TIVP038: Berkshire Hathaway (BRK.B): From Buffett to Abel w/ Daniel Mahncke & Shawn O’Malley

25:24Candies, Buffett bought businesses like the Washington Post, the Buffalo News, and also the Nebraska Furniture Mart. And the Washington Post investment was a good example of how Berkshire's philosophy in minority stake investments evolved. He bought a 12 % stake in the company in the bear market of the early 70s. And Buffett promised Catherine Graham, who led the company at the time, that he would never purchase any more shares without her approval. Buffett admired her a lot for her business sense and integrity. And this became something like a blueprint for Berkshire's future minority investments.

25:57Find good companies with strong franchises and exceptional managers, and then partner as a supportive and trusted and also as a permanent shareholder. There are a lot of great stories about Catherine Graham and Buffett. She was the first female CEO of a Fortune 500 company, which, by the way, reminds me of when we covered Estee Lauder and talked about Estee being such a bright and confident leader in what was still a predominantly male-dominated world. And it was the same for Catherine, obviously, with the difference being that she didn't have that same confidence. And actually, she was almost really the opposite, actually.

26:31But Buffett knew about her talent and spotted it and really reassured and helped her navigate a pretty tough situation. and of course the rest is history. She became one of the most influential women in American business history and there's even a newly released documentary about her on Amazon Prime and Buffett's in there as well and also I should say the book The Outsiders which is a personal favorite of mine by William Thorndike tells the story pretty well and goes through the relationship with Buffett. I actually forgot that she was also mentioned in The Outsiders. I only had the documentary in mind but you're right and perhaps because of the success of this Washington Post investment Buffett found interest in other media companies as well In 1977, he bought the Buffalo Evening News.

27:11And at the time, Buffalo was a two-newspaper city, and Buffett believed that one paper would eventually dominate the entire city. However, the acquisition quickly turned into more or less a financial and also a legal headache, as the competitor fought aggressively, and even the regulators challenged the Buffett deal under antitrust laws. And for years, the paper lost money, and it drew a lot of criticism to Buffett and his investment side as well. But Buffett and Munger, as they always do, they didn't sell. They were convinced that the local newspaper had inherent monopoly economics. And eventually, the patients did pay off because the competitor just couldn't keep up.

27:48And the Buffalo News became the city's only major daily. And with that, economics improved massively as well. It's fascinating to me that Buffett invested in so many simple companies with these kind of regional focuses. I mean, there's so many exciting public companies out there doing stuff at the cutting edge of technology. And for most people who aren't wired like Buffett, seeing that gives them a lot of FOMO. And then yet there's Buffett, who became the best investor of all time, in many ways just choosing some of these household name basic businesses that were kind of just around the corner.

28:22And whether that's with furniture markets or newspapers. So I do think there's a lot of truth to investing in what you know. and Buffett has never claimed to understand tech, but he certainly understands furniture and newspapers. And we shouldn't forget, we're talking about Omaha. We're not talking about New York or San Francisco where for what it's worth, you have a couple more companies to choose from, but that's also, as you just said, part of your circle of competency, right? In one of our previous episodes, we also talked about the investment in the Nebraska Furniture Mart. It's another example of not only a local investment, but also a very strong female founder with Ms.

28:56Blumpkin. and it would be too much now to go through all of the investments that Buffett made. But in essence, the 80s were a decade when Buffett acquired many strong brands with local customers and outstanding managers. And choosing high-quality managers really was important since Buffett wasn't interested in getting operationally involved most of the time. The general idea was for Berkshire to have a decentralized management structure and provide financial backing and liquidity. And only when managers reach out to him, he would also, of course, offer advice. You know, that's something our friend Jacob McDonough, who wrote this really excellent book on the history of Berkshire, especially the early history, in this private presentation he gave to our intrinsic value community of investors, he brings up that same point.

29:36And being a company owned by Berkshire basically gives you the chance to do business more aggressively than as a standalone company. You don't need to be as conservative or to have as much of a safety cushion as other companies because Berkshire can inject liquidity in these kind of special circumstances where might be needed. And when you think about the pandemic, for example, it helps to know that you're backed by a company with hundreds of billions of dollars in cash instead of having to finance your business without really any help in a lockdown. So that's just one small example of how being in the Berkshire ecosystem can be very advantageous and can kind of change the psychology of running your business.

30:15But how about we talk about the next pillar of Berkshire and go on to look at their energy business. The move into energy seemed a bit surprising at first. Buffett liked businesses, famously, with really a limited need for reinvestment. And that is not what the energy industry is. Energy is a very capital-intensive business. And yet, in 1999, he bought MidAmerican Energy for about$2 billion. And later, that company was renamed to Berkshire Hathaway Energy, or just B-H-E, and became one of the most important businesses in the Berkshire empire. So why did they make that investment? What did he like about the company back then?

30:56And how is that business doing today? Interestingly, just a year before Buffett bought Mid-American Energy, he held a speech at the University of Florida, and a student asked him about utility and energy stocks. And this is what Buffett said back then. What do I think of what? The electric utility industry? Well, I've thought about that a lot because you can put big money in it. And I've even thought of buying entire businesses. There's a fellow in Omaha, actually, that's done a little of that through Cal Energy. But I don't quite understand the game in terms of how it's going to develop with deregulation.

31:34I mean, I can see how it destroys a lot of value for the high-cost producer once they're not protected by a monopoly territory. And I don't for sure see who benefits and how much. I mean, obviously the guy with very low-cost power, some guy's got hydropower, you know, at two cents a kilowatt or something like that, has got a huge advantage. But how much of that he's going to get to keep and everything, or how extensively he can send that outside his natural territory. I haven't been able to figure that out so that I really think I know what the industry is going to look like in 10 years. But it is something I think about, and if I ever develop any insights, you know, the call for action, I will act on them.

