March 9, 2016

Owners of Berkshire stock should consider selling now because.....

Warren Buffett's annual letter to shareholders of Berkshire Hathaway came out over the weekend, and let me start my analysis of it with my standard disclaimer that Buffett is the single greatest investor of all time. No one will likely ever duplicate his investment performance, and his cult status among investors is not and will never be in jeopardy.

I, like the legions of The Oracle's fans, worship at his (and Berkshire vice chair Charlie Munger's) investment altar.

Over the roughly 50 years that Buffett has controlled Berkshire Hathaway (1965-2015), the company's share price has risen by an average 20.8% per year vs. just 9.7% for the S&P 500. The company's book value has also compounded at a 19.2% annual rate.

All told, Berkshire shares cumulatively gained 1,598,284% (!!) between 1964 and 2015 vs. 11,355% for the S&P 500 (including dividends). All of that is a testimony to Buffett's unprecedented five decades of success.

But ...

While Buffett has certainly earned Berkshire investors' confidence, the company's recent returns (i.e., since the 2007-08 market meltdown) have been conspicuously disappointing -- falling far short of the company's historical outperformance. This forms the basis of my short thesis for the stock. 

Most Berkshire shareholders accept Buffett's often-quoted belief that the best holding period for an investment is "forever."  But not everyone has such a long timeframe, nor a client base that's willing to dismiss multi-year periods of underperformance. As Baupost's Seth Klarman recently wrote, it's a tiny club of investors who can wait years for good returns:

"Only a small number of investors maintain the fortitude and client confidence to pursue long-term investment success even at the price of short-term underperformance.

Most investors feel the hefty weight of short-term performance expectations, forcing them to take up marginal or highly speculative investments that we shun. When markets are rising, such investments may perform well, which means that our unwavering patience and discipline sometimes impairs our results and makes us appear overly cautious.

The payoff from a risk-averse, long-term orientation is -- just that -- long term. It is measurable only over the span of many years, over one or more market cycles."

Buffett filled his latest letter to shareholders with his customary discussion of investment philosophy, business segments, politics, etc. There are also plenty of the kind of amusing quips that The Oracle has dispensed throughout the years. My favorite:

"Woody Allen once explained that the advantage of being bisexual is that it doubles your chance of finding a date on Saturday night. In like manner -- well, not exactly like manner -- our appetite for either operating businesses or passive investments doubles our chances of finding sensible uses for Berkshire's endless gusher of cash. ... Beyond that, having a huge portfolio of marketable securities give us a stockpile of funds that can be tapped when an elephant-sized acquisition is offered to us."

The stock's inferior recent returns are a byproduct of Berkshire's growing size and the weak performance of its investment portfolio. From Dec. 31, 2008, to Dec. 31, 2013, Berkshire failed for the first time under Buffett to outperform the S&P 500 over a five-year period.

Berkshire's share price also fell 12.4% in 2015, the third year in seven that the stock has under-performed the S&P 500. And given that the stock only outperformed the S&P 500 by about 0.2% in both 2013 and 2014, Berkshire has finished basically in line or worse than the S&P 500 in five of the past seven years.

In fact, Berkshire's lack of out-performance has been significant since 1998. That's an 18-year period, despite preferred investments in Bank of America (BAC), Goldman Sachs (GS), General Electric (GE), etc., offered to no one else in 2008 (when Berkshire hadn't materially beaten the S&P 500 on a 10-year basis).

In this year's annual letter, The Oracle explained in the quote above the benefit of the company's flexibility to either acquire companies or passively invest large sums in non-control positions. But my rationale for shorting Berkshire reflects concerns about both the company's investment and acquisition activities -- and the inferior returns derived from them.

Size Matters

There's little doubt that size matters when you talk about corporations. The larger the company, the more difficult it is to achieve future gains and out-performance.

Frankly, I think Berkshire's sheer size in terms of capital, sales and profits represents the biggest hurdle to the company's future growth and performance. Based on recent returns, there's ample evidence that Berkshire's greatest enemy is the company's past successes, which represent a meaningful headwind to operating and share-price yields. (Apple (AAPL) is in a similar boat.)

In a seeming admission that Berkshire has grown too large to allow for easy capital allocation, Buffett has over the past decade delegated money management to company executives Ted Weschler and Todd Combs. He's also assigned a large commitment that Berkshire has made for acquisitions to private-equity firm 3G.

