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Berkshire Hathaway, Inc. (NYSE:BRK) is a holding company that, through its insurance subsidiaries actively invests its float, or the money taken in from premiums before claims are paid out. Berkshire owns stock in a diverse group of over 50 public and private companies in various industries ranging from manufacturing, retail, and energy to finance.

The company is famously managed by Warren Buffett, who was named Chief Executive Officer (CEO) of the year for 2008 by Morningstar, an independent investment research firm.^[1] Buffet has compounded Berkshire's book value (a key valuation metric of the company) over 24% annually for nearly 43 years.^[2] Buffett has accomplished this incredible feat by successfully reinvesting Berkshire's float in wholly-owned private companies as well as publicly traded stocks like Coca-Cola, Wells Fargo (WFC), American Express, and Procter & Gamble Company (PG).

On November 3, 2009, an agreement was reached between Buffett's Berkshire Hathaway agreed to purchase Burlington Northern Santa Fe (BNI), the second largest railroad company in the United States for $34 billion in cash and stock.^[3] This deal, if approved by the shareholders of BNI would be the largest in Buffett's career, as he announced the deal is "an all-in wager on the economic future of the United States." However, the massive deal does not come without potential costs. Earlier this year Berkshire already lost its top credit ratings from Moody's (MCO) and Fitch rating agencies, and S&P said it may downgrade Berkshire from its current AAA rating after investigating its financial situation after the deal.^[4]

As part of the deal, Buffett was able to secure an $8 billion loan from J P Morgan Chase (JPM) and Wells Fargo (WFC), paying somewhere between 1% and 2% above the LIBOR rate.^[5] With the three month LIBOR hovering near 0.25% at the time of the deal, this constitutes what many believe to be an incredibly cheap loan. Also, despite Buffett's long standing disdain of stock splits, Berkshire was forced to split its B-class shares in a 50:1 split to avoid a large capital gains tax on the deal.^[6]

Business Overview

Buffett has achieved Berkshire's success by a combination of superior underwriting and investments in companies with durable competitive advantages. However, Buffett himself has cautioned investors about the hindrances of Berkshire's enormous size and the difficulties achieving the same out-sized returns going forward. Also, because Berkshire has a significant number of insurance policies as well as significant investments in many different sectors including banks and manufacturing firms, its portfolio and the company's profits are exposed to risk in the event of prolonged and widespread economic downturn. Warren Buffet's successor as the head of Berkshire after Buffet's eventual departure has not yet been announced, and has caused concern about whether the company will continue to outperform the market.

Berkshire Hathaway's performance in 2009 has fallen dramatically from its historical performance, generally due to the market collapse that began with the 2008 Financial Crisis. Further complicating the matter were the long term put options on the S&P 500 (SPX), FTSE 100 Index (FTSE), Dow Jones Euro Stoxx 50 Index (SX5E), and the Nikkei 225 Index (N225) Buffett sold in March of 2008.^[7] Buffett has since admitted the move was a mistake, and the subsequent decline in global markets has forced Berkshire to post losses on its financial statements; however, since the options are European style options, the company does not actually have a cash loss.

Business and Financial Metrics

Berkshire's underwriting discipline has led to a negative cost of float (i.e. underwriting gains/losses as a percentage of insurance float) between 2006 and 2008. No-cost or negative cost of float allows the company to enjoy investment income and gains without having to pay claims in excess of premiums taken in. In other words, the company operates at an underwriting profit, such that it takes in more in premiums than it pays out in claims.

