In the 2014 Berkshire Hathaway Inc. (BRK.A, Financial) (BRK.B, Financial) shareholder letter, a 50th anniversary edition, Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) review the last 50 years and the next 50 years.
Buffett wrote an interesting review of conglomerates, which today generally have a bad reputation with investors. They typically suffer from a conglomerate discount to compensate for complexity, lack of transparency and potential management lack of focus. He explains why Berkshire’s structure has worked so well.
The era of conglomerates
In the late 1960s, the business world witnessed the height of conglomerate popularity. During this era, conglomerate CEOs adopted a rather simplistic strategy: they inflated their conglomerate's stock prices, often up to 20 times earnings, through a combination of charisma, promotional tactics and questionable accounting methods. Once the stock was soaring, they rapidly issued new shares to fund the acquisition of businesses trading at lower earnings multiples.
These acquisitions were then subjected to "pooling" accounting, artificially boosting per-share earnings without any substantive improvement in the acquired businesses. Wall Street, captivated by these financial manoeuvres, readily endorsed the strategy, often ignoring the gaping disparities between reported earnings and actual business performance.
Role of Wall Street and the media
Buffett highlighted how Wall Street's infatuation with these practices intensified as the 1960s progressed. Auditors turned a blind eye to accounting irregularities, and investment bankers reaped substantial fees from mergers generated by these tactics. However, the per-share earnings gains of conglomerates stemmed primarily from exploiting price-earnings differences, driving CEOs to acquire businesses with mediocre prospects.
The media played a crucial role in fanning the flames of this merger frenzy as well, celebrating conglomerates like ITT, Litton Industries, Gulf & Western and LTV, effectively turning their CEOs into celebrities. Nevertheless, the era of conglomerates eventually unravelled, akin to Napoleon meeting his Waterloo. It became clear these business models, based on serial share issuances at inflated prices, redistributed wealth but did not create it.
Berkshire Hathaway's approach
Buffett underscored his firm stance at both Buffett Partnership Ltd. and Berkshire Hathaway, never investing in companies bent on incessantly issuing shares, as such behavior often signals promotion-centric management, weak accounting practices, overpriced stock and sometimes outright dishonesty.
He delved into the allure of Berkshire Hathaway's conglomerate structure, emphasizing that when employed judiciously, it offers an ideal framework for long-term capital growth. Despite capitalism's general ability to allocate funds efficiently, obstacles often impede the rational movement of capital. CEOs with capital tied up in declining operations hesitate to redeploy it, fearing layoffs and admissions of mistakes.
Advantages of the Berkshire Hathaway model
In contrast, Buffett noted Berkshire Hathaway, with its conglomerate structure, boasts unique advantages. It can seamlessly allocate capital between businesses at minimal cost, unencumbered by industry biases or the pressures to maintain the status quo. Additionally, the company's ability to invest in common stocks provides diverse opportunities that often outshine those offered in full acquisitions.
Buffett elaborated on the strategic advantage of buying pieces of excellent businesses through common stocks. This approach sharpens decision-making, while gains from marketable securities have enabled Berkshire to undertake significant acquisitions that would have otherwise been financially challenging.
Capital allocation and buyouts
Moreover, Berkshire Hathaway's structure offers unparalleled opportunities and flexibility in capital allocation. It can swiftly shift funds between businesses, avoiding taxes and intermediation costs, and capitalize on opportunities beyond the reach of most companies. Although there are limitations to evaluating the economic prospects of some businesses, Berkshire's smaller limitation outweighs that of executives confined to a single industry.
Buffett juxtaposes Berkshire's appeal with the two common paths for business owners looking to sell completely. The first option, selling to a competitor, often leads to layoffs and discord among loyal employees. The second option involves selling to Wall Street buyers, formerly known as leveraged buyout firms but now rebranded as private equity.
Berkshire Hathaway as a preferred home
Buffett dispelled suggestions to spin off Berkshire's businesses, as they are more valuable as part of the conglomerate. Separating these entities would incur additional costs, particularly in governance and regulatory aspects. Additionally, certain tax advantages result from Berkshire owning multiple subsidiaries. Berkshire Hathaway Energy, for example, benefits from tax credits achievable due to the conglomerate's diverse income streams, providing a competitive edge in renewable energy projects.
Conclusion
In conclusion, Buffett's 2014 letter offers a retrospective on the rise and fall of conglomerates in the late 1960s, illustrating their pitfalls and the advantages of Berkshire Hathaway's conglomerate structure. It emphasizes Berkshire's commitment to efficient capital allocation, investment flexibility and providing a permanent home for outstanding businesses. This conglomerate model aligns with Berkshire's unwavering dedication to long-term capital growth and shareholder value.
