The Uncertainty of Warren Buffett's Succession Plan

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The last week of February always marks a special time for followers of Wall Street, as Warren Buffett publishes his must-read Shareholder Letter for Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). Currently trading near all-time highs, Berkshire is fast approaching a time of rapid transformation in leadership and corporate practice. The question, then, is whether Buffett can put in a place a framework to support the stock's valuation once he is gone.

At 82 years young, Buffett (and his long-term vice chairmen, 89-year-old Charlie Munger) are fast approaching the end of their careers. Naturally, talk of succession has steadily increased over time, culminating most recently in Buffett's 2011 Shareholder Letter, where he stated that he has chosen a successor (without naming the heir to the Berkshire empire). 

Buffett is giving managers Todd Combs and Ted Weschler increasingly greater authority to manage Berkshire's $88 billion stock portfolio. This should come as no surprise, since any money manager will need some time behind the wheel of an $88 billion portfolio before being given the freedom to drive alone. But developing and then promoting skilled managers does not guarantee a successful transition, either for the company's fundamentals or the stock's performance.

Using Apple as a recent example, the impact of losing a once-in-a-generation CEO or leader can be profound. After skyrocketing on the incredible success of the iPad in the months following Steve Jobs' death on Oct. 5, 2011 , Apple has since lost over 36% of its market cap. This volatility comes after two years of a near-linear appreciation from October 2009 to October 2011. Apple is still currently trading slightly less than 18% higher than when Jobs passed away, but there are serious questions about the company's future ability to bring innovative, premium products to market without Jobs' leadership and vision.

Beyond the leadership succession plan, Buffett has begun a corporate transformation in preparation for his departure from the company. From the announced buybacks beginning in September 2011 and again in December 2012, to current speculation of a forthcoming dividend for Berkshire, Buffet is changing the expectation for what shape his company will take in the future.

The dividend speculation is particularly interesting when contemplating the future of Berkshire. Buffett puts the theory more eloquently in his own words here, but the general idea is that a dividend should be instituted when the rate of return on capital is higher in investments outside the company. If the company is able to invest the money at a higher rate of return internally, then the company should in theory not provide a dividend.

Most, if not all, Berkshire investors would probably agree that giving Buffett the freedom to invest capital will likely provide a higher rate of return than investing the money elsewhere. His track record is second to none, and justifies Berkshire's historic no-dividend policy. It follows, then, that an announced dividend would imply that Buffett and Munger no longer think they can provide returns greater than those available by investing outside of Berkshire.

This reality shouldn't alarm investors. As Buffett himself has said in interviews and recent Shareholder Letters, it is far more difficult to produce consistently above-market returns when managing $88 billion-plus in equities and a $424 billion balance sheet. And with over $40 billion in cash in Berkshire's coffers as of Sept. 30, 2012, the size of the investments necessary to put such a tremendous amount of capital to work are staggering. (Hence Buffett's "elephant gun" metaphor.)

So what should we expect from Berkshire as Buffett and Munger's succession plan continues to unfold? A dividend is highly likely, if not this year, then certainly in the years to come. Buffett's willingness to expand the share buyback program in December 2012 suggests that he feels a need to change the corporate policies currently in place. While investors were willing to allow Buffett the freedom to invest the capital via Berkshire, when Buffett steps down, they will not give the same freedom to his successor. 

The greater risk to shareholders is the change in leadership. When Buffett and Munger step down, Berkshire will still be a strong fundamental company worth an investment. But expect increased volatility, increased uncertainty, and even more changes in how the company handles all its cash and its investments.  

jayhjenkins has no position in any stocks mentioned. The Motley Fool recommends Berkshire Hathaway. 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!

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