Over the past few years, BRK has been able to increase both its revenue and operating income significantly. For the second quarter of 2009, Berkshire Hathaway had net earnings of $3.3 billion, a significant increase from its 2008 level of $2.9 billion.^[8]

Berkshire typically earns about half of its revenue from its insurance businesses. In 2008, its net underwriting gain was $1.81 billion, a slight decrease from its 2007 underwriting gain of $2.18 billion.^[9]. Berkshire Hathaway anticipates that price competition in most of its insurance markets will continue to reduce underwriting profits in the future. Berkshire Hathaway’s net earnings from its non-insurance businesses reached $4.099 billion in 2008.^[10]

Trends and Forces

Warren Buffett as a proven and patient value investor

Buffett's track record as a value investor and sheer financial strength has earned him an incredibly valuable reputation within the financial industry. The value of this reputation can be seen through Buffett's deals with General Electric Company (GE) and Goldman Sachs Group (GS). Both companies came to Buffett, and he came away with very favorable deals in both instances, getting preferred stock that earn a 10% dividend as well as billions in warrants from both companies.^[14][15] He was approached first by these companies both because of his reputation as well as the fact that he simply had the funds that most investors did not at the time. In private equity deals, Buffett's reputation also earns him an advantage, as he tends to keep companies together rather than selling off parts of companies.

Because of his long term proven success and fundamental role he plays within Berkshire Hathaway, some Berkshire Hathaway owners have expressed concern about Buffett's succession based on his advanced age. Buffett, 79, has led the capital allocation decisions of the company since present management took over in 1965, and he has announced that the Board of Directors has determined a very short list for a successor CEO. The company intends to split the current CEO role into two roles: CEO (covering operations) and Chief Investment Officer (cover capital allocation and investment decisions). Buffett has indicated that there is a short list of candidates for CIO. Some have speculated that GEICO chief Tony Nicely, reinsurance guru Ajit Jain, or GEICO's investment star Lou Simpson will succeed Buffett as CEO.

Risk from slowing economies, Hurricanes, and Global Climate Change

The economic downturn that began in 2007 increased Berkshire Hathaway's risk as it acts as an insurance company and invests heavily into a many well known companies, including banks. This put Berkshire at risk since it relies on the strength of its investments and in relatively uncorrelated loss from insurance. A prolonged or widespread economic crisis would severely hurt Berkshire Hathaway's earnings.^[16] A large part of Berkshire's insurance operations is also focused on underwriting natural disasters such as hurricanes and earthquake risk. Risks related to these policies are generally very difficult to assess and model given the year-to-year variability of hurricane frequency and intensity. This is further complicated by potential long-run shifts in patterns in light of possible effects of global warming. BRK will face financial trouble if its losses from an economic downturn or weather conditions exceed its expected limits.^[17]

Berkshire's massive size limits the potential for outsize returns

Building Berkshire's book value depends on the company's ability to reinvest the large sums of cash flowing into the company and the over $40 billion already in its coffers. The company generates cash flow and float of some $150 million per week,^[18] which is typically reinvested in either fixed-income securities, equities, or private companies. As the stock and the flow of cash at Berkshire grows, the company's returns will continue to approach those of the market as it becomes increasingly difficult for Berkshire's to sustain its historical returns of over 20% per year.^[19]

Berkshire competes with private equity purchasers for acquisitions of wholly owned subsidiaries

Berkshire's favored investment is in large, privately-held businesses. As such, the company competes with private equity money to find target acquisitions, and increased activity in the space has led to heightened competition and fewer deal opportunities. Berkshire differentiates itself and attracts sellers of businesses by offering them long-term ownership, the hallmark of the company's investment strategy. Often sellers are family or individual owners looking to monetize their interest in a closely-held business. They seek a buyer who, unlike most private equity firms, does not look toward an "exit" of the business and are less likely to interfere with how it is currently managed. Berkshire must maintain its investing track record to continue attracting deals at favorable prices.

Competition

Investments

Berkshire operating subsidiaries compete against a diverse array of companies in each of its many industries. While generally the businesses operate in industries that are highly competitive, Warren Buffett has focused on acquiring subsidiaries with competitive advantages, which he calls economic "moats," enjoying substantial differentiation or cost-advantages.

