3 Things You Need to Know About Berkshire Hathaway

Worldwide Invest Better Day 9/25/2012

You know a little something about Warren Buffett. You've seen his wise quotes, you know him as one of the greatest investors of our time, maybe you've even read some excerpts from his annual letters to Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) shareholders.

But does knowing about Warren Buffett mean that you know about Berkshire Hathaway? Not necessarily. So in the spirit of The Motley Fool's upcoming Worldwide Invest Better Day, let's take a look at a few things that investors should know about the mighty Berkshire Hathaway.

1. Berkshire: What it is and what it isn't
It may be easy to assume that Berkshire is little more than Warren Buffett's investment vehicle, and that the success or failure of the enterprise rests solely with him. There was a time when that was more or less the case. Today, however, it's not an accurate view of the company. Here's a look at where Berkshire's earnings come from:

Segment 2011 Net Earnings
Insurance $3.7 billion
Railroad $3 billion
Manufacturing, Service, and Retail $3 billion
Utilities and Energy $1.2 billion

Source: Berkshire Hathaway annual report.

Buffett played a prominent role in putting this conglomerate together as the acquisitions that Berkshire has made over the years were largely his call. Where does he come in today, though? Primarily through the new acquisitions that Berkshire makes as well as the insurance segment. Berkshire's underwriting profit for its insurance arm was poor in 2011, but even in a "normal" year, the investment income that it derives from investing insurance premiums constitutes the bulk of the earnings in that business. And it should be no surprise that it's Buffett himself that's making most of the major investing decisions there.

Outside of the insurance business, though, Buffett has little to do with the day-to-day operations. The brilliance of Buffett over the years has been to buy companies with management that he trusts. Doing that has allowed him to focus on what he does best -- allocating capital and investing -- rather than on trying to tinker with management decisions at individual subsidiaries.

So today, Berkshire is much less a play on Warren Buffett and his investing prowess and much more a multi-industry conglomerate whose success lies with the quality of the individual businesses and the state of the overall economy.

2. No dividend? No problem.
Berkshire Hathaway does not pay a dividend. For many investors, that's considered no bueno as they -- for good reasons -- prefer companies that pay out a reasonable chunk of their profits to investors. But passing on Berkshire simply because it doesn't pay a dividend could be a big mistake.

The reason for this is that dividends are a great way for managers to return capital to shareholders rather than using it in wasteful ways like ill-conceived projects, overpriced acquisitions, or poorly timed buybacks. The ability of Warren Buffett to take the profits earned by the Berkshire companies and put them toward the best opportunities is the primary reason Berkshire investors benefit from having Buffett at the helm. If Berkshire paid a dividend, it would take the company's capital and put it in your hands to reallocate rather than Warren Buffett's. Is that really what you'd want?

As we look out into the future, eventually Buffett will no longer be managing Berkshire. At that point, this question may need to be revisited. Buffett and the Berkshire board have taken pains to put together a succession plan in preparation for the day that Buffett departs, but he'll be a tough guy to replace. If Buffett's replacement(s) can't prove they're as successful as capital allocators, then investors may be right to demand a dividend down the road. But that day isn't today.

3. It's not just Buffett
Yes, we can all concede that if Warren Buffett were no longer at Berkshire, it would be a big loss. Buffett's right-hand man Charlie Munger may be a slightly lesser-known name, but in most investing circles, his name would also quickly come up as a big loss were he to exit Berkshire.

But since identifying quality people is very important to Buffett, the key players at Berkshire go much deeper than just Warren and Charlie. And while having a deep bench of smart, trustworthy people is a great benefit, it's also a potential risk if any of them were to jump ship.

If you're not intimately familiar with Berkshire, the names Ajit Jain and Tony Nicely may not ring any bells. However, Jain is the brains behind Berkshire's highly specialized, big-money insurance and reinsurance operations, while Nicely has been running the Berkshire auto insurer GEICO for going on two decades. Nicely was a key reason why Buffett opted to buy all of GEICO in the first place, while of Jain, Buffett's said that he's "probably made a lot more money for Berkshire than I have." The loss of either Jain or Nicely could be particularly painful for Berkshire, and the two of them just scratch the surface.

When you drill down to look at the component Berkshire companies, many of them are simply great, product-driven businesses. After all, Buffett's said that he likes companies that could be run by a ham sandwich. That said, if you want to understand Berkshire's success, it's also important to understand who the key people are, and what the risks are if they end up out of the picture.

