Idiot-Proofing Berkshire Hathaway

I'd love to be able to reveal the next CEO of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) -- that would be quite a scoop -- but I can't. However, preparing for the post-Buffett Berkshire is more than simply selecting an operating CEO and a CIO (chief investment officer). I think the shift toward highly capital-intensive businesses that Buffett highlighted in his most recent shareholder letter is another part of that process. Let me explain.

They need lots of cash
Berkshire doesn't break out capital expenditures by subsidiary company, so I used some publicly traded peers to highlight the significant investments some of its more recently acquired companies require:

Berkshire Hathaway Company

Publicly Traded Peer

Capital Expenditure / Operating
Cash Flow (2009)

Burlington Northern Santa Fe

Union Pacific (NYSE: UNP  )

76.8%

Marmon Group

General Electric (NYSE: GE  )

35.1%

MidAmerican Energy

Exelon (NYSE: EXC  )

53.7%

Source: Capital IQ, a division of Standard & Poor's.

Buffett has spent a lifetime building Berkshire Hathaway, "a sweeping canvas that is his masterpiece," in the words of his biographer, Alice Schroeder. While he takes a hands-off approach to the running of Berkshire's subsidiary companies, one of his critical roles is capital allocation -- deciding what to do with the enormous gobs of cash these companies generate (in the 12 months to Sept. 30, 2009, Berkshire free cash flow was $6.2 billion).

Idiot-proofing Berkshire Hathaway
Shifting toward capital-intensive businesses and accepting "decent returns" (Buffett's words) over outstanding ones is Buffett's solution to the problem of Berkshire's size -- quite simply, there are fewer external opportunities to reinvest Berkshire's cash that will make a difference to its bottom line (Microsoft (Nasdaq: MSFT  ) has the same problem). But I think Buffett's rationale may go further than that. Increasing Berkshire's internal cash requirements is a means of protecting his "masterpiece," by reducing the risk that his successor will make ill-considered investments with the cash.

Buffett once quipped: "I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will." Embracing capital-intensive companies may be an effort to mitigate that risk within his own enterprise.

Warren Buffett is simply playing with too much money to invest in small-cap stocks, but you aren't. Anand Chokkavelu highlights the home run stock that Buffett can't buy.

Fool contributor Alex Dumortier has no beneficial interest in any of the stocks mentioned in this article. Berkshire Hathaway, Exelon, and Microsoft are Motley Fool Inside Value recommendations. Berkshire Hathaway is a Motley Fool Stock Advisor choice. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (16) | Recommend This Article (45)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 08, 2010, at 2:18 PM, benknoll1 wrote:

    Spot on.

    The author has captured the essence of what Buffett is trying to do, I believe. Buffett has always followed his 2 essential rules: #1- Don't lose money; #2 -

    Remember Rule #1. His latest moves are ones calculated not to maximize return under his few remaining years at the helm, but to minimize the risk of loss in the years following his departure.

    The only point the author misses is that Buffett is also reducing his risks in the insurance sector. I suspect this is also part of his calculation to make the culture of the company less prone to taking big financial bets once he and Ajit Jain are gone.

  • Report this Comment On March 09, 2010, at 6:06 AM, jpaa74 wrote:

    It's probably because I'm a complete idiot, but after reading this article, I still don't understand your proposal on how to "Idiot-proof BKR."

    Quote #1:

    " Increasing Berkshire's internal cash requirements is a means of protecting his "masterpiece," by reducing the risk that his successor will make ill-considered investments with the cash."

    Are you saying that by increasing BRK's internal capital expenditures, this will make it idiot-proof? That doesn't make any sense at all... ROE, ROA, ROIC, you name it, would go down the drain... How are capital expenditures not also "ill-considered investments with the cash?" Capital expenditures is a necessary evil, and something that needs to be taken into consideration when estimating a company's intrinsic value.

    Quote #2:

    "Embracing capital-intensive companies may an effort to mitigate that risk within his own enterprise."

