Since becoming involved with the Rule Maker portfolio last fall, I have on occasion (usually after spending time with Bill Mann) voiced the opinion to my co-managers that we should give Berkshire Hathaway (BRK.A) more consideration as a Rule Maker. I have always just felt that Berkshire is a company that embodies the Rule Maker ideal, while at the same time, I've realized that the company has never conformed to our statistical criteria. But I was never really able to find the perfect logical rationale to support my contention.
Recently, I was amazed to see that the rationale that had been escaping me was perfectly captured by Bill Mann in a his May 23 Fool On the Hill. Bill simply asks a great theoretical question: If you could only buy one stock in your lifetime, which would it be? After listing the various attributes that an investor would want to capture in that one swing of the bat, Bill came to the conclusion that he would choose Berkshire Hathaway.
While I haven't taken a poll, my guess is that if you asked every writer at Fool HQ to name their "stock for a lifetime," Berkshire Hathaway would at least be considered by a large majority of them. I guess it just strikes me as a little illogical that a company that would consistently show up as a strong candidate to be the only stock that many of us would ever own doesn't merit inclusion in this portfolio.
In researching for my recently published report on Berkshire Hathaway, I studied Berkshire's business more closely than ever before. In doing so, I came to some conclusions that surprised me. Before I share those with you, let's review Berkshire's business with respect to our Rule Maker Criteria.
- Dominant Brand -- Berkshire owns a stable of companies with respected brands, but doesn't have a single dominant brand that resonates with a mass consumer audience like Coca-Cola (NYSE: KO) or Intel (Nasdaq: INTC).
- Repeat-Purchase Business -- Many of Berkshire's businesses are repeat purchase in nature. See's Candies, Buffalo News, and Dairy Queen are just three examples that come to mind.
- Convenience -- I would also give Berkshire the nod when it comes to convenience. Many of Berkshire's retail businesses have many locations covering large regions of the U.S., and the majority of the businesses offer Internet, telephone, and mail-order sales.
- Expanding Possibilities -- Berkshire is engaged in several businesses with exciting opportunities, most notably Executive Jet, MidAmerican Energy, and GEICO. In addition, Chairman Warren Buffett and Vice Chairman Charlie Munger are constantly searching for new attractive uses of capital, so long as those opportunities lie within their area of expertise.
- Familiarity and Interest -- Yep.
- Sales Growth > 10% -- By virtue of both organic growth and acquisitions, Berkshire Hathaway has almost tripled insurance revenues since 1997, and non-insurance companies have averaged well over 10% annual growth for the past decade.
- Gross Margins > 50% -- Six for six so far, but here's where we start to run into trouble. Berkshire is, in terms of revenues, predominately an insurance company. Many of Berkshire's insurance operations involves paying out more in eventual losses than the company receives in premiums. Of course, the company intends to make money by investing the premiums until such time as a loss occurs. Unfortunately, there is no meaningful way that I can think of to measure gross profit margins for this activity.
The other problem is that the operating businesses that Berkshire owns are typically high turnover, low profit businesses. While these companies typically generate excellent return on assets and invested capital, they don't have high gross margins. I calculated that Berkshire's non-insurance operating companies turned in a gross margin of just over 32% in the first quarter of this year. That's not even close to our target.
- Net Profit Margins > 7% -- In 1999, Berkshire just missed our net profit margin goal with a 6.5% performance. But in 1998 and 1997, the company turned in net margins of 20.5% and 18.2%, respectively.
- Cash no less than 1.5x Debt -- There is no company that I can name that has more capital strength than Berkshire Hathaway. As of March 31, the company had over $67 billion in cash! That's comparable to the entire market capitalization of Yahoo! (Nasdaq: YHOO) or Schering-Plough (NYSE: SGP) or American Express (NYSE: AXP). With that sum of cash, Berkshire could buy Gap Inc. (NYSE: GPS) two times over, with four helpings of T. Rowe Price (Nasdaq: TROW) thrown in for good measure. With long-term debt of about $2.3 billion, Berkshire's cash-to-debt ratio is just under 30 to 1.
- Foolish Flow Ratio -- Berkshire doesn't break out current assets and liabilities, but my "modified" Flowie for Berkshire came in well under 1.00.
- Cash King Margin > 10% -- Berkshire hasn't achieved a Cash King Margin over 10% since 1997, when the company turned in an impressive 20.6% performance.
Now, here's what surprised me. Although I strongly believe in the company -- I own two "baby B" shares of Berkshire (BRK.B) myself, and intend to hold them for a long, long time -- I won't be pushing for Berkshire's inclusion into our portfolio. While I believe that we could easily defend such a choice, I also believe that Berkshire Hathaway's unique characteristics don't lend itself to be classified as a Rule Maker (or anything else, for that matter.)
Berkshire Hathaway can only be Berkshire Hathaway, and to try to make it conform to any type of mold would not do the company justice. It is a collection of amazing businesses run by some amazing people. What it is not is a dominant consumer brand business designed to make the rules of a single industry. And none of Berkshire's businesses would qualify as a Rule Maker in their own right.
For our sample portfolio which is designed to teach investing based on a clear blueprint, we would run the risk of confusing more than anything. That's because Berkshire isn't a company that I invest in because it meets a list of criteria; I invest in it because I believe that I understand the company's unique strategy of value creation, and because I have complete trust in management's ability to execute that strategy. The strategy at Berkshire just happens to have very little to do with the business model that we look for in Rule Makers.
Here's another interesting thing about Berkshire. Warren Buffett, Berkshire's chairman and investing legend, has acquired a wide variety of businesses over the last 30 years. Many of them are low-profit, high-asset-turn businesses like Nebraska Furniture Mart and Borsheim's. Some of them are high-profit businesses with a consumer monopoly, like Buffalo News or FlightSafety. But as long as they meet Buffett's acquisition criteria, he doesn't really show much of a preference for a specific business model.
On the other hand, let's look at Berkshire's portfolio of "passive" investments. Buffett shows a definite preference for a specific business model in his portfolio holdings. Berkshire owns 8% of Coca-Cola, a Rule Maker; 11% of American Express, another Rule Maker; 9% of Gillette (NYSE: G), which is not a 'Maker now, but arguably was back when Buffett purchased it. Then, there is 18.3% of Washington Post (NYSE: WPO), very much a Rule Maker-type business.
In fact, the only companies that don't meet the Rule Maker model in Berkshire's major holdings are the two banks and Freddie Mac (NYSE: FRE). None of Berkshire Hathaway's long-term portfolio holdings are low-profit, fast-turnover anythings. I may be alone here, but I find that to be a powerful statement in favor of investing in Rule Maker stocks for the long run from one of the world's most successful long-term investors.
This calls for a poll: Does Berkshire Hathaway belong in the Rule Maker portfolio? Tell us what you think.
Have a great weekend!