The Berkshire Success Recipe: Concentrated Portfolio With Diversified Operations

• Berkshire has managed to find a balance between a diversified business and an alpha-rich portfolio.
• The company’s efficiency is reflected in its low risk, which also limits growth.
• Insurance and energy freight are its key businesses with high barriers to entry.
• Management may refrain from growing the portfolio, and move into a liquidation and return strategy.
• Buffet’s replacement is advertised as continuing at a stable pace, even if so, performance may not be replicated.

As we discuss Berkshire, it becomes apparent that it is a non-tech equivalent to the mag-7 companies. The company’s portfolio consists of many, well-managed businesses that lend support to each other's operations. The management team operates simple, yet strong businesses, each having a well-defined model and core competence. 

Many of Buffet’s operating stakes are mature companies that are market leaders within their segments. However, excluding the energy business, they have limited avenues for growth acceleration.

In the analysis below, I will discuss Berkshire as a portfolio manager, as well as their operating businesses. Finally, I will estimate the value of the company.

The analysis's primary sources are the latest Q2’24 report and its press release.

The Equity Portfolio Is Preparing To Deploy New Capital

In the last five years, we can notice a subtle shift in BRK from a company that buys stakes of other firms, as well as its own stock, to a company that is more frequently starting to sell and capitalize on assets.

During this period, the maximum quarterly buyback was close to $9B, while the company hit the lowest point of $345M just this quarter. This isn’t to point out financial weakness, but rather, a change in approach from equity assets to liquid assets. Investors may be wondering why is  management shifting to generating returns from cash equivalents? In my view, while cash may not deliver a large return, in uncertain times it is the only asset that retains and increases in value from short-term fixed instruments. 

Looking at the latest (Q2’24) balance sheet, this seems to be exactly what management is doing: reducing risk, while maximizing short-term cash returns. The company holds more than $224B in cash equivalents, composed mostly of (short-term) U.S. Treasury bills.

Berkshire’s recent cash & investments balance

The total portfolio value of BRK is around $518B, with equity securities reduced from $346B to $276B YoY. This is partly what indicates the change of direction to stable assets. 

Below, we see a breakdown of the company’s equity assets by category:

Berkshire’s value of equity investments

Most of the equity portfolio continues to be concentrated around Apple (29.9%), Bank of America (14.4%), American Express (12.3%), The Coca-Cola Company (9%), and Chevron (6.5%). Notably, in the last 6 months, BRK sold $97.1B worth of assets, significantly more than the $28.5B sold in 2023.

Buffet views the potential loosening of interest rates as a headwind to BRK’s portfolio, for which he thinks that hedging with the cash position will be protective to his investors. This may sound counterintuitive to the narrative of loosening rates in order to support equity valuations, however the reasoning behind this is that loosening rates in this scenario would be a result of an economic downturn. Companies with a large balance sheet will benefit from lower refinancing rates of their debt, however a weaker consumer will reduce overall sales and the net result would hypothetically be a negative economic impact with falling asset prices.

Should this scenario occur, BRK’s management will have a large opportunity to use their cash position to acquire beaten-down companies. An economic reset like this benefits cash holders and gives them opportunities to buy assets on the cheap. However, there have been many economic doom forecasters, and the U.S. economy, along with the U.S. consumer have shown incredible resilience. In this case, BRK will have still taken advantage of high rates on cash, and will be able to redeploy that cash to new opportunities.

To summarize, it seems that BRK has positioned itself defensively against potential economic headwinds, and is likely to come out ahead in the coming years.

Note that this is an unconventional position at the moment as many portfolios are still long, especially long on tech.

Berkshire’s Operating Businesses Providing Heaps Of Cashflows But Low Growth  

Besides asset management, Berkshire also produces revenues of $370B, that have grown at a CAGR of 7.7% over the past 10 years. The company also has a healthy bottom line with a net profit margin of 18.3%, yielding $67.9B. 

