Updated from 10:35 a.m. EDT.
"The investor of today does not profit from yesterday's growth."
-- Warren Buffett
I have worshiped at the altar of Warren Buffett since the late 1970s -- ever since an investor and acquaintance, Conrad Taft, introduced me to his investment methodology and style at Berkshire Hathaway (BRK.A) . Indeed my writings over the last seven years have often been punctuated with Buffett-isms. I have repeatedly objected to, scoffed at and refuted criticisms of Buffett's strategy on this site and elsewhere.
That said, the rationale behind avoiding/shorting Berkshire Hathaway's common stock must be segregated from my respect/worship of the greatest investment icon of the last half century.
Berkshire Hathaway's beginnings were as humble as Warren Buffett has remained today. Its birth took place when he began to acquire the shares of Berkshire Hathaway (nee Berkshire Spinning and the Hathaway Manufacturing Company) in the early 1960s. His initial investment performed poorly but provided a platform for unprecedented growth through a series of well-timed acquisitions of publicly held companies. Berkshire stands, with a market value of about $200 billion, as the sixth largest company in the U.S. -- behind
Procter & Gamble
The insurance business line represents the most important contributor to Berkshire -- both as a percent of aggregate earnings as well as the all-important generation of cash flow for Buffett to invest in companies that are perceived to sell at a meaningful discount to estimated intrinsic value. Berkshire's shares have compounded in excess of a 21% annual rate -- or at twice the rate of growth for the S&P Index. Last year Berkshire's shares rose by over 25% against a 3% rise in the S&P Index.
"The future is never clear, and you pay a very high price in the stock market for a cheery consensus. Uncertainty is the friend of the buyer of long-term values."
-- Warren Buffett
As discussed below I have concluded that Berkshire's shareholders face a number of headwinds. Value will be more difficult to add than ever before, reflecting (among other things) the company's size, fiercer competition in the search for undervalued investments and a potentially more hostile economic and stock market backdrop. As well, the issue of Buffett's stewardship could weigh on the shares over the near term. In the extreme, the company could (without Buffett at the helm and in the fullness of time) be viewed as just another diversified conglomerate without a "moat."
There Will Never Be Another Warren Buffett: However, in part because of lucrative hedge fund compensation, the investment landscape is now inhabited by a lot more smart and aggressive managers combing for "value" -- far more than five, 10, 20 or 30 years ago. Over time Buffett has been increasingly willing to "guide" investors through his strategy by providing investment insights. It is said that imitation is the greatest form of flattery, and, through the years, a number of managers have imitated Buffett's strategy of "stepping over 1-foot bars" and buying at a discount to intrinisic value (making, in cases, the search more of a science than Buffett's "art" by even computerizing his process). Importantly, "newer" hedge fund managers -- like Duquesne's Druckenmiller, and SAC's Cohen -- have become the "new" Buffetts by developing more aggressive multi-strategy styles that have produced returns far in excess of Berkshire Hathaway. Others (particularly private equity firms like Kleiner Perkins Caufield & Byers) have realized more ebullient returns by embracing the technology sector, an integral growth driver that Buffett refuses to invest in. As a result of the above developments, the degree of outperformance of Berkshire's shares vis a vis the market has been narrowing - over the last decade (+12.5% vs. +4.7%) from the prior two decades (+31.7% vs. 15.0% and +36.8% vs. +9.7%). I expect that outperformance to continue to narrow. Not only is the value approach becoming a more efficient proposition as it is today littered with more participants, many more smart investors (activist hedge funds, longer term Buffett-like investors such as Edward Lampert and private equity firms) -- are armed with large and ever growing war chests putting them on the same level playing field today as Buffett. This leaves fewer rocks for Buffett to uncover. Finally, the timely and comprehensive dissemination of information is vastly superior in 2008 vis a vis the past. As a result (and in regards to investing in Berkshire), Mae West might have been wrong when she said, "Too much of a good thing can be wonderful." To paraphrase Buffett, the future holds less "cinches" and finding investment "fish in a barrel" will likely grow more difficult.
Investors Will Likely Immediately Dump Shares If Buffett Is No Longer at the Helm:Warren Buffett will be 78 years old in August 2008 (Charles Munger is 84). I am not signaling that he plans to step down even though his diet apparently consists almost entirely of unhealthy Cherry Cokes and cheeseburgers! (His actuarial life expectancy is another nine years!) Buffett has said that he intends to split his job into two positions -- a CEO and a CIO (he has already announced that a search is on). But should he decide to begin to delegate responsibilities (sooner than later), it can be expected that many long-term investors in Berkshire will likely consider cashing out. Considering the shares' liquidity (the average daily trading volume is roughly 1,000 shares) and the disproportionate role that Berkshire has on many individual and institutional investor Buffett devotees' portfolios this could put pressure on the stock.
