Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) is one of the world's most successful companies. Over the last 52 years -- during which Warren Buffett has been chairman and CEO -- it compounded its investors' wealth at a remarkable rate, turning an original $1,000 investment into nearly $20 million for its earliest investors.
The three charts below explain how Berkshire grew to become as large as it is today, and why the future is likely to yield lower returns for the company's investors going forward.
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1. Borrowing at negative rates
It's my strongly held opinion that Berkshire's future success will be driven not by its assets, but by its liabilities. Although its history was built by Buffett's legendary ability to pick great assets, my opinion is that its future will be driven by the quality of its liabilities.
Berkshire's insurance companies are its most important operating businesses. Because they generate an underwriting profit (premiums reliably cover insurance losses and expenses), the $105 billion of "float" that they generate acts as a negative interest rate loan to Berkshire. Since 1998, cumulative pre-tax underwriting profits have tallied to 3.6% of premiums earned over the period, giving Berkshire billions of dollars of funding at a negative cost.
There are two ways to outperform the average: Earn an above-average return on assets, or pay a below-average rate on liabilities. Increasingly, the latter is looking easier for Berkshire than the former.
Chart by author.
As long as Berkshire has an above-average liability generator in the form of Ajit Jain, who manages Berkshire's reinsurance business and generates a colossal amount of float, the exit of Warren Buffett and Charlie Munger probably won't be all that impactful to the company's operations or its profitability. (BH Reinsurance generates about half of Berkshire's float, and most of it is very long-lived float that can be invested for years, if not decades.)
2. Capital at work
Berkshire has become much more entangled in capital-intensive businesses like energy and railways in the years since the 2008 financial crisis. Property, plant, and equipment on the balance sheet grew from $36.2 billion at the end of 2007 to $152.8 billion at the end of 2016, an astonishing 332% increase in just one decade.
Net of depreciation. Chart by author.
These capital-intensive businesses are the very reason why Berkshire will almost certainly generate lower returns going forward than it has in the past.
But the trade-off for lower returns is remarkable stability in earnings. BNSF and Berkshire Hathaway Energy should produce profits even in a deep economic downturn. Indeed, even in the depths of the financial crisis, BNSF earned a profit. Likewise, electricity demand is resilient even in recessions, giving Berkshire Hathaway Energy a steady earnings generator.
3. Quantifying the cash and capital drag
Buffett uses book value as a barometer for Berkshire's performance, and by that measure, it has recently failed to live up with the returns of the S&P 500 index. In fact, Berkshire's book value grew at a compounded rate roughly 3% less than the S&P 500 in the five years leading up to the end of 2016.
This is only partially driven by Berkshire's large-scale investments in low-return rails and energy projects. Berkshire has more than $96 billion of cash sitting on the balance sheet, earning virtually nothing during a time when stock prices have only gone up.
Chart by author.
At the most recent annual meeting, Buffett cast doubts about Berkshire's ability to grow its intrinsic value at a rate exceeding 10% per year unless interest rates move higher. Although rising rates would weigh on the profitability of its capital-intensive businesses, higher rates would be a boon for its insurance operations, which generate the bulk of their earnings power from investment income earned on their massive bond portfolios. (With more than $70 billion in U.S. Treasury bills, Berkshire is earning very little on most of its cash.)
Alas, Berkshire is perhaps more likely to outperform when markets move lower, rather than higher. Note that while the S&P 500 generated negative returns in 12 years since 1965, Berkshire's book value has declined in only two years. Book value declined in 2001 due to losses from the 9/11 terrorist attacks, and again in 2008 when stock market declines temporarily battered its investment portfolio.
Berkshire may be a boring business in bull markets, but in downturns, the stability of its core businesses and investment portfolio really shines through.
