Future Acquisitions and Investments
Given the current size of Berkshire's operations, the biggest hurdle facing the firm, in our view, is going to be Berkshire's ability to consistently find deals that not only add value, but are large enough to be meaningful. While the $9 billion Lubrizol deal is sizeable, it barely puts a dent in Berkshire's growing cash hoard.
We were a little surprised to hear Buffett talk in a bit more detail about the "large international firm" Berkshire was recently considering buying. However, the deal did not go through because the size of the firm would have required Berkshire to use stock as part of the purchase price. Buffett and Munger have long been hesitant to use company stock when acquiring companies, reluctantly agreeing to do so during last year's purchase of Burlington Northern Santa Fe. The two men are strongly opposed to using what they consider to be an undervalued currency--that is, Berkshire's shares--to buy any company, as it would require them to sell part of their stakes in Berkshire's existing and, in their opinion, strong operating subsidiaries in order to acquire another business. Aside from stating that the potential acquisition "would have made headlines," Buffett did not offer any more information that would have given a hint as to what industry the international company operated in, let alone the name of the company itself.
Addressing our concern that Berkshire's size would make it increasingly difficult for the firm to find acquisitions large enough to move the needle, Buffett noted that it has become increasingly harder to get an edge when acquiring publicly traded firms. The need to invest substantial sums of money further decreases Berkshire's opportunity set, which affirms our opinion that future returns are almost certainly going to be less than they were in the past. And though Buffett continues to prefer acquiring privately held businesses, we would note that there are only a handful of privately held firms out there that would be large enough for Berkshire to consider purchasing. All of which means that Berkshire would need to either commit to even larger acquisitions of publicly traded firms, or increase the sheer number of deals that it does in any given year, in order to move the needle, which would raise the risk level associated with its acquisition strategy.
Despite the company's recent trend of acquiring more capital-intensive businesses, such as BNSF, both Buffett and Munger continue to believe that capital-light businesses are better. This makes sense as the companies most likely to generate high returns on capital (an essential criterion for a Berkshire investment) tend to have smaller capital requirements. That said, with many of Berkshire's existing businesses currently having low capital requirements (and, as a result, spitting off a lot of cash), we still see the need for businesses that require a lot of capital--such as utilities and railroads--making it all that much harder to guess where Buffett might be pointing his elephant gun next.
Excess Cash on the Balance Sheet
Buffett was quite open and candid in his comments about the increasing amounts of cash on Berkshire's balance sheet. Admitting that the company had too much cash on its balance sheet, which is especially troubling given the low-interest-rate environment and the extremely meagre returns that cash is generating, both Buffett and Munger commented that they've been looking at a number of acquisitions to put the cash to work. At the same time, the two men admitted that it has become increasingly difficult for Berkshire to put capital to work, noting that the opportunity set for capital allocation is getting much smaller as the company gets bigger.
Buffett also discussed how he allocates Berkshire's cash between various short-term investments. As opposed to some other companies, Berkshire puts nearly all of its cash in Treasury bills, despite the near-zero returns that these assets have been generating. Buffett believes, and we tend to agree, that the incremental few basis points of return that would be gained from other cash investments would not be worth the risk that they entail. Buffett also believes that holding Treasuries provides the firm with the nimbleness needed to respond to opportunities quickly.
As for thoughts about returning cash to shareholders--whether through dividends or share repurchases--Buffett conceded (for the first time that we're aware of) that Berkshire would eventually pay a dividend. Although unlikely to happen on his watch, he noted that a dividend would be paid by Berkshire when the firm's managers believed that reinvesting a dollar of capital would not generate in excess of a dollar in market value.
Buffett also alluded to the fact that Berkshire's shares would likely go down on the day that a dividend was announced, given that the news would send a signal to investors that the firm no longer had profitable reinvestment opportunities. All that said, we continue to believe that Berkshire could end up paying a special one-time dividend in the near term, especially if its cash balance continues to grow and the firm has limited investment opportunities with which to put money to work.
Thoughts on the Economy
Buffett remains very optimistic about the long-term prospects for the United States, believing that the form of capitalism found in this country is a very powerful driver of prosperity. Much as he has done in the past, Buffett pointed back to a number of struggles that the US has overcome. Most notably, he illustrated that since he was born in 1930, the year in which the US entered the Great Depression, the standard of living for Americans has improved by 6 times. Although Buffett does acknowledge the fact that the current slate of developing economies are likely to grow faster than the United States, which will decrease our relative prosperity, he thinks it would be a good thing, as both he and Munger feel that if other countries do not enjoy economic gains similar to those generated in the developed world, it would cause a great deal of unrest across the globe.
In contrast to their outlook for the US, Buffett and Munger (with the latter being particularly outspoken) are extremely concerned about the prospects for the eurozone, especially the long-term viability of the euro. This is the first time that we can recall either of them being so openly bearish about the region. Munger repeatedly chastised Greece for what he categorised as irresponsible behaviour. He analogised that country to a member of a partnership who only wants to drink all day while using the others' credit cards to lounge at the country club. Furthermore, Munger believes that the initial response to the European credit crisis was the equivalent to using a "pea shooter on an elephant."
In their opinion, the situation in Europe remains very precarious, with Buffett feeling that the European banks will continue to struggle as long as some nations in the European Union are unable to resolve their debt problems. He also noted that it might be difficult for some countries, such as Germany, to remain tied to a common currency if they have to keep bailing out other nations in the union, such as Greece. Both Buffett and Munger believe that the EU is in difficult straits because it lacks an ability to hold countries accountable for their actions.
The Insurance Market
While discussing Berkshire's preliminary first-quarter results, Buffett noted that the quarter would likely go down as the second highest period of losses for the reinsurance industry--trailing only the third quarter of 2005, which included a number of large hurricanes, including Katrina. Of an estimated $1.7 billion of catastrophe claims for the quarter, Berkshire expects to record more than $1 billion as a result of the earthquake and tsunami in Japan. This is basically in line with the proportional exposures other reinsurers have been reporting.
Due to the large first-quarter losses, Buffett expects Berkshire's insurance underwriting operations to lose money in 2011, which would be the first time in nine years that Berkshire has lost money on underwriting. Although we certainly understand Buffett's conservative stance on the business, we're not quite as pessimistic as he is owing to the fact that a large portion of Berkshire's (and the industry's) results on an annual basis are driven by the hurricane season in the US, which does not occur until the third quarter. Even though the odds this year favour a poorer season for the insurance industry, given the relatively low level of hurricane activity during the last couple of years, and early predictions calling for a more active hurricane season this year, we would note that hurricanes are nearly impossible to predict with any accuracy on an annual basis. At this point, though, it does look it would take a year of low hurricane incidence to drive Berkshire's insurance underwriting back into positive territory during 2011.
Apart from the statements made about the firm's preliminary first-quarter results, there was relatively little discussion about the insurance operations during the course of the weekend--a fact we found to be slightly disappointing given that the business represents approximately 60% of our estimate of Berkshire's fair value. Buffett did comment on insurance acquisitions, however, noting that he has looked at some reinsurers during the last couple of years, but that none of them had met his investment criteria.
Both Buffett and Munger believe that reinsurance is a difficult business, and that few of the companies in the industry have durable competitive advantages. Although not opposed to acquiring insurance firms, Buffett insists that the companies he does acquire have a moat. In our view, the best time for Berkshire to have acquired an insurance company has already passed. At the depths of the financial crisis, many high-quality insurers were trading at fractions of their net asset value. As the markets have rallied, though, many of these firms have increased in value, leaving a much smaller margin of safety for long-term investors.
Berkshire's Noninsurance Subsidiaries
The vast majority of Berkshire's noninsurance subsidiaries are cyclical businesses, which are sensitive to economic forces. In particular, the fortunes of a number of the firm's smaller operations--such as Shaw, Acme Brick, and Benjamin Moore--are closely linked with the housing market, relying on new-home construction or renovations to drive growth. Buffett admitted that the housing and commercial real estate markets remained very difficult but that the situation was likely to revert back to a more normal operating environment over time.
He pointed to the fact that the US is creating households at a faster rate than housing units, a trend which is obviously unsustainable. Buffett believes, though, that a rebound in the employment market is the real key to jump-starting an improvement in the housing market. A stabilising job and housing market would provide a tailwind for these businesses, affirming their long-term prospects. All that said, these businesses (which are included in Berkshire's manufacturing, service and retailing segment) don't represent a significant portion of the firm's total value--with insurance, railroads, and utilities accounting for more than three fourths of our estimate of Berkshire's fair value--making any discussion of their prospects more anecdotal in nature.
Effects of the Japan Disaster
Apart from the insurance losses, Berkshire had relatively minor exposure to the earthquake and tsunami in Japan. Buffett did, however, note that one of Berkshire's subsidiaries has a plant (that was recently upgraded) that is approximately 50 kilometres away from the Fukushima power plant. Considering its proximity, the plant has been shut down since the quake hit. The uncertainty as to when the plant will be allowed reopen will have an impact on that particular subsidiary.
Buffett and Munger also commented on the resiliency of the Japanese people, believing that the country would be able to rebuild and continue on a track toward economic prosperity. As for the disaster's impact on domestic nuclear-power expansion amid concerns at the Fukushima power plant, neither man felt that it would halt plans to build more plants in the US. Buffett noted that nuclear power is an important part of the world's equation in dealing with its emissions problems and that compared with other fuel sources, it has been relatively safe. Munger commented that we have to have the courage to take some risks and that the level of technology going into nuclear power plants today is significantly greater than that which went into plants like Fukushima, which was built some 40 years ago.
Morningstar senior stock analyst Greggory Warren contributed to this article.
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