Concentrated Investments

Many Berkshire Hathaway shareholders have a very large percentage of their net worth invested in the company. What are the risks of concentrated investments in general and Berkshire in particular?

Introduction

The Capital Asset Pricing Model (CAPM) is often criticized for relying on a concept called Beta (β) which measures the correlation of the historic volatility of a security relative to the overall market. Investors are supposed to demand higher returns from securities that have a high β and lower returns from securities with a low β.

This mechanistic approach to valuation, anchored on historical volatility, is criticized as being backward looking and for not taking into account, or even examining, actual business risk which requires a deep level of analysis and understanding.

While I agree that CAPM and β have serious limitations, we should not disregard the entirety of academic finance. In particular, we should acknowledge that there are indeed two types of risk facing investors in equity securities:

1. Systematic risk refers to risk that is inherent in the entire market. This is risk that an owner of a fund tracking a broad-based index like the S&P 500 or the S&P Total Market Index cannot avoid through additional diversification. These risks include macroeconomic and geopolitical factors that impact nearly all businesses.

2. Unsystematic risk refers to risk impacting a specific business. Factors such as poor management, loss of reputation, changing consumer tastes, or any other factor that impacts only a specific business, or a small group of businesses, falls into this category. Investors can reduce unsystematic risk through diversification.

From the standpoint of academic finance, investors should not expect to be paid to bear unsystematic risk of individual securities since this risk can be diversified away. However, investors should demand higher returns from individual investments with a higher β, reflecting a higher sensitivity to the systematic risk impacting all businesses. In order to achieve returns higher than the market, an investor is forced to tolerate more volatility, as expressed by the β of his overall portfolio.

One can debate whether volatility is a good proxy for true business risk and whether the CAPM is a sensible valuation approach. I do not believe that it is, but plenty of investors disagree. However, it should be self-evident to everyone that individual companies do have unsystematic risk and that investors can in fact reduce such risks through diversification across industries or even the entire market.

All investors have the simple and easy option of owning an index fund of the entire U.S. market and there are similar index funds for foreign markets as well.

Since it is true that any investor can own the entire market through a mutual fund or exchange traded fund (ETF) at minimal cost, it follows that the owners of individual securities must expect a return greater than what is expected from the entire market. I would argue that this should be the case regardless of the β of the stock because I do not consider β to necessarily reflect true business risk. I would not be comforted by the low volatility of a low β stock to the point where I would accept lower than market returns because I do not regard volatility as representing true business risk.

As a long term investor who does not require immediate liquidity from stocks, short-term volatility is not a factor I worry about. I am indifferent to short-term volatility.

If you agree that the decision to own any individual stock requires the expectation of a return greater than a broad-based index fund, it logically follows that we should have good reasons for such an expectation. If we are indeed taking on unsystematic risk specific to an individual stock, then we should demand compensation for doing so. If we elect to have concentrated positions in individual stocks, we are effectively saying that we expect returns to be more attractive than owning an index mutual fund or ETF.

Taking a concentrated position in a single business is a risky proposition.

There are endless scenarios where things could go off-track and permanently impair the value of your investment. For proof of this fact, read the Wall Street Journal on any given day to see the wreckage of failed companies. While the overall market has advanced, albeit irregularly, over long periods of time, it is common for individual companies to disappear forever. No matter how high your net worth might be or how long it took to build, multiplying that figure by zero will make you flat broke.

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Conglomerates

The situation gets interesting when we consider conglomerates that are comprised of business units operating across multiple industries. In such a case, we have a single company that has some level of unsystematic risk but one that is far more internally diversified than a company operating in a single industry.

In such a case, is it reasonable for an investor to own this type of company in a concentrated manner? Is it reasonable to believe that a well-run conglomerate can provide sufficient diversification? Can we justify owning it as a cornerstone of a portfolio with a particularly large allocation?

In my opinion, since owning even the most widely diversified conglomerate still entails more business risk than owning a broad-based index fund, it is logical that we would only be willing to do so if the expected return from the conglomerate exceeds what we can expect from the index.

Some investors might argue that we can accept lower expected returns from a conglomerate than from a broad-based index if the conglomerate’s stock is less volatile (that is, if the conglomerate has a lower β). While that may be a defensible position, I do not regard volatility as an approximation of true long term business risk, nor does short-term volatility bother me psychologically. So I would want any conglomerate to have an expected return greater than an index fund.

It is important to consider the internal structure of a conglomerate to determine whether problems in one business unit can “infect” other business units.

There are several ways in which such infections can occur. If there are major problems in an important business unit within a conglomerate, it is likely to take up significant time for top management and potentially distract them from other businesses. If the problem is one that seems like it can be solved with additional capital, management may choose to do so which could take capital away from other business units or prevent return of capital to shareholders. Depending on the legal structure of the conglomerate, adverse lawsuits against one unit could create financial liability for the conglomerate as a whole. There are many other troubling scenarios.

Due to the potential for “infection” from one business unit to another or to the conglomerate as a whole, internal diversification is not necessarily equivalent to owning multiple securities in terms of risk mitigation. For example, assume that you own a conglomerate with units in the following industries: coal mining, automobile insurance, and ice cream. There is more risk involved in owning these units within the conglomerate than if you own them as separate securities representing stand-alone businesses selling coal, auto insurance, and ice cream.

The upside of the conglomerate structure is that management can allocate capital across business units in smart and tax-efficient ways. Excellent capital allocation is an absolute prerequisite of any conglomerate structure. If capital allocation is not far above average, management will add no value that shareholders could not get from owning the businesses as separate individual corporate entities.

My conclusion is that owning a conglomerate operating in multiple industries and run by excellent capital allocators can potentially represent a less risky investment compared to owning a single security of a business operating in just one industry. However, this does not necessarily mean that one can own a conglomerate as the cornerstone of a portfolio. To get to that point, there must be truly extraordinary benefits delivered by managers with a long history of excellent capital allocation.

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Berkshire Hathaway

Note to readers: Nothing in this section should be considered investment advice.

Now that I have set the stage, let’s consider the unique case of Berkshire Hathaway, a conglomerate with a nearly six-decade record of excellent capital allocation under the stewardship of Warren Buffett. I have written about Berkshire Hathaway’s overall record many times over the years, so I will not take up the space to make a new case for Berkshire’s record in this article. I think that it is widely recognized that Warren Buffett’s capital allocation record has been exceptional over multiple decades.

Two weeks ago, Berkshire shareholders reacted with sadness when Charlie Munger passed away just five weeks short of his hundredth birthday. It is impossible to know what Berkshire’s record would have been without Charlie Munger. There is no doubt that his impact was large, as Warren Buffett has said on many occasions. Berkshire shareholders lost half of an exceptional team. I am sure that Mr. Buffett continues to mourn Mr. Munger not only as his most trusted advisor but as his closest friend.

It is only natural for Berkshire shareholders to turn their attention to Mr. Buffett’s advanced age. At 93, Mr. Buffett says that he “feels good” but knows that he’s playing in “extra innings”. Charlie Munger was very important to Berkshire but he was not running the company on a day-to-day basis in the way Warren Buffett does. When Mr. Buffett leaves the scene, there’s no doubt that it will be a huge blow to the company.

Like many longtime Berkshire Hathaway shareholders, I own a concentrated position in the company. This happened because I accumulated Berkshire shares over a period of many years funded by aggressive savings from employment income. Effectively, I used Berkshire Hathaway as an alternative to an index fund knowing that I was not merely buying a single business but a large array of businesses across many different industries. The combination of my high savings rate and appreciation of the stock has led to my current concentrated position, most of which is held in taxable accounts.

For shareholders in my position, the question is whether Berkshire Hathaway continues to represent a sensible vehicle for a very large percentage of net worth. With Mr. Buffett in charge, we have been able to gain a level of assurance due to the fact that around 99% of his net worth is invested in the company. He has worked for almost no compensation and our financial results have moved in lockstep with his results. There is a total alignment of economic incentives and no agency costs.

While the timing is uncertain, we know that at some point over the next decade, someone other than Warren Buffett is going to be running Berkshire Hathaway on a day-to-day basis. Even if Mr. Buffett lives to be a centenarian, it is highly unlikely that anyone over a hundred years of age could have the energy to run Berkshire Hathaway as CEO and we might end up with Mr. Buffett as Chairman with Greg Abel as CEO.

Can we still regard Berkshire Hathaway as the cornerstone of an investment portfolio with Greg Abel serving as CEO?

I think that the answer is yes, both because Mr. Abel is a proven executive skilled at capital allocation and operational oversight, and because Warren Buffett has worked with him for decades and has full confidence in his abilities. Under Mr. Abel’s leadership, Berkshire will still be comprised of the same business units at first, with incremental capital allocation changing the composition of the conglomerate only slowly over a long period of time. Incentives will still be aligned through Mr. Abel’s ownership of Berkshire stock. CEO compensation will no doubt be higher than what shareholders paid Mr. Buffett, but I expect the board to exercise restraint.

I have long-term concerns about Berkshire Hathaway that have to do with voting control, but these concerns will not manifest immediately when the reins are turned over to Mr. Abel. Mr. Buffett’s Class A shares will slowly be converted to Class B shares with reduced voting control and given away to charitable foundations. After a decade, the remaining Class A shares will be owned by the diminishing number of early Berkshire shareholders, other rich individual investors, and institutions.

My main concern is not the succession from Warren Buffett to Greg Abel, but the succession from Mr. Abel to an unknown individual sometime in the future.

Greg Abel is currently 61 years old. Warren Buffett has said that he wants his successor to have a long run, so I assume that Mr. Abel is willing to work well past normal retirement age. If we assume that Mr. Abel is willing to serve as CEO until he is 75 or 80, we might expect another succession to occur in the late 2030s or early 2040s. However, nothing is assured and this might occur much sooner.

Berkshire has a bench of talent, but we know little about executives currently in their late 30s or early 40s who are likely to be CEO candidates in the 2030s or 2040s. It is quite possible that Mr. Abel’s successor will be someone who Warren Buffett never worked with or even someone who is not currently employed by Berkshire Hathaway. Will that person fully understand and maintain Berkshire’s unique culture?

By the 2040s, Berkshire’s Class A ownership is likely to be dominated by large institutional investors. It would be unreasonable to assume that Berkshire will not trend toward a more typical corporate structure as these dynamics take hold.

I have ideas for how this might be delayed, but it would only represent a delay of an inevitable move toward a being a more “normal” company. I do not regard the way “normal” companies are run to be desirable and so I view this trend as negative.

My overall sentiment at this point is that Berkshire Hathaway will remain a very unusual company for a long period of time, but that it is nearly inevitable that the ownership structure will change to the point where the company starts to resemble a more typical large American company. Mr. Abel’s presence is key to maintaining the culture for as long as possible, and his job will include ensuring that his successor will also be committed. We could be pleasantly surprised by the endurance of the culture.

I cannot tell other shareholders what, if anything, to do with their own concentrated positions in Berkshire Hathaway, but I can share my current thinking on what I will do with my own shares.

• I plan to retain the bulk of my shares held in taxable accounts for as long as possible to enjoy continued tax deferred compounding and avoid capital gains taxes on shares with a low cost basis. I view the majority of my taxable shares as permanent holdings that will be there if future circumstances require but I hope will ultimately pass to my heirs and enjoy a step-up in cost basis when I die.

• In tax-deferred retirement accounts, I am much more open to diversifying into other investments gradually over time, but will do so only when I believe Berkshire Hathaway is trading at or above intrinsic value.

• I regularly follow other companies and have occasionally made investments in recent years, but I am not a full time stock picker. Therefore, any tax-deferred account sales would likely be directed toward an index, although not necessarily the S&P 500. Therefore, Berkshire’s valuation relative to the contemplated index fund investment is also a consideration when it comes to diversification.

All of this assumes that the ship continues to head in the right direction and there are no signs of major changes of a detrimental nature that would cause a reassessment. While I doubt such an adverse outcome will occur anytime in the near future, and probably will not occur through the 2030s, the future is ultimately unknowable and anyone with a concentrated position in a company, even in a well-diversified conglomerate, must remain alert to the possibility of decline.

One additional impediment exists in my case which I am sure is a problem for many other longtime shareholders. I admit that have emotional attachments to Berkshire Hathaway, Warren Buffett, and Charlie Munger.

I regard Berkshire Hathaway as a model for how to run a public company. Warren Buffett and Charlie Munger are moral and business exemplars, and I am proud of the fact that I have owned shares for nearly a quarter century. At least part of my identity as an investor is the fact that I own shares. I dislike the idea of parting with my shares from an emotional standpoint. It would represent a loss of identity.

Rather than being embarrassed about this emotional attachment to Berkshire Hathaway and its leaders, I would rather face this risk head-on. I need to remain aware of my biases as I evaluate the direction of the company in the long run, and I need to be ready to potentially sell shares when conditions warrant. There is a difference between well-reasoned optimism and slavish cult-like devotion. I do not believe that I’ve ever fallen into cult-like behavior, but it is a risk worth considering.

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Conclusion

Ultimately, owning Berkshire Hathaway or any other concentrated investment is a judgment call that everyone has to make for themselves.

I do not regret choosing Berkshire as my primary investment when I was a young man. But If I was starting over today, I would simply dollar cost average into a broad-based index fund. It would not make sense to use Berkshire Hathaway as an index substitute starting in 2024 as I did starting in 2000. I think that there is a reason Warren Buffett often makes the same recommendation. Broad diversification remains the best option for most people. Very few investors have the ability to beat the market.

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Long Berkshire Hathaway.