From the beginning of time, there has been a yearning urge by humans to discover the secrets of success. The kind of success which enables a textile company to become a conglomerate called 'Berkshire Hathaway'. Surprisingly, it has been noticed that this "glorified firm" has not been doing as well as expected in recent times. This essay tries to look into the cause of this declining trend.
This essay will be divided into 5 sections; Section 1 will look into the Background of Berkshire Hathaway Inc. Section two tries to describe and analyze the performance of Berkshire Hathaway over time. In section three, Berkshire is compared with S&P 500. The fourth section deals with the analysis of Berkshire's performance using CAPM. Coming at the end after all others is the conclusion.
BACKGROUND OF BERKSHIRE HATHAWAY
Berkshire Hathaway traces its roots to a textile manufacturing company established by Oliver Chace in 1839 as the Valley Falls Company in Valley Falls, Rhode Island. In 1929 the Valley Falls Company merged with the Berkshire Cotton Manufacturing Company established in 1889, in Adams, Massachusetts. The combined company was known as Berkshire Fine Spinning Associates.
In 1955 Berkshire Fine Spinning Associates merged with the Hathaway Manufacturing Company which was founded in 1888 in New Bedford, Massachusetts by Horatio Hathaway. After the merger Berkshire Hathaway had 15 plants employing over 12,000 workers with over $120 million in revenue and was headquartered in New Bedford, Massachusetts. In 1962, Warren Buffett began buying stock in Berkshire Hathaway. He bought up enough shares to change the management and soon controlled the company. Buffett initially maintained Berkshire's core business of textiles, but by 1967, he was expanding into the insurance industry and other investments. As at November 2009, Berkshire Hathaway has a market capital of $160,198,776,500.
Berkshire Hathaway Inc. is a holding company owning subsidiaries in a variety of business sectors. The Company's principal operations are insurance business conducted nationwide on a primary basis and worldwide on a reinsurance basis. Berkshire has other operations which include aviation training, The Buffalo News, and retail furniture businesses, as well as shoe, candy, and rug manufacturing.
The long-term economic goal of Berkshire is to maximize its average annual rate of gain in intrinsic business value on a per-share basis. The preference would be to reach the goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. One of Berkshire's strategies is "value investing". Warren Buffett argued that the essence of value investing is buying stocks at less than their intrinsic value. Warren Buffet describes value investing as "finding an outstanding company at a sensible price" rather than generic companies at a bargain price.
DESCRIPTION AND ANALYSIS OF BERKSHIRE HATHAWAY'S PERFORMANCE
The performance of Berkshire Hathaway's stocks has been extraordinary. From 1965 to 2008, a share unit of Berkshire Hathaway has yielded an average return (mean) of 21.35%. Berkshire typically earns about half of its revenue from its insurance businesses. Berkshire has never spilt its shares since inception till date; this reflects its high performance.
Berkshire's portfolio is made up of is made of highly diversified stocks which implies lower level of risk (volatility).Berkshire's portfolio ranges from a furniture industry to financial services to energy industry, the list goes on.
Also, Berkshire is a pure long-term capital gain stock. Instead of giving part of the earnings back to the shareholders, which are taxed twice, the company reinvests all earnings (Robert M.P, 2001 pg101), this explains why Berkshire has a large Buy and Hold return of 362498.60% from 1965 to 2008.
Berkshire had only two years of negative returns in forty four years, and these can be attributed to economic catastrophe in 2001 and the 2008 economic crisis.
Another reason for Berkshire Hathaway's high returns is that it pays a minimal amount to corporate management unlike some other big corporations of its status.
The CEO of a company to some extent influences its returns. In the case of Berkshire, the mention of the name Warren Buffett fondly called "the oracle of Omaha" (who is known as the most successful investor of all time) is enough to encourage investment, which in turn drives the share prices up. On the whole, it is entirely conceivable that CEO founder status may affect the firm's financial performance (Jayaraman, N. 2000).
Also the long run effects of takeovers (acquisitions) can be a cause of the downturn of growth trend in recent times. This notion can be supported by the work of Loughran T. and A. M. Vijh ( 1997) who argue that whereas the shareholders who sell out after some period after the acquisition gain from the acquisitions, those who hold the shares for a long period, find that their gains diminish over time.
