Dueling Fools

Dueling Fools
The Buffett Buffet
January 20, 1999

Berkshire Hathaway
Bear's Den

by Bill Barker (tmfmax@aol.com)

The working title for my yet-to-be-started autobiography is I'm Not Worthy, and in all likelihood it will prominently feature the tale of TMF Max being put in the position of attempting to cast aspersions on this fine company. Despite my reservations in undertaking this role, however, these Duels kind of presuppose two people taking opposing sides, so those who worship at the Temple of Warren will please forgive me for what follows -- duty calls.

Let's start with the fact that according to the latest 10-Q, Berkshire actually decreased in book value between December 31, 1997 and September 30, 1998, yet the stock price moved up about 40% during that time. Hold on a second -- doesn't Buffett state in his letter to shareholders every year that the movement in per-share book value is usually a pretty good proxy for the movement in intrinsic value of the company? And in that case, if Berkshire were priced even remotely accurately at the end of 1997, shouldn't Berkshire have pretty much kept its end of 1997 market valuation, which is, oh, $20,000 a share less than what it goes for today?

The reason that Berkshire's shareholder equity value decreased during the first three quarters of 1998 is that Berkshire's portfolio was hammered during that time. I should note that since the end of September, Berkshire's holdings of Coke, American Express, Gillette, Disney, Freddie Mac, Washington Post Co., and Wells Fargo have made a little bit of a comeback. Very little actually. For the year, Berkshire's equity portfolio ascended a mighty 7% or so, not quite in line with the S&P's 28% rise.

I'm not going to make a big deal out of a little short-term underperformance by either Berkshire itself or its core holdings. Hey, the market surely hasn't, gleefully bidding up Berkshire's price 52% during the year despite the lack of forward progress by so much of the company's equity and also shrugging off the fact that operating earnings for the company as a whole moved up maybe 10%.

Still, it is worth examining a little bit where the momentum is going on Berkshire's equity portfolio as a proxy for its capital allocation strategy going forward. As a diverting little exercise, take a quick look over at the Rule Maker Portfolio, and tell me what you see. There are some great technology and pharmaceutical stocks that had quite a year in 1998 -- Microsoft, Pfizer, Schering-Plough, Cisco, Intel, etc. Certainly a buy and hold philosophy applied to enormous companies continues to have great promise, and it's no wonder that the RM Port beat the market in 1998. But not all the Rule Maker stocks had such a great year. In fact, the bottom two performers in the portfolio, Coke and American Express, trailed the market's returns badly. Coincidentally, Coke and American Express are two of the three largest holdings of Berkshire Hathaway.

Now Coke and American Express were unarguably fantastic allocations of capital when Berkshire picked them up, as were Gillette and Disney, but those companies were all acquired quite a while ago, when each company traded at a far more reasonable multiple than any have sported in quite a while, or ever will again in all likelihood. Prospective buyers of Berkshire today are acquiring a lot of equity which takes the form of companies that are not only fully priced, but as a group are demonstrating essentially no growth at the moment. By the way, despite the stagnant share prices of Berkshire's core equity, I don't notice Berkshire picking up a lot more of any of these companies at these prices despite the large amount of cash that Berkshire currently has to play with.

While one simply has to trust Buffett's abilities to find good and safe allocations of capital going forward, one must also trust Buffett's words about the very real limitations on these abilities. In his 1994 letter to shareholders, Mr. Buffett wrote:

"Charlie Munger, Berkshire's Vice Chairman and my partner, and I make few predictions. One we will confidently offer, however, is that the future performance of Berkshire won't come close to matching the performance of the past... A fat wallet... is the enemy of superior investment results. And Berkshire now has a net worth of $11.9 billion compared to about $22 million when Charlie and I began to manage the company. Though there are as many good businesses as ever, it is useless for us to make purchases that are inconsequential in relation to Berkshire's capital. (As Charlie regularly reminds me, 'If something is not worth doing at all, it's not worth doing well.') We now consider a security for purchase only if we believe we can deploy at least $100 million in it. Given that minimum, Berkshire's investment universe has shrunk dramatically."

Berkshire's fat wallet has, of course, grown positively obese since those words were penned, and the shrinking universe that Buffett refers to above is smaller than ever. To date, investors have ignored the fact that the company's most central asset -- the ability to skillfully allocate excess cash from operations -- is largely neutralized by the full prices in today's market and economy. At a price to "look through earnings" multiple of roughly 40, Berkshire continues to trade at a valuation that implicitly accepts that Berkshire operates with the same advantages it always has.

However, the full valuation in the market of the kinds of companies that Buffett likes to acquire, complemented by Buffett's unwillingness to put capital into the more risky (and more rewarding) technology sector, means that of late Berkshire has been limited to allocating capital into such items as silver, oil, and zero-coupon bonds. I'm not even going to pretend to know the likelihood of these capital allocations providing superior investment returns, but I do know one thing: Berkshire's shrinking investment universe combined with Buffett's insistence on taking no chances in companies whose earnings aren't perfectly foreseeable means the hurdles are getting very high.

Considering the fact that Buffett has been willing in the past to publicly express caution when the company "is not undervalued," prospective buyers should beware.