How Warren Buffett Could Give a Nod to His Successors

Source: Aaron Friedman.

Warren Buffett just turned 83 years old, an old age by Wall Street standards.

While it's likely that Buffett will remain at the top of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) for at least a few more years, now more than ever, focus is turning to his successor. He's hired two great portfolio managers, Ted Weschler and Todd Combs, who both beat the S&P 500 index by double digits in 2012.

The two new hires run independent portfolios worth as much as $5 billion each after Buffett upped their assets under management in 2012. But their portfolios have little effect on Berkshire's $200 billion book value. Berkshire is still a bet on Buffett, not his successor. Just how and when will Buffett hand over the Berkshire portfolio to new managers?

Signaling confidence in his picks
Warren Buffett is undoubtedly one of the greatest investors who has ever lived. His approval is worth its weight in gold -- and he knows it.

During the financial crisis, Buffett bet big on Goldman Sachs at a time when the rest of America thought the banking system would crumble. Goldman Sachs paid 10% dividends on preferred stock sold to Buffett, effectively licensing his "brand" as a stamp of the bank's quality. He later bought a railroad, Burlington Northern, when economic recovery looked lightyears away.

Then, most recently, he took a position in Bank of America, a move that sent the stock soaring. Interestingly, Buffett later added that he dreamed up the deal from his bath tub, never influenced by some crazy Excel spreadsheet or a Manhattan office building stuffed with investment bankers. When you can make deals from your Ohama bathroom and send a stock rocketing, you know you're doing something right.

Buffett stimulated confidence in America when it seemed America's best days had come and gone. Now he needs to instill confidence in his replacement. How can he do that?

Reloading the elephant gun
Buffett's elephant gun is his massive cash haul generated from Berkshire's incredible annual profits and insurance float. He's always on the hunt for elephants: big, easy-to-understand businesses that can move the needle for Berkshire.

Recently, Buffett's made moves that will shore up many of the questions about Berkshire's future capital allocation. Burlington Northern Sante Fe requires more than a billion dollars in new investments each year. This year, a Berkshire subsidiary will swallow NV Energy  (UNKNOWN: NVE.DL  ) , a capital-intensive utility that will also require billions in committed capital on an ongoing basis.

Furthermore, he's instituted a new policy of share repurchases. Should Berkshire Hathaway trade at less than 1.2 times book value, it'll repurchase shares. All of these investments and policies create some certainty about capital allocation, but they don't instill much confidence in Buffett's new successor. Buffett's effectively taking many of the capital allocation decisions away from the next head of the greatest investment company in the world.

I believe Buffett will make one final hurrah -- one big move to show the markets that Ted and Todd are just as capable as the Oracle of Ohama. And he'll do it in a big way by making an acquisition to reload the elephant gun. There's no better way to show confidence in an asset manager than to give them more money to manage.

Doubling down on Berkshire's future
My short-list pick for an elephant gun reload is Chubb  (NYSE: CB  ) , a leading property and casualty insurance company. It's a perfect Buffett-style stock: boring, float-generating, and incredibly profitable.

Chubb's attributes make it an exceptional company to join the Berkshire club. Like GEICO, it always seeks to make an underwriting profit on insurance lines, never relying completely on investment performance to boost profitability. It's also an incredible capital allocator; when underwriting margins are squeezed, the management team delivers with share repurchases.

If you aren't familiar with how Chubb manages its business, you'd likely find its 10-year compounded premium revenue growth rate of 1.5% a signal to run away. But because Chubb has an unmatched focus on writing insurance only when it is profitable, investors who bought 10 years ago and held today would have turned each $10,000 invested into more than $40,000. Underscoring those gains is a share count that has dwindled by nearly 27%.

If Buffett were to acquire Chubb Insurance, it would be a pure bet on the skill of his portfolio managers since Chubb's underwriting is fantastic. The only way to improve the business is to improve the performance of its $40+ billion investment portfolio.

Buying one more massive and profitable insurance company is a way to tell the markets that Buffett and Munger have the utmost faith in Berkshire's future managers. It's a contrarian move, which is why I think it's a perfect match for Buffett's last hurrah.

Warren Buffett has made billions through his investing and he wants you to be able to invest like him. Through the years, Buffett has offered up investing tips to shareholders of Berkshire Hathaway. Now you can tap into the best of Warren Buffett's wisdom in a new special report from The Motley Fool. Click here now for a free copy of this invaluable report.

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