Warren Buffett Is Not Irreplaceable for Berkshire
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Is Warren Buffett irreplaceable? Can Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) continue thriving without its genius leader? Buffett is clearly a unique person and an exceptional business leader, and he will be missed by all those who love the markets and investing ... even more by Berkshire investors.
However, given the size of the company, and its current approach to investing, Berkshire Hathaway will most likely continue making great investments and increasing shareholder value in the long term, even without Warren Buffett.
Warren Buffett is already 82 years old. Even if he is in excellent health for his age, and he hopefully has many long years of healthy life ahead of him, investors need pay close attention to succession plans and what they mean for Berkshire.
Berkshire´s operating subsidiaries are managed quite independently by their respective CEOs, so there won´t be many changes there after Buffett is gone. But investment management is obviously a critical area in which Buffett has been enormously valuable for Berkshire over the decades, and this raises the question whether the company will continue making those profitable investments when the legendary investor is not calling the shots anymore.
There is one important thing to consider about this discussion: when Buffett was managing small amounts of money and flying under the radar, he was achieving returns that would be practically impossible to replicate by any other investment manager. By simply making opportunistic investments at bargain prices, Buffett was making a killing when managing small amounts of money.
But now that he is investing billions of dollars, things are dramatically different. Buffett needs to go after big companies nowadays, and that makes it much harder to buy high-quality businesses at attractive valuations. In his own words:
"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I've ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that."
It´s the financing, stupid
Size has its disadvantages when it comes to investing returns, but Berkshire has adapted to the challenge and the company has found ways to increase performance by capitalizing the financing side of the equation. To begin with, it’s worth noting that the Berkshire has access to leverage at amazingly low costs thanks to the company´s insurance operations, and this is a big positive when it comes to increasing returns on investments.
A research paper by Andrea Frazzini and David Kabiller from AQR Capital Management examined the amazing performance that Berkshire has obtained over the decades, and the authors find that leverage is a big plus for the company. The article estimates that Berkshire´s average annual leverage ratio has been in the 1.6 to 1 zone. But Buffett´s secret source when it comes to leverage consists of paying an almost ridiculously low cost on those funds. The estimated average annual cost of Berkshire’s insurance float has been only 2.2%, more than 3 percentage points below the average T-bill rate, according to the authors.
Besides, Buffett has been putting a lot of attention on the financing terms of the deals in which he gets Berkshire involved lately, with the Heinz (NYSE: HNZ) acquisition being a good example to consider. At a valuation of 20 times earnings estimates for next year, the purchase price for Heinz doesn´t look particularly attractive. But Buffett is not only getting an equity stake in the company.
In addition to warrants, Berkshire is also investing $8 billion in preferred equity yielding a juicy 9% annually. This is a spectacular yield, especially in times of ultra-low interest rates and for a company like Berkshire, which gets financing at exceptionally low costs. Heinz has generated between $800 million and $1 billion in free cash flow per year in recent years, and the preferred dividends should amount to something like $720 million – 9% of $8 billion – so Buffett is getting a big chunk of the annual cash flows generated by Heinz with the preferred shares.
Berkshire made several deals of this kind, involving preferred stock and warrants, during the credit crisis. Buffett negotiated a deal with Goldman Sachs (NYSE: GS) in September of 2008 to invest $5 billion in preferred stock yielding 10% and warrants for 43.5 million shares at $115 per unit. The agreement was renegotiated this year, and Berkshire will become a major shareholder in Goldman Sachs under the new terms of the deal.
Under the new agreement, Goldman will deliver to Berkshire a number of shares that is equivalent to the difference between the average closing price over the 10 trading days prior Oct. 1 and the exercise price of $115 for the warrants. If the stock remains in the area of $150/$160, where it has been trading over the last weeks, for example, that means that Berkshire is getting a sizable position of between 10 million and 12 million shares of Goldman Sachs without putting any money down.
As things turned out, Buffett reduced the risk of his position in Goldman Sachs during the crisis while securing a juicy yield with the preferred stock, and the warrants provided a lot of upside potential to the transaction. When it comes to the risk and return tradeoff, the financing of this deal makes it very different than a simple purchase of Goldman Sachs common stock in 2008.
Other big deals like General Electric and Bank of America during the crisis were done under similar conditions, a combination of preferred shares and warrants to control the risks and maintain upside potential. These are smart moves, without question, but it’s not as extraordinary as making 50% annually by investing in smaller companies.
More importantly, it sounds like something that can be done by Buffett´s successors once he is not there to make investment decisions at Berkshire anymore.
Buffett is not investing in deeply undervalued hidden gems any more; he is using Berkshire´s access to cheap financing to invest in low-risk situations under convenient financing terms. Being Warren Buffett probably helps when it comes to getting these deals done, but there is no reason to believe his successors won´t be able to structure similar arrangements after he is no longer running the company.
Every person is unique, and Warren Buffett is truly out of this world. But when it comes to investing in Berkshire, investors should keep in mind that the Warren Buffett of 2013 is much easier to replace than the Warren Buffett of 1950, at least when it comes to his critical function of making investment management decisions at the company.
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Andrés Cardenal owns shares of Berkshire Hathaway. The Motley Fool recommends Berkshire Hathaway, Goldman Sachs, and H.J. Heinz Company. The Motley Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!