SPENCE Asset Management

The Unique Structure of Berkshire Hathaway March 2011

The unique structure of Berkshire Hathaway, in conjunction with the remarkable investment minds of Warren Buffett and Charlie Munger, has created a tremendous case-study for all aspiring investors.

It is important to realize first and foremost that Warren Buffett and Charlie Munger designed and shaped their own investment vehicle. Those who are tempted to toss in a “yes but,” when evaluating the astonishing achievements of these two legends should realize that any “but” discounts the architectural wisdom of Buffett and Munger. In creating flexibilities in their structure they have enabled themselves to take full advantage of their wisdom and become fabulously wealthy. The massive fortunes created for those who hitched their wagons to Berkshire came as a result of the fact that Buffett and Munger engineered the proper specifications for a unique investment machine.

Over the final weekend of February Warren Buffett posted yet another of his annual letters to shareholders. No doubt there were countless hits on the Berkshire website by anxious investors. Many may have been hopeful that some insight might come from this year’s edition that would help them with their next trade. Our perspective on the wisdom of Buffett and Munger comes with a broader context. Having read every letter Buffett has written to shareholders since 1977 as well as Munger’s book “Poor Charlie’s Almanack” several times brings a certain perspective. We feel that the latest letter to Berkshire shareholders is most useful when it is put into the context of everything else Buffett has said in all of his letters for the last thirty-four years. What follows are my observations on the most recent Buffett letter. I humbly offer them within the context of what I feel is most important to understand about Buffett and Munger.

As I mentioned earlier, Buffett and Munger created their own marvelously efficient and adaptive structure. In this year’s letter Buffett goes to some length explaining all of the advantages of the Berkshire model. This explanation serves at least two purposes. First, it describes why Berkshire can do things other companies cannot do. And second, it reveals the sheer genius of the architects of the Berkshire structure.

Exhaustive studies of Buffett and Munger have been most valuable to our professional training. Because they have both generously shared their insights, we have gained a much more intricate understanding of what actually makes a business truly superior. And one can see from the earliest years of Buffett’s letters that he and Charlie Munger certainly practiced what they preached most of the time, but not ALL of the time. Perhaps what made Berkshire such a phenomenal performer in the early years was the ability of Buffett and Munger to: 1) identify and acquire businesses that possess large amounts of enduring goodwill, and 2) at least equally important (if not more important) to acquire businesses that utilize a minimum of tangible assets. With almost a sixth sense, the Berkshire acquisition machine was able to correctly identify enduring economic goodwill. And to this very day, the greatest contributors to the enormous earnings powers of Berkshire come from operations that utilize “a minimum of tangible assets.”

This brings us forward to the most recently released Buffett letter to shareholders. At this stage in the constant adaptation of the investment machine known as Berkshire Hathaway, it is exceedingly difficult for the company to find, based on the size of acquisitions it requires, 1) companies that possess large amounts of enduring goodwill AND 2) companies that utilize relatively low amounts of tangible assets. Simply put, Berkshire has slowly had to adapt and evolve its acquisition strategy to accommodate its enormous size. Compromises are being made. Naturally, Warren Buffett has gone to great lengths to spell out the difficulties of deploying large amounts of capital. However, we are not sure that most observers grasp the sheer magnitude of this difficulty.

Of course as Buffett lowers expectations so they are more in line with practical realities, he and Munger continue to brilliantly navigate the ever more challenging obstacle course they face. In this year’s letter Buffett speaks extensively of the BNSF acquisition and of the anticipated need to add billions of additional capital to that operation for as far as the eye can see. Though Buffett does not necessarily refer to basic principles he taught in previous letters to shareholders, one quickly recognizes that he is actually adding caveats to his description of the earnings power of BNSF. In the end, we feel it is important to recognize that the profits generated by BNSF for Berkshire are more “restricted” than the earnings generated by a GEICO or a See’s Candy.

As a matter of practice, and due to our modest size, we are not forced to make investments in companies generating large portions of restricted earnings. And because of our modest size we can avoid investment in most heavily regulated industries. In the content and tone of this year’s Berkshire shareholder communication we see Buffett is engaging in the management of the tedious relationships Berkshire has with regulators of BNSF and Mid-American. When additional capital investments are required in heavily regulated industries, fair treatment by regulators is the dividing line between decent returns and subpar returns.

Knowing the direct and vicarious business experiences of Buffett and Munger over the decades can provide great assistance to any money manager who is managing a modest sum of investment capital. We learned long ago that these two men developed a strong preference for businesses that require little in tangible assets. And in previous letters Buffett has gone to great lengths to differentiate between “good growth” and not so good growth. He often described “good growth” as being attainable without the company adding significant amounts of capital. He has also described not so good growth as growth in unit volume and/or sales volume that can only be achieved when shareholders invest additional capital at sub-par returns.

To make a long story short, what we see Buffett and Munger forced to do now, due to the sheer size of Berkshire is comb through mostly capital intensive businesses looking for investment. Having so much capital to deploy, they simply can no longer find sufficient sized positions available in less capital intensive businesses. Thus, Buffett’s writing in this year’s letter seems to be preparing shareholders for the possibility that due to massive capital outlays associated with BNSF much more modest investment returns from that holding are likely.

As Berkshire moves to the future and away from it’s remarkable past, it might be important to recognize the sheer adaptive brilliance of the investing minds of both Buffett and Munger. Since they continue to be Berkshire’s architects, it is also important to admire the awesomely flexible structure of their modern investment machine. Additionally, I can think of no two other individuals who could deploy such large amounts of capital as brilliantly as they have. It should come as no surprise that men who are brilliant enough to have built a magnificently adaptive investment machine would continue to find ways to navigate the impediments to success that have been created by…their prior successes.

This year’s reading of the Berkshire letter is most helpful to us if we are reminded of the historical context. We are free to learn from Buffett’s stated preferences without the burden of huge cash redeployment burdens. Other Berkshire letters to shareholder readers should be clear: Buffett is not advocating a transaction in a major rail company, rather, he is using the discussion of his BNSF transaction to remind us of the most fundamental elements of his investment philosophy.

Finally, Mr. Buffett is right on target when he speaks of fund consultants and academics and their investment style boxes. The Buffett quote, “At Berkshire our only style box is “smart.” That says it all.

Jim Spence, Registered Principal • Spence Asset Management

Spence Asset Management, Inc.
2455 E. Missouri Ave. Suite C Las Cruces, NM 88001 575-556-8500

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