IS BERKSHIRE HATHAWAY ANTIFRAGILE? SEEKING ALPHA

Is Berkshire Hathaway Antifragile?

by: Chris Wallendal CFA

 

 

Summary

 

- Berkshire Hathaway has amassed a record cash horde of over $128B, or greater than 23% of the company's current equity market capitalization.

- Berkshire Hathaway's large cash position should be viewed as a potential war-chest, not as a drag on the company.

- As explained by Nassim Nicholas Taleb, cash reserves are antifragile, whereas debt creates fragility.

- I conclude that the record cash pile lessens Berkshire's fragility, but there are still too many risks to label the company antifragile as a whole.

- Still, I believe that there is a better than not chance that the market will present Buffett an attractive investment opportunity in the not far future, and so I own BRK.B.
 

Berkshire's Cash Balance

 

Berkshire Hathaway (BRK.A) (BRK.B) has more than doubled its cash and short term investments over the past four years as its portfolio and subsidiaries continue to generate significant cash flows for the holding company. This is likely to have further swollen from the $128B reported in 3Q2019 as the company has not made any recent "elephant size" acquisitions. "Elephant size" may soon need to be upgraded to "whale size" if much of this cash is to be put to work in a single transaction, while the likelihood of Buffett suddenly finding multiple targets at attractive prices seems remote with equity prices near record levels.

 

This has led to calls for Berkshire to use it or lose it via dividends and/or large share repurchases. The current low returns on cash and equivalents adds to this sentiment. Others suggest that the company may simply be patiently waiting for more opportunistic prices, perhaps envisioning a grander repeat of the Goldman Sachs (GS) preferred stock and warrants deal from 2008.

 

I agree with the latter and want to expand further on how this is consistent with Warren Buffett's "Owner's Manual" for Berkshire shareholders and on how this relates to some of the insights of Nassim Nicholas Taleb, author of the Incerto Series (Skin In the Game, Antifragile, The Black Swan, Fooled by Randomness, and The Bed of Procrustes).

 

An Owner's Manual

 

Warren Buffett wrote "An Owner's Manual" in 1996 (with periodic updates) as a way to inform shareholders of how he and Charlie Munger would approach managing the holding company of Berkshire Hathaway. In Buffett's usual colloquial fashion, he describes the company's sparing use of debt as follows:

The financial calculus that Charlie and I employ would never permit our trading a good night’s sleep for a shot at a few extra percentage points of return. I’ve never believed in risking what my family and friends have and need in order to pursue what they don’t have and don’t need.

He goes on to describe how the "float" from the insurance subsidiaries and deferred taxes are two large sources of low-cost funding which, while creating liabilities, come without the drawbacks of debt. The majority of the operating subsidiary debt is matched to long term assets in the railroad and utilities businesses and is non-recourse to the holding company.

Regarding the stock market, Buffett describes his aim to collect assets at attractive prices over the long term as being aided, not hurt by, falling prices:

Overall, Berkshire and its long-term shareholders benefit from a sinking stock market much as a regular purchaser of food benefits from declining food prices. So when the market plummets – as it will from time to time – neither panic nor mourn. It’s good news for Berkshire.

This applies to purchasing entire companies or marketable securities, as well as the ability for the portfolio companies to buy back their own shares at depressed prices.

This implies that Buffett is willing to retain earnings and wait for market opportunities. He does, however, have a mechanism to check that he is creating value:

The five-year test should be: (1) during the period did our book-value gain exceed the performance of the S&P; and (2) did our stock consistently sell at a premium to book, meaning that every $1 of retained earnings was always worth more than $1? If these tests are met, retaining earnings has made sense.

So far, Berkshire Hathaway has met that test, so presumably we shouldn't be holding our breath for a dividend or large share repurchase.