    This last sentence I don't understand at all... If I interpret it the way I believe what you're trying to say, all I can conclude is that you must be sarcastic, as again, this doesn't make any sense...

    In my (very humble, and not very intelligent) opinion, the best way to "Idiot-proof" BRK after the Oracle is gone is to stipulate that if BRK is trading below a price that would equate to an earnings yield that Buffett would consider provides shareholders decent returns on their money, then buy back the shares. If it trades above this price, then pay out the earnings in dividends (taking dividend taxes into consideration in the equation of course).

    That way, and Idiot wouldn't be able to waste shareholders capital, which increasing internal capital expenditures certainly would...

    Sorry, I really don't understand your reasoning, but then again, you're the CFA and I'm the idiot (or fool with a small "f").

  • Report this Comment On March 09, 2010, at 9:05 AM, ryanalexanderson wrote:

    Snowballinvestor,

    My interpretation is that capital-intensive businesses have very high barriers to entry and may have appropriate margins. If small, nimble investors can stick to small businesses that Buffett is locked out of, to get an advantage, then Buffett should pursue spaces where large amounts of capital are required - getting -him- an advantage when negotiating deals. Since he's good at that.

  • Report this Comment On March 10, 2010, at 7:45 AM, jpaa74 wrote:

    Thanks ryanalexanderson, your explanation makes a lot of sense and I'm starting to understand the reasoning much better now. Much appreciated!!

    However, I still don't agree with the author that a capital intensive business would be something that Buffett would look for on purpose. He's always said to buy businesses that consistently generate loads of cash, and at the same time done need to reinvest that cash just in order to stay in business, but rather can be used for expansion and to grow the business, as long as the retained earnings can generate above average returns, and ideally close to the company's average ROE, ROA, and ROIC, or else give the money back to shareholders either by share repurchase, or through dividends.

    I also don't think that businesses that require a lot of capital to be reinvested in order to just stay in business adds THAT much to increase the barrier to entry for other firms. Take BNSF for example, I believe their moat has more to do that the states gave them land when the railways were first built, and even if states would give a potential competitor land as well, they would no way be able to compete with BNSF. It's kind of like Buffett's "survival of the fattest" which he used when describing why a town or city will eventually only be able to economically have one news paper. Having two means that neither would be profitable, but one newspaper is very profitable as they have (or used to have at least before the Internet) a monopoly for advertising revenue in that town or city.

    Lastly, although I do understand your explanation and it makes sense to me, I don't see ANY mentioning about "barriers to entry" "Moat" "Competitive advantage" etc in the article. Perhaps one was supposed to get this any way, but it certainly didn't come to my mind.

    Personally I think Buffett would be much happier if companies such as BNSF were less capital intensive and I certainly don't see how it would make BRK "Idiot-proof" after the Oracle is gone...

    This article still really doesn't make any sense to me at all, but again, it may be just me...

    If someone could explain the point of the article to let's say a five year old with below average IQ, I'd be all ears, and very thankful! Cheers.

  • Report this Comment On March 12, 2010, at 11:15 AM, StarWitchDoctor wrote:

    great quote and very true. You must either focus on the CEO and his abilities or you must focus on idiot proof cash flow. as we reach our twilight years, we should be taking our cues from rich men that are slightly older than us.

    Hence buffets movements are what i am watching. Perhaps there is no point to the article, perhaps its like in the border, to educate, amuse and enrich.

    I dont think there is any investment advice in the article and perhaps therefore it appears to have no POINT.

  • Report this Comment On March 12, 2010, at 1:43 PM, downisland wrote:

    Idiot proofing Berkshire is right! I understand the author's point. Who says the next CEO will be as good at allocating capital as Buffett.

    Buffett took 34 Billion out of his sucessor's hands and said instead of your "good ideas" let's just put this enormous chunk of change into a railroad. Railroads have moats, a new economic lease on life, a good rate of return, can compete in an inflationary environment and will hopefully provide years of stable long term returns. I hope Ajit doesn't leave.

