Warren Buffett’s house needs remodeling. Barron’s made a bullish case for Berkshire Hathaway (NYSE: BRK.A) this weekend touting Mr. Buffett’s sizeable, and growing, war chest. The article, quite frankly, is missing the point. BRK.A is an ugly conglomerate in need of restructuring.
The primary rationale behind the conglomerate structure is that the company will benefit from diversification. Thus, it should be better able to withstand the ups and downs of the market cycle. In addition, they should have a financing advantage over more focused but smaller firms. However, with the company’s triple-A rating now gone, some of the relative funding advantage has been lost. Recall, American International Group (NYSE: AIG) and General Electric (NYSE:GE) both had this advantage which allowed their financial subsidiaries to become market leaders – which ultimately inflicted significant pain on shareholders. Perhaps an unintended consequence of the conglomerate structure?
Over the past 10 years, BRK.A has grown at a compound annual rate of approximately 5%. This compares to purchasing a 10 year bond yielding 5.43% in January of 2001. I know the cheerleaders will say that BRK.A outperformed the S&P whose compound annual return was less than 1% over that same period, but is it the right metric of comparison?
At some point, BRK.A will lose its luster as a cult stock and it will be valued on its performance alone. The Barron’s article points out that BRK.A has seen its “premium” multiple decline from a ten average of 1.6x book to 1.3x book today. However, should the company trade at a premium? Conglomerates, by definition, should trade at a discount reflecting the “forced” purchase of unwanted businesses. Further, as pointed out in the Barron’s article, you have analysts covering the stock who do not fully understand each of the disparate business lines.
The Oracle of Omaha often talks about investing the “float” from its insurance operations. If this is a hedge fund in drag, don’t investors deserve higher annual returns? Perhaps that is why the guy who once called derivatives “financial weapons of mass destruction” is now short S&P equity put options to the tune of $2 billion. As an aside, it should be noted that most P&C insurance companies do not have large equity holdings. The reason for this is asset/liability management. For example, if significant claims come in at one time, the insurer would need to liquidate the portfolio at potentially unattractive prices to pay for the losses.
Berkshire owns large stakes in Coca-Cola (NYSE: KO), Wells Fargo (NYSE: WFC) and American Express (NYSE: AXP) totaling $30 billion in market value, this is approximately 15% of BRK.A’s $200 Billion market cap. The (high-class) problem now is that they have held the stocks for so long, selling would create significant taxes. If you’re an investor, you could purchase each of these stocks on your own. Why should you pay Buffett a premium to buy them for you? Short of any activism by Berkshire’s management team, I fail to see the utility in owning them – how about spinning them off in a trust. Wouldn’t you rather pay an active hedge fund manager who is going to generate alpha on an annual basis?
There are a number of studies that extol the virtues of spin-offs. McDonalds’ (NYSE: MCD) spin of Chipotle (NYSE: CMG), up over 900% from its $22 IPO price in January of 2006, is a perfect example. The spin allowed investors to value the high growth chain separately from its slow but steady growing parent. MCD, for its part, has held its own since the spin more than doubling in price while the S&P has been flat. Recent news of Fortune Brands (NYSE: FO), ITT (NYSE: ITT) and Wendy’s/Arby’s (NYSE: WEN) deciding to become more focused entities have proven that the conglomerate discount is real. In fact, ITT jumped 16.5% just on the announcement that was going to break up the firm – not bad for a $10 billion company.
Will Berkshire break-up? Not in Mr. Buffett’s lifetime (go ahead, prove me wrong). While he has been a good steward of investors’ capital over the long run – it’s time to see the stock for what it is. There is value in being the elephant in the room, but if you can’t generate outsized returns, perhaps that capital is better utilized when placed in more nimble hands. If Buffett and his merry men want to run a hedge fund, they should file the appropriate documents and raise capital. If young guns without proven track records can raise multibillion dollar funds, I’m sure Buffett et al would be able to do likewise.