How Berkshire Hathaway Got Bigger by Getting Better (Part Two)
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In part one of this series loosely based on a story inspired by Chick-fil-A founder Truett Cathy I went through two of Warren Buffett’s principles from his “Owner’s Manual” for Berkshire Hathaway (NYSE: BRK-B) shareholders. If you’re unfamiliar with the story, back in the 1980s when Boston Chicken (now known as Boston Market) was growing rapidly after raising capital, Chick-fil-A's management team spent a long time discussing how they too could get bigger in order to fend off this threat. After hearing all he could take on the topic, Cathy pounded the table and said, “I am sick and tired of listening to you talk about how we can get bigger. If we get better, our customers will demand we get bigger.” Warren Buffett is an excellent case study of a manager who concentrates on becoming better and his company has grown bigger as a result. In this article I want to review his third and fourth principles of ownership.
“Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future – a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.”
The managements at too many companies are focused solely on increasing the earnings per share of their company’s stock to please Wall Street’s analysts. Berkshire takes a totally different approach, as the focus is on increasing the value per share. They do this through smart capital allocation, which is especially apparent in their share buyback program. Not all buyback programs are created equal -- take a look at how poorly executed buyback programs can destroy value.
In another exceptional article by Morgan Housel titled “Buybacks: The Fastest Way to Burn Money,” he details the buyback program at JPMorgan Chase (NYSE: JPM). In the article he details JPMorgan’s poorly timed buybacks as the company repurchased billions of dollars’ worth of stock in the middle of last year. But when shares fell by more the 25% due to Eurozone fears coupled with the debt ceiling debacle and the downgrade of the US, the company had already exhausted their program. What’s just mind-boggling is the quote from CEO Jamie Dimon when he said, “Yes, it would have been wise to wait…we’re sorry.” If that wasn’t enough, this past March the company had a new $15 billion buyback program authorized after the stock surged 50% from those autumn lows. They had no problem buying back shares while they were riding high but after the London Whale’s bad bets have tanked shares, the company suspended the buyback program even with shares down by a third.
Morgan also mentions the terribly planned buyback at Netflix (NASDAQ: NFLX). In the first three quarters of 2011 the company went on a $200 million buying spree of their own stocks at an average price of $221 per shares. Just a few months later the company was selling shares to raise $200 million of capital for 70% less than they had been repurchasing them. Talk about an incineration of shareholder wealth. When management doesn’t have a long-range plan for their capital, it usually is wasted on shortsighted thinking.
Berkshire of course takes a completely different approach, one based on strict discipline. In order for the company to buy back shares, two metrics must be met -- shares must trade at a price below 1.10 times book value and the company’s bank accounts cannot drop below $20 billion. This accomplishes two goals -- one, the company won’t buy back their shares at inflated prices a la JPMorgan, and they won’t run out of money and have to sell shares at a discount to book value. By being better at allocating their capital, the company has grown bigger as they are not incinerating capital on bad buybacks.
“Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.”
Buffett invests like an owner and views holdings in the investment portfolio the same way he views businesses that are directly owned. The top two holdings, Coca-Cola (NYSE: KO) and IBM (NYSE: IBM), are companies that Berkshire holds more than a 5% stake in with each holding consuming at least $12 billion worth of capital. In both cases these are well established companies with bankable brands and a long history of success. Buffett is looking at an investment in IBM or Coke as if he were acquiring the whole company.
We can learn a lot from that mentality -- when making an investment we need to do so with an owner’s mentality. If you find an investment that generates cash and consistently earns above average returns on capital, why would you sell? We need to remember the words of wisdom from Peter Lynch that “Although it’s easy to forget sometimes, a share is not a lottery ticket… it’s part-ownership of a business.” Unless the business is grossly overvalued or the long-term fundamentals are deteriorating, why would you part with an exceptional business?
Stay tuned for Part III where we look at how Berkshire’s approach to seeing behind the accounting numbers has helped make the company better, and from there, bigger.
latimerburned has a diagonal call on Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway, International Business Machines, JPMorgan Chase & Co., The Coca-Cola Company, and Netflix. Motley Fool newsletter services recommend Berkshire Hathaway, Netflix, and The Coca-Cola Company. 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. If you have questions about this post or the Fool’s blog network, click here for information.