Learn more, Buffett would approve
Hopefully this has helped you get a more complete picture of Berkshire Hathaway and what makes it tick. But don't stop the learning here. With the Worldwide Invest Better Day right around the corner, The Motley Fool is delivering lots of great articles to help you become a better investor. Click the bar below to find out more.

The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (10) | Recommend This Article (24)

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 September 24, 2012, at 4:42 PM, Darwood11 wrote:

    Here's my problem with BRK and why I don't own any of the stock. BTW, this applies to other good companies which I've passed by because they don't pay a dividend.

    The core question I've had to wrestle with as a small investor is this. How am I to ever get anything out of growth companies and avoid getting hammered by fees and capital gains taxes? The other concern is this. I really don't want to reduce my stake in a good company and I'd rather use "the company's money" to grow that stake. But with BRK, the only way I can increase my stake is to take my hard earned cash, or the cash spun off via dividends from the stock I own in other good companies, and use it to purchase more BRK.

    Yes, I do think I can do well with the money spun off from my dividend payers, and I prefer to have that opportunity. BRK with no dividends robs me of that opportunity! So I disagree with Mr. Buffett and I do think I can do well, and perhaps better than BRK, and I have! In the last 10 years my portfolio has increased in value 13 times. No sleight of hand, no penny stocks, etc. Just old fashioned work, save, invest.

    So I am then faced with a dilemma. Should I "buy and hold" in growth companies such as BRK and sell in small pieces at some time in the future, and pay brokerage fees for each sale, and taxes on the gains? How else to be able to use or gain access to MY money?

    Here's an example. When Mr. Buffett got a special deal from GE, that was great for BRK and lousy for GE shareholders. So who got something out of this? I'd have preferred that Immelt gave the chance to lend to the GE shareholders, but that's for another comment.

    So how did it turn out for BRK stockholders? For anyone who bought BRK-A back in 2002, it's been a good ride. For anyone who bought in 2007, the stock is finally getting close to its highs in that year.

    BRK simply doesn't seem all that attractive to me as a "buy and hold" investor. Why? because unlike Mr. Buffett, who gets paid by BRK, the only way I'll ever get any money out of his company is to sell stock, and I can't "hold" forever, and there is a tax man to pay.

    So, I'd rather purchase stock in good companies that award a dividend and automatically reinvest in the same company, or take cash, pay the taxes, and reinvest that dividend elsewhere. So far, I have reinvested all dividends in stocks from all originating companies. For that reason, prudent investing and by adding each year to my Roth, I've seen a nice "kick" to the value of my portfolio However, some day, I may decide to take that dividend as cash and let the stock churn it out, year over year.

    My cost to date? Pay any federal taxes on that dividend, but avoid reducing my stake.

    My advantage? I have the opportunity to reinvest those dividends as cash and reinvest them anywhere I choose.

    That's why I'm not a BRK fan.

    Do I have any other "growth" stocks? A few, but I prefer to buy good, solid companies that pay dividends. I do have a well invested portfolio, that includes stocks and bonds and mutual funds and commodities. In other words, I'm diversified.

    To gain access to "growth" companies, I can and do buy actively managed mutual funds. I checked as I posted this, and none of them own BRK. A coincidence? Or am I missing a wonderful opportunity?

    This somewhat lengthy comment is in the spirit of contributing to "invest better" week.

  • Report this Comment On September 24, 2012, at 5:19 PM, JohnCLeven wrote:

    BRK.B agressively buys back shares at 1.1x book value. The stock is currently $88.70 and selling at 1.2x book value. This means an effective "price floor" around $80.

    Now, it's also important to note that book value has grown at a compounded annual rate of 19.8% since Buffett took over in the 1965. That rate of coumpounding has slowed due to Berkshire's immense size to about 10% compounded annually from 2001-2011. With this price floor, Berkshire's stock price should grow in line with book value growth over the next 3-5 years. If the P/BV measure expands, however, that will magnify the returns.

    What this essentially means is that a 3-5 year in BRK.B is extremely unlikely to result in a permanent loss of capital. It's upside is probably only 7-10% per yr, 12% max, but the downside is nil. So if you want to sleep soundly with 7-10% returns, invest in BRK.B. If you think you can do significantly better in than 10% per yr, than don't waste your time w/ BRK.B.

    Long BRK.B, UPS, and COH.

  • Report this Comment On September 24, 2012, at 5:58 PM, Darwood11 wrote:

    @JohCleven:

    "What this essentially means is that a 3-5 year in BRK.B is extremely unlikely to result in a permanent loss of capital. It's upside is probably only 7-10% per yr, ..."

