In early 2022, there have been some notable signs that it is becoming more of a Berkshire Hathaway kind of stock market. All of the Covid outperformance from Ark Invest’s flagship Innovation ETF relative to Berkshire Hathaway was wiped out, and Warren Buffett’s company surpassed Meta in market value.
Speaking of the recent run and rally in 2021 as well, “It has had a good year,” said James Shanahan, Edward Jones analyst. Shares are up roughly 5% this year amid a broader U.S. stock market that recently dipped into correction.
As Berkshire releases its latest earnings and annual letter to shareholders, some of the biggest issues for the future of the company have not changed, even as the market tumult has, in the short-term, put its approach back into favor. And the big issues are, literally, best portrayed through the biggest numbers. At one point this year, before investors turned to Berkshire as a flight to safety trade, its stake in Apple and its cash on the balance sheet were both rivaling the value that the market was giving to all of the Berkshire operating companies combined (roughly $150 billion – $160 billion each). That has changed, but the underlying issues remain.
Apple and a stock concentration issue unlike any other
Warren Buffett’s long-time aversion to technology is now long gone and Apple now the company’s biggest stock holding, and long-time Berkshire Hathaway expert and George Washington University professor Lawrence Cunningham says in hindsight it’s become clear that the Berkshire bet on Apple should never have been much of a surprise. By the time it started acquiring Apple shares it was clear how large a runway the company had for growth and scale. Certain kinds of technology themes might still be a bridge too far for Berkshire, such as pure-play EVs and AI, but with Apple over the past decade, Cunningham says, what has been seen is a market leader similar to an auto company in the 1920s.
Apple has done so well, though, that it has created a stock concentration issue unlike any Berkshire has faced before. At one point this year, Apple’s value within the Berkshire stock portfolio was equal to the value of all of Berkshire’s operating companies combined. The stake is currently valued at around $150 billion and as Berkshire has gained amid the market volatility, the value of Apple relative to the rest of Berkshire has come down, but it’s still huge, and represents a little under half of all the stock owned by Berkshire.
Cunningham says investors should focus less on Apple’s weight in Berkshire than the fact that Buffett has always believed in holding a concentrated stock portfolio. That hasn’t changed. “Concentration has never worried them,” he said. “They’ve been happy to have big percentages in just a handful of stocks,” he said.
The difference now is that instead of that concentration being in a handful of financial and consumer stocks, such as American Express, Wells Fargo, Gillette, and Coca-Cola, it is in the market’s largest company. But if four companies in the past could represent half of its stock portfolio, it is logical that in a market dominated by technology today, the biggest company in the world might represent even more.
“No single stock has ever reached the value of the operating companies,” Shanahan said. “There has never been a position that large. But don’t forget, the way we’ve been thinking about it is that the operating companies are largely ‘old economy’ and industrials, manufacturing, retail, services and transportation. The pivot to tech, namely Apple, as an investment provides some balance to that.”
And Apple did help to answer a question Berkshire had been facing for years when it was concentrated in financial stocks and having difficulty outperforming the index while not owning any tech. “They needed to get more exposed to tech and if you take a higher-level view, the Apple exposure isn’t particularly outsized relative to the businesses,” Shanahan said.
As far as tech investments go, even as tech corrected this year with many hot companies in the space facing investor concerns as the market rotated away from growth stocks short on free cash flow and facing the impact of higher interest rates, worries about cash generation is not something any investor can say about Apple.
A new explanation for the role of Buffett’s cash
Berkshire’s last reported cash value was similar to the Apple stake, at just under $150 billion. This issue is nothing new for Berkshire and it has been aggressively buying back its own shares in recent years as an alternative to elevated asset values across industries in a market flush with liquidity and where competition for deals from private equity and sovereign wealth funds remains intense.
“The prices just don’t make sense to him,” Cunningham said.
Berkshire isn’t going to buy distressed properties. “They are not equipped to buy broken companies and fix them, the dog business with a view to put in new management and make a turnaround,” Cunningham added.
The experience with Brazilian private equity firm 3G as a partner on Kraft Heinz was supposed to be a culture match, but that attempt at being a financial ally on a management turnaround plan hasn’t worked out and suggests what could have become a broader part of Buffett’s deal-making approach as cash on the balance sheet ballooned won’t be as readily available as an option as once thought.
The biggest challenge in the last market downturn for dealmakers was the level of government support, limiting the opportunities for Berkshire to play a “lifeline” role. “You can’t compete with the government cost of capital,” Shanahan said. But if the economy weakens, there isn’t the expectation we will see the level of government support observed in either 2008 or 2020.
Still, Cunningham says he wishes Buffett would talk about the cash problem in a new way, and less about it as a hoard that has to go to M&A. He says Berkshire simply needs to hold more cash on the balance sheet than it ever has historically given the world we live in today. He noted that insurance is a huge part of the Berkshire operating business and the potential calls on capital related to insurance continue to grow in a world with more frequent catastrophes from hurricanes and floods to droughts and tornadoes. Buffett – and even more so his long-time partner Charlie Munger – has resisted efforts to think about running a business in terms of climate change, but Cunningham says Berkshire shareholders are due for an update on how Buffett thinks about the right level of cash to hold given potential for catastrophes. He, for one, thinks the cash held should be higher than it has been historically.
