Warren Buffett (Trades, Portfolio) is undoubtedly the most respected value investor in the business. His company, Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), has delivered staggering returns to investors over many decades, making it one of finance’s greatest engines of value identification, exploitation and creation ever. Long-time Berkshire watchers might even be forgiven for considering adding, after death and taxes, a third certainty to life: That Berkshire Hathaway will always deliver healthy compound annual growth.
The decades-long track record of high performance has been one of the few “sure things” during multiple market cycles. But as with any investment prospect, we must look to the future, not the past (though the past is admittedly often prologue). So for those who do not currently own Berkshire stock, the question is this: Is now a good time to buy?
Everyone knows the bull case: Compound annual growth for decades, exceptional capital deployment, remarkable management, etc. add up to a great company. This article, instead, addresses a few of the doubts that might cause an investor to worry about diving into Berkshire. Specifically, we will ask and answer three vital questions that will help shape a final thesis in light of the exceptional financial performance we already know so well.
A question of valuation: Is Berkshire overpriced?
As with any company, we must examine Berkshire’s financials. We will not dwell on the aspects of high performance, which are broadly known, but rather on valuation metrics compared to historical norms. By that means, we can determine whether Berkshire’s current valuation of about $500 billion is justified.
Berkshire’s price-earnings ratio is about 28.2 times, quite a distance above its five-year average of 16.8 times. That might raise a value investor’s eyebrow at a glance, yet Berkshire has never cared much about the price-earnings ratio, instead favoring other fundamental measures of performance. Indeed, the general bull run has thrown a lot of historical price-based valuations out of whack.
Comparing other fundamental measures, we see Berkshire’s current share price and valuation are not quite so off their historical norms. A price-book ratio of 1.7 times and price-to-cash flow ratio of 11.7 are not radically out of alignment with the past five years’ numbers, 1.4 times and 10.8 times respectively. They are above the historical trend, but still reflect a high degree of value. Across the board, Berkshire’s multiples trade at a discount compared to the industry average.
Is Berkshire overpriced? No. The stock is not as cheap as one might like, but it has certainly not diverged from fundamentals in any extreme way.
A question of size: Is Berkshire too big?
When a company delivers consistent compound annual growth and never distributes profits as dividends, we know it has to be growing significantly. Berkshire has always hoarded its cash and redeployed it to new acquisitions and growing its multifarious businesses. Buffett has always been of the impression that he can make more profitable use of cash flow through reinvesting than through distribution. That attitude has been proven correct time and again. But it has also meant Berkshire becoming a giant, sprawling behemoth of a company. That can have consequences for long-term growth.
Specifically, when a company is as vast as Berkshire, it takes more to “move the needle,” so to speak. This has led the company to deploy capital in ways Buffett had previously avoided, such as partnering with private equity juggernaut 3G Capital on the acquisition of Kraft Heinz (KHC, Financial). Thus far, the search for new and profitable opportunities has been quite successful, despite facing the headwinds of an apparent bull market in everything. However, opportunities for growth may eventually stagnate or become harder to find. The bigger Berkshire gets, the harder it may find the task of delivering value through reinvestment.
In Berkshire too big? Not yet, but it is something to keep in mind. Whether Berkshire can continue to grow at its current pace or not, there are other share price-enhancing activities it could undertake. Longtime shareholders have been comfortable with never getting dividend payouts. A transition one day to offering dividends from Berkshire’s vast profit-machine could sustain share price appreciation even as compound growth slows.
A question of leadership: Will Berkshire drift without Buffett at the helm?
At 87, Buffett does not have a lot of time left, actuarially speaking. While he has no intention of leaving the company, investors cannot expect him to last too many more years. Since Berkshire has been “The Warren Buffett Show” for decades, it is understandable to question whether it will be the same company when he is gone.
This month, Buffett made his latest move to set Berkshire on a stable footing for the future by appointing senior executives Ajit Jain and Greg Abel as vice chairmen of the board and handing over significantly more leadership responsibility to them. These men are seen as the top contenders to replace Buffett one day, and both have demonstrated exceptional skill leading their business units. Whoever takes over, it will be hard to fill the void left by Buffett. He is no mere executive or business leader; he is a legend whose name has become synonymous with investment genius.
Furthermore, there are concerns about the development of alternative nexuses of power within the firm. Todd Combs and Ted Weschler, who have been Buffett’s investment strategy deputies, will retain significant power as heads of investment decision-making after Buffett’s departure. A big, complex organization needs clear leadership and any intimations of internal conflict could shake confidence in the venerable institution.
Will Berkshire drift without Buffett at the helm? Probably not. Buffett has chosen his team well and they are all familiar with their strengths and the needs of the organization. Whoever ends up in the top job will have many years of experience within the organization to draw upon, and the other principal actors will in all likelihood contribute to the continuity of the corporate culture and strategy that has made Berkshire a household name. Perhaps further down the line, when the successor’s successor must be chosen, things might change. But for now, and for years after Buffett’s departure, leadership and strategy should be as good as ever.
The verdict: Bet on Buffett
Buffett will inevitably leave the stage, as all men must. But the institution he has forged was built to last. Buffett himself has suggested the stock price might jump in the immediate aftermath of his departure – though that may be a bit overly optimistic. When the "Oracle of Omaha" is off the scene, there may be some volatility as investors work out their nerves and look for signs the transition is smooth and the long-term performance set to be uninterrupted. Buffett has assembled and groomed a team of exceptional value creators. His legacy should be in good hands.
So should investors buy now? Since Buffett will likely be around for years and the volatility in his absence likely short-lived and muted, there does not look to be a much better time to get in more cheaply. A broader market correction might open an opportunity in the next year or two, but even that is not guaranteed. After all, in times of crisis, investment capital flows to safety. Berkshire might even find itself buoyed up in a time of crisis.
Berkshire remains a valuable, stable and worthwhile company to own – and that thesis is unlikely to change in the foreseeable future.
Disclosure: I/We own no stocks mentioned in this article.
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