    Fine, it's upside may or may not be "7-10% per yr." but I can't eat a return that I can't access, and since 2007, BRK has not even broke even. Not even close to "7-10% per yr" and that was with a sweetheart deal from GE.

    As I said, if you bought BRK back in 2002, you are in a nice position. Anyone who purchased after 2006 is not doing anywhere near "7-10% per yr."

    The fundamental question I face with each purchase I face is pretty simple. Do I buy on the hype, or on the facts?

  • Report this Comment On September 24, 2012, at 6:12 PM, TMFCrocoStimpy wrote:

    @Darwood11

    One approach to generating income from growth stocks such as BRK is to use covered call options, selling out of the money and pocketing the premium as your income stream. Occasionally you will get your stock called away, to be sure, but the frequency and degree of income are part of the details each investor works out. Definitely not a strategy for everyone, but I do know quite a few investors that use this strategy.

    -Xander

    Disclosure: Long BRK-B

  • Report this Comment On September 24, 2012, at 6:17 PM, TMFKopp wrote:

    @Darwood11

    A couple of quick thoughts:

    - "As I said, if you bought BRK back in 2002, you are in a nice position. Anyone who purchased after 2006 is not doing anywhere near "7-10% per yr.""

    Why are you anchoring to 2002 or 2006? It's 2012 and the only purchase you can make today is Berkshire in 2012. On both a book value and tangible book value basis, Berkshire trades at a lower multiple today than it did either of those years. The case to make would be why it won't perform from 2012 on, not that it didn't perform from 2006 to 2012.

    - You pay taxes on dividends just like you pay taxes on capital gains.

    Matt

  • Report this Comment On September 25, 2012, at 11:28 AM, JohnCLeven wrote:

    @ Darwood

    "Fine, it's upside may or may not be "7-10% per yr." but I can't eat a return that I can't access, and since 2007, BRK has not even broke even. Not even close to "7-10% per yr" and that was with a sweetheart deal from GE."

    1. The book value of BRK.B increased from 109.89B in Mar '07 to 181.72B in Mar '12. That is a compounded annual return of 10.58%. I judge BRK.B on the success of it's business not it's stock price. If the business succeeds over time, the price will eventually follow.

    2. You are correct that, "Anyone who purchased after 2006 is not doing anywhere near "7-10% per yr."

    That is because the stock price has lagged behind the growth of the underlying business aka making BRK.B a much better buy today than it was in 2007. As TMFKopp indicated, BRK.B was not selling at the low P/BV that is is today in 2007, nor did BRK.B have an agressive buyback program at 1.1x BV.

    3. If you inist on being able to "eat a return that I can access", that's great, only buy dividend payers." Investors however can do very well without adhering to that strict dogma. Ask anyone who held APPL over the past decade can attest to that.

    "The fundamental question I face with each purchase I face is pretty simple. Do I buy on the hype, or on the facts?"

    We have the same philosophy, we just have different strategies. I see facts that support BRK.B, and you do not. Only time will tell who is right or wrong. Good luck!

  • Report this Comment On September 25, 2012, at 5:34 PM, Darwood11 wrote:

    Matt, Xander and @JohnCLeven;

    Thanks for the dialogue and hanging in there with me.

    I truly appreciate it.

  • Report this Comment On September 28, 2012, at 11:36 AM, sodaonroy wrote:

    The point that everyone is missing is that Warren gave a ton of shares to the Gates foundation. Foundations require income from their investments. If BK does not start paying a dividend, Gates Foundation will just have to sell the shares, otherwise, they are worthless to them

  • Report this Comment On September 28, 2012, at 11:45 AM, whyaduck1128 wrote:

    We already know that the Fool worships any and all things Buffett, that you consider him infallible, and that anything he touches is blessed. Why do you feel the need to publish an article a week about it?

  • Report this Comment On October 11, 2012, at 2:11 AM, thidmark wrote:

    "For anyone who bought in 2007, the stock is finally getting close to its highs in that year."

    If you bought B shares 13 months ago, you'd be up about 33 percent.

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: 2029006, ~/Articles/ArticleHandler.aspx, 12/21/2014 4:20:11 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...

Apple's next smart device (warning, it may shock you

Apple recently recruited a secret-development "dream team" to guarantee its newest smart device was kept hidden from the public for as long as possible. But the secret is out. In fact, ABI Research predicts 485 million of this type of device will be sold per year. But one small company makes Apple's gadget possible. And its stock price has nearly unlimited room to run for early-in-the-know investors. To be one of them, and see Apple's newest smart gizmo, just click here!


Advertisement