Friday, December 18, 2015

Create Your Own Miniature Berkshire Hathaway

One of the very first things I did when I initially started investigating investing and a potential strategy that could work for me and my goals was read about Warren Buffett. Of course, it’s almost impossible not to run into the guy and his amazing story as a general citizen, let alone as someone who’s actively seeking knowledge about how to go about investing in a successful manner.
I won’t bore you with all the details of his life, but I’m currently re-reading his biography,“The Snowball: Warren Buffett and the Business of Life”, and I can’t help but continue to find inspiration in what he’s done and how he’s gone about doing it.
While I’d like to write a lengthier post someday specifically pointing out some great concepts about Warren’s personal life, I’d like to discuss the transformative business decision to take control of Berkshire Hathaway Inc. (BRK.B) and how it can apply to regular investors like you and I.

Rolling A Snowball

In the early 1960s, Warren Buffett began buying stock in Berkshire Hathaway, feeling that its stock was priced below its intrinsic value. After a rebuffed buyout offer from Berkshire management, Buffett actually increased his ownership stake until the point he was able to take over the company. At the time it was a failing textile business, which is an awfully strange business from which to launch the greatest investment empire the world has ever seen. However, this vessel had an extraordinary captain.
What’s important to note at this point is that Buffett started to invest in the insurance industry soon after taking control of Berkshire. He purchased National Indemnity Company in 1967 for $8.6 million, and later began buying up GEICO. These decisions were crucial, as it allowed him to abandon the sinking ship that was the textile business at Berkshire, while simultaneously leveraging the float of insurance operations. See, the float is the money that is collected from premiums, pooled up to be used until some or all of it is paid out later through claims. Prudent underwriting allows a decent enough spread between premiums and claims, which creates a profitable enterprise. But leveraging that float money by investing it intelligently through superior capital allocation really compounds one’s results. And that’s effectively where Buffett started seriously rolling his snowball.

Capital Allocation

Berkshire now owns a variety of insurance operations, and these are at the core of his mighty empire. However, Berkshire is far from just a massive insurance operation, and that concept is at the heart of what I’m discussing today.
Buffett used that float money and incoming capital from early operations to create a truly unique and enviable company with wholly owned subsidiaries in businesses like: Dairy Queen, Fruit of the Loom, Helzberg Diamonds, NetJets, and BNSF, along with major equity stakes in public companies, including: Wells Fargo & Co. (WFC)The Coca-Cola Company (KO)International Business Machines Corp. (IBM), and American Express Company (AXP). Berkshire has also recently announced plans to buy the fifth largest auto dealership in the US, which means Berkshire will literally be invested in planes, trains, and automobiles.
Berkshire has its fingers in all kinds of pots. Think media, energy, banking, insurance, clothing, jewelry, transportation, real estate, retail, technology, food, and consumer goods. When one area of the economy – like energy – is weak, the odds are good another area of the economy – like real estate – will pick up the slack. In the meanwhile, Buffett, via Berkshire, is collecting a constant influx of capital with which he can allocate as he pleases. This capital comes his way not only through the float that the insurance operations generate, but also via profits from the wholly owned subsidiaries and dividends from the equity stakes in public companies.

Creating Your Own Berkshire

I don’t think it’s all that impossible to create a unique and miniature Berkshire Hathaway of your own. Although, miniature might be the understatement of the century since we’re talking about a company with a market cap north of $300 billion.
So let’s delve into what kind of steps are necessary to create your own mini Berkshire (the how) and what that end result might look like (the why).

Load Your BB Gun

Buffett often refers to the capital that piles up as a result of his insurance operations, private subsidiaries, and dividends from equity stakes in public companies as his “elephant gun”. Berkshire has now grown to the point to where it takes massive acquisitions to really move the needle for the company. And you can see this with some of his more recent moves, including the purchase of BNSF and deal involving Heinz. These are elephants, and thus need elephant guns to take them down.
However, the good news is that you and I do not need an elephant gun to take down targets that will move the needles for us. We aren’t dealing in acquisitions worth billions of dollars, but stock purchases on the order of $1,000 or $2,000 at a time can make a material difference in our day to day life. And targets of this size simply need a BB gun to take down.
What’s even better news is that it’s a lot easier to get your hands on a BB gun than it is an elephant gun. Thus, it’s possible to a much smaller degree to replicate what Buffett has done, and I’ll admit that I’ve basically been imitating Buffett somewhat as I’ve marched from being worth less than zero to managing a portfolio slowly nearing $200,000. They say imitation is the sincerest form of flattery.
I look at my BB gun as the savings I’ve been able to generate by living below my means. I’ve never made a lot of money – up until 2010 I had never made more than $40,000 in a single year (my annual SS statements depressingly remind me of this fact). And even during the last year or so of working in the auto industry I made north of $50k. Certainly not the type of income that moves mountains. Now that I’m writing full-time I’m making even less. However, I’ve already discussed that saving more is more effective than earning more.
The excess capital that you’re able to generate through the difference between your job income and your expenses is your BB gun. Load that thing up and go hunting! Because taking down targets only allows you more ammo in the future to take down even bigger targets. Shoot, reload, and shoot again.

Invest In High-Quality Businesses That Throw Off More Cash Flow

So you may not have world-class insurance operations that build up an elephant gun, but Buffett wasn’t working with the kind of capital he is now if you look back to where he started in the early 60s.
The good news is that the excess capital you’re able to generate through your own hard work is just the start. The key is to leverage that capital by investing in great companies that pay regular and reliable dividends, and increase these cash payouts regularly.
See, the increasing cash payouts these investments send your way gets funneled into your cash pile, slowly growing the size of your BB gun. And it’s no secret that you can invest in the same public companies that Buffett does.
Buffett has major investments in Coca-Cola, IBM, and Wells Fargo. So do I. And so can you. These are all publicly traded stocks that anyone with some cash and a brokerage account can invest in. What’s even better is that all of them have a propensity to not only hand out regular cash payments to shareholders via dividends, but they also have histories of increasing these cash payouts. While Wells Fargo’s track record was interrupted by the financial crisis, Coca-Cola has a 52-year streak of increasing its dividend on an annual basis. IBM has a 19-year streak. You see where this is going.
Look to own stakes in businesses with low debt, great management, high returns on equity, solid margins, numerous competitive advantages, and histories of excellence.
I currently own minority stakes in 51 different businesses. And this collection of high-quality businesses should send me near $6,000 in dividend income over the next year. That $6,000 is a decent little BB gun all by itself, but will soon turn into $8,000, then $10,000 and eventually $20,000. And it will continue to grow thereafter. This cash flow is extremely flexible and can be used for personal expenses right now, but actively andselectively reinvesting it assures that it will grow over time. I’m combining this $6,000 with all the savings I’m also able to generate via living frugally, thus supercharging the capital I have available to allocate. That’s $6,000/year extra I have available to me to allocate. $500 per month. That’s real cash flow that is almost assuredly coming my way no matter what, and even better it’s highly likely to continue increasing for the rest of my life before you even factor in continued capital input and allocation.
Regularly generating free cash flow of your own by maximizing your income potential while simultaneously minimizing expenses and then allocating this capital into great companies that will assuredly send you more cash flow over time is a surefire way to create a situation where you’re basically inundated with cash. You’ll have to grab an umbrella for all the cash that will be raining upon you, which is a most wonderful situation for a capital allocator to be in. It’s the situation Buffett has found himself in, and it’s a situation you can find yourself in as well. You may then have to wonder whether or not it’s prudent to invest in an umbrella manufacturer.

Focus On Value In Addition To Quality

Of course, you’ll want to invest in high-quality companies when the price is advantageous relative to value, but avoiding businesses that are low in quality and unable to produce generous cash flow and increase their dividends for lengthy periods of time is even more important. After all, getting a great deal on a turd still leaves you holding a turd at the end of the day. However, even the greatest businesses in the world can be poor investments over the short and medium term if the price is paid is far too high.
Buffett is infamous for his ability to swoop in on great businesses precisely when they’re experiencing troubles that are transient in nature. Deciphering temporary problems from long-term fundamental issues is difficult, but, generally speaking, great businesses tend to continue being great more often than not. I believe, as does Buffett, that betting on quality will serve you well over the long haul.
This ability to buy when everyone else is selling requires one to be an independent thinker. Acquiring consensus in your decisions is not only not necessary in order to be a successful investor, but it can actually be a hindrance. Don’t worry about what everyone else is doing or what mood Mr. Market is in. Focus on fundamentals, focus on value, and focus on quality.
Buffett is of course also able to swoop in and buy when everyone else is selling because he generally has a lot of cash on hand. Some of this cash is necessary due to the insurance operations within Berkshire; however, that cash pile gets built through the power of cash flow. Do not discount the power of savings and cash flow, as the aforementioned inundation of cash allows you to buy precisely when the apex of maximum value is reached, which can lead to exemplary returns and higher yields over the long haul.