 

The Opposite of Fragile

 

Source: Antifragile: Things That Gain From Disorder

 

 

In Antifragile: Things That Gain From Disorder, Taleb explains that the opposite of fragile is not strong, robust, or unbreakable as most people seem to think. Rather, the exact reverse of fragile is that which benefits, i.e., is strengthened by stressors and shocks. This is such a foreign concept that Taleb needed to coin a new word for it - "antifragile".

 

However, he also gives many examples of how all living things and surviving systems must have some measure of antifragility in order to survive in an unpredictably changing environment. The stress of exercise makes us stronger, not just in our muscles, but also by increasing our bone density and causing a cascade of beneficial health effects which we cannot fully understand given the complexity of our biology. Another example can be found in psychology - while post-traumatic stress syndrome is well-known (fragile), much less discussed is post-traumatic growth, individuals who are psychologically stronger as a result of surviving a trauma (antifragile). Tom Brokaw used "The Greatest Generation" to describe those who grew up during the Great Depression and World War II. Taleb even points out how committing a crime can destroy a fragile professional, say a money manager, or enhance an antifragile actress by getting her more publicity.

This concept can also be applied to debt, which creates fragility. Sure, if all goes according to plan and the individual or company repays their debts, they will have benefited from the loan in terms of spending or investing power. However, they risk losing most or even all of their net worth if the unforeseen and unfortunate befalls them.

 

Cash savings are the exact opposite of debt. As such, it doesn't just create financial robustness, but can also be viewed as creating antifragile optionality for the saver. Taleb likens it to redundancy in a system. Just like having spare parts (two kidneys, or extra inventories of a commodity, for example), having extra spare cash can be highly beneficial when an unforeseen opportunity arises.

 

Is Berkshire Hathaway Antifragile?

 

From the above, it is obvious that having an enormous cash stockpile well in excess of its debt and operating/reserve requirements reduces fragility for the company.

 

In addition, the insurance and reinsurance businesses are also, if well-managed, capable of being antifragile. Why? Taleb points out that if they suffer losses (the stressor) which do not take them under, then they can often use the disaster which caused the loses as an excuse to raise premiums. However, the insurance underwriting business only accounts for 2.7% of Berkshire's total net earnings.

 

Taleb also points out that sheer size can create fragility, as in too big to fail interconnected banks. However, in Berkshire's case, this is mitigated by the largely decentralized and hands-off style of management at the holding company, allowing even the wholly-owned operating companies great freedom to run themselves.

 

Although utilities may hold up relatively well in an economic downturn, the company's railroads, energy, consumer products, building products, jet sharing, etc. would all take a hit along with the vast investment portfolio, which includes large investments in the very fragile banking sector. So taken as a whole, Berkshire Hathaway is not antifragile in the short run in the event of a shock or recession, but may prove less fragile than the market as a whole due to the cash pile. This could lead to antifragility in the longer term if the cash is well-invested at depressed prices before a market recovery. However, such "contingent antifragility" does not make sense as it requires future events which are impossible to accurately forecast.

Despite the fact that Mr. Buffett has lived for nearly nine decades and may live quite a bit longer, I do not believe him to be immortal. All individuals are fragile. So even though he has carefully thought about and planned for his succession, it is likely that his eventual removal will change investor sentiment towards the stock, at least among those who believe that his investment track record is the reason to own the stock. Taleb has much to say on the subject of past returns as well, especially in Fooled By Randomness, but for the purposes of this article, I'll limit my comments to just that thought. To repeat: if some owners of Berkshire Hathaway stock are there because they believe that Buffett's future returns will drive out-performance, then it seems to follow that his loss would change their sentiment in a negative way.

 

So although the company's growing stash of cash and Warren Buffet may both still be around for a future market crash, there is no way to forecast if and when he will make a whale of an investment or what the result will be over time. However, I am willing to bet a modest portion of my portfolio on the possibility that this will happen and I thus do own the stock.

 

Note that an investor can also replicate this less fragile composition of Berkshire to say, the S&P 500, by simply owning a smaller amount of stock and a large cash position in their own portfolios.