  • Report this Comment On March 12, 2010, at 2:20 PM, gimponthego wrote:

    Here's your 5 year old right here..with a typical question one would expect from a 5 year old. Now that I own several shares of BRKB, I'd love to know what stocks compose this symphony of Capitalist Delights.

    Would someone steer me in that direction, please? I trade within my IRA at my long time bank. Would the info come via them, Fidelity, The Street or is there an initiative I should take? Thanks In Advance! J.

  • Report this Comment On March 12, 2010, at 2:53 PM, Cane07 wrote:

    Most here have hit on one of Warren's secrets, even if the author did not. It's competitive moats. Most of BRKs holdings have some sort of significant competitive advantage in network, scale, cost, "marketing brand awareness", etc...

    The "idiot-proofing" becomes easier to do for BRK because its more difficult for a business with significant competitive advantages (i.e. moats) to be mismanaged. Though, it's almost always possible. Technologies, regulations, and times in general change. At one time, General Motors, Pan Am, and even Warren's Washington Post company had very wide moats. These have either seen their moats widdle away to nothing or become smaller in size.

    You can't idiot-proof a business. But moats help you maintain advantages and make it easier to survive the decisions of idiots for a little while longer (than otherwise would be)

  • Report this Comment On March 12, 2010, at 10:18 PM, RaiddinnRZ wrote:

    Warren Buffett doesn't buy a business unless he thinks it will throw off obscene amounts of cash flow starting like 3 - 5 years out.

    He bought Burlington Northern and every other company for exactly that reason.

    Trust me when I say that he isn't going to buy a company for anything other than FCF generation.

    Whether the business is capital intensive or not doesn't really matter. If it is hugely capital intensive and still manages to throw off obscene FCF, its good. Better is low capital intensiveness, but high and high is better than low and low.

  • Report this Comment On March 13, 2010, at 7:44 AM, jpaa74 wrote:

    Hi RaiddinnRZ

    I agree fully with you. As long as the FCF is high enough, regardless of how high the firm's capital expenditures are, to provide shareholder a decent return on their capital, I'm all for it, and I believe this is the reason why Buffett bought this business. NOT because it would "Idiot-proof" BRK once He is gone, as the author of this article is trying to argue...

    Hi downisland,

    I'm all for Idiot-proofing BRK as well, and agree that investing a lot of the cash he already had on the books in a great business that will throw off more cash in the future is a great decision, instead of invested in something that would return less on invested capital, which his successor possibly would have done.

    However, this is NOT what the author is arguing... The author is arguing that by ingesting in companies that are capital intensive, Buffett's successor wouldn't have any cash left to do stupid things with, as the capital intensive business would eat up all the cash generated by the other great businesses. At least if I understood the article correctly, and I actually wrote him and got the response that that was indeed his point...

    To me, this is just bizarre... but then again, I'm just a 5 year old fool on the hill...

    (I wish the author would comment here to clarify his point, so I'm not putting words in his mouth, but I have from the beginning emphasized that I really don't understand the point of this article, and an article without a point, what's the point with that?)

  • Report this Comment On March 13, 2010, at 7:46 AM, jpaa74 wrote:

    Hi RaiddinnRZ

    I agree fully with you. As long as the FCF is high enough, regardless of how high the firm's capital expenditures are, to provide shareholder a decent return on their capital, I'm all for it, and I believe this is the reason why Buffett bought this business. NOT because it would "Idiot-proof" BRK once He is gone, as the author of this article is trying to argue...

    Hi downisland,

    I'm all for Idiot-proofing BRK as well, and agree that investing a lot of the cash he already had on the books in a great business that will throw off more cash in the future is a great decision, instead of invested in something that would return less on invested capital, which his successor possibly would have done.

    However, this is NOT what the author is arguing... The author is arguing that by ingesting in companies that are capital intensive, Buffett's successor wouldn't have any cash left to do stupid things with, as the capital intensive business would eat up all the cash generated by the other great businesses. At least if I understood the article correctly, and I actually wrote him and got the response that that was indeed his point...

