A Volunteer to Be Buffett's Berkshire Bear

Last Friday, Warren Buffett asked for a volunteer to be the bear on his panel of analysts at the upcoming Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) annual meeting. If Mr. Buffett is still looking, I'll happily volunteer to be the standard bearer for bearish sentiment.

I'm not crazy enough to short Berkshire Hathaway's stock, as I don't think there's much room for it to fall given the company's financial strength and reasonable valuation. Still, I've been sour on its prospects to outperform for years -- even publicly dueling as a Berkshire bear as far back as 2007. Indeed, the case for being a Berkshire bear is in many ways stronger today than it was back then.

Size still matters 
The biggest issue facing the company from an outperformance perspective is that today's Berkshire Hathaway is even larger than the company was six years ago. Size matters in investing, and not always in a good way. To quote Buffett himself:

Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that. 

With a market capitalization of over $252 billion, Berkshire Hathaway is gigantic. For it to grow faster than the overall market, it needs to not only deliver everything it has been delivering, but also add a substantial amount of new incremental value, as well. If you assume the market will deliver around a 10% annualized return -- not far off from its long-run trends -- that means Berkshire must grow by an astounding $25 billion just to keep pace.

Whence the growth?
Yet when you look at Berkshire's operations over the past few years, they've shown solid results -- but hardly spectacular growth. Pulling from its recently published annual report:

Measure

2012

2011

2010

Cash From Operations

$20,950

$20,476

$17,895

Capital Expenditures

$9,775

$8,191

$5,980

Free Cash Flow

$11,175

$12,285

$11,915

Source: Berkshire Hathaway's most recent 10-K. Dollar amounts in millions.

The company still pulls in substantial amounts of cash, but its capital expenditures have risen faster than its operating cash. As a result, the company's free cash flow has hardly budged in the past few years and is actually below 2010 levels. Berkshire's purchase of the Burlington Northern Santa Fe railroad likely has a lot to do with that. Railroads are notoriously capital intensive businesses, and Berkshire now has to keep investing in that infrastructure just to keep its existing trains moving.

There's nothing wrong with capital intensive businesses, but the money that is tied up just to keep those operations steady is money that can't otherwise be used to grow the company or invest elsewhere.

Where's the value?
Additionally, Berkshire Hathaway's stock isn't exactly cheap. With shareholders' equity clocking in at around $191.6 billion, its market cap of $252 billion represents a better than 30% premium to book value. That's pricier than many of its peers, though somewhat justified by Buffett's willingness to buy back Berkshire Hathaway stock whenever it dips below a 20% premium to book value.

With a stock trading at a premium to book and to many in its industry, stagnant free cash flow, and no dividends, what's left to support the company's ability to outperform? In large part, it hinges on Buffett's investing prowess, which, while substantial, can only do so much to fight the size penalty.

What say you, Warren?
Taking out a short position on Berkshire Hathaway would seem silly, given its incredible balance sheet strength, cash-generating capabilities, and reasonable (though still somewhat premium) valuation. Still, if Buffett wants a bear at his annual meeting, there's a case to be made that the company is no longer really in a position to sustainably outperform. This Fool will gladly make that case.

If you're still looking for your bear, Mr. Buffett -- let me know.

Warren Buffett's long track record of success has made him one of the best investors of all time. With Buffett at the helm, Berkshire Hathaway has grown book value per share at a compounded annual rate of 19.8% for nearly 50 years! Despite an incredible historical track record, investors have to understand the key issues to watch moving forward. To help investors, The Fool's resident Berkshire Hathaway expert, Joe Magyer, has created this premium research report on the company. Inside, you'll receive ongoing updates as key news hits, as well as reasons to both buy and sell the stock. Claim a copy by clicking here now.


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