In its stock selection, the company seeks similar characteristics, but due to its size, must compete for favorable prices against the substantial sums of money invested in large-cap securities. As shown by the accompanying chart, Berkshire's equity portfolio consists mostly of large, well-known companies. Buffett must continue being able to deploy large sums of capital into these opportunities at favorable prices. As evidenced by the large portfolio weightings of the stocks owned by Berkshire, Buffett is not afraid to make very sizable bets when he believes a company has a durable competitive advantage and is available at a reasonable price.

^{[20] [21] [22]}

Insurance Market Share

Some competitors of its bread-and-butter insurance operations are as follows: Please note that Geico was acquired by Berkshire in January 1996, however, do to its significant size it is useful for comparison.^[23]

Below is a table of estimates of reinsurance company market shares. In 2007, $168 billion in premiums were written. This is 9.8% higher than the previous year, when $153.1B were written in 2006. The reinsurance industry is largely comprised of a few international firms who hold large market share positions in addition to a smaller, fragmented base of firms with more insignificant global market positions. Firms compete on a mix of price, terms, and financial strength. Notably, Berkshire has the highest credit rating available (AAA), and one of the most proven capital structures in the world.^[25]

Share Classes

Berkshire Hathaway has two classes of stock, A Shares and B Shares. The B-shares represent 1/200th voting rights and 1/30th ownership rights of the A-shares. The B-shares can not be transformed into A-shares. BRK's ownership of B-shares gives it a significantly smaller authority in a given company, but are also less expensive.^[27] Historically, B shares have traded very close to the 1/30 value of A shares.

Footnotes

1. ↑ International Business Times: "Morningstar Names Warren Buffett of Berkshire Hathaway as Its 2008 CEO of the Year" 7 Jan 2009
2. ↑ Forbes Newsletter Watch "Investment Newsletters Un-Buffetted"
3. ↑ Buffett's Berkshire buying Burlington Northern RR. Samantha Bomkamp. BusinessWeek.
4. ↑ Berkshire May Lose AAA From S&P on Burlington Deal. Andrew Fry. Bloomberg.
5. ↑ Buffett Cuts Sweet Deal for Burlington Northern Loan. The New York Times.
6. ↑ Berkshire's B-Share Split. Peter C Beller.
7. ↑ Philip Guziec. Warren Buffett's Option Investments. Trading Today's Market.
8. ↑ BRK 10-Q 2009 Item 1 Pg. 3
9. ↑ BRK 10-K 2008 Item 7 Pg. 28
10. ↑ ^{10.0 10.1} BRK 10-K 2008 Item 7 Pg. 29
11. ↑ ^{11.0 11.1 11.2} BRK 10-K 2008 Item 8 Pg. 58
12. ↑ BRK 10-Q 2009 Item 1 Pg. 3
13. ↑ BRK 10-K 2008 Management's Discussion "Insurance-Underwriting" p.29
14. ↑ Buffett boosts Goldman Sachs with $5-billion investment. The LA Times.
15. ↑ Ron Haruni. Warren Buffett Investing Billions in General Electric. The Wall Street Pit.
16. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.19
17. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.18
18. ↑ Charlie Parker/CBS Interview with Warren Buffett, July 2006
19. ↑ Forbes Newsletter Watch "Investment Newsletters Un-Buffetted"
20. ↑ BRK SEC 13F-HR, Institutional Holdings, Filed: Nov. 14, 2007
21. ↑ Fat Pitch Financials "Berkshire Hathaway Portfolio Holdings as of September 30, 2008" 17 Nov 2008
22. ↑ BRK Q-3 13F 2008 "Investment Discretion"
23. ↑ BRK 10-K 2008 Item 1 "Business" p.3
24. ↑ Insurance Information Institute: Major Players "Top Ten Writers of Private Passenger Auto Insurance By Direct Premiums Written, 2007"
25. ↑ Insurance Information Institute: Media "REINSURANCE INDUSTRY" 21 July 2008
26. ↑ Insurance Information Institute: Media "Top Ten Global Reinsurers" 21 July 2008
27. ↑ BRK 10-K 2008 Item 1A "Risk Factors" p.21