Berkshire’s 10-year historical TTM revenue and net income

Looking at the bottom-line, we can see that profits exhibit some degree of cyclicality, which is why I will opt to analyze the company on an average earnings basis over the trailing 3 years. This seems to be a good way to capture profit cyclicality, and a better measure of the kind of earnings growth investors can expect in the future. 

The 3-year average net income for the company comes up at $55.5B. This will be the basis for my future estimates.

The company operates a multitude of segments, where the biggest continues to be insurance, bringing in a total of $26B in revenue last quarter. 

GEICO is the largest insurance branch and produces a 17% operating margin with $1.79B in EBIT. The branch primarily underwrites private passenger auto insurance.

We can see the revenue breakdown of Berkshire's segments in the table below:

Berkshire’s Q2’24 segment revenue breakdown

The other segments are a combination of coal, natural gas, utility, and transportation companies.

• BNSF: operates one of the largest railroad systems in North America. The revenues from this segment contribute 6% to the total and are stable with little room for expansion. The majority of revenue comes from shipping services, including: consumer, industrial, agricultural products, and coal. Their quarterly net earnings of $1.23B are likewise not expected to fluctuate too much in the future.
• BHE: mainly operates natural gas pipelines and holds a 75% interest in a liquefied natural gas (LNG) business. The net margin for the business is 13%, down from 16% YoY. This is a regulated business, which means that the margins can’t move much higher than historical levels. However, the company can still increase the absolute value of net income by reinvesting and expanding the infrastructure.
• Pilot: operates travel centers, fuel wholesale, and fuel-only retail locations. Berkshire recently gained full control of the company, and the business isn’t in its best shape, with revenue declining 12%, most of which was attributable to declining fuel prices after 2023. The business is exposed to broad economic activity in the U.S. which is why I expect a re-acceleration once growth picks up after the current tightened economy.
• McLane: is a wholesale distribution of grocery and non-food products to retailers and restaurants. Sales declined some 3.3% YoY due to lower volume, primarily in the restaurant business. This is a high-turnover, low-profit business and I don’t expect it to generate more than a fairly low return on capital - around 7%.
• Manufacturing: Berkshire owns a cluster of these businesses that produce industrial, building, and consumer products. The segment grew 3.9%, and has a 15% pre-tax margin. Industrial products are leading the profit contribution with a 17.9% margin and a 47% revenue contribution in the segment. In my view, this segment is diversified, stable, and has the potential to keep growing.
• Services: include aviation services from NetJets and FlightSafety, TTI - electronic components distribution, IPS - construction management services. The company also owns the fast food chain Dairy Queen, a lease transportation business XTRA, furniture business CORT, petrol logistics with Charter Brokerage, media with Business Wire, and a TV station in Miami WPLG.
• Retailing: primarily consists of BHA (Berkshire Hathaway Automotive) with 69% of the total revenue contribution. The business owns 80 auto dealerships, selling new and pre-owned automobiles. The service, retailing, and McLane fundamentals are broken down in the table below:

Berkshire’s Q2’24 service revenue & pre-tax earnings breakdown

The combined 3 segments declined 2.7%, with the services business exhibiting the strongest resilience and largest margin at 12%. 

We can see that Berkshire operates a diversified set of non-tech companies, which limits their competition with the tech sector and allows them to focus on their traditional business foundations. 

Part of the companies like Pilot are not operating as well as they used to. This is somewhat an effect of the overall economic activity, but also connected to the firm itself. The upside from buying a sub-optimal business is that you can get it on the cheap, and create value by improving operations. Conversely, the downside is that you have to be right, and not buy into a business that is in a decline beyond their control. Arguably, we can see Pilot as being a potential success story with this approach as freight still needs a strong physical network to function, and an example where the company struggled with this decision is buying the stake in Kraft Heinz, where consumer preferences for organic/trendy food have meaningfully changed their shopping behavior.

