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Monday, March 1, 2010

Ahead for Berkshire Hathaway: Utility-Like Returns?

Warren Buffett's 2009 Annual Letter
Investors who expect Berkshire Hathaway's future performance to match its historic returns are guaranteed to be disappointed.

So who is the author of the above quote (paraphrase actually)?

Some money manager or securities analyst trying to making their "bones" with a rare "sell" call on Berkshire Hathaway? (Full disclosure: Berkshire is the ultimate parent company of Edina Realty, which I suppose would make Buffett my boss if I weren't an independent contractor).

A competitor, perhaps?

Try Buffett himself.

Blunting the sting at least a little bit: Buffett makes the same warning every year, noting that "the law of large numbers" -- which certainly applies to multi-hundred billion behemoths like Berkshire Hathaway -- makes it increasingly difficult to rack up market-beating performance, year after year.

Different this Time

And yet, careful readers of Buffett's letters through the years will discern a true watershed in this year's annual letter:

Berkshire Hathaway is slowing turning itself into a utility.

As such, its returns going forward are sure to be more utility-like: stable and solid, to be sure, but lower -- and subject to government approval (sufferance?)

Again, the words come straight from the . . . er, horse's mouth:

Permitting and construction periods for generation and major transmission facilities stretch way out, so it is incumbent on us to be far-sighted. We, in turn, look to our utilities’ regulators (acting on behalf of our customers) to allow us an appropriate return on the huge amounts of capital we must deploy to meet future needs. We shouldn’t expect our regulators to live up to their end of the bargain unless we live up to ours.

--Warren Buffet, 2009 Annual Letter to Shareholders

In fact, the following passage clearly seems addressed not to shareholders, but to Berkshire's regulators, who increasingly hold sway over the company's future performance:

With few exceptions, our regulators have promptly allowed us to earn a fair return on the ever increasing sums of capital we must invest. Going forward, we will do whatever it takes to serve our territories in the manner they expect. We believe that, in turn, we will be allowed the return we deserve on the funds we invest.

--Warren Buffett

So what is the template for future Berkshire investments and acquisitions?

More companies like capital-intensive -- and regulated utility -- Burlington Northern Santa Fe.

"Ever Increasing Sums of Capital"

As Buffett acknowledges, this historic shift to capital-intensive, regulated industries (albeit monopolies, to be sure) is a function of decades of compounding returns at 20%-plus. No doubt more corporations wish they had this problem.

Yet it violates one of Buffett's two heretofore cardinal investing maxims: 1) only invest in businesses you understand; and 2) avoid capital-intensive businesses.

The reason to avoid capital-intensive businesses is that they act like an anchor on investment returns; even Buffett acknowledges as much:
The best businesses by far for owners continue to be those that have high returns on capital and that require little incremental investment to grow.

That's still good advice for investors -- advice they eschew at the expense of their future returns.

Heir Apparent

The other under remarked tidbit in this year's annual letter is that Buffett clearly has anointed a successor: David Sokol, the co-head of Berkshire's Mid-American Energy subsidiary.

Sokol has been temporarily dispatched to stop the hemorrhaging at subsidiary NetJets, an aviation operation that offers fractional ownership of jets.

This represents a signal departure for Buffett, who famously leaves incumbent management alone.

Sokol's "special assignment" is a tacit nod that he's being groomed for more and bigger assignments prospectively. And who knows their way around regulated utilities -- the parent company's future -- better than the guy who successfully shepherded Mid-American for 15 years?

Lastly, no Warren Buffett letter is complete without one great, homespun quote.

Here is my candidate for this year's:

"Sing a country song in reverse, and you will quickly recover your car, house, and wife."

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