I underscored the issue that "size does matter," back in 2013 when I peppered Buffett and Munger with questions at Berkshire Hathaway's annual shareholders meeting in Omaha:

"Question: As it is said, Warren, 'Size matters!' In the past, Berkshire bought cheap or wholesale -- for instance, Geico, MidAmerican Energy, the initial Coca-Cola (KO) purchase and Benjamin Moore. Arguably, your company has shifted to becoming a buyer of pricier and more mature businesses -- for instance, IBM (IBM), Burlington Northern Santa Fe, Heinz and Lubrizol (LZ), which were done at price-to-sales, earnings and book-value multiples well above the prior acquisitions and after the stock prices rose.

Many of the recent buys might be great additions to Berkshire's portfolio of companies. However, the relatively high prices paid for these investments could potentially result in a lower return on invested capital. In the past you hunted gazelles, but now you are hunting elephants.

To me, the recent buys look like preparation for your legacy, creating a more mature, slower-growing enterprise. Is Berkshire morphing into a stock that has begun to resemble an index fund that is more appropriate for widows and orphans rather than past investors who sought out differentiated and superior compounded growth?

In the past, you have quoted Benjamin Graham saying: "Price is what you pay -- value is what you get." Are your recent deals and large investments bringing Berkshire less value than the deals done previously?

Buffett admitted that Berkshire won't grow as rapidly in the future as it has in the past, but said it will still generate a lot of incremental value. 'We think we will do better than the giants of the past,' he said. Munger chimed in and said much of the same. Warren then exclaimed: 'Doug, you haven't convinced me to sell the stock, but keep trying!'"

-- Doug's Daily Diary, Conversing with the Oracle (May 5, 2013)

Graham and Dodd's Security Analysis Is From 1934, Not 2016

"The old idea of 'permanent investments,' exempt from change and free from care, is no doubt permanently gone. Our studies lead us to conclude, however, that by sufficiently stringent standards of selection and reasonably frequent scrutiny thereafter, the investor should be able to escape most of the serious losses that have distracted him in the past, so that his collection of interest and principal should work out at a satisfactory percentage evening times of depression.

Careful selection must include a due regard to future prospects, but we do not consider that the investor need be clairvoyant or that he must confine himself to companies that hold forth exceptional promise of expanding profits."

-- Benjamin Graham and David Dodd, Security Analysis (1934)

The basic precepts of Security Analysis, a classic investing book first published in 1934, reflect the thoughtful teachings of Benjamin Graham and David Dodd from 82 years ago. But we're now in 2016 and live in a flat, interconnected and ever-changing world where longstanding business franchises are routinely upended by disruptive innovators.

Cash flow might be the king that Warren Buffett serves. But if the moats protecting Berkshire's investments are more vulnerable to attacks (and subject to analytical misinterpretation in an era of disruptive and innovation), the value of future cash flow drops.

The same applies to the value of float -- an important contributing factor to Berkshire's previous successes. Float diminishes in value when interest rates are near zero, or when investment decisions are wrong-footed or less successful than in the past.

Breached Moats

Berkshire's investment portfolio consists of a number of old-economy companies with "breached moats" and less-defensible franchises. These include:

   - Coca-Cola (KO). Old economy.

   - IBM (IBM). Old economy.

   - American Express (AXP). Losing its franchise value in a more-commoditized market for financial products.

   - Wells Fargo (WFC). A plodding and undifferentiated super-regional bank.

   - Deere (DE). A casualty of exported commodity deflation.

   - Wal-Mart (WMT). Very old economy.      

Expensive Acquisitions of Mature Businesses

As 85-year-old Buffett's unparalleled career closes in on its final decade, we can see that many of Berkshire's acquisitions over the past five to eight years represent The Oracle's legacy.

The recent acquisition of Precision Castparts and other firms solidify a more bullet-proof Berkshire portfolio that's increasingly insulated from catastrophic events in its numerous business lines. But there's a price to the reduced vulnerability that Berkshire has gained from diversification and massive size -- much slower growth.

As I've previously written, Buffett "used to 'chase gazelles' in his acquisitions, buying companies that were available on the cheap due to controversies (i.e., Geico, Coca-Cola and American Express). But now, he chases elephants -- slow-growing and mature companies that sell for expensive prices."

