Risks and Rewards of Berkshire Hathaway

Warren Buffett has built Berkshire Hathaway, Inc. (BRK.A, 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 Warren Buffett is no longer serving as chair and chief executive.

There’s also the danger of a credit downgrade and the possibility that government regulators will designate this behemoth as a company that is systemically important to the U.S. economy.

Berkshire’s Beginnings

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 $660 billion as of August 2022 and ranks among the top 10 of all U.S. companies by market cap. 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.

Those who risked investing in Berkshire early on profited hugely. Berkshire Class A shares sold for a handsome $9,500 in mid-August 1992. Twenty years later, they were trading around $450,000. 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 were trading around $300 a share in early August 2022.

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 90 as of this writing, having run the company for more than 50 years. Still, he and his 97-year-old lieutenant Charlie Munger, vice-chair 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 over the years. But on May 1, 2021, during the annual shareholder meeting, Charlie Munger made an offhand remark indicating that Warren Buffett would be succeeded as CEO by Greg Abel when Buffett eventually steps down. Abel is CEO of Berkshire Hathaway Energy and vice chair in charge of noninsurance operations.

In an interview with CNBC published on Monday, May 3, 2021, Buffett confirmed the news: “The directors are in agreement that if something were to happen to me tonight, it would be Greg who’d take over tomorrow morning.” Buffett also disclosed that the 69-year-old vice chair of Insurance Operations, Ajit Jain, is next in line behind Abel.

Munger’s 2015 letter indicated that Greg Abel and Ajit Jain are both world-class CEO material. But Abel is younger and perhaps more used to being in the limelight, which presumably is why he is the heir apparent. 

Two other executives who likely will play a significant role in managing Berkshire: Ted Weschler and Todd Combs, portfolio managers who 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.

Credit Downgrade Risk

A more pressing issue is credit downgrade risks to Berkshire’s debt. In 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.

The agency has also previously downgraded Berkshire twice. 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.

Berkshire Hathaway’s Recent Performance

Berkshire posted total revenue of $245.5 billion in its 2020 fiscal year (FY), which ended December 31, 2020. Total revenue fell 3.6% during the year amid the adverse economic impacts of the 2020 global crisis. The company noted that the crisis has adversely affected nearly all of its operations, but to varying degrees. Revenue and earnings from most of the company’s manufacturing and its service and retailing businesses declined considerably in the second quarter but several of these businesses improved significantly in the third and fourth quarters.

Net earnings fell 47.1% compared to 2019, for total net earnings of $43.3 billion in 2020. The significant decline was mostly driven by earnings declines across most of Berkshire’s business segments, which were partially offset by a $40.7 billion gain before taxes and non-controlling interests in the company’s large equity portfolio. As of changes made to GAAP in 2018, the company is required to include unrealized gains and losses arising from changes in its investment portfolio in its reported earnings. This accounting change contributes to earnings being significantly more volatile than they otherwise would be.

Importance of Being Berkshire

It doesn’t pay to be too important to the U.S. economy. Another risk is whether government regulators will define Berkshire 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.

The Bottom Line

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.

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.