Sat, 3 May 2014
In his take on the first half of the Berkshire meeting, Morningstar's Matt Coffina discusses why he thinks Berkshire failing to grow faster than the market during the last five years is no reason to worry.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We're at the halfway point of the 2014 Berkshire Hathaway annual meeting; I'm checking with Matt Coffina, the editor of StockInvestor, to get his take.
Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's start with cost of capital and how Warren Buffett thinks about cost of capital. This was a question actually posed by our colleague, Greg Warren. Did anything in his answer surprise you about how Buffett and Munger think about what it actually costs them to fund some of these deals?
Coffina: I thought Buffett's answer was really interesting. This is a question that we often wonder about as to how does Buffett think about cost of capital and how does he think about Berkshire's cost of capital. And he sort of poked fun at the whole idea. He basically said that Berkshire's cost of capital in his mind is the return that they could earn on their second-best investment opportunities.
So they're basically just comparing the universe of investment possibilities and then they pick the best one. Now that makes sense if you decided that you're going to invest in something. But it doesn't really help you solve the question of should we be investing at all, should I be holding cash or should I maybe be paying a dividend, which is something that's always on investors' minds with Berkshire.
So I was little disappointed not to get a more firm answer from him on that point, but basically he said, "We just always evaluate all the investment opportunities that are out there, and our cost of capital is the return we could earn on our second best opportunity. And anything that could beat that then we're going to with the best opportunity."
Glaser: There was a question from the audience about leverage. Why does Berkshire not think about maybe adding some leverage now given where the rates are and where they could borrow? Do you think that argument made sense? Did you buy on why Buffett and Munger aren't making those moves?
Coffina: Well, you could tell that Buffett of 40 years ago would think very differently than Buffett of today. Forty years ago, I think given the mix of businesses that Buffett has as well as the low-interest-rate environment that we're in currently, Buffett said he would be willing to take on another $30 billion or $40 billion of debt, and certainly that would increase Berkshire's returns of the cost of somewhat higher risk. However, Buffett, first of all, he doesn't want to change course, so they've established this pattern over the last 50 years of not having a lot of leverage. They don't want to change that perception.
And second of all, Buffett really pointed to the other forms of leverage that Berkshire does have that aren't exactly debt. But for example, the insurance business generates a lot of float. They're able to invest money that doesn't really belong to them, and that's a form of leverage, which actually carries lower costs than explicitly borrowing money than the debt markets would. So I think they're comfortable with the current level of leverage that they have.
It's not like opportunities are exactly jumping out of the water at them right now. They are having trouble putting even the cash that they have to work. Taking on leverage to generate a lot more cash wouldn't necessarily make sense in the current environment. But Buffett did say, that if a really big fish, big opportunity came along, say a $50 billion opportunity, that they would find a way to make that happen, even if it meant issuing some debt. He seemed to express some regret actually about funding the Burlington Northern Santa Fe acquisition with equity primarily. The equity that Berkshire had to issue to get that deal done ended up having a pretty significant cost since Berkshire's stock itself has done quite well since that deal was completed.
Glaser: For the first time on a five-year rolling basis, Berkshire's book value didn't grow as much as the S&P 500. This has been a benchmark that they had set for themselves some time ago. Do you think this is significant? Should investors think that maybe Berkshire's gotten too big to really grow quickly?
Coffina: Well, I think you have to look back one more year and see that six years ago in 2008, Berkshire's book value per share outperformed the S&P by more than 20 percentage points. There was a huge outperformance in 2008, and they have subsequently underperformed in 2009 through 2013. Buffett basically said that the company isn't always going to outperform in a very strongly rising market. They more than make up for it in the down years, so that over a full market cycle, the company should on average outperform the S&P.
Also worth keeping in mind, something that Charlie Munger pointed out, which is that Berkshire pays corporate income taxes at 35%, whereas the returns of the S&P 500 are on a pretax basis. So the company is also already setting a very high hurdle for itself to try to keep up with the S&P 500 returns on an aftertax basis. But I think still over a full market cycle, Berkshire is very likely outperform, but it will underperform in the strong bull runs like we've seen over the last five years.
Glaser: Finally, let's talk about corporate culture; it came up a number of times. There were some hints that maybe Warren and Charlie think corporate culture is going to have to change somewhat. Maybe they'll have a little bit more organizational structure around it when they leave. Do you think it's a major threat to the firm that a huge bureaucracy could spring up after they depart?
Coffina: I don't think there is much risk of that. Basically right now they take a completely hands-off approach. They let the subsidiaries do whatever they think is best. Buffett talked about one of the major weaknesses of their management style being that they've been very slow to change personnel. So they really like the managers that they have. They're good friends with them and they're hesitant to change their manager, even if the business is clearly underperforming.
Buffett talked about an example where they took the manager straight out of the executive chair and put him in an Alzheimer's home. So I think that there probably is room for them to be a little stricter, maybe to have a little more control over the subsidiaries. Something Buffett mentioned, in particular, is setting up kind of a sweep account that would take all the cash from the subsidiaries, the excess cash, and bring it up to the parent level, where maybe it could be earning a somewhat higher return. But I'd be very surprised to see a big change in Buffett's corporate culture.
The model only works because they're so hands-off. It also came up, the top of the other conglomerates, and a lot of other conglomerates have not performed well over time. And in large part that's because they've been trying to meddle in all these different businesses where they didn't necessarily have expertise. Buffett believes in hiring great managers, and then giving them free reign to do what they think is best.