32:15Because I think I can understand the attractiveness of the product and all the aspects of certainty of user need and the fact there's a bargain and all of that. I understand. I just don't understand who's going to make the money 10 years from now. And that keeps me away. So while you're right in saying that Buffett up to this point preferred capitalized businesses, he did appreciate just a steady demand and the monopoly-like market structure and also the ability to invest billions at reasonable and stable rates of returns. So he decided to pull the trigger a year after that speech because he finally felt like he had found the right people.

32:55Again, the right management is essential for Buffett whenever he does make an investment. So the company was run by CEO David Sokol and owned by Walter Scott. With the right management, Mid-American Energy, or Berkshire Hathaway Energy, expanded quite aggressively. Today, it's one of the largest owners of wind and solar assets in the US with over$100 billion in assets. And Greg Abel, who we know is now Buffett's successor at the top of Berkshire, was actually crucial for that expansion and success, I think. He joined Mid-American in the early 1990s and became CEO of Berkshire Hathaway Energy in 2008, overseeing this expansion into renewables.

33:35And I remember there was one question on the energy business and sustainability at this year's meeting. It's been something of a hot topic, you might say. Yeah, I remember that. It was about the remaining coal operations, I think. And in my opinion, he handled it quite well. Although there were some people, at least judged by the reaction in the crowd, who were not fully satisfied with the answer. But the truth is that BHE has reduced its coal operations significantly in the last 20 years. in 2005, coal still generated over 70 % of BHE's power. Today, that's less than 30%. And there's a plan to retire all coal plants in the next 25 years.

34:13So Berkshire Hathaway Energy today is mostly a collection of three large utility companies, then a lot of smaller ones. So the big three are Mid-American Energy, as one of them, Nevada Energy, and Pacific Corp. Those are the other two. And in this business segment, you can clearly see the advantage of being part of Berkshire. Since Buffett acquiring MidAmerican, the energy segment has never sent a single dollar of profits to Berkshire. All the profits they earn stay within the business to grow the capital base or they reinvest it into the business. And that's very different for its competitors.

34:45Utility businesses, they're not the most attractive businesses for most investors. So they often spend a lot of money on dividends. About 75 % of profits on average are spent on dividends. And now you have to imagine you are an average energy company paying out three quarters of your profits to shareholders and you compete with a company that can reinvest all its money into growth. I guess that's a pretty difficult fight to win, right? And that's pretty much how BHE grow to cover over$140 billion in assets. And that's more than 10 % of Berkshire's total assets. That might not sound that much, but these are infrastructure assets.

35:23So they threw off predictable returns for decades. The insurance business, for example, has a significantly larger asset base, but it consists largely of financial securities with lower near-term earnings power. And I would say that's the main objective and the power of the energy business for Berkshire because it just provides a company with a long-term reinvestment outlet. While most other subsidiaries, especially those smaller companies like Seas Candy or Neboska Furniture Mart, they generate excess cash, but they can't use it internally at high returns. usually you'd want as much cash for buffett to be deploying as possible but berkshire's cash is already at about 350 billion dollars so berkshire is not lacking cash to invest but they're really lacking investment opportunities so having some of these capital intensive businesses where you can put tens of billions of dollars to work generating decent returns that's actually a kind of a good thing for Berkshire.

36:21And a similar heavy asset business is BNSF, Berkshire's railroad business. So what can you tell us about this other capital heavy business that Berkshire has taken on? So BNSF stands for Burlington Northern Santa Fe. And it's another one of those, as you said, companies that probably wouldn't excite many retail investors. But at some point, it was Berkshire's largest deal in company history because Buffett paid$26 billion in cash and stock. It's not an example of Buffett's patience because he followed the industry for decades but avoided it for a long time because it was kind of over-regulated.

36:59That just made it a pretty tough business to be in. But by the mid-2000s, the industry has changed quite significantly. Most importantly, the race system had been consolidated into just a few large players, which basically gave them a duopoly or at least an oligopoly position in their regions. And that's when the industry became much more attractive to Berkshire. And in classic Buffett manner, he used the years around the financial crisis to make his investment. He acquired BNSF for a total of$44 billion. So it was quite a big commitment, I would say. And the investment thesis was really as straightforward as it gets.

37:35The system in place is pretty much a barrier to entry in itself. It just doesn't make sense to build more tracks. And so, as Buffett puts it, as long as the American economy will prosper and grow, so will BNSF. Well, I felt it was an opportunity to buy a business that is going to be around for 100 or 200 years. It's interwoven with the American economy in a way that if the American economy prospers, the business will prosper. It is the most efficient way of moving goods in the country. It's the most environmentally friendly way of moving goods. And both those things are going to be very important.

38:13But the biggest thing is the United States is going to do well. So as Buffett said, it's just a very effective and also environmentally friendly way to move goods. There's just not that much that can hurt the long-term thesis for railroads. With Buffett, it always seems so simple. It's like when you watch an NBA game and you see the pros just make dunking look completely effortless. And then, you know, I mean, it's not. Buffett just thinks about what businesses will still be here in 50 years so well and whether he can predict how much cash those businesses will produce. And you and I have looked at close to 40 companies by now just for this show.

38:50And we know firsthand that the idea might be simple, but execution is not to consistently do this for six plus decades. I mean, that's incredible. And with railroads, I think he nailed it again. It generates billions of dollars in reliable profits each year. It requires massive infrastructure that, as you said, would really be nearly impossible to replicate today. And then it's diversified in itself in a way. You know, sure, railroads move with the economy, but their mix of agricultural, industrial, and consumer goods cargo can provide exposures to different parts of the U.S. economy's growth.

39:25And so we just talked about coal a minute ago. Coal is actually a large part of what Berkshire Railroad transports. and it'd be easy to say there's a risk there because less coal also means less business for the railroad. But Buffett keeps things really simple and just says, look, railroads are one of the most effective ways to transport any type of good. So they're always going to be used. And if less coal is getting transported, most likely it's just going to get substituted for something else, maybe grain, for example. It's such a simple framework, but it's hard to imagine it won't be at least directionally right as long as the economy grows.

