Last Friday, Warren Buffett asked for a volunteer to be the bear on his panel of analysts at the upcoming Berkshire Hathaway Inc. (NYSE:BRK.B) annual meeting. If Mr. Buffett is still looking, I’ll happily volunteer to be the standard bearer for bearish sentiment.
I’m not crazy enough to short Berkshire Hathaway’s stock, as I don’t think there’s much room for it to fall given the company’s financial strength and reasonable valuation. Still, I’ve been sour on its prospects to outperform for years — even publicly dueling as a Berkshire bear as far back as 2007. Indeed, the case for being a Berkshire bear is in many ways stronger today than it was back then.
Size still matters
The biggest issue facing the company from an outperformance perspective is that today’s Berkshire Hathaway Inc. (NYSE:BRK.B) is even larger than the company was six years ago. Size matters in investing, and not always in a good way. To quote Buffett himself:
Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.
With a market capitalization of over $252 billion, Berkshire Hathaway Inc. (NYSE:BRK.B) is gigantic. For it to grow faster than the overall market, it needs to not only deliver everything it has been delivering, but also add a substantial amount of new incremental value, as well. If you assume the market will deliver around a 10% annualized return — not far off from its long-run trends — that means Berkshire must grow by an astounding $25 billion just to keep pace.
Whence the growth?
Yet when you look at Berkshire’s operations over the past few years, they’ve shown solid results — but hardly spectacular growth. Pulling from its recently published annual report:
|Cash From Operations||$20,950||$20,476||$17,895|
|Free Cash Flow||$11,175||$12,285||$11,915|
The company still pulls in substantial amounts of cash, but its capital expenditures have risen faster than its operating cash. As a result, the company’s free cash flow has hardly budged in the past few years and is actually below 2010 levels. Berkshire’s purchase of the Burlington Northern Santa Fe railroad likely has a lot to do with that. Railroads are notoriously capital intensive businesses, and Berkshire now has to keep investing in that infrastructure just to keep its existing trains moving.
There’s nothing wrong with capital intensive businesses, but the money that is tied up just to keep those operations steady is money that can’t otherwise be used to grow the company or invest elsewhere.