How Berkshire Hathaway Got Bigger by Getting Better (Part Six)

By Matthew DiLallo - July 11, 2012 | Tickers: AXP, BRK-B, SBUX, WFC | 0 Comments

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As we continue on our journey through Warren Buffett’s “Owner’s Manual” for Berkshire Hathaway (NYSE: BRK-B) shareholders I hope that you’ve gained some insight as to what’s made the company such a great investment.  I’ve been looking at each principle laid out in the owner’s manual from the perspective gained on a story inspired by Chick-fil-A founder Truett Cathy.  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.” In the principle we’ll review today we’ll see how Berkshire measures whether their principles focused on being better truly enabled the company to grow bigger.

Principle #9:

“We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.”

Over the past few decades there have been a number of companies that have burst on the scene that have had a real mission that they were pursing with noble intentions.  I think the first sentence of this principle speaks volumes when it comes to these companies to make sure they are checking their results.  They are receiving capital from shareholders and it is their fiduciary responsibility to manage that capital appropriately. 

Starbucks (NASDAQ: SBUX) is one such company that is striving to strike a balance between noble intentions and shareholder returns.  They strive to be a responsible company and say that they’ve, “always believed that businesses can - and should - have a positive impact on the communities they serve.  So ever since we opened our first store in 1971, we dedicated ourselves to striking a balance between profitability and social conscience. We continue to believe that the ultimate way to scale the power of brand is to share the good we do so that Starbucks and everyone we touch – can endure and thrive.”  To do this Starbucks focuses on being responsible with their resources by looking for ways to use sustainable methods.  Whether setting a goal to have 5% of beverages served in personal tumblers or reducing energy and water consumption by 25%, these measures should reduce costs over time.  This will at least offset increased costs endured by some of their other goals or even increase their overall profitability.  For shareholders, these noble intentions have to lead to results or they’ll be demanding their money back.  Over the past five years Starbucks has grown their earnings per share by about 20% annually and project to grow it slightly faster over the next two years.  Since its IPO the stock is up over 7000% verses a market that’s up just a few hundred points showing that their noble intentions are leading to exceptional results.

Berkshire’s own noble intentions are to reinvest each dollar of retained earnings to generate at least a dollar of value to shareholders.  Over the past five years the market as measured by the S&P 500 is down 11.22% while Berkshire Hathaway’s stock is up by 11.11%.  Taking a simplistic look at returns, a dollar invested in the S&P 500 would be worth just 89 cents without taking inflation into consideration whereas that same dollar invested in Berkshire would be worth $1.11 again without considering inflation.  That’s 22 cents of outperformance for Berkshire’s shareholders.

Buffett does go on to clarify what he means about returns on a rolling five year basis because in times of a sharp stock market decline their returns can be deceiving.  He stated that, “The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.”  This of course is a bit more challenging to figure out but by using this interactive chart for the A shares you’ll find that from March 31^st 2007 until March 31^st 2012 Berkshire’s book value per share has gained 53% while the S&P 500’s has lost about 1%. 

One of the keys to their success is investing retained earnings into companies that are also growing their own book value.  Two key holdings, Wells Fargo (NYSE: WFC) and American Express (NYSE: AXP) have grown book value by 89.8% and 92.64% respectively over the five year time frame.  Berkshire can think that both Wells Fargo and American Express are great businesses with fantastic business models and management but the noble intentions of investing in them for those reasons must be backed up by the results each company puts up. 

Berkshire truly is a company focused on becoming a better company first.  Because of this it has resulted in the company growing much bigger, so much so that a big concern is that their large size will inhibit future returns.  Shareholders still benefit from the fact that even as the company grows bigger; Buffett is ensuring that they continue to work on becoming better.  It’s a great cycle and one that’s proven through their results. 

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