39:59and perhaps also the population, that's probably also a big factor, you will have more and not less demand for transporting goods. It makes a lot of sense for Berkshire. But it's also true that these investments that won't generate outsized returns, and that's true for Berkshire Hathaway Energy as well as BNSF, but they can consistently generate at least decent returns. And considering that Berkshire has to invest tens of billions of dollars each year and even hundreds of billions of dollars if you consider the cash position, And Buffett just needed to find places to invest a lot of capital for a decent and reliable return.

40:33And he's kind of doing it on a big scale. And many smaller investors do it on a small scale when they invest in Berkshire, looking for reliable and decent returns. And outstanding returns are what investors in Berkshire hope for when they look at the equity portfolio, which is currently worth still about a quarter trillion dollars. And that sounds like a lot, and it is. But it is also$100 billion less than in 2023. The portfolio is consisting of about 41 positions, I think, right now. And it might sound like that's a lot, considering that Buffett is famous for his concentrated portfolio approach.

41:07But the top 10 positions still make up more than 85 % of his portfolio. So the portfolio is a lot more concentrated than it looks at first glance. And looking at the top 10 positions, we see a couple names that he already has owned for decades. American Express is one of those interesting examples. It's Berkshire's second largest position today, and Buffett made his first investment in the company in the 60s at a time when Amex was involved in a scandal, in the so-called salad oil scandal. And it was really more about a company called Allied Crude Vegetable Oil. And this company was using fraudulent accounting and machinery to inflate its inventory of salad oils.

41:47And American Express was the company that was supposed to be responsible for checking Allied crude vegetable oils inventories. And, well, they missed it big time. I mean, they didn't even notice the amount of oil they said the company had in stock would have actually exceeded the entire oil supply of the United States. And to add insult to injury for as bad as it sounds, American Express even loaned money to Allied Crude itself and took on some of this fraudulent inventory as collateral. And of course, that severely hurt Amex's balance sheet and reputation. And the stock declined 50 percent. And some fear, you know, American Express might not survive this.

42:26And Buffett used that opportunity as a way to really express his faith in the company by taking 40 percent of his partnership's money and investing it into American Express. And as we know today, that paid off tremendously. It's quite an interesting story. And we looked at so many different turnaround stories here on the show. And Buffett is often quoted as saying, turnarounds seldom term. And yet he's famous for buying companies in tough times. And in this case, he just believed in the strong brand and customer loyalty that this scandal wouldn't have any lasting damage. And I guess what I want to say is that not every turnaround is the same.

43:02When we looked at Estee Lauder, for example, we saw a mismanaged company with deteriorating financials and a questionable position for the future. When we looked at LVMH, we had a very strong brand that is struggling currently, especially with demand, but most likely due to macroeconomic factors. And then when we look at PayPal, we have a business that is not even really a turnaround. The overall business continued to grow, but the stock still crashed due to just high expectations in mostly 2021. So what I want to say there are many different turnaround plays. For anyone who wants to learn about investing, and since you listen to the show, I guess that's true for most of you here, I would highly recommend studying older investments of Buffett, Munger, Greenblatt, all of those great investors.

43:44We will soon actually host a call in our community where we will go through some of the early Buffett letters and also analyze his thought and investment process back then. And the case that he does often discuss is obviously Coca-Cola. It's just a great example of how he operates. He initiated his position, I think, in 1987 after the stock market crash. And then he accumulated a position of roughly$1.3 billion in the following years. The special thing about Coca-Cola is how well that company is compounded. I mean, other quality companies like Sea's Candy, for example, did well too for a period of time.

44:17But Coca-Cola did it on a global scale, which really just has turned it into such a remarkable investment for Buffett over the years. It wasn't cheap, but trading at a modest multiple in the mid to high teens, despite having a really unrivaled global distribution network, this iconic brand, and a dominant share in the beverage market made it really an obvious pick for Buffett. And again, the greatest thing about Coca-Cola was the pricing power. I said in one of our last episodes, but I'm pretty confident people will still be drinking Coca-Cola in 50 years. And if that's the case, and Coca-Cola can continue to raise prices in line with inflation, maybe plus some extra, you don't need much more than that for a really successful investment to pan out.

45:03And by now, Coca-Cola has paid Berkshire multiples of its original cost basis, just in dividends alone. I mean, last year, the dividend was$800 million, and the equity stake was worth$28 billion. But you have to admit that not all of Buffett's investments paid off that well. In 2015, Berkshire partnered in an relatively unusual manner with the Brazilian private equity firm 3G Capital to finance the merger of Heinz and Kraft Foods. And Buffett is not a big fan of private equity, to say the least. But with few opportunities in public markets, it looked like this deal could have served as a new way to make investments if it had worked out.

45:41But it didn't go that well. I mean, Buffett overpaid and the competitive pressures, I think they were stronger than he anticipated going into that investment. It might be a good example of why Buffett generally likes to work with founders or CEOs directly, because in this deal, Berkshire took more of a financing role. And the private equity firm was responsible for the operational side. Buffett did say that they were aligned on how to approach it, but at least from the outside, it seemed like a typical private equity deal with a lot of cost-saving measures that eventually compromised product quality and ultimately hurt the brand more than it helped the business.

46:16And what followed were several billion dollar wet downs. To be fair, though, it's not like Berkshire lost a ton of money on Kraft Heinz. Considering the dividends and the value of the stock, the return actually has been about 60%. Annualized, that's about 5%, so well below his usual threshold. But for one of his biggest mistakes, it's bearable, I guess. I mean, the only thing that bothers me is that this is a company that, you know, a young Daniel bought into thinking this couldn't go so wrong if Buffett is in there. when we talk about berkshire's equity portfolio i mean we can't get around buffett's most successful investment ever in terms of absolute dollar profits and that was in 2016 when buffett bought apple and pretty quickly made it berkshire's largest holding apple was actually the one position that overtook kraft heinz as the biggest portfolio holding and kraft heinz used to be 20 percent of berkshire's portfolio and only when apple entered the picture that has changed by 2023 apple made up about 50 percent of the equity portfolio which meant that berkshire owned over 170 billion dollars of apple stock and more recently though buffett sold a significant portion of that apple position and last year he sold off half the position and last quarter he sold another 20 million shares and apple is still the biggest position in the portfolio but at 22%, it's not as much of an Apple proxy anymore as it has been in the past years.