Rejecting Innovation and Favoring Cash Flow

Buffett only invested in technology in recent years via Berkshire's purchase of a large stake in IBM (a deal that hasn't worked out very well so far).

As the Oracle wrote in this weekend's letter to shareholders: "I now spend 10 hours a week playing bridge online. And as I write this letter, 'search' is invaluable to me."

The 85-year-old very late to the party -- and after Berkshire's poor IBM experience, he's not likely to embrace the future opportunities in technology as aggressively as perhaps he should.

Are Auto Dealerships Another Big Misstep?

"This is the beginning of a journey that will have no end. Cecil and Larry (Van Tuyl) have given us the ideal platform with which to build an auto-dealership business that will be thriving and growing 50 and 100 years from now. The fun has just started."

-- Warren Buffett, on buying Van Tuyl Group of auto dealerships, as quoted in Automotive News (March 10, 2015)

I'd like to highlight Berkshire's recent purchase of the Van Tuyl Group of auto dealerships because I think he might have been investing in another industry whose moat isn't as secure as he believes.

It's worth noting that in buying Burlington Northern a few years back, Buffett failed to envision the declining role of coal (a key railroad cargo) in the U.S. economy. It turns out that Burlington's competitive moat was far less secure than it appeared when Berkshire acquired the railroad giant. If Burlington was still public, how low would the shares be selling today?

Similarly, Berkshire's 2015 acquisition of the Van Tuyl Group might be in exactly the wrong sector to invest in for the future.

Auto dealerships are highly dependent on repairs and maintenance as revenue sources. But these seem vulnerable to what many see as inevitable, swift market-share gains for electric cars that have fewer parts and require far less maintenance than gas-powered models do. The growth of "car-sharing" services is another risk to the Van Tuyl acquisition.

To me, the Van Tuyl and Burlington purchases potentially represent a continuation of an unsuccessful "old-economy" strategy that's failed Berkshire since 2009.

As Warren Goes Gently into that Good Night

The challenges of Berkshire's size and Buffett's age in allocating capital to investments and acquisitions are illustrated by his delegation of capital authority to others. The Oracle is stepping back and will likely continue to do so over the balance of the decade. He's certainly earned that privilege.

I expect even more delegation ahead, which shouldn't be surprising for an 85-year-old man (even a relatively spry one). But while Todd Combs, Ted Weschler and 3G are all capable, they're not likely in the same league as Buffett. Why should investors "pay up" for an unfamiliar, less-accomplished group of capital allocators?  

The Bottom Line

As I noted above, Warren Buffett is arguably the greatest investor of all time.

But Berkshire Hathaway's shares might be increasingly vulnerable to more-ordinary results and returns in the future, as today's Berkshire Hathaway is no longer anything like your father's Berkshire Hathaway. Indeed, based on Buffett's own preferred metric of book-value increases, Berkshire has under-performed the S&P 500 in five of the last seven years.

As I've repeatedly written, my respect for The Oracle's many decades of unprecedented returns is different from my assessment of Berkshire's investments over recent years and my forecast for Berkshire's stock performance over the next several ones.

But from my perch, there's no longer a margin of safety in Berkshire's shares. I believe investors will begin to more seriously question the "Warren Buffett Premium" that Berkshire's results and returns over the past six years no longer justify to me.

Again, this is not your father's Berkshire Hathaway. Rather, it's a diversified, maturing company with investments in many old-economy companies that in hindsight either "over-earned" in the past or are being commoditized today. And many (like Wal-Mart and IBM) need to retool at a steep cost to deal with our changing economy and interconnected world.

However, Buffett has continued to favor cash cows and cash flow over innovation and technology. In fact, he's been ever more willing in recent years to pay rich prices for maturing companies. His legacy from this will be a Berkshire that's a diversified global corporation whose returns will likely resemble global gross-domestic-product growth. But the days of Berkshire's outsized gains in book value and share price seem like they're over.

Berkshire's current valuation metrics (1.2x tangible book value and other multipliers) thus seem inflated relative to its peers, especially given the company's diminished and likely less-than-consensus growth prospects.

The bottom line: If I were long Berkshire, I would consider selling now. The company's future prospects are nowhere near as robust as in the past -- and future returns are unlikely to meet consensus expectations.