Is Berkshire Hathaway an outdated relic? Is it a 'sell' without Warren Buffett?

Warren Buffett, the world’s most famous investor, has received an unusual bit of advice from The Economist: sell off your businesses one by one. Buffett’s businesses are all grouped under Berkshire Hathaway - which is thus just a shell holding company. In other words, Berkshire is a conglomerate, and conglomerates everywhere trade at a discount to a sum-of-the-parts valuation of the underlying businesses. The reason why conglomerates trade at a discount is simple: each of the businesses controlled by it has different earnings potential, making it difficult to value the holding company itself. Most analysts prefer to invest in companies that they fancy - and not a pot pourri of mixed-fortune businesses. Hence the “conglomerate discount”. Buffett’s conglomerate is an oddball: it trades at a 40 percent premium to the book value of its corporate holdings. The Economist believes that this premium is unique because this value is brought by the expertise of Buffett himself. Remove him from the equation - at 83, he isn’t getting any younger - and the premium could crash. Hence the advice: start selling the businesses one by one, if not now, then by telling his successors to do so. However, this advice is based on the assumption that all value was created by Buffett himself, and not the value-picking methodology he perfected over the years. His methods are well known. He spots companies with solid brands, good and steady cash flows, and at prices that understate the real value of the business. Once he buys into a company, he allows management to get on with the job and does not interfere. He holds stock for the long term, and does not pay dividends, since this allows earnings to compound. Buffett’s USPs are thus clear: good stock picking skills and allowing earnings to compound over the long term. Now, this technique may not be unique any more - or, at least, it need not be. It can be perfected by anyone tutoring under Buffett, or anyone who has been observing how Buffett does it. Moreover, stock deals may not be available at the lucrative discounts that Buffett used to get them when he was the only fisherman in the value pond. Today the discounts are lower. The 40 percent premium on book value may be because of Buffett, since the markets are run by human beings, and humans tend to go as much by emotion as rational thinking. Put another way, the chances are the value of Berkshire Hathaway may be over-estimated because of the market’s romance with Buffett. This suggests that Berkshire Hathaway is a sell, Buffett or no Buffett. There is, moreover, another reason why The Economist’s advice to Buffett is worth challenging. When businesses diversify, the non-operative holding company structure is probably the best form of ownership structure, since each company has a separate balance-sheet, separate visibility on profits, and can be separately listed to discover market value. Take, for instance, a company like Reliance Industries. Currently it is a single-company conglomerate with several businesses under it - petrochemicals, refining, oil and gas exploration and production, retailing, telecom, etc. The ideal structure for Reliance would be to disaggregate its businesses, list them separately under a holding company, and then let the Reliance holding company discover its true value. As against a current book value of around Rs 556, the Reliance share was quoted (on 2 May) at around Rs 928 - for a market valuation of over Rs 3,00,000 crore. The price is 1.67 times the book value. But the company holds cash of Rs 88,190 crore. Exclude the cash, and the price-book value ratio will fall to just over 1.1. In other words, the market is valuing Reliance’s business just marginally above book value. The answer to Reliance’s undervaluation could be to disaggregate its various businesses, list then separately, and convert Reliance into a holding company. This could be a route to raising the conglomerate’s value - though there can be two opinions on this. Reliance can be a Berkshire Hathaway by making its underlying businesses more visible, not less. Coming back to Berkshire Hathaway, The Economist’s advice to disband the holding company needs questioning for the following reasons. First, if the shares are quoting at a premium to underlying value, and the additional value is brought by Warren Buffett, then selling off the underlying businesses - which are obviously overvalued - will not get Berkshire shareholders any additional value. If the value of company A is A-plus because of Buffett, selling company A will not realise value A-plus as Buffett is missing from the equation. Second, if you are going to be a conglomerate, Berkshire Hathaway is the best way to run one. Anyone, and not just Buffett, will know how various businesses are performing, and any one company that is earning less than the cost of capital can be put on the block. Companies earning less than others can be sold off too and the capital deployed elsewhere to raise returns. This capital allocation decision is not dependent on Buffett’s expertise alone, as calculating a business’s real return on capital is a simple formula that any financial analyst can apply. T__hird, Buffett may have unique stock-picking skills that cannot be replicated. But the market does not lack for good stock pickers. What cannot be replicated is Buffett’s reputation built over 50 years. And the reason for Buffett’s outperformance may be because he got into the game early when stocks were grossly undervalued. He could buy when no one wanted to, sell when no one wanted to. This is the reason for his outperformance - going against a herd that has had to mark its purchases to market every day. This means anyone investing just like Buffett can do better than the market if he buys at the right stock at the right time and at the right value. And hold it till the returns come. Moreover, it is not as if Buffett beat the markets all the time. His decision not to buy tech shares since he did not understand the business was sound, but that also left his company underperforming the market for many years. He needed a tech crash to redeem his reputation. More recently, he has also been investing in tech, and bought into IBM a few years back. The real takeout could be that Berkshire Hathaway is overvalued because the market may be assigning an iconic value to him rather than the company. It is not about the conglomerate holding structure at all. If the premium on Berkshire Hathaway is because of Buffett, it is time to sell the company, not its underlying holdings. (Disclosure: Firstbiz is published by Network18, whose promoters have received funding from the Reliance Group) PS: You can read The Economist article on Buffett here