Pretend Like You Own The Entire Company

Berskshire owns quite a few companies outright. These are now wholly owned subsidiaries that send all of their free cash flow up the chain to parent Berkshire, where Buffett is able to allocate that capital in the best way he sees fit for Berkshire Hathaway shareholders (which includes himself).
So it’s easy for Buffett to fancy himself a business owner because he is one. Through Berkshire he directly controls many different companies. Although these subsidiaries have independent management teams and they run fairly autonomously, Buffett is the boss.
However, by owning stakes in publicly traded companies you’re an owner as well. You quite literally own a piece of a company when you buy stock in it, which is why it’s important to think like an owner. This line of thinking should course through your veins because by buying up stock in a company you should be pretending as if you own the entire company. After all, why invest $1,000 or $10,000 in a company if you’re not willing to buy the entire thing? Anything less than a complete commitment to an investment means you may start to question your thesis and fold when the stock price falls. Instead, a drop in a stock price should be seen as an opportunity if you really believe in the company and its future prospects.

Diversify

Berkshire owns a multitude of businesses under its umbrella, both via wholly owned subsidiaries and equity stakes in public companies. And these businesses are widely diversified throughout different sectors of the economy. This level of diversification means no one business can crater the mothership, which is how I recommend a miniature Berkshire Hathaway be built as well.
I currently control what I believe is already a teeny, tiny Berkshire Hathaway of my own. I have exposure to insurance, food, consumer products, rail, energy, finance, natural resources, real estate, national defense, technology, healthcare, retail, and telecommunications through my investments in 51 different high-quality companies. And my ownership stakes in these companies is increasing month after month, partly due to the increasing cash flow they provide me.
Diversification is probably the only free lunch an investor has. While going big on a few companies can lead to excellent returns if you’re right, it can lead to possible portfolio destruction if you’re wrong. I have a lot of faith in my ability to pick out quality at a value, but I’d rather not bet my financial independence on just a few companies. Unforeseen and unfortunate events may hit one or two companies, but the odds of 50 or more companies all suffering unexpected issues at the same time is extremely unlikely outside of a major recession, which is the exact opportunity that someone with regular and increasing cash flow relishes.
Berkshire has its fingers in a lot of pots. And I like that strategy. Different companies excel at different times, and some companies go through extended periods of low growth due to restructuring, acquisitions, or just poor economic conditions. However, if you own companies in areas of the economy that’s booming while others are more or less busting your prodigious cash flow remains…well, prodigious. Which means your role as supreme capital allocator (or thou who lives off of dividend income) isn’t challenged or hindered.

Conclusion

I’ve spent more than four years of my life building what I believe to be a miniature Berkshire Hathaway. I’ve done my best to comfortably live below my means, which has allowed me to generate the consistent cash flow necessary to invest in great businesses that pay and increase dividends. And these investments have provided further cash flow all by themselves, supercharging the capital I have available to allocate.
Combining more cash flow with an eager desire to invest only in the best businesses around means the portfolio grows and becomes higher in quality over time. My ownership stakes in businesses become larger, the cash flow they send me increases, and my wealth and freedom grows. I may not ever become a billionaire, but I am a guaranteed millionaire. And, frankly, that’s more than enough for me. I need approximately $20,000 per year to live a comfortable life. Thus, a $500,000 portfolio throwing off 4% in dividend income would get me there. A tiny Berkshire Hathaway, indeed.
Diversification, quality, value, and ownership are all themes you’ll want to master if you’re interested in building your own mini Berkshire Hathaway. It won’t be easy or quick, but over time you’ll be sitting on a portfolio with dozens of great businesses within it, throwing off more cash flow with which you can reinvest and further build out your ownership stakes. Eventually, it’ll throw off enough increasing cash flow for you to live off of. It won’t be quick or easy, but keep in mind that 99% of Warren Buffett’s wealth was built after his 50th birthday.
Full Disclosure: Long IBM, KO, and WFC.
What do you think? Are you busy building your own Berkshire Hathaway? 
Thanks for reading.

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1 comment:

  1. Jason, I always like the perspectives you share in your articles. Though we have somewhat different life styles and philosophies, we agree on dividend growth investing as the way to prepare for a secure financial future!

    Thanks and take care!
    FerdiS, DivGro

    ReplyDelete

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