How Berkshire Hathaway Got Bigger by Getting Better (Part Three)
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In the second part of a series loosely based on a story inspired by Chick-fil-A founder Truett Cathy I went through two more principles from Warren Buffett’s “Owner’s Manual” for Berkshire Hathaway (NYSE: BRK-B) shareholders. If you haven’t heard the story yet, back in the 1980’s when a Boston Chicken (now Boston Market) had just finished raising capital to expand; the management at Chick-fil-A spent a long time discussing how they too could get bigger in order to fend off this threat. After hearing enough talk about getting bigger, 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.” There are few better case studies than Warren Buffett of a manager who concentrates on becoming better. Because of this the company has continued to grow bigger. In this article I want to review his fifth and sixth principles of ownership.
“Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.”
Because of Berkshire’s model of owning whole businesses in addition to minority stakes of publicly traded companies their consolidated earnings don’t give a true indication underlying performance of their holdings. One pitfall that investors need to avoid is being too concerned by the current stock price and not paying heed to the underlying value of the company. Investors need to take a look at the long term fundamentals of a company’s industry and understand their competitive advantage. If they do that stock prices will eventually reflect the true value of the underlying business.
Berkshire for example is a big fan of credit card companies, holding shares of American Express (NYSE: AXP), Visa (NYSE: V) and MasterCard (NYSE: MA). The long term industry fundamentals are excellent as credit continues to take market share from cash. Of the three, they own the largest stake in American Express at $8.8 billion dollars or 13.2% of the company compared to less than 1% stakes in both MasterCard ($174 million holding value) and Visa ($354 million holding value).
While both Visa and MasterCard went public much later than American Express, it has some completive advantages that shouldn’t be overlooked which could give us insight as to why it is such a large holding. The company operates a “closed-loop network” whereby it captures more of the value on each link of the value chain. The company issues and manages its own card base, it originates lows to its users and it manages and runs its own network. Visa and MasterCard on the other hand use independent banks to issue cards and originate loans.
In this example we see Berkshire allocating more capital to the company with the differentiated business model. It’s important to note that while they don’t own a controlling stake in the company, they own a meaningful stake in a company that has more control over its brand and network, capturing more revenue along the way. Over time the value of that brand and its economic earning power will be fully reflected in the value of the shares. Investors who are long term owners of businesses won’t be concerned by an earnings miss if the company is investing more for higher future returns.
“Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable). In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains.”
Buffett is an exceptional allocator of capital but he also trusts management teams he’s invested in to also allocate their capital to earn high rates of return. When he buys shares in a business he’s going to get a return either from dividends or capital gains just like the rest of investors. He’ll take those dividends and reinvest them in the best opportunities for earning high returns on capital. Meanwhile he’s also banking on management to do the same with retained earnings to increase the value of their company.
Take Berkshire’s largest holding Coca-Cola (NYSE: KO) which has had a 5 year average return on investment of 23% while their industry has seen returns on investment of just 14% over the same timeframe. By investing in a business with above average returns, Berkshire is able to benefit from those returns instead of having to reinvest the capital themselves. While Berkshire certainly enjoys Coke’s dividend, they’d actually have been better served letting Coke reinvest the 51% of income being paid out via that dividend as Berkshire’s only earned a 5.5% return on investment over the same timeframe.
Stay tuned for Part IV where we look at how Berkshire’s debt and acquisitions. By being better in how they manage capital they’ve grown the company bigger.
latimerburned has a diagonal call on Berkshire Hathaway and has the following options: short OCT 2012 $55.00 calls on American Express Company, short OCT 2012 $60.00 calls on American Express Company, and long OCT 2012 $65.00 calls on American Express Company. The Motley Fool owns shares of Berkshire Hathaway, The Coca-Cola Company, and MasterCard and has the following options: short OCT 2012 $55.00 calls on American Express Company, short OCT 2012 $60.00 calls on American Express Company, and long OCT 2012 $65.00 calls on American Express Company. Motley Fool newsletter services recommend American Express Company, Berkshire Hathaway, The Coca-Cola Company, and Visa. 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.