Assumptions:

• I expect the portfolio management team to start deploying the accumulated liquid assets to buy undervalued companies that may be impacted by a harsh economic environment. This will give them the opportunity to create value by restructuring capital in badly managed businesses. The concentrated portfolio approach may work better with mid/small cap stocks, as opposed to holding a concentration of large caps. I suspect that management feels that they need to be more diversified when holding large caps, which is what they are trying to avoid, and will move back to targeting ownership of small/mid-cap stocks. A concentrated portfolio approach may need smaller companies in order to minimize market beta exposure and allow for high future growth opportunities. In a way this is what BRK initially did with Apple and reducing their exposure is consistent with their alpha strategy.
• While I expect Berkshire to rebalance their portfolio with $10B to $100B companies, they are using diversification in their operating business. This strategy allows the business ecosystem to support each other’s operations and not get in the way of market expansion.
• To summarize, the two points before: BRK will revert to employing a concentration strategy in their equity portfolio, and diversification across their operating business segments.
• Regarding their operating segments, I expect that while diversification has minimized the exposure to risk, it has also capped the growth of Berkshire to the growth of the economy. Even though management is experimenting to modernize with stakes in high-growth companies like Nu Holdings, they are too small of a stake to contribute significantly to growth.
• Revenue: Because of this, I expect the total revenue CAGR to be 3.6% through 2029. The resulting revenue comes up to $441.7B in 2029. This would be some 19% higher than the current $370.1B.
• Profitability: With the exception of some of the newer acquisitions like Pilot, I assume that Berkshire is running a very effective business, resulting in limited opportunity for margin expansion. Given the cyclicality of the bottom line, my average profit expectation revolves around 15%, which results in a net income of $66B in 2029.
• Earnings Multiple: I assume that Berkshire can deliver a combined return (growth + capital appreciation + buybacks) of 6% annually. Given that the company is stable and mature I can use a single-stage model to translate the expected 6% return into a PE of 16.7x (1/0.06). This is why my 2029 PE for the company is 16.7x, higher than the current 14.5x.
• Buybacks: I estimate that Berkshire will strike a balanced return to shareholders by returning half of the accumulated cash via buybacks and deploying the other half into acquisitions. I expect the company to re-accelerate buybacks in the coming years and reduce its share count by 1.2% annually. In the next five years, I expect Berkshire to reduce its share count to 1.357M shares.

Risks

• Repeating past investment success: to the extent that the past investment approach truly relied on a method, it is possible that management can repeat their success in the future. However, to the extent that it relied on the unique set of individuals that are Buffett and Munger, then we may need to reassess how the BRK portfolio may perform in the future.
• Size constraints: The larger the Berkshire portfolio becomes, the more it will inevitably be exposed to market beta, and be impacted by general market forces. This will remove management's ability to improve performance as the portfolio becomes more dependent on the economy and government policies. I would also not be surprised if management decides to stop focusing on growing the company and move to delivering returns via price appreciation.
• Change in management: Greg Abel is named as the likely successor to Warren Buffett. While he formally holds a high degree of power by running all non-insurance operations in the company, Mr. Buffet is still directing the main course of the company. It is unclear how a potential succession will translate for shareholders, hence the higher degree of caution some investors hold for extrapolating past successes from the Berkshire portfolio.
• Insurance business risk: In my opinion, the insurance industry is a high barrier to entry business propped up by regulatory inflation. This leads to a smaller competitor base and excess returns. However, should a government happen to remove some of the barriers to entry in the business, we will see the erosion of excess returns from this business. 
• Energy business risk: Berkshire has exposure in the production and distribution from traditional energy sources such as oil & gas. This makes the company sensitive to energy prices and government approaches towards these sources. Thus far, in the U.S. and EU, traditional energy has been heavily discouraged.

Valuation

Using my 2029 PE of 16.7x and a normalized net income of $66B, my forward value for Berkshire comes up to $1.1T.

Discounting back to today using a required return of 6%, I get a present value of $822B for the company. For BRK.A shareholders this results in a $606K value per share, and for BRK.B shareholders this results in a $407 value per share.