Charlie Munger (Trades, Portfolio), the legendary investor who shaped Warren Buffett (Trades, Portfolio)'s thinking to invest in high-quality companies, died at 99 a few weeks ago. Munger's demise has given rise to speculations about the inevitable passing of the Oracle of Omaha, who turned 93 last August. The guru's eventual departure from Berkshire Hathaway Inc. (BRK.A, Financial) (BKR.B) is a risk that needs to be assessed carefully as there is clear evidence of key person risk resulting from the bigger-than-life persona of Buffett. This discussion looks closely at Berkshire's succession plan, the expected changes in the company in the post-Buffett era and why Berkshire will thrive in the long term even without Buffett.
Changes are coming
When Buffett leaves Berkshire – for natural or personal reasons – the short-term market impact on its stock is guaranteed to be negative. In the long run, the market will – as Buffett has so often said – follow corporate earnings. Investors, therefore, need to focus on the long-term implications of this inevitable occurrence.
The first step is to look at the succession plan of Berkshire Hathaway. During the 2021 annual shareholder meeting, Munger – somewhat inadvertently – revealed the CEO of Berkshire Energy and vice chairman of Berkshire's non-insurance operations, Greg Abel, will take the helm from Buffett as the CEO of the company when Buffett is no more. A few months ago, Buffett applauded Abel, saying he understands capital allocation as much as Buffett himself does. Ajit Jain was also promoted to vice chairman of Berkshire in 2018, and he is currently involved in capital allocation decisions.
In Berkshire's 2022 annual report, it was officially confirmed that Abel will replace Buffett as CEO if the guru leaves the company immediately.
"If for any reason the services of our key personnel, particularly Mr. Buffett, were to become unavailable, there could be a material adverse effect on our operations. Should a replacement for Mr. Buffett be needed currently, Berkshire's Board of Directors has agreed that Mr. Abel should replace Mr. Buffett. The Board continually monitors this risk and could alter its current view regarding a replacement for Mr. Buffett in the future. We believe that the Board's succession plan, together with the outstanding managers running our numerous and highly diversified operating units helps to mitigate this risk."
In his most recent letter to shareholders, Buffett confirmed that any future CEO will have to tie up most of his or her wealth in Berkshire itself, which should ease the nerves of many investors.
"Our CEO will always be the Chief Risk Officer – a task it is irresponsible to delegate. Additionally, our future CEOs will have a significant part of their net worth in Berkshire shares, bought with their own money. And yes, our shareholders will continue to save and prosper by retaining earnings."
In addition to Abel and Jain, portfolio managers Todd Combs and Ted Weschler will help run the company's equity portfolio. The succession plan sounds reasonable as Berkshire is banking on executives who understand the company's culture to serve shareholders in the long run. However, this does not mean that Buffett's eventual departure will not lead to major changes.
First, Buffett, as CEO of the company, has vehemently denied the need to host quarterly earnings conference calls despite pressure from analysts and some investors. The guru, highlighting the importance of taking a long-term view of Berkshire's prospects, has avoided giving into the Wall Street pressure so far. In the post-Buffett era, this may become an easier battle for Wall Street to win with Buffett's bigger-than-life impact waning. For context, Buffett controls more than 30% of Berkshire's voting power with close to 99% of his personal wealth tied to the company, while Abel, at the end of the second quarter, owned a Berkshire stake valued at approximately $105 million, which represents a fraction of his estimated net worth of over $600 million.
Many analysts expect Berkshire executives to face intense pressure in the post-Buffett era to hold earnings calls and provide more transparency about investments, future plans and capital allocation decisions. With the absence of Buffett, many investors are also likely to ask for more transparency from the investment conglomerate before seeing quantifiable results of Buffett's successors adding value to shareholders.
Second, Berkshire Hathaway's trophy status as a company backed by arguably the best investor the world has seen will cease to exist beyond Buffett. Today, many investors religiously own the stock of Berkshire Hathaway to be part of a company managed by the legend. When the guru is no longer leading the company, Berkshire's appeal as a trophy investment will diminish, potentially leading to a valuation recheck in the market.
Third, Berkshire Hathaway will lose some of its edge when negotiating deal prices with target companies due to the absence of Buffett. Berkshire, time and again, has acquired controlling stakes in both public and private companies to grow its portfolio, and Buffett's presence more often than not has helped in negotiating favorable deal prices for the company. When the investment conglomerate loses this advantage, Berkshire may end up paying historically higher premiums to acquire target companies, thereby leaving an impact on investment returns.
Finally, under new leadership, Berkshire may focus more on returning excess capital to shareholders given that it is becoming increasingly difficult for the company to find deals that can truly add value to shareholders. This has a lot to do with the massive size of the company. When the new CEO takes over, he will have to find large enough deals that can move the needle for Berkshire, which is easier said than done. Failure to find such deals consistently – which is already proving to be the case – may force the new management to distribute wealth to shareholders in the form of buybacks.
Buffett's inevitable departure from Berkshire will result in several notable changes. However, as discussed in the next segment, the company seems well-positioned to thrive despite these changes.
Despite changes, Berkshire will thrive
There are several reasons to be positive about the post-Buffett outlook for Berkshire Hathaway.
First, Berkshire's railroad and energy businesses have become cash cows in the recent past, making capital allocation decisions easier for Buffett as these two business units continue to absorb large amounts of free cash flow and deploy them at attractive rates. BNSF, the railroad business, is headed by Kathryn Farmer, who joined the company more than 30 years ago as a management trainee. Berkshire Energy is headed by Scott Thon, who has been in the business for more than three decades. Because of the expertise brought to the table by these two executives, Berkshire's incoming CEO will have some breathing space when it comes to capital allocation decisions given the capital-consuming nature of these two businesses. More autonomy in capital allocation decisions means less probability of decision-making blunders. For long-term shareholders, this is a promising sign as Buffett's departure will not immediately affect major capital allocation decisions.
Second, Berkshire Hathaway has always placed a major emphasis on acquiring companies that fit well with its corporate culture which promotes entrepreneurship, and this will help the new managers focus more on new investments than managing the day-to-day business of the company.
Third, Berkshire's success as a massive conglomerate comes down to how Buffett has promoted a decentralized operating structure where the company employs a handful of people at its headquarters while allowing acquired companies to manage those businesses similarly to how they have done before the acquisition. This unique operating structure, which sets Berkshire apart from many other conglomerates, has enabled the company to focus entirely on capital allocation decisions. The incoming CEO after Buffett's departure, therefore, will only have to focus on the capital allocation part of the business, which is something Greg Abel and all the other key executives have been doing for many years now.
Takeaway
With Munger's passing, the inevitable future of Berkshire without Buffett has become a not-so-distant reality. A closer look at Berkshire's succession plan, corporate culture and operating strategy reveals the company is ready to thrive in the post-Buffett era. That said, investors will have to expect some major changes in the business when he is no longer running the company.
