Warren Buffett's US$100 billion problem: finding something big to buy

Berkshire Hathaway's options have grown scarce in a big-game hunt for acquisitions. Photo / AP

Warren Buffett celebrated his 87th birthday a few days ago, but the bigger number in his life is the US$100 billion (NZ$137b) mound of cash that his Berkshire Hathaway has stockpiled.

Buffett created his cash-gushing conglomerate out of an ailing textile firm that he took over more than 50 years ago. Berkshire Hathaway now has dozens of subsidiaries, from railroads to utilities to candy companies. It has 367,000 employees, US$24b (NZ$33b) in annual profit and market capitalisation approaching $500 billion.

Simply put, it's one of the most profitable enterprises ever created.

Insurance has been a big part of Berkshire Hathaway's runaway success, with Buffett smartly using the premiums people pay - known as "float" - to invest in privately and publicly owned companies. He is able to put the cash to work because most insurance claims are paid out years later.

The conundrum Buffett faces is an enviable one: What to do with all the money? In this case, $100 billion. The Sage of Omaha acknowledged the difficulties of deploying his cash during Berkshire's annual meeting in May.

"The question is, 'Are we going to be able to deploy it?' " he told the thousands of faithful who made the pilgrimage to Omaha.

By necessity, the investor must hunt for big game; it takes a big acquisition to meaningfully move the bottom line of a company the size of Berkshire Hathaway.

Last month, he tried and failed to buy Oncor, a Texas power-transmission firm, for $9 billion in cash. Sempra Energy outbid Buffett by US$450 million (NZ$620m).

The investor, who is notably averse to technology, is taking ever bigger stakes in companies such as Apple. He also this summer invested in Home Capital Group, a troubled Canadian mortgage lender.

Jonathan Brandt, an analyst and partner with the investment firm of Ruane, Cunniff & Goldfarb, is an expert on Berkshire Hathaway. He has to be. Berkshire Hathaway is the investment firm's largest holding. Brandt attends the Berkshire Hathaway annual meeting, where he sits on a panel of journalists and financial analysts who pepper Buffett and Vice Chairman Charlie Munger with questions.

I spent a couple of hours interviewing Brandt and other principals at Ruane, Cunniff & Goldfarb, including chief executive David Poppe and analyst John B. Harris.

One of the ongoing questions surrounding Berkshire Hathaway is that it doesn't pay a dividend and doesn't buy back its stock, two things that it could do to absorb some of that $100 billion.

Buffett has resisted paying a dividend, thinking that he can put the cash to more productive use through acquisitions. That's one of the places where we diverted the discussion.

"There's a lot of focus on whether or not Berkshire is going to pay a dividend," Brandt said. "I would be mildly surprised if it did start paying a dividend within the next three years. Maybe the most important aspect of that is it might indicate that [Buffett] doesn't think he can deploy the capital at a more attractive rate than the shareholders could with the distributed cash."

"But either share repurchases or dividends will keep [Berkshire's cash pile] from growing larger and larger and larger," Brandt said. "One of the reasons Berkshire moves up in the market cap rankings every year is that it doesn't pay a dividend. It doesn't repurchase shares. That doesn't have to do with why the returns are good. But it just piles up more and more money."

Poppe implied that Buffett still has his investor mojo.

"He remains quite confident that he will find things to buy over time, even with the limitations of size," he said. "He is very patient. Markets from time to time will give opportunities, and he is willing to wait for that opportunity."

But as the cash accumulates and the size of Berkshire Hathaway expands, the pool of companies that can add significant value dwindles.

"I just think it's harder to find investments," Brandt said. "If he is buying stocks, he can only look at market caps. Let's say he wanted or assumes he can go up to 10 percent of a company without running into possible [regulatory] issues."

"If he wants to put US$5b (NZ$6.8b) into something, it has to be a US$50b (NZ$68b) market cap. I don't know how many companies there are at $50 billion or above or $100 billion or above, but he has a limited set of opportunities for stocks and also for businesses he can buy," Brandt said.

"He does buy companies that are worth less than a billion, but it doesn't really move the needle. To do something like Precision Castparts or Burlington Northern Santa Fe Corporation, that's a US$35b to US$40b acquisition. And it's just hard to get a really good, cheap multiple on something that big."

Harris said that as Berkshire has grown, it has evolved from an investment firm into a conglomerate seeking to buy entire businesses - not just parts of them. Buffett in recent years bought all of Precision Castparts for US$32b, Burlington Northern Santa Fe railroad for $26.3b and Duracell batteries for US$4.7b.

"Warren has tilted the value of the enterprise much more toward owned businesses where you can look pretty far into the future and have a sense for what that business and its earnings are going to look like," Harris said.

Harris said Berkshire Hathaway's acquisitions of whole companies also includes high-quality earnings that come from increased sales, lower costs and conservative accounting.

"His skill as a capital allocator is still valuable and an important part of the investment case," Harris said.

Buffett historically made some of his biggest killings by buying private companies from owners, often families, who were willing to accept a discounted price in return for seeing their creation kept intact as part of Berkshire Hathaway. Those include Helzberg Diamonds, the Pampered Chef and Nebraska Furniture Mart.

The challenge now, illustrated by the Oncor misfire, is that Berkshire Hathaway is competing for big, public companies that are widely followed.

"It's just hard to find inefficiencies in the pricing of large companies," Brandt said. "It's not like other investors are going to vastly underprice a publicly traded company. And if it's a public company, the board of directors is not going to sell it to you at a discounted price. And if it's a big, family-owned holding, they're not going to sell it to you at a price that disadvantages them greatly. He can't dart in and out of stuff."

The float that Buffett consummately exploits these days comes courtesy of his many insurance and finance firms such as Geico, General Re and Central States Indemnity.

"Berkshire Hathaway, like all companies, still gushes cash every quarter, every year from its earnings," Brandt said. "But when the insurance float grows - and it usually does - the cash flow grows even more. As an extreme example, in the first quarter of 2017, Berkshire had operating earnings of US$3.6b, but its float grew by US$14b, four times its earnings."

A big chunk of float must be kept liquid to pay for claims on its insurance business. The rest can be put to longer-term use.

Brandt explains it this way: "There's a debate to be had about how much of the float can go into buying businesses and stocks, and how much needs to be in lower-return bonds and Treasury bills. Buffett indicated at the annual Berkshire Hathaway meeting that all but US$20 to US$25b can be put into businesses and stocks. But in a typical year, based on current earnings power, Berkshire will earn US$20b. If 85 per cent of that is free cash flow, and float grows, say $5b a year, the float growth would add almost 30 per cent to the annual free cash flow. And remember, that's on top of the US$100b that's already there."

Like I said, I wish I had Warren Buffett's problems.