47:42And I don't want to speculate too much, but seeing him sell more half of his position makes it very likely that he sees Apple as being quite overpriced. Otherwise, he wouldn't sell it and add another$70 to$80 billion to his already incredibly large cash position and basically pay tens of billions of dollars in taxes. He was okay with decent, but not outstanding returns for his energy and railroad investments. So seeing him reduce his Apple stake like that makes me feel like he thought Apple might not be delivering the same returns with the same certainty at least. It's hard to argue that Apple isn't richly valued when it's trading at 35 times earnings, even though it has really only hardly grown profits for years.

48:26I think its earnings kegger is like 1 % or 2 % for the last three years. And it's pretty clear that only so much more can be squeezed out of iPhone sales. which is the company's golden goose. And I've heard some speculation though that Buffett was also sitting on such substantial capital gains in Apple shares that he almost wanted to maybe lock in that profit today at a relatively lower tax rate. And obviously I'm entirely speculating, but we've all heard the headlines about America's growing budget deficit. And it's something that Buffett has spoken out against for really years now. So I think he does have a legitimate concern that over the coming decade, taxes could have to rise meaningfully to offset some of that deficit spending.

49:10And if so, higher capital gains taxes on investments is probably one of the first levers that gets pulled to help with that. And really the point being, between having a mature business at a very rich valuation and then having substantial capital gains on that could be subjected to much higher tax rates in the future. I think it does make a lot of sense for us to why Buffett would want to start trimming that position, even if there is that old adage about not trimming the flowers to water the weeds. And Apple has been quite a beautiful flower for Berkshire shareholders. But at some point, you do need to reap the benefits of that flower.

49:48You know, and I think the investment case is just really not as strong as it was a decade ago. So selling billions of dollars of Apple when you already have billions of hundreds of billions in unallocated cash, that just opens the door to questions about opportunity costs and really what would be better to invest that cash in instead. And the reality is that we have not had a meaningful bear market since 2009. So the market is arguably as richly valued as it has ever been. And I feel like we've heard that for years now, but it's true. And due to the law of large numbers, there's only maybe a small subset of maybe like 100 of the biggest companies in the US that could even really move the needle for Berkshire as potential investments.

50:35With that subset obviously being further limited by valuation and business quality. So there's really only a handful of companies that Berkshire Hathaway can invest meaningful amounts of capital. And the best thing for Berkshire would be a sustained bear market. They created more opportunities to deploy their cash. And with something like 50 % of our portfolio sitting in cash, Daniel, you could probably say that our intrinsic value portfolio would benefit from that in the same way. But to not go on that tangent, let's get to the last major part of the Berkshire Hathaway business, which is the manufacturing service and retailing.

51:13In sheer scope, this is actually the largest collection of businesses inside Berkshire. not insurance or railroads. In this segment, you can find everything from industrial giants to furniture stores to jet services. And last year, it produced over$13 billion in profits, which is over a quarter of Berkshire's overall operating profit. And manufacturing is by far the biggest piece, and it's divided into three bigger product categories, and that's industrial, building, and consumer products. And for obvious reasons, we won't go over all the businesses now, but there are some that stand out, and I think investors of Berkshire should just know them.

51:51On the industrial side, that would be Precision Caspers, which is the largest holding and it is a leading maker of aerospace components. And this was one of Buffett's largest acquisitions ever. He bought it for$32 billion in 2016. And Buffett actually said himself that this price has probably been a bit overly optimistic. And during the pandemic, PCC faced some serious headwinds as aircraft orders collapsed And the company still did came out on top just because it had a strong competitive position and thus remains strategically important, especially to the big buyers. So they supply to Boeing, Airbus and also the defense industry.

52:27Beyond PCC, you have companies like Lubazol Corporation, which is one of the largest manufacturers of specialty chemicals. You have Iska, which is a manufacturer of metal cutting tools and Marmon Holdings, which operates in a wide variety of segments. And one thing they all have in common is that they operate in industries with relatively few competitors and reasonably high barriers to entry. And with the financial flexibility of being backed by Berkshire, I think this leaves them in a pretty good position to be in. And building products, it's kind of similar. It's like a who is who of American housing and construction.

53:04And Clayton Holmes is the largest US producer of manufactured housing and also runs a mortgage business. Shaw Industry makes carpets and flowing, and Jones Manville produces insulation and roofing materials. And MyTech supplies building components and software. There are just so many companies you could go into. But again, they all pretty much have the same playbook as with the industrial businesses. I think every year when we walk into the shareholder convention, we're always just blown away by how many different businesses there are that I'm almost embarrassed to say I've never heard of. about.

53:38There's always a company every year where you walk in and you're like, oh, I didn't know they belonged to Berkshire. Dairy Queen? Didn't realize that. And just really shows you how ridiculously big and complex the company has become as a conglomerate. And we've looked at other trillion dollar businesses with Amazon and Alphabet before, but even there, there's two, three, four, five really core businesses. And Berkshire is just on another level because there's so many different businesses that they own. And yet with this business segment, for example, all that diversification doesn't really help them in a recession.

54:17I don't think when there's a slowdown in the housing market, I think all the businesses you just mentioned are going to struggle. And just a few months ago, I personally was seriously looking at buying my first house and it was really exciting, but it was hard to justify doing so with rates being where they are. and with the fact that the housing market really hasn't cooled off much either. So maybe that's my value investing perspective leaking into real world decisions. But I'm sitting here, I'm looking at these homes. I'm like, hey, it's kind of a hard pill to swallow that some of these starter homes at$300 ,000 maybe in 2020 are now selling for more than 500K.

