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Has Berkshire Hathaway Forgotten the Cardinal Rules of Effective Capital Allocation?


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Has Berkshire Hathaway Forgotten the...

It’s been several days since Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) held its annual meeting. This year’s version was a virtual affair hosted by Warren Buffett and Greg Abel, the company’s vice chairman of non-insurance operations. Much was discussed during the four-and-a-half-hour marathon. Berkshire Hathaway stock repurchases were a major topic of conversation.

Source: Krista Kennell / Shutterstock.com

That particular subject has got me wondering if Warren Buffett has forgotten the cardinal rules of effective capital allocation. 

For those who aren’t up to speed on the five tools of capital allocation, they are as follows: Debt reduction, internal growth, share buybacks, dividends, and acquisitions.

Anyway, Berkshire Hathaway stock is down 22% year-to-date  and has an annualized total return of 3.7% over the past five years, less than half the Morningstar U.S. Market Index. In light of those facts, it appears the company is not firing on all cylinders. 

Based on the five tools of capital allocation, I’ll consider if Buffett is losing his touch.

Debt Reduction

At the end of the first quarter, Berkshire Hathaway had $19.8 billion of outstanding debt. The debt of its insurance operations and non-insurance businesses other than Burlington Northern and Berkshire Hathaway Energy were $17.7 billion. Burlington and Berkshire Hathaway Energy had outstanding debt of $23.2 billion and $43.6 billion, respectively. 

That’s total debt of approximately $104.3 billion against $137 billion of cash or net cash of almost $33 billion. That’s a great position to be in during a pandemic. 

Generally, a company uses its free cash flow to pay down its debt. In Q1, Berkshire had free cash flow of $3.8 billion. During Q1, it added $1.6 billion of net debt to its consolidated balance sheet. 

Since we’re in the middle of a pandemic and Berkshire lost $50 billion in the quarter as its equity holdings cratered, minimizing its debt repayments looks like a smart call.

I guess it won’t be repaying much of its debt anytime soon. Cash is king at the moment. 

I’d give the handling of its debt position an “A.” 

Internal Growth

There wasn’t too much discussion during the annual meeting about the company’s plans for internal growth. However, with Greg Abel present to answer questions for investors, the company was able to reveal some of its plans for overall growth. 

Abel indicated that Berkshire Hathaway Energy plans to spend billions on capital projects over the next few years. It appears that the company’s focus on stocks is ready to take a break, as Berkshire will focus instead on its existing operations while it searches for its next big acquisition. 

Buffett and Abel mentioned that although a few of its businesses, especially its retail businesses , were getting some money from the parent to ride out the novel coronavirus, most have done an excellent job of adapting to the current market conditions.  

“Well, we’ve sent money to a few and we’re in a position to do that. We’re not going to send money indefinitely to anything where it looks like their future is not promising. It’s changed dramatically from what it was the year or so ago or just even six months ago,” Buffett said. 

“We will not fund a company where we think that it’s going to chew up money in the future.”

Buffett believes that his businesses can, for the most part, stand on their own two feet. The company’s highly decentralized business strategy has been effective. 

I would give Berkshire a “B” on internal growth. 

Share Buybacks

Share buybacks might have been the most controversial of the capital allocation tools discussed during the annual meeting. One of the questions  submitted during the meeting was, “why he [Buffett] didn’t repurchase Berkshire shares in March when they dropped to a price that was 30% lower than the price that he had repurchased shares for in January and February.”

The company repurchased $1.7 billion of its Class A and Class B stock in Q1. It paid between $214 and $226 per share, well above its current price. It’s possible that Buffett realized catching a falling knife wasn’t going to work, so Berkshire has paused its share buybacks recently until it gets a clearer picture of the pandemic’s real cost to the company. 

It’s easy in hindsight to say that Berkshire should have bought its shares earlier in the crisis. However, the company’s current share price hasn’t risen much since then. Maybe we’ll see more purchases in the second quarter, but I think that Buffett is more focused on keeping the entire business steady. 

“Historically, he’s been pretty visible in the marketplace, encouraging investors to take advantage of market downturns and being greedy when others are fearful,” Edward Jones analyst Jim Shanahan said of Buffett in a recent phone interview. “But if Buffett himself isn’t seeing opportunities, even in his own stock, what are we to think about the recent market selloff? Is it not a buying opportunity for long-term investors?”

Buffett did say during the meeting that he didn’t think Berkshire Hathaway stock was any cheaper than it’s been over the past year, a reflection of the uncertainty we’re facing. 

Could Berkshire have bought more of its stock during the first quarter? Probably, but who’s going to remember that two to three years from now. 

This is a much different situation than the Great Recession. The company’s handling of share repurchases remains conservative, and that’s okay. I give the company a C+ on this capital allocation tool.  

Dividends

Buffett likes to receive dividends. He’s not so keen on paying them out, opting instead to reinvest Berkshire’s earnings internally and in acquisitions. The Motley Fool’s Sean Williams estimated on March 5 that Berkshire would receive something like $4.7 billion of dividends from its $213 billion investment portfolio in 2020.  

This assumption probably didn’t take into account the sale of all four of the conglomerate’s airline stocks, but you get the idea. This pandemic has shown me that investors should never rely on dividend income. 

I believe that Berkshire should get an A+ for its handling of this capital allocation tool.

Acquisitions

I think Buffett’s mishandled the company’s acquisitions strategy. 

But my belief isn’t primarily based on the firm’s inability to bag an elephant in recent years. With private equity firms spending like drunken sailors and possessing an estimated $1.5 trillion of dry powder, business owners are no longer looking to sell their companies to Buffett because they know they’ll get more from private equity. 

In June 2019, I suggested two things Berkshire could do to make its stock more attractive. 

The first was to sell McLane Company, Berkshire’s wholesale food and beverage distributor. McLane generates 20% of the company’s overall revenue but only 6.1% of its operating profits before taxes. Berkshire paid $1.5 billion for McLane in 2003. I’m sure it could have gotten a better return just by buying back its stock. 

Capital allocation isn’t just about acquisitions; it’s also about divestitures. Selling McLane would be a case of addition by subtraction.

Secondly, and more importantly, I argued that Berkshire should carry out a spinoff, something that I first mentioned in August 2017. 

“It might be wiser for Buffett to spin off $30 billion of the excess cash plus McLane Company, its wholesale distribution business,” I wrote in August 2017. “The separately traded company would be run by his chosen (but yet unnamed) successor, which would allow it to begin succession planning while buying some smaller businesses that might not fit the Berkshire Hathaway M&A criteria.” 

For me, Berkshire gets a D for this capital allocation tool, primarily because it’s lacked an outside-the-box plan to utilize its excess cash better.  That failure has caused Berkshire stock to move sideways over the past five years. 

Don’t get me wrong, I still think Berkshire is worth buying. And the company does allocate capital better than most. But we’re talking about Warren Buffett, not some rookie. The bar is much higher for the Oracle of Omaha.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.

    

 

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