Berkshire is NOT a fund

It has great management and a variety of holdings – but there are fundamental differences that mean this stock is no fund substitute

Andrew Willis 3 December, 2019 | 1:20AM

Warren Buffett

We had a Morningstar subscriber reach out with an interesting question:

I was thinking of using Berkshire Hathaway as a mutual fund – it has a strong parent, legendary people (Warren Buffett and Charlie Munger), and since they’re legends, I’m assuming the process is A-grade too. Plus, you say it’s undervalued, so the price is great and that performance, oh boy!

There may appear to be some similarities, but Berkshire Hathaway (BRK.ABRK.B) is no fund. It’s just a stock – a stock that holds many companies and has excellent active management that many people like, but still, just a stock.

Four-star-rated Berkshire has built itself a wide-moat, with an edge up on the competition thanks to influential majority holdings and an array of exclusive privately-held companies, particularly in the insurance space.

There’s no doubt that there’s some strategic, active asset management at play with Berkshire, but it’s still one company, exposed to individual stock-specific risks.  

Eggs in one basket
“When investing in a single stock, you’re placing your entire investment in one company’s success,” says Morningstar’s data journalist for investor education, Michael Schramm. “This exposes investors to unsystematic risk—in other words, company-specific risk that a diversified portfolio can reduce.”

Jason Heath, certified financial planner and Managing Director at Objective Financial Partners agrees. “One of the most important factors when investing is to be diversified – to avoid putting all your eggs in one basket. You want to own investments that zig when others zag.”

Mutual funds or exchange-traded funds have ‘zigs’ and ‘zags’ occurring within. But with Berkshire – if something happens at the top – say Buffett steps down – the whole holding will zig (or zag).

The immortal legends?
“While Berkshire Hathaway is a broadly diversified conglomerate, which can help in market downturns, it’s still exposed to unique business risks. For instance, it’s particularly exposed to key-person risk in with Buffett and [Vice-Chairman] Munger,” says Schramm.

“Berkshire depends on two key employees, Buffett and Munger, for almost all of its investment and capital-allocation decisions,” notes Morningstar senior stock analyst Greggory Warren, “With Buffett [having turned] 89 in late August 2019 and Munger turning 96 in early January 2020, it has become increasingly likely that our valuation horizon will end up exceeding their life spans.”

Morbid, but definitely something our subscriber (and anyone who wants to invest in Berkshire) should consider.

Berkshire’s leadership concerns and business-specific operational considerations – such as a need to keep enough liquid assets on hand to cover its insurance liabilities – set it apart from your typical balanced fund, adds Warren.

But Berkshire is also unlike your average stock and evaluating the benefits of adding it to your portfolio may involve considering it as its own breed.

Different – in a good way
Investors should start by acknowledging that although it’s special, Berkshire is a stock and needs plenty of company; especially if you’re not holding a balanced mutual fund that holds important allocations in fixed income. Heath recommends holding at least 20 stocks to ensure adequate diversification.

Next, it’s worth considering Berkshire-specific blind spots. “While Berkshire Hathaway is a diversified conglomerate, it lacks exposure to major market segments such as energy, and has big overweightings in areas like financial services and technology,” notes Schramm.

Berkshire also doesn’t offer a dividend – so if you’re saving a spot for income or distributions, it might not be the right bet. However, depending on the type of account you’re holding it in, this apparent downside can turn into tax efficiency.

“Berkshire Hathaway doesn’t currently pay a dividend, which means it’s more tax-efficient than some mutual funds [or stocks] that do distribute gains,” notes Schramm. “But investors should keep in mind that Berkshire’s dividend policy could change.”

“A Berkshire investor gets their return through capital appreciation,” adds Heath. “In an RRSP, TFSA, or RESP account, how you earn your return doesn’t matter. But for an investor in a taxable, non-registered account, capital gains are taxed at a lower rate than dividends.”

Have realistic return expectations
From a performance perspective, Berkshire’s returned 25% annualized since 1965, notes Warren. “Over the long run, it has outperformed the S&P 500, but the outperformance has continued to decline over time. Berkshire hasn’t had a 10-year period of outperforming the S&P 500 since 2002,” says Heath.

“As the company has grown so much in value and as markets have become more efficient, it makes it harder for the big company to beat the markets,” adds Heath.

However, “Berkshire should generate returns in excess of our estimate of its cost of capital. Book value per share, which serves as a good proxy for measuring changes in Berkshire's intrinsic value, increased at a 9.5%, 11.7% and 10.1% CAGR the past five-, 10-, and 15-year time frames,” says Warren. “We believe the advantages provided by Berkshire's business model should allow the firm to expand book value (and returns on equity) at a high-single- to low-double-digit rate in the near-to-medium term.”

Berkshire’s class B shares are currently undervalued at a 13% discount to our fair value of US$253.00 a share, currently trading around US$220.50.

Also (like some fund managers), stagnant performance can be attributed to a ‘battening down of the hatches’ through an increased cash allocation ahead of a potential recession. “The equity bull market that began more than a decade ago is likely to end sometime in the near to medium term,” says Warren.

"To reach your financial goals, you need to ensure that your investments line up with your risk profile and investment time horizon" says Morningstar Canada's Director of Investment Research, Ian Tam. "When you buy a fund, its stated investment objective as defined in the fund prospectus tells you whether the fund lines up with your goals and properly correlates to the rest of your portfolio. Berkshire does not disclose this. For example, Buffett and his management team have the authority to increase their cash stockpile. Although Buffett may have a good reason for doing this, the increase in a cash position may not be what you are looking for in the context of your overall asset allocation in particular as it relates to your own financial goals. Certainly one reason you may not want to use Berkshire in place of a fund.”  

Finally, Berkshire’s a Buy – as a stock. 
Warren sees Berkshire as “a long-term investment idea that is likely to hold up better than most firms in a downturn,” especially given its cache of more than US$100 billion in cash that could be committed to investments, acquisitions, and share repurchases. At the same time, “the company has significantly more illiquid assets on hand than any fund manager could ever muster,” adds Warren.

Let’s be honest, we are one of the people who like the stock. In fact, we think it’s a great stock. Asides from a long legacy of performance that has elevated Berkshire founder Buffett to ‘prophet’ status, today “Berkshire’s diversification, strong balance sheet, capital allocation, excess returns and attractive valuation” make it an appealing buy right now, says Warren.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Berkshire Hathaway Inc A332,232.12 USD0.03
Berkshire Hathaway Inc B221.47 USD0.09

About Author

Andrew Willis

Andrew Willis  Andrew Willis is a content editor for Morningstar.ca.