Berkshire Hathaway: The Future Skynet?

Kyle is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Okay, it is highly unlikely that our favorite conglomerate, Berkshire Hathaway (NYSE: BRK-A), will start churning out robots hell-bent on destroying the world. That being said, I think many of us would find the idea of robot Buffett clones quite appealing, as long as they stuck to compounding Berkshire’s assets at high rates. Now that we've got that out of the way, let me tell you what I really believe: Berkshire Hathaway is on its way to taking over the world!

For anyone unfamiliar with the company, Berkshire Hathaway (NYSE: BRK-B) is a holding company run by Warren E. Buffett, known to some as the Oracle of Omaha. Warren purchased the company in the 1960s when the company was simply a textile manufacturer. Over the course of 50 years, Mr. Buffett has compounded the company's book value by an astonishing 19.8% per year by purchasing investments in various forms, as well as acquiring other companies. To put that into perspective, $1 earning 19.8% return annualized would equal $8,372 after 50 years. Amazing, isn’t it?

data by YCharts

Molding the company into its current form took a process that spanned many decades. Buffett took what was once a failing textile manufacturer and began to bolt on other operating components. His philosophy was quite simple: take the cash being produced by the underlying components and put it to work in investments with high rates of return. As time went on, Mr. Buffett added rocket fuel to the company’s growth by introducing a new concept: insurance float. Using this float, Buffett was able to make investments in operating companies and equities using cash that would not need to be paid out for a number of years. This turned out to be a quite profitable endeavor.

The operating companies found in the Berkshire family may surprise you. See’s Candies, a producer of some of the most delectable chocolate treats, was purchased by Mr. Buffett in 1972. You may also recognize the names Pampered Chef, Nebraska Furniture Mart, Helberg Diamonds, and maybe even a little known insurance company, GEICO (alright, who can honestly say they do not know the gecko?). These are but a few of the highly profitable companies safely tucked away in the Berkshire Hathaway operations portfolio.

Taking over the world is not the job of a single man, even if he is Warren Buffett. The good news is, Berkshire Hathaway has more than just its CEO helping it on the path to world domination. The combination of growing operating earnings and investments are playing their part. First, let’s look at what kind of cash the company is creating. According to the 2011 annual report (2012 should be out by the end of February), the company created free cash-flow of approximately $12 billion. That is big, especially when you consider that a number of Berkshire’s subsidiaries were hit hard by the housing downturn. So, every month, approximately $1 billion is able to be allocated to investments or acquisitions, on top of the $42 billion cash horde. Buffett has stated on a number of occasions that he has his “elephant gun” loaded and would love to bag a big acquisition.

In addition to the cash being produced to purchase more investments, the company has a large equity portfolio. The companies in this portfolio typically have similar characteristics: highly profitable, well known products or franchises, great management teams, and futures that can be reasonably predicted. There is another factor that a number of these names have going for them: stock repurchases!

Coca-Cola (NYSE: KO) has been in the Berkshire equity portfolio for many years now. If you look through Berkshire’s annual reports over the years, you will see an interesting phenomenon. In the 2000 annual report, you will see that Berkshire owned 200 million shares of Coke, or 8.1% of the entire company. In the 2011 annual report, there were the same 200 million shares, but Berkshire now owned 8.8% of the company. The reason for this is that Coke has been actively buying back its stock for a number of years. The chart below shows the steady decline in the shares outstanding, and the steady increase in operating profits. The “lollapalooza effect,” as Charlie Munger would call it, is that not only is Berkshire getting a bigger piece of the earnings every year, but those earnings are growing!

data by YCharts

International Business Machines (NYSE: IBM) is a more recent addition to the Berkshire portfolio after Mr. Buffett purchased a 5.5% stake in 2011. This came as a surprise to many, due to Buffett's usual aversion to the technology sector. He explained this deviation by explaining how IBM is more of a services company now than a technology company. The great thing for Berkshire shareholders and future owners of the world is that IBM possesses the same characteristics as Coca-Cola. As you can see in the chart below, IBM has been very aggressive in reducing its shares outstanding. Coupled with increasing earnings, this looks like it will turn out quite nicely for Berkshire Hathaway and its shareholders.

data by YCharts

Wells Fargo (NYSE: WFC) has been a member of the equity portfolio for some time, but its size has increased substantially since the most recent economic downturn. As you can see below, Wells Fargo’s share count does not go in the same direction as that of Coca-Cola and IBM. During the credit crisis, the bank was forced to issue more shares in order to raise capital. Now that the crisis is over and banks are stronger than ever, the company can use its increasing earnings to repurchase shares. Over the next 5 years, we may see the bank’s chart start to look a bit more like those of Coke and IBM.

data by YCharts

So, Berkshire may not be dominating the world in the next 5 years, but Warren Buffett is positioning the company in a way that may lead to that conclusion. In 50 years, with the combination of operating earnings from the company's subsidiaries combined with what could be a majority stake in the giants listed above, Berkshire Hathaway may well be the largest company the world will ever see. It is one thing to say this, but quite another to believe it and put money where the mouth is. It is for the reasons listed above and the low valuations Berkshire has seen over the last year that the company has grown from 5% of my portfolio to just under 50%. I also intend to add to my position for as long as the company trades below $100 per share (the B shares, not the A shares!).

RoyalScribe owns shares of Berkshire Hathaway, Coca-Cola, and Wells Fargo, and is long Jan 2015 $65 calls. The Motley Fool recommends Berkshire Hathaway, Coca-Cola, and Wells Fargo. The Motley Fool owns shares of Berkshire Hathaway, International Business Machines., and Wells Fargo. 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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