Why Berkshire Can Beat the Market

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Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) has humble roots as a textile mill in the early 20th century, but when a dying business was coupled with the world's best investor, it grew quickly. This year, Warren Buffett's Berkshire Hathaway appeared at number 5 on the Fortune 500, which ranks companies by revenue.

Investors fear that the size and scope of Berkshire Hathaway will prevent it from repeating its historical growth in book value. As the company grows larger, it needs more and more new investments of a size that are material and impactful to its bottom line. Warren's looking for “elephants” - companies in the tens of billions of dollars that Berkshire can add as wholly-owned subsidiaries.

The year 2012 was the ninth time in 48 years that Berkshire Hathaway failed to grow book value at a rate above the annual return of the S&P 500 index. As the company becomes larger, it becomes more difficult to grow at the average of the whole market.

Why Berkshire doesn't need to grow at the market rate

There are two problems with judging Berkshire against the broader market. First, as Berkshire grows larger, its reliance on its wholly-owned companies is greater. There is no way to give these companies a public mark. Stocks can rise or fall in value disproportionately to their earnings. Berkshire's investments are accounted for at book.

Secondly, there is reason to believe Berkshire Hathaway's businesses are of a much higher quality than the S&P 500 as a whole. Berkshire Hathaway's insurance business is incredible. Between reinsurance, property and casualty lines, and specialty insurance holdings, Berkshire's underwriting profits were $1.625 billion in 2012, giving the company an incredible $73 billion float. Few insurance companies earn underwriting profits, let alone a float worth more than $73 billion.

Its wholly-owned companies are also exceptionally positioned. See's Candies is a rockstar – a small rockstar – but a highly-profitable company that has an exceptional share in localized markets. Likewise, a new purchase, Heinz, is a leading brand in a slow-growing food space. These businesses will go on to live for decades, perhaps even another century.

The value of longevity

A company is worth more when it has a durable, competitive position that will allow it to exist in perpetuity. That's the real answer why Warren Buffett says his favorite holding period is “forever.”

Warren's stable of companies at Berkshire Hathaway have a lot more longevity than your average S&P 500 component. A company that trades for 10 times earnings but survives for only 15 years is a much worse company that one that trades for 15 times earnings and lasts for centuries. This is, I believe, the leading difference between Berkshire Hathaway and all S&P 500 components.

Business quality is further compounded by Berkshire's capital allocation. Whereas most companies allow excess cash to sit on their balance sheet, uninvested in new projects or returned to shareholders, Buffett's most recent plans would allow Berkshire to repurchase shares at any price below 1.2 times book value. The company has made use of the policy only once when it acquired $1.2 billion of Class A stock from a “long-time shareholder.”

A compounding machine in action

Berkshire's capital allocation will likely change tremendously when Buffett makes his final exit. Investment managers Ted Weschler and Todd Combs will undoubtedly have more under management, but a policy of share repurchases may make for much easier (and smaller) acquisitions and outside investments.

Berkshire still has the capacity to throw billions of dollars into remaining ideas. Buffett's stake in his “Big Four” of American Express, Coca-Cola, IBM and Wells Fargo increased in all cases in 2012, but it's only in American Express that Berkshire can claim ownership of more than 10% of the company. Buffett's firm owned 13.7% of the card processor and payment network at the end of the year 2012.

These core holdings will continue to be a place for billions upon billions of dollars of Berkshire Hathaway's growing cash pile. Between repurchases of Berkshire Hathaway stock at 1.2 times book value and consistent capital allocation to its public stock portfolio, Berkshire Hathaway has nearly $1 trillion of equity investments on its investment radar. That's just the equity value of Buffett's “Big Four” plus Berkshire Hathaway.

Most of the hard work is done

Warren Buffett and Charlie Munger are fantastic capital allocators and investment researchers. Berkshire Hathaway undoubtedly has millions of pages of research locked away over the 48 years that Buffett has been at the helm. These ideas will certainly lead to new and bigger equity investments, but only when the price is right.

There are still plenty of investment opportunities for Berkshire Hathaway – and its managers know when they're getting a fair price. Make no mistake, Berkshire Hathaway can continue to beat the market.

Thanks to the savvy of investing legend Warren Buffett, Berkshire Hathaway’s book value per share has grown a mind-blowing 586,817% over the past 48 years. But with Buffett aging and Berkshire rapidly evolving, is this insurance conglomerate still a buy today? In The Motley Fool’s premium report on the company, Berkshire expert Joe Magyer provides investors with key reasons to buy as well as important risks to watch out for. Click here now for instant access to Joe’s take on Berkshire!

Jordan Wathen 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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