Berkshire Hathaway is the investment vehicle of Warren Buffett, often thought of as the most successful investor of our time and given the moniker ‘The Oracle of Omaha’ because of his reputation. Since taking over the management of Berkshire Hathaway in 1965, Buffett has watched the S&P 500 gain nearly 6500%, with a compounded rate of return of 9.2%. That’s pretty impressive stuff, but when compared to the overall gain in Berkshire Hathaway, it pails into insignificance.
The per-share book value of Berkshire Hathaway has increased a mind-blowing 513,055% from 1964 to the end of 2011: that’s a huge 19.8% compounded annual rate of growth. The question is how has Buffett achieved this, and is there anything that we as investors can learn from his methods?
Buffett and Berkshire Hathaway
Buffett’s interest in The Hathaway Manufacturing Company began in the 1950’s. The company had been founded by Seabury Stanton as a cotton milling concern in 1888, and the inherited by his son, Jack Stanton. After the end of the First World War, the cotton industry in the United States fell into decline, hit by the Great Depression and increasing competition from abroad.
But profits were plowed back into the company, and somehow it weathered the storm and began to grow again, until, by the mid 1950’s it had merged with Berkshire Fine Spinning Associates and employed over 12,000 people operating from 15 plants, and had revenue of $120 million per year.
But decreasing milled cotton prices, under pressure from cheap foreign imports, and increased competition both at home and abroad took its toll once more, and by the end of the decade the company had closed more than half of its operations and laid off thousands of staff.
In 1962, Buffett and his investment associates began buying shares in Berkshire Hathaway. He felt that there was intrinsic value in the company not recognized by the market, and considered the shares undervalued. He continued to buy shares until, in 1963, he was the company’s largest shareholder.
He wanted to take a more active role in the company, in efforts to turn it around, but was thwarted by arguments with Stanton. So Buffett carried on with his share purchases until he had acquired 49% of the voting rights at a cost of around $15 per share. He then forced a management change that saw Ken Chace installed to run the textiles side, and Buffett in charge of the financial side of the business.
Under this structure, the financial and investment arm grew, but the textiles arm continued to contract. Eventually, in 1985, Buffet was forced to close down the loss making textile business. He considered it structurally unsound, and unable to be turned around.
The real strength of Berkshire Hathaway’s investment arm began when, in 1967, Buffett bought two Nebraska based insurance companies (National Indemnity and National Fire and Marine Insurance). He found the strong and steady cash flow produced by the premiums it collected intriguing, and considered they could be invested in liquid securities to produce extra earnings.
In 1976, Buffett started buying shares in another insurance company, GEICO. He had been introduced to the company as long ago as the 1940’s, when his mentor, Benjamin Graham bought a 50% stake and floated it on the stock exchange.
Thirty years later. GEICO had run into problems and incurred heavy losses on risky insurance business, and its share price had crashed from a high of $42 to just $2. But Buffett considered the core business of the firm to be strong, and took a large holding. The business started to improve, premium risk fell away, and profits firmed.
But in 1994, the business began suffering again, this time from increased competition in its markets, and Buffet bought the shares he didn’t own for $2.3 billion. The stream of premiums from the insurance businesses grew, and now forms the backbone of his investment finances.
As Buffett wrote in his 2011 Letter to Investors, the insurance businesses provides a ‘delivery of costless capital that funds a myriad of other opportunities. This business produces “float” – money that doesn’t belong to us, but we get to invest for Berkshire’s benefit.”
In fact, the five insurance businesses that Berkshire Hathaway own and operate produced underwriting profits of $17 billion during the nine year period from 2002 to 2011, as insurance premiums outstripped claims and payouts. All this money has been used to invest in buying stocks and shares, bonds, or other companies that Buffett and his investment team consider undervalued.
Berkshire Hathaway’s investment methods
The company, under the direction of Warren Buffet, actively seeks other companies it considers have a good core business with great cash flow but which are, for one reason or another, undervalued by the market.
It also invests in established businesses that have similar valuation and cash flow profiles to the businesses that it buys. Berkshire’s investment team know the valuation they place on businesses and cash flow, and when it considers company shares to be valued below their own estimates they will consider investing. They look for companies that have strong profits and a progressive future, as well as mature businesses that are leaders in their field and give a good dividend stream.
For example, Berkshire owns 13% of American Express, 8.8% of Coca-Cola, 5.5% of IBM, and 7.6% of Wells Fargo.
The insurance premiums it receives and the dividends it gets from its shareholdings are reinvested in the business. It doesn’t pay out a dividend to its shareholders. In a sense, its returns are made in a similar fashion those made by investors who reinvest the dividend they receive on their own investments.
Berkshire Hathaway historical returns
The returns made by the company have, over the long term, outstripped the S&P 500 Index against which Buffet measures the company’s performance. But the pace and regularity with which its book value has outperformed the index is astounding.
Buffet has always said that the book value of Berkshire Hathaway should outpace the S&P 500 Index in a bad year for equities: the dividend stream helps, but so too does the premiums from its insurance businesses, profits from the companies it owns, and its method of investing in undervalued companies for the long term
Since taking over at Berkshire there have been 42 five-year periods for which Buffet has been responsible. Each single one showed a growth greater than the S&P 500 benchmark. In fact, there have only been eight individual years in that time when Berkshire’s book value has underperformed the benchmark. And that’s with the return on the S&P 500 calculated in pre-tax terms, and the gain in Berkshire calculated after tax.
The lessons to be learned
Berkshire’s results stem from two main fundamental practices:
- Firstly, investment is made into companies that have been thoroughly researched, perhaps even followed for years, and at prices below what is considered to be fair value. This is the overriding principle behind all of Berkshire’s investments. Not all the investments work out the way that is expected, but a greater number become winners than losers.
- Secondly, Berkshire uses its cash flow from its businesses to reinvest at zero cost of capital, and reinvests any dividends received. This not only reduces its cost of capital, but also takes advantage of the benefits of compounding returns over the long term.
We may not have the resources at our disposal that Buffett has, but we can still learn a lot from his investment methodology.