54:53I mean, that's just five years. And you're talking about prices having nearly doubled or doubled in many cases, especially in the market I live in. And so those kinds of gains in home prices over the last decade are really almost certainly not sustainable, I'd think, over the next decade. So there's a real risk of a reset in housing that, again, ripples across Berkshire's businesses. But of course, that's just me speculating on macro. And Daniel, I know we try to make a point on the show of not speculating on macro because it's really most often kind of a waste of time to spend it thinking about what ifs in these different scenarios.

55:32But anyways, long term, I think it has been great that Berkshire has been levered to the fate of the US economy. But that also means it's not immune from recessions and housing slowdowns either, especially in this segment. you know buffett loves to praise you know being born in the us and investing in the us and all that i think that's also one of the things we talked about after the shareholder meeting but it just paid off so well for him right all of these companies have strong market positions and with the backing of berkshire they don't necessarily have to worry about not surviving in cyclical downturns even if they come it's just a good example of how berkshire can be a structural advantage for the companies they don't and eventually of course that is an advantage for Berkshire itself again.

56:17It kind of reminded you, as you told me, of Comfort Systems, a company we also covered on the show many episodes back. And it's similar on the consumer side, right? I remember when we entered the convention, and you just mentioned it, this year's annual meeting was my first time being there. And I saw so many companies that I didn't even know were owned by Berkshire. One of them was Forest River RVs. We were standing there in front of this huge motor home and a boat next to it. And actually Buffett gave an interview with the founder of that company just a couple of minutes after we stood there and looked at it.

56:47And Forest River is one of the many consumer-facing manufacturing companies that 90 % of Berkshire shareholders probably never really noticed. And it's been part of Berkshire for 20 years now. And it's a great example of one of the quiet compounders within Berkshire and also Buffett's emphasis once again on management. In his 2024 annual shareholder letter, he told the story of how he met Pete, who is the founder and still the CEO of the business and basically decided over just one dinner to buy the company. I think to some people that would really sound reckless, but there are so many of these stories and a lot of his most successful investments felt like these moments where he's betting on the founder more than the actual business itself.

57:28And, you know, when you have 80 years of experience in business and assessing management teams, I do think you get a feel for people that is maybe a bit of a competitive advantage for him. And it's not only a feeling though, I mean, Buffett also looks a lot at incentives. And so, you know, is the founder only profiting when the shareholders benefit or are they making money regardless, as is really often the case across Wall Street and with most major corporations? And as you know, Daniel, Berkshire's compensation structure is highly aligned with shareholders. And really the entire company structure is one of a kind.

57:59Maybe it's just me, but I don't know any other trillion dollar companies in corporate America with really no centralized budget, no HR, and really as little corporate bureaucracy as humanly possible for a company of that size. Berkshire is just as unique as it gets in terms of having no HR, having no corporate bureaucracy, all of that. I mean, you pretty much have about 30 people at the headquarters in Omaha, and that's it. Munger once put it perfectly with his typical wit, so let's listen to that. Yeah, the truth of the matter is that we have decentralized power in the operating businesses to a point just short of total abdication.

58:43And we don't think our system is right for everybody. It has suited us and the kind of people that have joined us. But we don't have criticism for other people like Emerson Electric or something who have. As I said, this works because above all, Buffett and Munger paid attention to the character of the people they work with. We all know Buffett's saying, in looking for people to hire, you look for three qualities. Integrity, intelligence, and energy. And if they don't have the first, the other two will kill you. And no matter what founder story you go through, you will always see that the people Buffett chose were clearly honest people.

59:21That was true for Pete Legal from Forest River, for Rose Blumpkin, from Nabuscus Furniture Mart, and also for Chuck Huggins from C.S. Candy. And Buffett and Munger themselves, as you kind of mentioned, famously only earned$100 ,000 per year. There are no stock options, no performance bonuses, and no other perks. If Berkshire is doing well, Buffett is doing well. And it's the same for every other shareholder of the company. And since it turned out that Buffett was quite good at allocating capital, well, that turned out to be quite well for everyone involved in the business. And talking about capital allocation, I think we can skip the obvious, which is that Berkshire invests a lot of the money its businesses generate and then send to Omaha into stocks.

1:00:00Beyond that, though, Berkshire occasionally repurchases its own stock, but only when Buffett and perhaps in the future Greg Abel think that Berkshire stock is undervalued. Interestingly, Berkshire didn't buy back a lot of stock recently, which might indicate that Buffett himself didn't think or is not thinking that Berkshire is hugely undervalued. valued. And very significant repurchases happened back in 2020 and 2021 when Berkshire bought back shares worth about$60 billion. Considering that Buffett isn't buying other stocks either, which could have indicated that there are just simply some better opportunities in the market, and I guess it's likely that he's going to wait for a better opportunity to buy Berkshire 2 with the stock trading at a multiple of about 14.5 times operating profits.

1:00:46But before we get to the valuation and you tell us whether you think Buffett is right about the valuation of Berkshire, which I'm sure he maybe knows a little bit more than us. How about we talk about the elephant in the room? And that's Buffett's retirement and Greg Abel as the new CEO. And naturally, the older Buffett got, the more people have speculated what happens when Buffett steps down. And at the 2021 shareholder meeting, Charlie Munger kind of gave that answer away. A question from the audience was about whether Berkshire might be too difficult to manage for a single person who is not Buffett or Munger, to which Buffett replied that Berkshire is already so decentralized that it only works with the right culture.

1:01:22And then Munger added in that we do have that culture and Greg will keep it. And since then, we know Greg would basically be the one to follow Buffett. After this year's annual meeting, we also now know the timing of when that will happen. So how do you think about this? Do you think it can impact Berkshire's performance in the future to have this change? Or is the company so decentralized and set up for success that for the next five, 10 years, it really doesn't matter? Honestly, I'm not completely sure. Generally speaking, I'm not concerned. I do believe that Berkshire's culture has been the main driver of business success for Berkshire, especially in the recent past, where Buffett's capital allocation skills were less of a factor in the company's returns.

