This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge.”
Warren Buffett recently revealed that Berkshire Hathaway (NYSE:BRK-A)(NYSE:BRK-B) has "poured billions and billions and billions of dollars" into his energy business and said "we're going to keep doing that as far as the eye can see."
For $2 billion in 1999, Berkshire Hathaway acquired a 76% stake in MidAmerican Energy, which it just renamed to Berkshire Hathaway Energy a few months ago. At the time Buffett said:
We buy good companies with outstanding management and good growth potential at a fair price, and we're willing to wait longer than some investors for that potential to be realized. This investment is right in our sweet spot.
And when discussing the acquisition in the annual letter to Berkshire Hathaway shareholder, he added:
Though there are many regulatory constraints in the utility industry, it's possible that we will make additional commitments in the field. If we do, the amounts involved could be large.
Just this year, Buffett said, the business will have made investments totaling $15 billion in its renewable energies portfolio that and perhaps another $15 billion could be made in the years to come. There's no denying that Berkshire's "additional commitments" have been "large."
But when you consider that these investments came from the same man who once said his preference was to find businesses that require "a minimum of new capital investment," questions surrounding the massive investments begin to rise.
But the aforementioned Buffett quote provides a helpful clue to why the investment has been so big.
The huge difference in outcome
The quote found at the top of the article was made in the 2010 letter to shareholders.
Buffett wants us to see that smart investors consider the "what-will-they-do-with-the-money" factor when making an investment in a business.
A company can really only do only five things with the money it earns: invest in existing operations, acquire other businesses, pay down debt, buy back shares, or issue dividends. And of course, how well companies allocate their capital is the critical wheel that drives the return shareholders see.
And as it relates to Buffett, he prefers to invest in his own business or acquire other businesses.
So why is he pouring all this money back into his energy business instead of acquiring others?
Not only does he believe that this "reinvestment" will "add to the company's current value," but early evidence indicates that it already has, and as a result, the "difference in outcome" was "huge."
The reason for the reinvestment
Buffett had an almost identical paragraph in both the 2012 and 2013 letters to shareholders that read:
Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investments in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. It is meanwhile in our self-interest to conduct our operations in a way that earns the approval of our regulators and the people they represent.
And when asked why MidAmerican Energy continues to pour money into its operations at the latest meeting for shareholders, its CEO provided a remarkable bit of insight:
Generally we are the lowest-cost provider. We rarely have rate increases. Thus, regulators are very supportive of our projects.
At its core, the investments made by Berkshire Hathaway have been used to satisfy customers and regulators, the two essential groups that dictate the success of its energy operations.
What this all means to investors
I know what you may be thinking: This sounds great in theory, but how has it all worked out in practice, and what does it mean to the bottom line at Berkshire Hathaway?
A simple calculation of pre-tax earnings over revenues reveals that since 2009, profit margins have risen from 13.4% to 14.2%, netting an extra $100 million to Berkshire's bottom line.
In this, we can learn that Buffett may have been wrong -- or at least misleading -- as it's not just customers and regulators that should be happy with these investments. Berkshire Hathaway shareholders need to be happy as well.