Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is widely regarded as one of the strongest businesses in the world. With its diverse revenue streams built on a collection of high-quality, competitively advantaged operating subsidiaries and a fortress-like balance sheet containing nearly $100 billion cash, Berkshire is built to last.
Yet even the best companies can falter, and investors would be wise to identify the key risks to the stocks they own. In this regard, here are three scenarios that could bring about a decline in Berkshire Hathaway's stock price.
1. Buffett steps down
The $420 billion masterpiece that is Berkshire Hathaway is largely a creation of Warren Buffett. He's considered by many to be the best investor in the world, perhaps even of all time. It's Buffett's capital allocation skills that have allowed Berkshire to grow its book value at a compounded annual rate of 19% over a span of five decades. In turn, Berkshire's stock has returned more than 20% annually during this time, compared to less than 10% for the S&P 500 index. All told, Berkshire Hathaway's shares have surged a mind-blowing 2,000,000% since Buffett took control of the company in 1965.
It's therefore understandable that Berkshire investors dread the day Buffett is no longer at the helm of the company that's rewarded them so handsomely for so long. He is now 86 years old, so it's a scenario Berkshire shareholders must factor into their outlook for the company.
For these reasons, it's possible that Berkshire stock price will fall sharply on the day Buffett eventually steps down. When this does occur, it's also likely that Berkshire will respond with a large share repurchase program, particularly if its stock price were to fall to the 1.2-times-book value threshold that Buffett identified as representing a terrific bargain.
More importantly, the company has a succession plan in place. Berkshire's board of directors has already selected Buffett's successor as CEO, although it declined to make the identity of this person public. Buffett has also asked that his son Howard be made non-executive chairman to help preserve the culture and core values of the company.
Perhaps most importantly, Buffett's handpicked lieutenants will manage Berkshire's investment portfolio after he's gone. Ted Weschler and Todd Combs have significantly outperformed the overall market during their time at Berkshire, and Buffett has steadily increased the amount of Berkshire's capital entrusted to them in recent years. Weschler and Combs are proven, battle-tested investors, and Berkshire's investment portfolio should be in good hands when Buffett hands over the reins to them.
2. Core holdings falter
Of course, it's also possible that Berkshire's stock could fall while Buffett is still at the helm. And one way this can happen is if the company's major investments underperform.
Nearly 70% of Berkshire's $160 billion publicly traded investment portfolio is held in just six businesses: Kraft Heinz, Wells Fargo, Apple, Coca-Cola, American Express, and IBM. And at least four of these companies are dealing with significant issues. Wells Fargo was recently rocked by a scandal in which its employees were found to have opened millions of unauthorized accounts for its customers. Coca-Cola is struggling with increasing concerns regarding the negative health effects of its core soda beverages. American Express has lost major clients to its rivals. And IBM has largely underperformed Buffett's expectations, so much so that Berkshire recently sold off 30% of its stake in the company.
With so much of its investment capital tied up in these six stocks, Berkshire's overall returns will be significantly impacted by their performance. And if these stocks underperform, so too could Berkshire Hathaway.
It's also important to note that much of the funds Buffett and his lieutenants have to invest come from the float produced by Berkshire's insurance operations. Essentially, the premiums these businesses receive up front are often not needed to pay out claims until some distant time in the future. These funds thereby serve as a low-cost loan to Berkshire, which it can then invest at high rates of return thanks to Buffett's prowess. As we've seen, these returns -- and the float that makes them possible -- play a vital role in Berkshire's success.
However, Berkshire's key auto insurance operations may soon face the risk of disruption, namely from the threat posed by self-driving vehicles. Most of the causes for auto accidents are attributed to driver error; driverless cars, on the other hand, have built up a largely positive safety track record during their testing phase. In turn, it's expected that there will be less of a need for auto insurance once these self-driving vehicles go mainstream. In fact, my colleague Jeremy Bowman notes that the auto insurance market could decline as much as 60% by 2040, according to accounting firm KPMG, as "radically safer" vehicles help to reduce accident frequency by 80%.
Buffett himself has acknowledged the risks of driverless vehicles to the insurance industry. He believes, though, that it will be a long time before self-driving vehicles have a significant impact on Berkshire's businesses, as he expects less than 10% of the vehicles on the road will be autonomous a decade from now. If Buffett is correct, the threat posed by self-driving vehicles may be more of a longer-term risk, but because of the importance of Berkshire's insurance operations to its overall business model, it's still one that bears watching by investors.