1:02:04And Abel knows that culture like few others do. He came up through the ranks through Berkshire's energy division and has worked closely with Buffett for about a decade now. What gives me a little pause though, is that I know so little about his skillset. I remember that there was a question this annual meeting on what makes Greg Abel so special. And like I mentioned to you afterwards, I didn't find the answer too inspiring. He was basically just reassuring that Greg is the right guy and a good fit. But knowing that only an hour later, he would tell us Greg is the new CEO. I think he could have used that opportunity to just be a little more precise.

1:02:38I mean, Greg has to follow in the footsteps of one of the best to ever do it. And we know how much emphasis Buffett puts on choosing the right people to work with. So while I trust him, I would have liked to get a better idea of why exactly he chose him. That said, a couple of years back, Buffett did give Greg credit for his capital allocation skills, for example, and we see that in the video here. Well, the answer is that Greg, I'm going to turn it over to him, but the answer is Greg understands capital allocation as well as I do. And that's lucky for us. and he will make those decisions, I think, very much in the same framework as I would make them.

1:03:17And we've laid out that framework now for 30 years. To the extent that uncertainty from Buffett stepping down gives us chances to buy Berkshire at attractive prices, I'm all for it because I do think the company can persevere for years to come, which gives us ample time to assess Greg as a capital allocator too and really as a manager of the business. And I don't think going forward, we should be blindly loyal to Berkshire just because it is Berkshire. But also, it's not like the portfolio of companies built up over the past 60 or 70 years is just going to disappear the day that Buffett steps down.

1:03:52And now though, to move along a bit, how about we go over to the valuation and use that to cover the financial side of the business in a bit more detail and just think about whether we want to actually add Berkshire to our intrinsic value portfolio. Well, today we changed it up a bit because instead of doing a DCF, I chose to go with a sum of the parts valuation for a company like Berkshire, which is so diversified. I think that's probably appropriate to do. And so for the sum of the parts, we mostly look at the balance sheet and then later at the capitalized earnings for sum of the operations.

1:04:23So we start by looking at cash. I only count the cash that is under the insurance and other part of the balance sheet. What I do not count is the cash from BNSF, Utilities and Energies. Because as we discussed, they're capital intensive businesses and they reinvest their earnings and the cash instead of sending it to Omaha. If Berkshire can't really use that cash, we shouldn't count it, at least in my opinion, at least not here. I mean, of course, it is still part of the valuation because when we look at the capitalized earnings, since it is still put to work for Berkshire, we will see how it impacts the valuation, just not directly through, you know, Buffett allocating that capital.

1:05:01After cash, we add the fixed maturities that Berkshire owns, which can also be found on the balance sheet. And combining that, just cash and bonds, they alone are worth already more than a third of Berkshire's current$1 trillion market cap. All that cash, I think, raises the stakes for Greg. I mean, it would be one thing if Greg were inheriting a situation where he didn't have to do much for the time being, but he'll likely feel the pressure to make some big decisions relatively soon. There is a lot of capital to be allocated. And ideally, that would have been done by Buffett before a handoff.

1:05:35But of course, Buffett is not going to do that if there aren't sufficiently attractive investments available for him to pour that cash into. Well, as you said prior, we're in one of the longest bull markets in history. And the set of companies Berkshire can invest in is already small. So either we see a shift with more tech investments in the future. I mean, we've seen that with Snowflake before, for example, which was definitely not a Buffett investment. or we will have to wait for potential bear market to see the capital being deployed in some equities. Speaking of which, let's talk a bit about the equity portfolio.

1:06:06I mean, you can make valuing this part of the business as complex as you want. Berkshire is reporting the value of its equity portfolio and its filings. And I would suggest most of the time you just go with that number. However, you should also be mindful of stock prices. If you think a large holding is massively over or also underpriced, you should adjust for that in the valuation. So for example, when Apple was still a 50 % position in Berkshire's portfolio, I would argue it would have made sense to value Apple itself and then adjust the value in Berkshire's portfolio based on what you think Apple is actually worth.

1:06:38since Apple has corrected quite a bit since its all-time highs and is now only a little more than 20 % of Berkshire pretty much in line with American Express. I keep it on the books unchanged. For the record, if it still would be a 50 % position or if you want to go really into the detail, I would have adjusted the value downwards a little bit. So you're not making any adjustments for the equity portfolio? Not in terms of equity values, no. But I do adjust for taxes that Berkshire would need to pay on unrealized gains if it were to realize those gains by selling equity. So you mentioned that in Apple's case, he might have paid less than the usual tax rate.

1:07:16But for my model, I use the 21 % casual tax rate. And that would result in about$40 billion now for the entire unrealized gains of the portfolio. Okay. So where are we now? I mean, we have about$350 billion through cash and cash equivalents and bonds. And then looking at your model, it looks like you've got another$230 billion for the equity portfolio. So that takes us to$580 billion of Berkshire's valuation already. And we haven't even talked about the railroads or the utility businesses. And we also haven't talked about the equity method investment. Those are basically the companies which Berkshire owns more than just a small piece of the business, but also not all of it.

1:07:55So that's where you can find companies like Kraft Heinz or Occidental Petroleum, for example. And these are accounted for as if Berkshire would own the entire company. So instead of reporting it mark to market, Berkshire just reports its share. So for the last 12 months, that share was about$25 billion. And again, you can just find that number on Berkshire's balance sheet. The great thing about Berkshire is that its reports are so well structured. It's a complex business, but you can find most things relatively quickly. And in contrast to some other companies where you sometimes feel they add complexity just for the sake of doing so, and maybe so investors can't fully follow the business.

1:08:32Berkshire really tries to make it as easy as possible to follow along. That's true. And I mean, some companies like BNSF, for example, they even still release their own filings and annual reports. It's kind of mind boggling to think about how many companies Berkshire owns that would literally be worth tens of billions of dollars and would sometimes even be Fortune 500 companies. But within Berkshire, and you look at the annual reports, they're sometimes just more or less a footnote. BNSF is definitely not just a footnote. It has an average earnings power of about$5 billion a year, and it's not growing by a lot.

1:09:05But due to its mode and stable earnings, I think a multiple of 15 for their business is probably fair. And that would result in a value of about$80 billion. And I give the same multiple for Berkshire's energy business, which also leads to a valuation of about$55 billion. And this valuation is quite interesting because Buffett bought Greg Abel's 1 % stake of the business just three years ago. And BHE's implied valuation in that deal would have then been$90 billion. That could make you think that$55 billion is way too low for valuing the energy business. However, about a year ago, Berkshire bought the remaining 8 % stake of the business that it didn't yet own.

1:09:44And that deal only had an implied valuation of the energy business of about$50 billion. So a lot closer to our estimate here and over 40 % below the 2022 valuation. considering there are only two years between the deal with abel and then the acquisition of the rest of those berkshire energy shares either greg made an incredible deal or buffett did when he bought the rest of the company and i mean i don't believe that buffett would have given greg any form a special deal he's known for always acting the best interests of the common shareholder and paying abel double what his stake is worth doesn't sound like that and i think really what happened here is that the wildfires that we've seen in the past few years have impacted the value of the energy business really severely, especially with that increased regulatory scrutiny that comes with that.

1:10:28And so Buffett himself mentioned in an annual filing last year that the intensity and frequency of those fires increased and will continue to increase. And the cost that arose for Berkshire Energy can really only be estimated in the years to come, but it's substantial. And he's even said that they're sort of in survival mode for some of these energy companies. So it's not unreasonable to think the valuation of the energy operations has really been severely impacted by all of this wildfire stuff. Yeah, that could definitely be the case. I mean, we mentioned how regulation impacted the railroad industry in the past and that for the longest time, it wasn't an attractive place to invest in.

1:11:04And it's similar for utilities and perhaps after some decades of more or less favorable regulation, this will change for energy in the future. And that would be a worst case scenario. And if we're just talking about a more difficult time for companies in the space, I would still personally bet my money on Berkshire coming out on top of that, but it's still a risk that we have to face. I just don't think any other company in the industry is as good at assessing risks as a company that quite literally is a huge insurance conglomerate. And speaking of insurance, there are only two businesses left in our sum of the parts valuation, and that's insurance and the entire manufacturing service and the retail block.

1:11:44So I would start with the manufacturing business, I think. The manufacturing segment makes, as I said,$13 billion in earnings per year. And again, I will put a 15 times multiple on that, which leaves us with about$200 billion as a price tag for that business. Fun fact, we only own one company right now in our intrinsic value portfolio that's worth more than that. And that's Alphabet. All other companies are worth less than Berkshire's manufacturing business alone. It's funny because we took a some of the parts approach with Alphabet too. And it's interesting that with Berkshire, some of these companies may be worth more on their own, especially if the market no longer pays the same premium for Berkshire stock that it did for years while Buffett was at the helm.

1:12:29And with Alphabet, for better or worse, I do think thanks to the big data synergies that they have and from AI, it was actually probably more of an implicit bet that the whole thing is worth more than the sum of its parts. Because data from Google search and YouTube, for example, can be used to support other parts of the business, which is why, in my opinion, at least, the conglomerate valuation for Alphabet is actually very reasonable and attractive. because I think there are a lot of these internal synergies that are hard to quantify, but add to the company's overall value in a way that you don't see with a conglomerate like Berkshire.

1:13:05I do agree. We just recently had the talks about selling Chrome potentially for$35 billion to perplexity. And I think something like that would hurt Google way more than any one subsidiary leaving Berkshire. Although I would argue that this is also the case with many companies within Berkshire as well. It might feel like a Buffett premium that was paid by investors for a long time. But I think of it more as a Berkshire premium. As we mentioned, the financial backing by Berkshire is a huge advantage, especially in difficult times or recession. And there are many businesses that I personally wouldn't buy as a standalone company.

1:13:39But within Berkshire, I think the risks are much more limited. So I think there's also a synergy going on in Berkshire that doesn't only represent, you know, a Buffett premium. All right. I think that leaves us with the insurance business or better said the insurance underwriting business since the insurance business is how cash, bonds and equity investments are funded. And we can't just add a balance sheet value of the insurance business to our sum of the parts because otherwise if we did that, we would just count all of the investments again. So instead, we are looking at the underwriting business and its earnings.

1:14:11And Berkshire is one of the, as we just said multiple times in this episode, one of the few insurance companies that actually turns a profit on their underwriting business. So there is some volatility in the earnings, but particularly over the last years, the business has performed quite strongly, earning about$9 billion in underwriting profits. And that's an implied underwriting profit margin of about$10, which is really an exceptional result. And that's probably not a sustainable margin in the long term, but it's still as if it's only half of that. I mean, Adam Mead, for example, who does a phenomenal job of reporting on Berkshire, and I've linked to some of his sources and his work in the show notes, he assumes a 4 % profit margin on underwriting in the long term.

1:14:52I think that's a fair assumption. I personally went with 5 % looking at the more recent historical numbers, but I would say the difference is trivial. Generally, in a complex business like Berkshire, there are many times when you have to make an assumption or adjustments that other people just may not make. Buffett once argued that Geico, for example, is probably worth more than its underwriting profit and the float combined just due to its margin profile and its growth outlook. And this time I put a multiple of 12 on those earnings because 15 will be, in my opinion, too much for an insurance company, even one that is superior to its competitors and backed by the entire ecosystem of Berkshire.

1:15:29So that leaves us with a price tag of$53 billion for the insurance business. And if you compare that to a year prior, as I said, because they actually earned a 10 % margin, you could argue that this business is worth$100 billion if they keep that margin going. But I would say that's probably not sustainable in the long term. So now as the last part of the model, we only have to subtract the debt that Berkshire holds at the parent company level. So you can find that at the parents' balance sheet. And that number is about$20 billion, which means that after all this, and I guess it was quite a long process, we end up with a fair value of almost$975 billion.

