As everyone knows, Warren Buffett and Charlie Munger are living legends in the investing world. Despite the fact that Berkshire Hathaway Inc. (NYSE:BRK.B) (NYSE:BRK.A) was originally an investment mistake made by Warren Buffett in response to Seabury Stanton trying to pull a fast one on him, Berkshire Hathaway has become one of the most widely admired corporate holding companies and it sports a $206B market capitalization. Berkshire Hathaway has increased its per share book value by a compounded annual growth rate of 19.8% from December 31, 1964 to December 31, 2011. This easily outpaces the 9.2% Compounded Annual Return of the S&P 500 Total Return Index during this time period. The cumulative return differential is even more striking because Berkshire’s cumulative gain in book value per share was 513,055%, which dwarfed the 6,397% total return of the S&P 500 Index during this time period. Berkshire’s previously unimpeachable allocation of shareholders capital is a reason why our firm has a long position in Berkshire’s Class B shares.
However, Berkshire’s best days are certainly behind it. While Berkshire’s growth in book value since the beginning of 1999 has continued to beat the S&P 500, its annual growth during this time was 8.1%. While this soundly beat the S&P 500 during this time period, it was less impressive when we consider that the Vanguard Total Return Bond Index Institutional Share Class returned 5.7% during this time period. In this 13.25 year period, Berkshire’s per share book value growth has an above average “hit ratio” of 60% versus the S&P 500, however, Berkshire’s per share book value growth had previously beat the S&P 500 91% of the time from 1965-1998 and every year from 1981-1998. We can see that Berkshire is not only dealing with the law of large numbers, but that its investment ideas are declining around the same time the cash is piling up. This explains why even though Buffett has made large controlling investments and acquisitions in diverse businesses, Berkshire and its subsidiaries have amassed $70B in cash and liquid fixed income securities. This also explains why Berkshire’s per share book value has grown at nearly twice the rate of its Class A stock price since the beginning of 1999.
Sources: Berkshire Hathaway 2011 Annual Report and Morningstar Direct
We think Berkshire should take some or all of that $70B that is festering on the balance sheet in low-yielding cash and fixed income securities and use it to pay dividends or buyback shares. Berkshire announced a share buyback last year, but it seems to only have repurchased $67M in Berkshire shares last year. If Berkshire took all the cash and fixed income securities and paid it out to the shareholders, this would represent a dividend of $42400 per Class A share and $28.2667 per Class B share. This represents 34% of Berkshire’s June 30th share price of 124,945 per Class A Share. Or if Berkshire took all the cash and fixed income securities and used it to repurchase Berkshire shares, it would result in a static reduction (assuming no market price impact) of 560,246 shares, which is 34% of Berkshire’s shares outstanding.
Source: Berkshire Q1 2012 10-Q
We admire very much Warren Buffett and Charlie Munger’s record leading Berkshire Hathaway. We are impressed with how Buffett transformed Berkshire from a fading New England textile mill company into the world’s leading diversified conglomerate and investment holding company. Unfortunately, Berkshire has gotten so big we believe that it is suffering from a “conglomerate discount”. The premium on Berkshire’s shares relative to its book value is less than 15% and we believe that investors rightly see Berkshire as “Warren Buffett’s personal mutual fund”. We believe that since even Warren Buffett admits that Berkshire’s best days are behind it, that it should beginning paying dividends to shareholders. We found that cash and low yielding bond securities represent 17% of Berkshire’s assets and ~39% of Berkshire’s equity.
In conclusion we believe that Berkshire should easily pay out all of these assets to shareholders in a one-time special dividend. If the business units need cash, Berkshire can certainly borrow that money back from the capital markets at low interest rates and it can service the interest payments with on-going cash from its investments and business units. This pro forma special dividend would reallocate $70B of low yielding assets from Berkshire’s balance sheet into the hands of astute and educated investors, who can reallocate the proceeds to investments with higher growth prospects than government and corporate bonds and bills. We believe that the market would treat a significant dividend or stock buyback from Berkshire as a positive signal from that company and would compel investors to bid up Berkshire’s Class A and B shares. Berkshire could either pay a portion or all of its cash and fixed income debt securities as a one-time dividend and or use a portion or all of its operating cash flows as an on-going dividend. Warren’s friend Bill Gates has done that to a degree at Microsoft (MSFT). The proposed dividend would also generate up to $70B in taxable income to investors, which would yield up to $14B in additional taxes for federal, state and local governments. We take note of this because we believe that this windfall of taxable revenue would be a good start in satisfying Warren Buffett’s Tax-Me-More op-ed in the New York Times and his Tax-Me-More interview on PBS. We are holding on to our Berkshire shares because we believe that there is unrealized value in the company, particularly if investors see clarity with regards to its capital allocation program and its eventually leadership successor(s).