Berkshire Hathaway’s Cash Fortress

Berkshire Hathaway’s Cash Fortress

As small and large businesses alike clamor for government bailouts, Berkshire Hathaway is sitting comfortably atop of a cash pile of US$ 128 billion. How would Berkshire Hathaway navigate the pandemic with the help of this enviable cash pile?

Berkshire Hathaway has long been the shining example of financial conservatism and what sets them apart is their perspective on cash. While most companies consider cash to be a safety net, Berkshire treats cash as ammunition that can be deployed opportunistically at times of financial distress to acquire companies at attractive price points.

During the near decade-long bull run following the financial crisis of 2008-09, Berkshire Hathaway built up a massive cash balance on their balance sheet while near-sighted managers took on cheap debt to finance acquisitions or to return capital to shareholders which left their balance sheets highly levered. This aggressive approach worked wonders for managers as they saw their stock prices rise and as a result their equity linked compensation. 

As during all bull market runs, many ‘experts’ were claiming that the business cycle was dead and that holding cash was analogous to an anchor weighting down return on equity. However, the business cycle proved to be far from dead and the COVID-19 pandemic pushed the economy into the worst recession since The Great Depression. Suddenly, all the leverage and risk taking seems unsustainable and numerous companies are on the cusp of bankruptcy.

It is important to note that Berkshire Hathaway will not come out of this pandemic unscathed. Their exposure to the US economy through their portfolio is broad based and it is inevitable that their equity position will see a significant decline in the near term. However, with a cash buffer of US$ 128 billion it is a foregone conclusion that the virus would not threaten the solvency of Berkshire Hathaway. 

Source: Berkshire Hathaway Annual Reports (2010 - 2019)
Note: Data visualization created using Tableau

So, the natural question that follows is how Berkshire Hathaway will deploy their cash to use. Has the economic situation deteriorated to such a level that they will keep the cash as a reserve, or will they strategically deploy their cash to snap companies at cheap prices?

Cash and Investments

To understand Berkshire’s cash strategy, it is important to understand their insurance business. Berkshire Hathaway pursues a unique strategy for managing their insurance liabilities. While most insurance companies engage in duration matching, i.e. invest in fixed income securities designed to match the duration of their expected liabilities, Berkshire pursues a much more flexible approach. They have maintained a large portfolio of cash and equity investments for decades while fixed income has shrunk in both absolute and percentage terms. 

In terms of size, cash has grown from US$ 38 billion in 2010 which was 29% of the overall portfolio to US$ 138 billion in 2019 which represents 41% of the portfolio. Equity has expanded from US$ 60 bn in 2010 (45% of the portfolio) to US$ 248 bn in 2019 (60% of the portfolio). Over the same time horizon, fixed income has declined from US$ 34 bn in 2010 (26% of the portfolio) to US$ 19 bn (5% of the portfolio).

As mentioned earlier Berkshire Hathaway is not immune to the impacts of the pandemic and it is important to note that Berkshire Hathaway equity investments have shrunk to US$180 billion by the end of the Q1 2020. However, the trend is clearly evident – Warren Buffett has preferred to invest in equity securities as opposed to fixed income securities which offer measly yields in current low interest regime. Also, he has allowed to cash to build up on the balance sheet despite the insignificant yields on cash.  

The reason for this strategy is explained by an excerpt from Berkshire Hathaway’s 2018 Annual Report:

“Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.

In the years ahead, we hope to move much of our excess liquidity into businesses that Berkshire will permanently own. The immediate prospects for that, however, are not good: Prices are sky-high for businesses possessing decent long-term prospects.”

-Berkshire Hathaway Annual Report 2018

Warren Buffett expressed his interest to deploy his excess liquidity to acquire new businesses in full. However, the financial environment of 2010’s rarely afforded the opportunity to takeover companies at attractive prices because most companies were overvalued during the decade long bull run. Therefore, Buffett chose to increase Berkshire’s holdings of marketable securities. This accounts for the massive increase in their equity portfolio in both absolute and percentage terms.

Float

An insurance company takes premiums from clients in exchange for covering future losses. Depending on the type of insurance, claims can arise soon after the payment of premiums or not for decades into the future. Insurance companies attempt to make money on their underwriting but often fail to do so. An underwriting profit is achieved if the premiums collected exceed the claims. However, even if an insurance company fails to make money on the underwriting, they can achieve overall profitability by investing the ‘float’ they hold between the time the premiums are collected to the time the claims are paid.

Berkshire’s growth over the years has been fueled by the growth in float coupled with the management’s ability to achieve underwriting profits. Over the last seventeen years, Berkshire has achieved underwriting profitability sixteen times. In addition to achieving underwriting profits, the float has been available for reinvestment in order to earn additional returns.

 

Source: Berkshire Hathaway Annual Reports (2010 - 2019)
Note: Data visualization created using Tableau

The stable float has allowed Berkshire to invest shrewdly and venture beyond fixed income securities that most insurers invest in. The table below shows Berkshire’s float to its investment portfolio:

Source: Berkshire Hathaway Annual Reports (2010 - 2019)
Note: Data visualization created using Tableau

What the data set shows is that Berkshire seems to maintain cash plus fixed income securities at a level that approximately equals the float.

Deployable Cash

The key question is how much of Berkshire’s US$ 128 billion is truly deployable? This is a key question because the answer will determine the valuation of Berkshire Hathaway. If the cash pile is considered as an alternative to fixed income securities that is maintained due to the rock bottom interest rates, then there is not significant value that can be created. However, if the cash pile is considered as ammunition for Buffett to make valuable investments then there is an opportunity for significant incremental value creation.

Having read the annual reports, it is clear that Berkshire wants to deploy the cash for opportunistic investments and that it does not treat the cash as a temporary holding that will be invested into fixed income when the interest rates normalize. During the 2008-09 financial crisis, Berkshire invested aggressively in General Electric Co., Goldman Sachs Group Inc and bought Burlington Northern Santa Fe Corp. outright.

However, this time the situation is different. We are dealing with not just a financial recession but with a health crisis where people’s lives are at risk. I believe this time Berkshire will err on the side of caution and will be primarily focused on coming out the other side of the crisis with excess liquidity. In the past Berkshire has brokered excellent deals with companies that were in desperate need of capital. For example, in 2011, Berkshire bought US$ 5 billion in preference shares of Bank of America yielding 8% (thereby capping the minimum return at 8%) and bought warrants to purchase 700 million shares of common stock. It would be conceivable that Berkshire Hathaway will strike similar such deals but only once the pandemic is brought under control and the long-term impacts on business operations have fully been analyzed and digested.

The lack of attractive deals could also be due to the massive rescue packages passed by the US Congress and the Fed’s actions to inject additional liquidity into the overall financial system and into specific industries and companies that are in dire financial straits. Berkshire may have excess cash but no executives will turn to them for help when the government is rolling out cheap capital and providing safety to short-sighted managers.

Conclusion

We are currently in the midst of the most severe economic downturn since the Great Depression and Berkshire Hathaway may very well find attractive investments at favorable entry prices that offer reasonable margin of safety and the potential for attractive returns. This type of environment would normally offer numerous opportunities, but we cannot completely ignore the fact that both the pandemic and the government’s response is unprecedented.  Given Berkshire Hathaway’s penchant for caution it is reasonable to assume that they would want more clarity before deploying their massive cash pile.