    To me, this is just bizarre... but then again, I'm just a 5 year old fool on the hill...

    (I wish the author would comment here to clarify his point, so I'm not putting words in his mouth, but I have from the beginning emphasized that I really don't understand the point of this article, and an article without a point, what's the point with that?)

  • Report this Comment On March 13, 2010, at 8:58 AM, jpaa74 wrote:

    One example of a highly capital intensified (although also a commodity type business, so can't really be compared with other capital intensive business, such as BNSF, which clearly has a huge moat with sharks and piranhas in it) is the original Berkshire Hathaway company when they were just a textile mill. Buffett has many times said it was one of his worst investment, a cigar-butt with no puff left in it, and that he would have been a lot better off if he had never heard of the company, and allocated his capital in other businesses.

    I believe that this was part of his learning experience though, and that he now detest companies which requires high capital to be reinvested in the business, just to stay in business. With BNSF though, other benefits, such as the great moat, most efficient way to transfer goods, which will always be needed, and will just increase with time, were worth more to Buffett, even when taken in to account the negatives such as the high capital intensiveness, strong ly unionized, and highly regulated, etc.

    Just my two yens' worth...

  • Report this Comment On March 13, 2010, at 1:43 PM, buffettphan wrote:

    To poster Gimponthego, The below link will take you to a list of the stock holdings in Berkshire-Hathaway's portfolio. It can be sorted six different ways, just by clicking on the appropriate heading.

    http://www.cnbc.com/id/22130601/site/14081545/

    Congratulations on you new investment.

  • Report this Comment On March 15, 2010, at 2:54 PM, TMFAleph1 wrote:

    @snowballinvestor & RaiddinnRZ,

    You do know that capital expenditures are subtracted from operating cash flow in order to obtain free cash flow, right? Higher maintenance capex results in lower free cash flows.

    Alex Dumortier, CFA

  • Report this Comment On March 17, 2010, at 7:46 AM, jpaa74 wrote:

    TMFMarathonMan,

    Yes, I'm fully aware (and I'm sure RaiddinnRZ is as well) that free cash flow is operating cash-flow (EBITDA) minus the capital expenditures, and that Buffett uses this (or estimates a company's future free cash-flow as, quoting Keyenes he'd "rather be vaguely right than precisely wrong!") and discounts it back to today\s dollars using either the long 10 year Government bond as the risk free rate and as a yard stick to compare againts (as risk free as you can get I suppose), or whatever the minimum return he would like the investment to return to him and his shareholders. (most of us I would think doesn't need any accounting lectures...).

    Again, what's your point though? Why in the world would LOWER free cash-flow EVER be a GOOD thing, and how would it Idiot-proof BRK without at the same time COMPLETELY DESTROYING shareholders value? This is something Buffett would NEVER do.

    In what investing scenario would LOWER free cash flow be a good thing, and something actually desireable? In my little world, the higher the free cash-flow, the better the investment (just one criterion though among many others).

    Again, I'm the fool (small f) though, and you're the CFA (I'm CISA and CISSP though, but not flag waiving it), and I'm really not impressed!

    Would appreciate a more thorough answer and ideally answers to my questions as well.

    SnowballInvestor

  • Report this Comment On March 28, 2010, at 4:02 AM, jpaa74 wrote:

    It seems I won't be getting any answers to my questions, or any explanation regarding the point and logic behind this article (except from ryanalexanderson, which I much appreciated), so either there's some serous flaw in my logic, and I'm the bigger fool, or something is seriously wrong with the reasoning of this article as to how to fool-proof BRK. Until some kind Fool proves me wrong, I'll assume the former.

    SnowballInvestor.

    PS, if any of my former posts offended the author or anyone else, I sincerely do apologize. It was certainly not my intention; just to understand the logic and reasoning in the article on how the arguments laid out (including the clarifications in the posts) would fool-proof BRK after the Oracle has left us (may it be a long long time till then!).

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1130187, ~/Articles/ArticleHandler.aspx, 9/21/2014 4:32:44 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement