Berkshire Hathaway: lucky or good?

Good morning. I am ready for the mindless artificial intelligence hype to end . . . and be replaced by mindless fusion power hype! A theoretical question: if it became clear tomorrow that cheap, clean, abundant fusion power would be available at commercial scale in a decade, and that no company or nation would have a monopoly on that technology, what would happen to the total value of world stock markets? It might go down, right? Email me your guess: robert.armstrong@ft.com.

Berkshire Hathaway: lucky or good?

Berkshire Hathaway released its second-quarter report over the weekend, and there wasn’t loads of news in it. The cash pile continues to grow and is near all-time highs, at $147bn, and Warren Buffett’s conglomerate/investment fund is selling a lot more stocks than it is buying. What stuck me, however, was this chart in the FT story, showing that Berkshire is underperforming the S&P this year:

This fact tickled my confirmation bias, because my hypothesis has long been that Berkshire cannot outperform the wider market for any significant period of time. At $768bn in market cap, and with exposure to a wide variety of economic sectors, it is the market, roughly speaking. The genius of Warren Buffett and Charlie Munger is very great and proven by their historical record. But they have arrived at a scale where they are up against the law of large numbers, and the best they can hope for in the long term is a tie.

That said, the last time I checked in on the company, a year and a half or so ago, Berkshire was outperforming the S&P by quite a lot, helped by its heavy weighting in energy. This made me worry my hypothesis might be wrong. So it was nice for my ego to see things swing the other way. 

Not so fast. Looking over a longer timeframe, Berkshire has sustained its streak of outperformance since the beginning of last year: 

As a result of this upward burst, Berkshire now leads the S&P over 10 years, too — 201 per cent versus 200 per cent, or about seven-hundredths of a percentage point of outperformance a year, a teensy-tiny difference, according to S&P Capital IQ. So my thesis still seems to hold over the longer run. But the last 10 years have been odd enough, and the recent outperformance at Berkshire has been significant enough, that it is worth asking whether in the last year and a half Berkshire has been lucky or good. 

The obvious first thing to think about is Apple. According to Berkshire’s second-quarter report, as of June 30, the company’s holding of Apple was worth $178bn. That was fully half the value of Berkshire’s stock portfolio and 17 per cent of its total assets. Apple’s shares have fallen since, but even so, Berkshire’s Apple stake is equivalent to about a fifth of its current market cap (Apple’s weighting in the S&P, by contrast, is 7 per cent). However I measure it, this is about as concentrated a position in a single stock as any big, large-cap equity manager I have ever heard of (excluding crazy people). 

So is Apple responsible for Berkshire’s run of great performance? Some of it, but not a huge amount. While Apple has been great in 2023, since the beginning of last year, when Berkshire began to shine, the stock has returned just over 3 per cent, 7 points better than the S&P. The exact contribution of Apple to Berkshire’s performance is impossible to calculate, of course, because Berkshire’s value does not directly correspond to the net value of its assets; that value includes a franchise premium that fluctuates. But the direct contribution of Apple to Berkshire’s market cap since the start of 2021 was in the low billions of dollars. The total rise in Berkshire’s market cap in that period was close to $100bn.

Berkshire’s other big overweights are in energy, utilities, rails, and insurance. Looking at the performance of those industries, it becomes clear that while a good run for the insurance industry has helped, energy — which is about 16 per cent of Berkshire’s after-tax earnings, when the stock portfolio is excluded — remains the key story. The huge run in energy company values in early 2022 has not been reversed. 

So, speaking very roughly, the strong performance at Berkshire can be summed up as a little help from Apple, a little help from insurance, and a lot of help from energy. Of course Berkshire’s individual companies are not performing exactly like their sectors, and their individual performance may be part of what is making the difference with the S&P 500. But sector performance in the areas where Berkshire is overweight gives us a pretty good hint. 

Another factor that may have supported Berkshire’s stock price is the Federal Reserve. Its huge cash pile has gone from yielding roughly zero to yielding 4 or 5 per cent. To put it differently, the opportunity cost of holding all that cash, in hopes of making an acquisition, has gone down.

The question is whether those overweight positions in thriving industries (and Apple, which is an industry in itself at this point) represent a superior asset-picking strategy coming to fruition at last, or a matter of being in the right place at the right time. Is what we are seeing at Berkshire the basis for long-term outperformance versus the S&P 500? If not, it’s almost certainly better for most investors just to own a S&P 500 index, because S&P 500 does not have a hugely revered, brilliant CEO who is 92 years old. 

One way to make the case for long-term outperformance is that Buffett has focused on buying assets in industries that have high barriers to entry, compounding earnings, but no glamour whatsoever. After a decade or two in which the market has rewarded sexier sectors like tech, Buffett’s bets on energy, railways, insurance, utilities and the like are poised to outperform in decades to come. I like this theory because I am a value guy. But the absolutely huge position in Apple dilutes the argument a great deal. 

A trickier question is whether a cash-hoarding company like Berkshire is permanently more valuable, relative to non-hoarders, in a higher rate environment. I am not sure how to answer this. It is hard for me to imagine that excess cash, at any yield, is not a drag on stock performance over the long run. A public company is supposed to earn a margin above the risk-free rate; a higher risk-free rate should not by itself make a company more valuable. And it does look to me like Berkshire’s size has brought it to a point where it cannot deploy its cash flow efficiently. On the other hand, if the higher rate environment brings higher asset price volatility and lower equity valuations with it, Buffett may get more attractive opportunities to put that cash to work quickly and for high returns.

On balance, I think my Berkshire-cannot-sustainably-outperform-ever-again hypothesis stands in the face of the new evidence. But I’m not sure, and I’d be keen to hear from readers. 

One good read

The natural gas industry in America is absolutely wild.