1:16:07Compared to today's prices, that would indicate a slight overvaluation of, let's say, 5 % to 6%. But looking at it from a price-to-book angle, you could also make the argument that Berkshire seems slightly cheaper right now than it did in recent years. I'll be honest. I've never been one to focus too much on price-to-book because it's not as useful of a metric as it used to be. And as a multiple of operating profits, Berkshire does actually seem to be trending slightly below the median valuation the market has paid for the stock since 2019, which is not nearly as precise of a framework as what you've done, Daniel, but it kind of works.

1:16:40The point being is that the stock is probably about fairly valued with a case to be made that it's maybe slightly overvalued, but also reasonable people could say that it's slightly undervalued. And either way, at current prices, we're not buying a stock that is obviously a home run where we'd be expecting to dramatically outperform the market. And on the other hand, though, we often like to joke that that Berkshire is kind of a backdoor way of getting a diversified index fund without any of the management fees and with some of the best capital allocators who have ever lived sitting at the top of it.

1:17:09So through that lens, it feels like a bet on average returns with maybe less business and valuation risk than the S &P 500 currently and no management fees as you'd normally get through an ETF or mutual fund. And that is really how I would think about investing in Berkshire at these levels. And until we can find better opportunities, it may not be a bad placeholder to have Berkshire in the portfolio as an alternative to having such a large cash position. Not to say we should put all our cash into Berkshire, but maybe a chunk of it could be a good idea. But with that, let me ask you, where does that leave us, Daniel?

1:17:45I know that some legendary investors like Norbert Liu use Berkshire stock in a similar kind of way as like a placeholder. And I would personally be comfortable with doing that for part of our portfolio where we treat Berkshire shares in particular as sort of almost a flexible form of cash that we could sell as needed to roll into higher conviction bets. Because we know also there's not going to be a huge amount of volatility in Berkshire stock. So we're not taking on a ton of risk by swapping some cash into it and then maybe needing to sell some of it down the road if we had to. Right. I mean, sometimes you say it's a cop-out when we do not immediately decide on adding a position to the portfolio at the end of our podcast and refer to it for example to the newsletter and sometimes i look at the portfolio of other super investors and when i see a huge position in berkshire i feel like they use it as a cop-out i don't want our portfolio to become anything like a berkshire proxy just because it's an easy decision to make having said that we still have as you mentioned quite a sizable cash position and in theory that would earn only about four percent berkshire on the other hand can almost guarantee you a market-like return with the optionality of a 350 billion dollar cash position and some of the most skilled capital allocators on top of the company so the more positions we have in our portfolio the more we have to think about opportunity costs and comparing one position against the other one but right now i believe adding berkshire similar to what Norbit Lou is doing or has been doing is pretty much a no-brainer.

1:19:17So now we only have to think about what is the appropriate positioning? Is it 10 %? Is it 15 %? Where do you stand on that? I think starting at 10 % is reasonable. And as long as Berkshire doesn't get excessively overvalued for a period of time, we can always add to that if we feel like, okay, we're not finding as many opportunities to double down on or new investments to make, we can kind of allocate more to the Berkshire bet accordingly. But 10%, given that about half of the portfolio is cash, taking a fifth of that cash and putting it into Berkshire, that, I think that feels about right, because it still leaves us plenty of cash to use for other purposes.

1:20:02So yeah, I don't know. How do you think about that? And it sounds good to me. I personally use and see Berkshire kind of as a hedge as well. Not necessarily because it wouldn't go down in a cyclical downturn or in a recession, but just because it's a company that's so safe that you can be very comfortable putting your money into the company at a time like that. I always still remember buying Berkshire when COVID happened. And there were probably a lot of companies that outperformed it afterwards. But I was very confident that I could put my money into Berkshire at a time like that and I'd be safe.

1:20:33it's probably a good return as well. It performed pretty well in that time horizon. So I think putting down 10 % and if we do see the market going down more significantly and Berkshire is doing so as well, we could up that position to 15%. So I think that's a good compromise to take here. I mean, we're taking cash and then we're putting it into something that if a third of the market cap is cash, we're actually still keeping a decent exposure to cash even by allocating to Berkshire stock. That's a very good point. that's a very good point too but perhaps i wouldn't want to bet on it but i would just think the capital allocators on top of berkshire might even do a better job than the both of us all right with that how about you give us your hints for next week's episode so actually next week's pitch will kind of be similar in structure it's a diversified business in a way with royalty based revenue streams that make its earnings very consistent and high quality actually arguably more consistent than Berkshire's.

1:21:34And so it's probably a fairly valued stock like Berkshire. But again, the question is, will it still be worth adding to the portfolio as something that helps form the portfolio's foundation and as something of maybe an alternative to just sitting so much in cash still? And I would also say for anyone really looking for specific hints about the company, the CEO is pretty famous in his own right, and he gets referenced in music frequently. Usually in hip hop is where I've heard it. And that's because of the role that his company takes on in the industry, if that makes sense. But I think that's all I'll say for now.

1:22:09Okay. Actually, I'll give maybe one last hint. A pretty famous investor came out a few years ago in support of the stock and still holds it. But now I'm maybe giving away too much. Maybe, but I still think it's kind of a guessing game. I just wanted to give another hint, but I won't do it. Maybe then it's too easy. Okay. So of course I brought a Buffett quote today to end the episode. Anything else would have been unacceptable today. So Buffett said, quote, nobody buys a farm based on whether they think it's going to rain next year. They buy it because they think it's a good investment over 10 or 20 years.

1:22:44We buy Berkshire because we believe the same will be true for the company, even if Warren Buffett is not the person sitting as the CEO at the next annual shareholder meeting anymore. And with that said, have a great day and see you all next week.