The Three Pillars of Berkshire

Everybody knew it was coming but the results had to be seen to be fully appreciated. In the annual report released this morning, just about every page spoke of how Berkshire produced an outstanding year. And you can almost certainly count on more of the same in 2011, because the economy is slowly recovering, BNSF will be consolidated for the full year, and interest rates are rising (even if only a tad so far). With that perspective, let’s consider some of Buffett’s comments.

Berkshire is cheap and will beat S&P by "several points." Buffett wrote frequently and at length on Berkshire’s value in this letter. It’s atypical for him to sound so blazingly optimistic. The letter was permeated with a sense that he wanted to convey that Berkshire is undervalued. While Buffett did pay lip service to the annual chorus of “the future will never match the past,” his overall tone was more as if the heavens had opened up and the angel Gabriel was singing Berkshire’s song. 

By almost any measure, Berkshire is indeed cheap. Simply looking at the stock price vs. tangible book value, Berkshire has been trading below 2X tangible book vs. its former, fairly consistent valuation of around 2.3x tangible book. Moreover, the growth of the operating businesses means that Berkshire's multiple should be expanding. Using this very simple metric, if Berkshire were trading at around 2.5x tangible book, an A share would be worth $35,000 more than where the market is trading today.

Buffett also made a very striking prediction that Berkshire will beat the S&P by “several points” in the future. Several points is a lot. Buffett devoted a lot of space to what he called "normalized earnings power." He stated that the operating businesses will provide most of the firepower because they will grow faster than investment income. Training investors to think in terms of operating earnings is another key to Berkshire earning a higher valuation. Without getting into whether this is the right way to value Berkshire, or any stock, it's simply a fact that Berkshire's low return on reported equity has been a constraint on the valuation. The market has declined to value future earnings from potential acquisitions that might be made by Buffett as it would a predictable stream of earnings from an owned business. In this report, Buffett seems to be declaring victory in the sense that the operating businesses have now reached critical mass. 

Capital Management as Key Pillar of Value. In what was perhaps the most important section of the report, Buffett discussed what he called the three pillars of Berkshire’s value. Two of these he's talked about in the past. These are the two variables he feels that you need to know to value Berkshire as an investor – earnings of the operating businesses and the growth of the investment portfolio. The third pillar is capital management.

It goes without saying that historically, capital management has long been the single greatest creator of value at Berkshire. The company has been built from a series of capital transactions and asset/liability matching and capital allocation decisions over many years. Therefore it is not really surprising to see Buffett acknowledge this as the third pillar. Yet one could almost see Buffett salivating as he wrote that Berkshire is now generating $1 billion of free cash flow a month, a threshold it crossed this year. That’s an astounding figure. Wal-Mart, the world’s largest company, does not even come close to generating cash flows like this.

Buffett was speaking of free cash flows. In another part of the letter, he wrote about how happy he to be committing enormous amounts of capital to regulated businesses like BNSF and utilities. This is *not* coming out of the $1 billion! Berkshire will either be making acquisitions or buying securities to the tune of $1 billion or more a month for the foreseeable future. By way of comparison, the cash expended for the enormous BNSF acquisition took Berkshire about 16 months to accumulate (at today's run rate). Imagine Berkshire buying the equivalent of more than two BNSFs every three years. (In answer to the question below about cash flows, take a look at the cash flow statement. Over time, cash flows should at least equal earnings, if not exceed them.)

Managing this enormous amount of cash is absolutely critical to the future of Berkshire -- and this has implications for the CEO's role. In another key part of the letter, Buffett clarified one important fact about succession. As presently laid out, he has strengthened the role of the future CEO. He confirmed that there will not be a CIO. The future investment manager(s) will report to a CEO who oversees all of Berkshire's capital management. The investment manager(s) will not be coequal to the CEO and will be consulted, but will not have an equal vote on acquisitions. #1 I'm glad to see a bit of clarity on this subject. #2 think about what it means for the skills required to run the company. But more on that in a future post.

As an aside, Buffett has always personally liked having a lot of cash around and has a fascination with collecting it. If anyone had told him 50 years ago that someday he would own a substantial part of a business that produced $1 billion of free cash flow a month (that's almost $33 million every day), he might have had a heart attack out of sheer joy, & I would not be here today writing this.

The next best thing to an unregulated monopoly is a regulated monopoly. Returning to the subject of the regulated businesses, Buffett sounded awfully patriotic when he went on about how the money Berkshire will spend in these heavily capital-intensive businesses will be invested in America. I think by now we can all agree that he's repaid Obama for giving him that Presidential Medal of Freedom.

The patriotic talk did not distract those who know of Buffett’s dislike for capital-intensive business. There was clearly some scratching of heads going on today as people tried to reconcile Buffett’s newfound enthusiasm for throwing money into hard assets with his longstanding preference for businesses like See’s Candies that require no investment at all. Last year in discussing these hard asset businesses, he tempered his comments with a reminder that businesses that require no capex are better than those that do. Not this year.

Why then, is Buffett so fascinated with regulated utilities right now? The answer may surprise you -- and it is extremely revealing of his underlying opinion about the future of the economy.

Regulated utilities are one of the few businesses where you earn an automatic profit on your capex. Capitalized assets are folded into your rate base. As a result, the “real” economic return on invested capital of a utility is often quite a bit higher than the reported return. So profitable is the ability to increase the rate base in regulated industries that regulators’ main problem is preventing companies from capitalizing everything, including the tuna fish sandwich the CEO ate for lunch.

What happens when inflation accelerates? There may be a lag between cost increases and the ability to pass them along to customers, but ultimately utilities have a form of pricing power. Even better is the fundamental nature of regulatory rate-making rules for utilities. You are helped – not hurt -- by making capital investments in an inflationary environment. The utility gets a percentage of capex as profit – not a fixed dollar amount. Increases in capex generate increases in revenue, which fall to the bottom line in a proportionate amount. This means that margins are guaranteed by regulation.

It is the exact opposite of the economics of a "normal" capital-intensive business. 

We all know that Buffett loves monopolies. In an inflationary world, the next best thing to an unregulated monopoly is a regulated monopoly.

With respect to railroads, they are largely deregulated and they are attractive businesses with reasonable returns most of the time. One unique feature of railroads as a transportation business is that, unlike airlines, trucking, shipping,  they own the "road" as well as the means of transportation. Thus railroads are a form of toll bridge. Their pricing power is limited by alternative forms of transportation (trucking). Nonetheless, as prices inexorably rise over time, rate increases drop straight to the bottom line. The beauty of toll bridges in an inflationary world is that returns on capital that was expended long ago increase constantly. The more that is invested in a railroad in an inflationary world, the higher the return. 

It suggests that Buffett is pretty sure the economy is set on a course for major inflation.

 More later on the shareholder letter….