Porter Stansberry's open letter to Berkshire Hathaway's board of directors; Doug Kass' response and my thoughts

On Monday, my friend Porter Stansberry – the founder of Stansberry Research and currently a board member of our parent company, Marketwise (MKTW) – published An Open Letter To The Board Of Directors Of Berkshire Hathaway.

In it, he excoriated former CEO Warren Buffett for taking Berkshire Hathaway (BRK-B) in the wrong direction over the past 25 years.

Porter says that Berkshire was once "the greatest compounding machine the world has ever seen," writing:

Berkshire owns some of the world's best insurance companies. For decades it compounded its equity at more than 20% a year through underwriting profits – by growing its "float" consistently and by investing that float and all of its earnings into the world's best businesses, such as American Express (AXP), Coca-Cola (KO), and Apple (AAPL).

Almost as impressive, it long avoided the "conglomerate trap" – it didn't buy many whole businesses, whose operations it would have to fund with its own precious cash. And it owned no businesses that Warren Buffett couldn't fully handicap.

However, as he continues, things changed starting in 2000:

But, beginning in 2000 – and perhaps because of Buffett's age – Berkshire regrettably abandoned that discipline. It has since invested hundreds of billions of its hard-won cash into many businesses that no one can handicap.

Worse, it has repeatedly bought whole businesses with very average economics, even when partial stakes of excellent businesses were readily available on the public markets, perhaps because of a mistaken belief that the resulting tax efficiency would prove more valuable than simply buying the better business. (Analysis to follow.)

Berkshire has now become what Buffett mocked for decades: a conglomerate built for the ego of its management team, not for the benefit of its shareholders.

Porter then gives seven examples of companies Buffett bought outright, when instead he should've just purchased shares of the best publicly traded companies at the time:

1. See's Candies (1972, $25 million) vs. The Hershey Company (HSY)...
2. Nebraska Furniture Mart (1983, $60 million) vs. The Home Depot (HD)...
3. Dairy Queen (1998, $585 million) vs. McDonald's (MCD)...
4. NetJets (1998, cumulative capital about $18.7 billion) vs. General Dynamics (GD)/Gulfstream...
5. Clayton Homes (2003, $1.7 billion) vs. NVR (NVR)...
6. BNSF Railway (2009-2010, $34.5 billion equity value) vs. basket of public railroads (Union Pacific, CSX, Norfolk Southern)...
7. Berkshire Hathaway Energy (cumulative heavy investment since 2000) vs. ExxonMobil (XOM)

He summarizes:

On a capital-weighted basis, these decisions have cost Berkshire's investors almost $1 trillion...

Berkshire is just another poorly run conglomerate.

To "save the shareholders," Porter calls on the board to restructure the company:

... to realize the enormous value of its insurance companies and its investment portfolio. It is urgent that this occurs before the huge risks in the other businesses overwhelm the entire company. My proposed restructuring would unlock approximately $300 billion in enterprise value and re-rate the core business to a premium multiple.

Specifically, he writes that:

Berkshire should be restructured into five different businesses, organized around industries and optimal capital structure:

1. New Berkshire Hathaway SpinCo. (Insurance + Equities Portfolio) – about $600 billion. Retain $100 billion cash for catastrophic reserves. Freed of litigation risk and hundreds of billions in subpar businesses, this pure-play insurance compounder will command a 20x earnings multiple.
2. BNSF Railway SpinCo. – about $160 billion. Leverage appropriately, pay a regular dividend. Force the management team to compete on merit without the "Santa Claus" parent company.
3. Berkshire Hathaway Energy SpinCo. – about $50 billion. Public-utility investors will price the dividend yield and isolate wildfire risk. This must happen now.
4. Heavy Manufacturing SpinCo. (Precision Castparts et al.) – about $75 billion. Again, these businesses should be funded by debt and they should pay investors a dividend.
5. Consumer & Retail SpinCo. (See's Candies, Dairy Queen, Nebraska Furniture Mart, Clayton Homes, NetJets, Pilot Flying J) – about $110 billion. Brand-centric, consumer growth company. Freed to allocate capital into growth opportunities, this could become a rival to consumer products giant Procter & Gamble (PG).
6. Liquidate these laggards: Kraft Heinz (KHC) stake, Shaw, etc. – about $15 billion immediate cash.

Porter concludes:

This restructuring would unlock a huge amount of value and allow Berkshire's managers to unshackle themselves from what they've complained about for decades: too much capital.

After prudent reserves, $273 billion in excess cash would remain. Berkshire could immediately issue a $250 billion special dividend.

Hoarding that much capital inside a 10% [return-on-equity] conglomerate is management malpractice.

The board must take action.

I recognize that I have a bias here – other than my parents, there's no one I respect more than Buffett, who has been a mentor to me for more than a quarter century.

So, for another perspective, I turned to my friend Doug Kass of Seabreeze Partners...

Doug is a longtime admirer of Buffett, but also a longtime skeptic of the stock – so much so that Buffett invited him on stage at the 2013 annual meeting to ask tough questions (here is a 26-minute video).

