Warren Buffett has built Berkshire Hathaway, Inc. (NYSE: BRK.B) into one of the most recognizable companies in the world. Despite Berkshire’s phenomenal success, the company has risks for investors. These risks include who will run the company after Buffett is no longer at the helm, credit downgrade risk and the company being defined by government regulators as systemically important.
The Success of Berkshire
As of September 2015, Buffett has successfully built Berkshire into a market behemoth with a market cap of $326 billion. The large conglomerate is involved in a wide variety of businesses. The main core of the Berkshire empire is insurance. The company has lines in property, casualty and reinsurance. From this insurance base, Buffett has built Berkshire over the years with small and large acquisitions. The company has interests in everything from railroads to energy, cowboy boots and furniture.
Berkshire is still growing. Net revenues grew from $182 billion in 2013 to $194 billion in 2014, an increase of around 6.5%. Further acquisitions grow this revenue even more. Even though Berkshire is already large, it still has room to grow even larger.
Those who were brave enough to risk investing in Berkshire early on have profited handsomely. Berkshire Class A shares trade for around $192,000 a share, the highest-priced stock in the U.S. market. Buffett is not a believer in stock splits, saying he never split the stock because he does not want short-term speculators to try and profit on the stock. If the stock were cheaper, those speculators could jump in and out of positions. Still, smaller investors can afford the Class B shares that trade at around $129 a share.
Succession Plan for Berkshire
One of the main risks to Berkshire is the succession plan after Buffett is no longer with the company. Buffett is still going strong at 84, with 50 years at the helm of Berkshire. Still, he and his lieutenant Charlie Munger will not be around forever. To that extent, Buffett and Munger have discussed the succession plan in their famed letters to shareholders. Buffett plans to split the CEO position from the management of the large Berkshire portfolio.
The main question for investors is who might be the new CEO. Munger’s 2015 letter indicated Greg Abel and Ajit Jain are both world-class CEO material. Abel runs Berkshire’s utility and energy operations. Jain is the head of Berkshire’s vast insurance divisions. Jain is known as an underwriting genius who has earned the insurance operations billions over the years. Abel is younger and may be more used to being in the limelight. As such, he is more likely to take over.
Buffett has brought on two portfolio managers to help him with the company’s stock holdings, valued at around $109 billion. Ted Weschler and Todd Combs share responsibility for Berkshire’s vast portfolio. Weschler met Buffett by winning a charity auction for lunch with the Oracle of Omaha for $5 million. He previously ran the hedge fund Peninsula Capital Advisors. Buffett and Weschler became close after a few years. Buffett eventually extended an offer for Weschler to join Berkshire. Combs was also previously a hedge fund manager and joined Berkshire in 2010. Weschler and Combs have changed Buffett’s perspective to an extent. Buffett never invested in technology stocks until buying IBM shares in 2011, spending around $10 billion.
Berkshire is clearly considering the succession issue, which should allay some fears of investors. The larger question is whether the portfolio managers and the CEO will be able to match Buffett's performance. Buffett is undoubtedly a business genius on many different levels. The “Buffett premium” is a concept stating Buffett’s reputation and business acumen add value to Berkshire and the companies in which it invests. Only time will tell what happens with the Berkshire empire after Buffett and Munger are no longer there.
Credit Downgrade Risk
A more pressing issue is further credit downgrade risks to Berkshire’s debt. As of August 2015, S&P, the major credit rating agency, indicated it was placing Berkshire on the Credit Negative Watch list due to uncertainty about its acquisition of Precision Castparts Corp. Berkshire holds an AA investment-grade credit rating. The deal for Precisions Castparts, an aerospace and energy product manufacturer, is valued at $37 billion. Precision Castparts had net revenues of $10 billion in 2014.
S&P stated it has questions about how the transaction will be funded and how it will impact cash resources and leverage metrics at Berkshire. The agency has twice previously downgraded Berkshire. It downgraded the company in 2010 when Berkshire bought BNSF Railway, and then again in 2013, as it changed its standards for evaluating insurance companies. Still, Buffett is a conservative investor. As of 2015, the company has $66 billion in cash reserves. Although the Precision Castparts acquisition is large, it seems as if Berkshire has the resources to pull off the transaction.
Systemically Important Designation
Another risk is whether Berkshire will be defined by government regulators as systemically important. The Bank of England asked U.S. regulators why Berkshire was not on this list in 2015. This designation requires companies to submit to oversight by the Federal Reserve. It comes along with enhanced capital restrictions and liquidity requirements. These burdensome requirements could make future growth and profitability more difficult, and could hurt the company’s prospects.
Buffett has argued that Berkshire should not be slapped with this designation. He has indicated he is committed to keeping a $20 billion cash cushion at Berkshire. Another significant factor is Berkshire was able to stay strong during the 2008 financial crisis. The company provided short-term help and liquidity to other companies, including Goldman Sachs, General Electric and Harley Davidson, during the crisis. Thus, history has proven Berkshire’s ability to weather financial storms.
However, the government has placed the systemically important designation on other large insurance companies including AIG, Prudential and MetLife. Berkshire is undoubtedly one of the largest insurance companies in the world and has exposure to large catastrophic events. The Sept. 11 terrorist attacks and Hurricane Katrina cost Berkshire billions.
Berkshire is different from these other companies that operate mainly in the insurance sector. It is much more widely diversified in its businesses. The official standard is the company must have 85% or more of its consolidated assets coming from financial activities. Many of Berkshire’s recent acquisitions have come from outside of the financial realm. Thus, it is questionable whether Berkshire meets this requirement. Still, the threat of this designation is very real as it could hurt Berkshire’s future share price and ability to grow.
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