The loss (about $3.77 billion) which was made in 2001 was a result of the terrorist attack of the world trade centre in U.S. That of 2008 (about $11.5 billion) can also be attributed the current global financial crisis. The economic downturn that began in 2007 increased Berkshire Hathaway's risk as it acts as an insurance company and invests heavily into a many well known companies, including banks. This put Berkshire at risk since it relies on the strength of its investments and in relatively uncorrelated loss from insurance.
COMPARISON OF BERKSHIRE'S PERFORMANCE WITH S&P 500
S&P 500 is an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe. The S&P 500 is one of the most commonly used benchmarksfor the overall U.S.stock market (Investopedia).
The compounded annual gain of Berkshire Hathaway from 1965 to 2008 is 20.3 % whereas for the S&P 500 is 8.9%. The overall gain of Berkshire Hathaway and S&P from 1964 to 2008 is 362,498% and 4,236% respectively and within that time frame (44 years) Berkshire outperformed S&P 500 thirty eight times.
The stock portfolio of Berkshire is made of long term stock i.e growth stocks while that of S&P include some growth and more value stock. This accounts for the high BAHR of Berkshire compared to S&P.
The average return (mean) of Berkshire is 21.3% which almost doubles that of S&P which is at 10.5%. Berkshire's and S&P best percentage return were 59.3% and 37.6% in 1976 and 1995 respectively.
S&P and Berkshire have a correlation of 0.44 which means that they are not related because the value is close to zero. Hence, the stocks of the two portfolios are said to be random and have no relationship.
Within the timeframe, S&P had 11 years of negative returns while Berkshire had only 2 years of negative returns which were as a result of the terrorist attack in 2001 and the global recession in 2008.
Berkshire has consistently outperformed the S&P index. This has been a good sign of good investment strategies which were efficient and effective enough to beat the market for thirty eight times in forty four years.
ANALYSIS OF BERKSHIRE'S PERFORMANCE USING CAPM.
The capital asset pricing model is model that measures the relationship between risk and returns. The CAPM can be represented by the formula below:
C = Rf + (Rm - Rf) β
Where C is the cost of capital
Rf is the risk free premium which is usually cash
Rm is the market risk which is S&P in this case
β measures the volatility of risk compared with the market
The CAPM proposes that due to the inability to completely eliminate risk, the investors need a return that can compensate for the risk involved. For the purpose of this essay, the risk referred to here is the unsystematic risk.
From the table above, for the total period which the study covers Berkshire had a risk which was lower than the market risk by about 30.3%. This shows that in all, the portfolio of Berkshire is significantly safer than that of the market, and this is achieved through the diversification of Berkshire's portfolio.
Dividing the data into two equal series, the first half shows that the risk of Berkshire's portfolio was lower than that of the market but by a very small margin (2%). This signifies that during those years, Berkshire's portfolio was not very diversified, and hence accounted for the high returns in those early years.
The second half of the series shows that Berkshire's portfolio risk was more than half times less than the overall market risk (45%). In these years, Berkshire had plunged into different sectors of the economy, thereby increasing diversification and thus reducing risk. The latest acquisition of Berkshire is BNI (a freight rail transportation business) was done in order to further increase diversification and consequently reduce risk.
The alpha measures the excess returns of Berkshire above the market. For the whole period Berkshire made excess returns because the p-value is less than critical value 5%. Therefore, I can say that Berkshire made an excess return at 95% confidence level.
For the first half, Berkshire also had excess returns at 95% confidence level. This is because the p-value is less than the 5%.
Berkshire did not have any excess returns in the second half of the period. I attribute this to the closing bridge between the Berkshire and the market and like I argued previously, I believe this is due to the negative long term effects of mergers and acquisition. Also, Berkshire is a very large corporation and it has limited room for growth.
In the whole period, 17% of the variability of Berkshire's stock can be explained by the variability of the market. This suggests that there are other factors that affect the variability of Berkshire's stock apart from the market, for example management decisions, dividend payout policy etc. For the first and second period, 27% and 11% of the variability of Berkshire's stocks are explained by the variability of the market.
The evidence gathered from this study, suggests that Berkshire Hathaway has done tremendously well over the years and the returns it has yielded to its investors can tell the whole story. Unfortunately, it has not been doing as well as it had been doing since its inception, over the past few years. Its returns are declining and the gap between Berkshire and the market is gradually closing up. Investors are panicking, partly due to its recent performances and partly because its CEO Warren Buffett is getting older by the day and the fear that there would not be a successor that would run Berkshire as efficiently and effective as he did. Only time can tell if their fears will eventually come to pass, but for now Berkshire is still significantly getting returns higher than the market.
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