Cunningham says the last figure Buffett ever provided on the right level of cash to hold is so old it is $20 billion. “So I wish he would say that $20 billion figure is old. I doubt it’s $150 billion, but it is certainly nowhere near $20 billion,” he said. “Some portion is consistent with a need for a higher cash level, old-fashioned Berkshire prudence and not simply a lack of opportunity.”
In fact, he says if Berkshire had an opportunity to make a $150 billion deal tomorrow, the right response might be to think twice about it.
The insurance companies do carry reserves on their own to cover claims, but Buffett’s position has always been that even in the event an insurance company faces a bankruptcy risk or government bailout scenario, it won’t happen under Berkshire’s watch, and it needs cash to ensure its own insurance businesses. “He has always said those minimum capital statutory reserves are fine, but companies go bankrupt anyway with those, may be unable to pay claims even with those,” Cunningham noted.
Buybacks and the long argument over a dividend
At year-end 2021, when the value of Apple and the value of cash was almost equal to the value of the operating companies, the buyback math was more attractive in making the case the shares were undervalued, because the intrinsic value of the businesses Berkshire owned were worth more as the stock market value of Berkshire was being driven by holdings like Apple. And Berkshire in recent years has been buying back more shares as the value of the operating companies dipped relative to cash and stock holdings.
The share buyback opportunity that Buffett has been exploiting in recent years gets harder as its own stock price rises. That won’t go away completely as an option for cash because Berkshire has grown into the profile of a steady stock, not the “glamorous stock hitting the spectacular levels it once did,” Cunningham said.
It is arguably not as attractive as it has been in recent years for more buybacks, Shanahan said. But it has not become overvalued to a significant degree suggesting the opportunities for more buybacks are off the table. The record year was 2020, and the buyback activity has slowed, but it hasn’t stopped, and given the lack of alternatives in the market, there is likely still some “modest upside” Shanahan says, for Berkshire to proceed with some level of buybacks, though a more moderate case could mean cash again grows on the balance sheet.
Other ideas for all the cash, like a Berkshire dividend, have been speculated about for years, and yet, Buffett’s long-time aversion to forcing a taxable event on shareholders and the fact that amid all the talk there has been no dividend to date seems to suggest that if a dividend is coming, it won’t be until a post-Buffett era at Berkshire. Though Cunningham did say that as the shareholder base evolves and more investors from a new generation come into the Berkshire fold, and may hold different views on taxes than the previous generation, it could make sense to at least put the idea before shareholders again – and an annual shareholder meeting is the place to do it. Berkshire has done this before.
The Berkshire board and the activists
Earlier this month, long-time director Tom Murphy resigned after a bout of Covid, and that followed the death of another long-time director, Walter Scott, in 2021, and it speaks to a critical management overhaul at Berkshire where the board has long been dominated by a group of older, mostly white male executives. The push towards more diversity on boards is an issue for Berkshire, and recent replacements including Christopher Davis and Buffett’s daughter Susan suggest that there will continue to be a push-pull tension between greater diversity on the board and the need to preserve the Berkshire culture through board members who know Buffett well.
Long-time Berkshire investor and leader of value fund management firm Davis Selected Advisers,Chris Davis, in his 50s, brings down the average age on the board, but does not answer increasing calls for greater ethnic and racial diversity (former American Express CEO Kenneth Chenault became the first Black board member replacing Bill Gates in 2020, and Berkshire insurance head Ajit Jain is of Indian descent). Buffett’s daughter added to gender diversity, but is his second child to serve on the board. “She obviously knows Berkshire better than anyone and spends way more time with him than anyone else, even his wife, and knows the culture and do’s and don’ts, and she is also tough,” Cunningham said. “When he leaves, we know there won’t be exceptions or exemptions or waivers around core principles. She will speak up for that.”
The tension between creating greater board diversity and preserving institutional knowledge is important to monitor because recent and future board changes at Berkshire will determine the destiny of this company, Cunningham said, a significant issue for shareholders. It may become even more significant, he says, in a post-Buffett era, during which there is reason to suspect activist shareholders will come after Berkshire, both activists pushing to force financial and structural changes on the company – especially if it is still sitting on tons of cash and having trouble beating the index – and activists pushing for greater ESG focus from Berkshire, which it has resisted as a stated management approach with issues such as climate and diversity reporting. More Berkshire shareholders than ever before voted in favor of climate and diversity proposals last year.
“That power is coming, and Chris and Susan and the rest need to be prepared to handle it,” Cunningham said. To date, Berkshire has consistently said it appreciates the dissenting shareholder view on ESG issues but believes its companies do a good job and Berkshire as an umbrella organization does not control the individual companies it owns.
But with the shareholder support for ESG measures reaching 25% last year at the annual meeting, “that’s huge and not likely to decrease,” Cunningham said.
On the financial side of activists, the “Carl Icahns of the world,” the reason they have not gone after Berkshire is because Warren is there, and he has control of so many shares, but as he leaves and distributes more shares to the market, “those activists will pounce,” Cunningham said. “File proposals for strategic reviews, say Berkshire ought to pay a dividend with all that cash and no good ideas … and start selling off 10 companies tomorrow.”
Buffett needs people prepared on the board to fight. “He wants them there to say no,” Cunningham said. “Say this business model is durable and sustainable. But it’s going to be a different game when no one owns 20% of stock, and no one is Warren.”
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