What’s Berkshire going to do with all that cash?

Greggory Warren, CFA 28 March, 2019 | 2:00PM

With investment opportunities few and far between these days, Berkshire Hathaway (BRK.A)/(BRK.B) faces a near- to medium-term issue: large cash balances that (absent any sizable deals) will need to be returned to shareholders. While Buffett has been clear about share repurchases being his preferred option (relative to dividends) for reducing excess cash balances (not dedicated to acquisitions or stock investments) down the road, we expect him to be just as cost-conscious when buying back shares as he has been with other investments historically. As long as Berkshire’s shares trade closer to the five-year average multiple of 1.45 times book value per share, we think repurchases are unlikely.

Financial strength is a competitive advantage

Berkshire’s strong balance sheet and liquidity are among its most enduring competitive advantages. The company’s insurance operations are well capitalized and highly liquid, carrying greater levels of equity and cash relative to other insurers, which should help to offset potential losses. Berkshire generates large amounts of free cash flow from its operations and maintains significant levels of cash and equivalents on its balance sheet, which amounted to $103.6 billion at the end of the third quarter of 2018.

Buffett has been explicit about a need to keep around $20 billion in cash on hand as a backstop for the insurance business. We also believe the rest of the company’s operations require at least 2% of annual revenue on hand as operating cash, along with carve-outs for capital expenditures. As a result, Berkshire probably entered the fourth quarter of 2018 with an excess cash balance of just under $80 billion--dry powder that could be used for acquisitions, investments, share repurchases, or dividends. We continue to believe the company could return as much as $25 billion to shareholders midway through our forecast period, should cash balances approach $150 billion. Without prior regulatory approval, the company’s principal insurance subsidiaries alone could have paid as much as $13 billion as ordinary dividends during 2017.

Berkshire generally runs its operating companies and make ongoing investments without an overreliance on debt. When it does issue debt, it does so on a long-term, fixed-rate basis. Berkshire’s corporate debt load has risen the past couple of years, though, reaching $18.8 billion at the end of 2017, as the company has taken on debt to fund acquisitions.

Confidence in the controller of purse strings

Buffett has been chairman and CEO of Berkshire Hathaway since 1970. Munger has served as vice chairman since 1978. Berkshire has two classes of common stock, with Class B shares holding 1/1,500th of the economic rights of Class A shares and only 1/10,000th of the voting rights. Buffett is Berkshire’s largest shareholder, with a 31.0% voting stake and a 16.5% economic interest in the company (based on our estimates following his July 2018 annual charitable donations). Buffett has been a strong steward of investor capital, consistently aligning his own interests with those of shareholders, with Berkshire’s wide economic moat derived in part from the success that he has had in melding the company’s financial strength and underwriting ability with his own investment acumen.

Buffett’s stewardship has allowed Berkshire to increase its book value per share at an estimated compound annual growth rate of 19.1% during 1965-2017, compared with a 9.9% return for the S&P 500 TR Index. The company has not only increased its book value per share at a double-digit rate annually 42 separate times during 1965-2017 but also reported declines in its book value just twice during the past 53 years (in 2001 and 2008). Even with the company’s overall results being affected by the 9/11 terrorist attack and the 2008-09 financial crisis during the first decade of the new millennium, Berkshire still generated double-digit rates of annual growth in its book value per share seven times during 2001-10. While we think the company is unlikely to consistently increase its book value per share at a double-digit rate going forward, given the ever-increasing size and complexity of its operations, we believe it can achieve a high-single-digit to low-double-digit rate of growth during the next five years, much as we’ve seen since the start of the millennium.

Given Buffett’s impressive long-term record of increasing both book value per share and the value of Berkshire’s shares over the years, it is important that much of what he has built remains intact once he is gone. Succession was not formally addressed by Berkshire until 2005, when the company noted that Buffett’s three main jobs--chairman, chief executive, and chief investment officer--would be handled by one chairman (expected to be his son, Howard Buffett), one CEO (with candidates identified but not revealed), and several external hires (reporting directly to the CEO) to manage the investment portfolio. While we have clarity on the investment side of things, with Combs and Weschler expected to be the only outside hires to work with Berkshire’s investment portfolio, questions linger over who the next CEO will be.

Next leader will be capital allocator in chief

We continue to envision the main role of the next chief executive to be one of capital allocator in chief. With all of Berkshire’s operating businesses managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility for each business down to the subsidiary level, Buffett has had the freedom to focus on managing the investments and making capital-allocation decisions. He has noted at times, though, that the job requires more than just investing prowess and, as such, he would not advocate for a candidate to run Berkshire who only had investing experience, with no operational experience to speak of. Buffett has also been vocal about the next CEO coming from within the company’s ranks.

We continue to believe Jain, who was added to Berkshire’s board at the start of 2018 and gained the title of vice chairman, insurance operations, and Abel, who also joined the board and was elevated to vice chairman, noninsurance business operations, are the top two candidates to replace Buffett. While Jain is probably the first name the board might turn to, we think Berkshire would be better served longer term having him focus on overseeing the entire insurance business, which his new position allows him to do. While Jain’s experience has primarily been on the underwriting side of the business, his success there has been built on his ability to avoid making “dumb decisions” rather than making “brilliant” ones.

If the next CEO is expected to do nothing more than act as a caretaker for the business, tending to the needs of the managers of the different subsidiaries, overseeing the actions of the investment managers handling the company’s investment portfolio, and dealing with the capital-allocation and risk assessments that need to be made along the way, then we could not think of a better candidate than Jain. The only problem is that Jain has been on the record several times saying he does not want the job, which is the main reason we regard Abel--who not only brings with him the operational experience of running Berkshire Hathaway Energy for many years but has a ton of experience doing acquisitions--as the most likely choice to succeed Buffett.

About Author

Greggory Warren, CFA

Greggory Warren, CFA  Greggory Warren, CFA, is a financial services sector strategist for Morningstar.