Doug has long believed that "Berkshire Hathaway is too big to materially outperform overall U.S. corporate profits and too big to significantly outperform the S&P Index."

Here are his thoughts on Porter's proposal to restructure Berkshire:

Buffett has intentionally assembled an S&P 500-like suite of companies with a fortress balance sheet with nearly $400 billion of cash. I have thought, by design, that his moves over the last decade were more aimed at diversifying the product/company lineups that would resemble the U.S. economy or, to some degree, the S&P 500.

So, the last thing Buffett would do is split the company and expose shareholders in each spinoff to such non-diversified sector/industry exposure. He is content to mimic the global economy (on the top line and bottom lines).

Regarding Porter's analysis, Doug writes:

His analysis gives no credit to Berkshire's value/capital build of its investment portfolio, most notably the $60-plus billion gain in the Apple investment.

Also, Porter compares the actual acquisitions made in the last few decades vs. buying "best of class." Of course comparing Nebraska Furniture Mart to Home Depot or See's to Hershey will look bad for Berkshire. But to paraphrase Warren, "investment vision is always 20/20 when viewed in the rear-view mirror!"

Doug concludes:

Berkshire's biggest problem is not its structure, but its size.

Over the last few years, Warren has admitted that his success and Berkshire's size are the largest headwinds that the company faces.

Bottom line: The salad days in which Berkshire outperforms the S&P 500 and other diversified companies is likely over.

It has been built with that objective in mind.

To which Porter replied:

1. My analysis recognizes that without Apple, Berkshire would have been a disaster for the last decade.
2. My public company analog analysis is unambiguous and correct: Buying the clearly superior public company provides orders of magnitude better results. Plus no management required. Real lesson: Great businesses are worth paying up for, as long as you never sell.
3. Doug's reply ignores Buffett's horrendous post-global-financial-crisis investment record, including massive losses at Berkshire Hathaway Energy, Precision Castparts, and Kraft, and very mediocre results at IBM (IBM), Burlington Northern, and Bank of America (BAC). Objectively, the entire private-equity (buying wholly owned companies) experiment at Berkshire has been a disaster since 1999.
4. Doug may be right that Buffett "is content to mimic the global economy," but I think anyone who believes that the goal of any business should be to underperform the S&P is moronic. That's exactly why Berkshire must be (and will be) broken up.

Thank you, Porter and Doug, for sharing your thoughts! Here are mine...

While some of Porter's analysis benefits from 20/20 hindsight, he's undoubtedly correct that the company would be more valuable today had Buffett continued allocating the cash Berkshire generates from its insurance float and operations into buying minority stakes in publicly traded, world-class companies – like current holdings Apple, Coca-Cola, American Express, Moody's (MCO), Alphabet (GOOGL), Visa (V), Japanese trading houses, etc. – rather than wholly owned businesses.

I think this shift occurred primarily not for tax reasons, but due to Buffett's frustration with poor management and poor capital allocation by public companies he didn't control.

And Doug is correct that Buffett, whether deliberately or not, has built a diversified conglomerate whose stock performance has almost exactly matched the S&P 500 since the market bottomed during the global financial crisis on March 6, 2009.

You can see this in the 17-year performance chart below:

Their performance has also matched over the past 10 years:

Meanwhile, in the past one-year and three-year time frames, Berkshire's stock has trailed the market.

The stock's long-term performance is consistent with what I've been saying for years: Investors in Berkshire should have modest expectations and view it mainly as a proxy for the S&P 500.

As longtime readers know, when it comes to bigger upside in Berkshire's stock, I usually think that the best time to buy is when the stock is trading at a 10% or greater discount to intrinsic value.

As for whether new CEO Greg Abel and the board should break up Berkshire to unlock value and return it to its pre-2009 glory as a stock that consistently outperforms the market (as Porter recommends)... I think it's an interesting thought experiment – but that's all.

With a dual-class share structure and a handpicked board, Buffett has ensured that his "masterpiece" will continue in its current form for years, likely decades, to come. So nobody should buy the stock hoping for a quick pop from Berkshire adopting Porter's plan.

I'm optimistic about Berkshire's future under Abel's leadership. He might manage the business a little better, find good places to invest the $373 billion cash hoard Buffett left him, and start to pay a dividend.

But I'd guess that the stock will continue to closely track the S&P 500, with occasional opportunities for clever investors to buy it at a discount and earn a market-beating return.

This isn't a bad outcome, given that most stocks, funds, investment managers, and individual investors badly trail the S&P 500 over time.

One of the first things I did when I took over as editor of Stansberry's Investment Advisory was add Berkshire to our model portfolio. The stock is up more than 35% since then – a market-beating return in a little more than two years.

We've included Berkshire among the "World's Best Business" collection of our model portfolio – which includes stalwart insurance stocks like W.R. Berkely (WRB), American Financial (AFG), Travelers (TRV), and more.

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Best regards,

Whitney

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