussing the results of his massive investments in energy and railroads.
Buffett has made a series of bad stock investments
But that’s not the real problem. The real problem is that he has locked Berkshire into providing an unlimited amount of capital to its regulated utilities, investments that offer no chance of anything other than paltry returns. And nobody is going to stop him.
A legendary investor once warned about the fate of management teams that become so successful that pride morphs into hubris. I’m sure Buffett won’t listen to me. So maybe he’ll take the advice he himself once offered the management teams at the companies he owned. As he wrote in the 1996 letter to shareholders…
A far more serious problem occurs when the management of a great company gets sidetracked and neglects its wonderful base business while purchasing other businesses that are so-so or worse. When that happens, the suffering of investors is often prolonged…
Loss of focus is what most worries Charlie and me when we contemplate investing in businesses that in general look outstanding. All too often, we’ve seen value stagnate in the presence of hubris or of boredom that caused the attention of managers to wander.