Growth Has Slowed Recently: Berkshire has achieved compounded annual investment returns of 24% over the last 40 years, but returns have been less over the last five years. The market values the company at a premium to its peers as it appears to many that the historic outperformance and his investment alchemy can be duplicated. By implication, the $40 billion cash hoard at Berkshire is assumed to be a shore of latent investment value upon employment. By contrast I would argue that a combination of a more difficult stock market and economic backdrop when coupled with fiercer competition from other investment managers might render that $40 billion as having a "value" not much more than that $40 billion figure. In a recent Barron's column, Andrew Bary suggested that another conglomerate, Loews , could provide more value as (at that time) its shares sold at only 12x projected earnings and at a discount to its net asset value.
Buffett Says the Salad Days For Insurance, the Cornerstone of the Berkshire Complex, Are Over: After several years of no catastrophic experience it is inevitable that "the winds will roar or the earth will tremble... and results could be worse" in Berkshire's insurance segment. Regardless of 2008 catastrophic experience, profit margins will be under pressure in the face of a more competitive landscape. (Buffett expects insurance industry profit margins will shrink by about four percentage points in 2008 -- even barring a catastrophe).
An Outlook for Substandard Investment Returns and Uneven Economic Growth Will Provide a Headwind to Berkshire's Growth: My baseline view is that we are in a period of Blahflation (blah and inconsistent economic growth coupled with stubbornly high inflation) -- a difficult environment of headwinds for even The Master.
Berkshire Hathaway's Premium Valuation Has Seemingly Been a Byproduct of the Credit Crisis and the Perception of the Company As a Safe Haven: Its shares trade at a large premium to like financials and have increased in value by about 12% over the last six months (compared to an 11% decline in the S&P Index). Since March 5, 2007, Berkshire's shares are up by 26% vis a vis a 8% drop in the broader indices. Should stock market conditions improve, Berkshire's shares might underperform as deflated financial company shares regain their footing.
A Sum of the Parts Analysis, Relative EPS and Price/Book Comparisons of Peers Suggests that Berkshire's Shares are Overpriced Relative to the Market: A sum of parts analysis that compares Berkshire to its peers produces and assumes a 12x PE multiple on projected 2008 profits of $9750/share and a $121,000/share price target. A similar methodology assuming a melded price-to-book on insurance and other businesses at 1.6x and on finance and financial products of 1.25x yields a fair market value of about $125,000/share.
As Stock is Sold in the MarketPlace, Buffett's Contribution of (85%of his) Berkshire's Shares to Charity Could Create an Imbalance Between Demand and Supply as Stock is Sold in the Marketplace: Starting in 2006, Buffett began distributing Class B shares (602,500 shares at first and then declining by 5% a year). A shares convert into 30 Class B shares (1/200th voting rights), but not the other way around.
Some of Berkshire's Most Significant Stock Investments Seem Vulnerable to a Post Credit Bubble Crisis and May Not Recover for Years: The company is substantially exposed to not only financials but also to a weakening housing market and to pricing competition in insurance. While American Express ($9 billion investment market value), Coca-Cola ($9 billion investment), Wells Fargo ($7.8 billion investment) represent historically valuable business franchises, one can argue that they no longer will represent outstanding future value. They certainly have been a meaningful "paper" drain over the last 12 months. For now, Buffett's favorite holding period is forever, but Buffett's replacement could decide to sell any of these core positions (not likely, but always possible) and Berkshire would incur large capital gains taxes.
The Law of Large Numbers Works to Berkshire's Disadvantage: Buffett admits in this year's letter to shareholders that "Our base of assets and earnings is now far too large for us to make outsized gains in the future."
Berkshire's Disclosure is Weak and Opaque: There is little information on Berkshire's non-insurance operations contained in the company's financial statements and large forays into reinsurance/derivatives are not materially explained. There can always be negative surprises, especially considering the current seizure in the derivatives market and in light of the possibility of a more problematic and volatile future market environment. Over the years, investors have given Buffett a "mulligan" when he has made mistakes (e.g. General Re). When Buffett leaves Berkshire's helm, I expect investors to be less forgiving.
Know What You Own
: Berkshire Hathaway's biggest business operates in the insurance sector, and some other stocks in this sector include
. These stocks were recently trading at $16.68, $31.03 and $47.45 respectively. For more on the value of knowing what you own, visit
section, and to stay up to date on the insurance sector, don't miss
At time of publication, Kass and/or his funds were Short BRK.A and Long GE, although holdings can change at any time.
Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.