Warren Buffett built Berkshire Hathaway, Inc. (NYSE: BRK.B) into one of the most recognizable companies in the world. Despite Berkshire’s phenomenal success, the company has risks for investors. These risks include the choice of a successor who will run the company after Buffett is no longer serving as chairman and chief executive. There’s also the danger of a credit downgrade and the possibility that this behemoth will be designated by government regulators as a company that is systemically important to the U.S. economy.
Berkshire Hathaway was a failing textile company when Buffett bought it in 1964 and began turning it into the money-making monster it is now, with a market cap of about $490 billion as of late October 2018. The large conglomerate is involved in a wide range of businesses. Its subsidiaries are as varied as Dairy Queen, BNSF Railway and Helzberg Diamonds.
Still, the core of the Berkshire empire is insurance. The company has lines in property, casualty and reinsurance. Its brand names in the space include Geico, National Indemnity and Applied Underwriters.
From this insurance base, Buffett built Berkshire over the years with small and large acquisitions. The company now has interests in everything from railroads to energy to cowboy boots and furniture.
Berkshire is still growing. Net revenues increased 8.3% in 2015 over 2014. It increased 6% in 2016 from 2015 and added another 8.4% in 2017 from 2016. Its net revenue that year was about $242 billion.
Those who risked investing in Berkshire early on profited hugely. Berkshire Class A shares sold for a handsome $7,100 in June 1990. By the end of 2017 it was trading for around $289,200. Buffett is not a believer in stock splits, saying he does not want short-term speculators jumping in to profit on the stock. Still, smaller investors can afford the Class B shares that was trading at under $200 a share in late October 2018.
The Succession Question
One of the main risks to Berkshire is the improbability that anyone could match Buffett’s success. Buffett is still going strong at 88 as of this writing, having run the company for more than 50 years. Still, he and his 92-year-old lieutenant Charlie Munger, vice chairman of Berkshire, are not immortal. Buffett and Munger have discussed the succession plan in their famous letters to shareholders.
A number of names have been tossed around, but as of late 2018 there are four leading contenders.
Munger’s 2015 letter indicated that Greg Abel and Ajit Jain are both world-class CEO material. Abel runs Berkshire’s utility and energy operations. Jain is the head of Berkshire’s vast insurance division. Jain is known as an underwriting genius who has earned the insurance operations billions over the years. Abel is younger and perhaps more used to being in the limelight.
Buffett brought on two portfolio managers to help him with the company’s stock holdings. Ted Weschler and Todd Combs share responsibility for Berkshire’s vast portfolio. Weschler met Buffett by winning a charity auction for lunch with the Oracle of Omaha for $5 million. He previously ran the hedge fund Peninsula Capital Advisors. Buffett and Weschler became friends over the next few years and Buffett eventually brought Weschler into Berkshire. Combs was also a hedge fund manager when he joined Berkshire in 2010.
Weschler and Combs have changed Buffett’s perspective to some extent. Buffett never invested in technology stocks until 2011, when he spent around $10 billion on IBM shares.
For what it’s worth, these are the four people that Buffett says are really running Berkshire Hathaway now from day to day.
Berkshire is clearly considering the succession issue, which should allay some fears of investors. The larger question is whether the portfolio managers and the CEO will be able to match Buffett's performance.
Buffett is undoubtedly a business genius on many levels. The “Buffett premium” is the notion that Buffett’s reputation and business acumen add value to Berkshire and the companies in which it invests. Only time will tell what happens with the Berkshire empire after Buffett and Munger are no longer there.
Credit Downgrade Risk
A more pressing issue is credit downgrade risks to Berkshire’s debt. As of August 2015, S&P, the major credit rating agency, indicated it was placing Berkshire on the Credit Negative Watch list due to uncertainty about its acquisition of Precision Castparts Corp. In December 2016, Berkshire held an AA investment-grade credit rating after officially acquiring the company in the beginning of the year. By late 2017, S&P announced that Berkshire no longer faced a risk of downgrading.
Still, the agency has twice previously downgraded Berkshire. It downgraded the company in 2010 when Berkshire bought BNSF Railway, and then again in 2013, as it changed its standards for evaluating insurance companies.
Importance of Being Berkshire
It doesn’t pay to be too important to the U.S. economy. Another risk is whether Berkshire will be defined by government regulators as systemically important. The designation requires companies to submit to oversight by the Federal Reserve. It comes with enhanced capital restrictions and liquidity requirements.
These burdensome requirements could make future growth and profitability more difficult and could hurt the company’s prospects. It’s not out of the question in this case. The Bank of England asked U.S. regulators why Berkshire was not on this list in 2015.
Buffett has argued that Berkshire should not be slapped with this designation. He has indicated he is committed to keeping a $20 billion cash cushion at Berkshire.
Significantly, Berkshire was able to stay strong during the 2008 financial crisis. The company even provided short-term help and liquidity to other companies, including Goldman Sachs, General Electric and Harley Davidson, during the crisis. Thus, history has proven Berkshire’s ability to weather financial storms.
Nonetheless, the government has placed the systemically important designation on other large insurance companies including AIG, Prudential and MetLife. Berkshire is undoubtedly one of the largest insurance companies in the world and has exposure to large catastrophic events. The Sept. 11 terrorist attacks and Hurricane Katrina cost Berkshire billions.
Berkshire is different from these other companies that operate mainly in the insurance sector. It is much more widely diversified in its businesses. The official standard is the company must have 85% or more of its consolidated assets coming from financial activities. Many of Berkshire’s recent acquisitions have come from outside of the financial realm. Thus, it is questionable whether Berkshire meets this requirement.
Still, the threat of this designation is very real as it could hurt Berkshire’s future share price and ability to grow.