IF you’re wondering whether the Greg Abel era underway at Berkshire Hathaway Inc will mirror the Warren Buffett years, two Abel-led deals announced this week go a long way to answering that question.
Abel, it seems, has his own ideas. Both deals are distinctly un-Buffett. The oracle was famously selective.
He searched for reliably highly profitable businesses he could snag for a good price, even if it meant piling up cash while he waited.
Neither Abel deal would fit Buffett’s bill.
The first, a US$6.8bil cash acquisition of home builder Taylor Morrison Home Corp announced last Sunday, will add to Berkshire’s portfolio of a dozen other housing-related businesses.
It’s a deal young Buffett would have liked. Early in his career, he sought out companies that traded cheaply, what he called the “cigar-butt strategy”.
“A cigar butt found on the street that has only one puff left in it may not offer much of a smoke,” he wrote in his 1989 shareholder letter.
“But the ‘bargain purchase’ will make that puff all profit.”
At 12 times next year’s earnings, Taylor Morrison is about as cheap as it gets in a bull market.
The broad US stock market trades at nearly twice that multiple.
The problem with cheap companies, though, is they are rarely great businesses.
You can only get so far scrounging for cigar butts, as Buffett’s longtime sidekick Charlie Munger often reminded him.
“He actually hit me over the head with a two by four from the idea of buying very so-so companies at very cheap prices,” Buffett once recalled.
Munger argued instead for “really wonderful businesses that we could buy at fair prices”.
A wonderful business, in modern finance speak, is a quality company – that is, one with consistently high profitability and modest leverage.
Apple Inc was such a company when Buffett began purchasing its stock in 2016.
The company posted a return on equity (ROE) of 46% the year before, with an average ROE of 35% during the previous 10 years. It also boasted a gross margin of 40% in fiscal year 2015, averaging 38% during the previous decade.
More impressive is that Apple did it with almost no leverage.
Its debt relative to equity averaged just 10% over that time.
It’s not easy to find a higher quality company, and Buffett didn’t just pay a fair price for it, he practically stole it.
Apple traded at 10 times forward earnings when Berkshire began buying the stock, even less than what Abel is paying for Taylor Morrison.
And Taylor Morrison is no Apple.
The home builder reported an ROE of 13% last year, roughly matching its average over the last decade.
Its gross margin of 23% last year isn’t great, either, and only slightly higher than its trailing 10-year average of 21%.
Less flattering still is that those results were aided by a good dose of leverage.
Taylor Morrison’s debt-to-equity is nearly 40% despite having deleveraged considerably in recent years.
On the numbers alone, Taylor Morrison looks more like a cigar butt than a classic Buffett-Munger purchase.
But Abel may have plans for Taylor Morrison that Buffett wouldn’t normally consider.
Buffett tended to treat Berkshire’s companies as standalones, leaving their managers to go about their business independently of Berkshire’s other holdings.
Abel seems to have a different design, intimating that Taylor Morrison may benefit from synergies with Berkshire’s other housing-related businesses.
“Over time, we expect to unify our site-built homebuilding operations into a combined platform enabling us to deliver the dream of homeownership to more Americans,” Abel was quoted as saying in a statement.
The combination would presumably aim to boost Taylor Morrison’s financial results, a move Buffett would likely have been reluctant to undertake.
Same for the aspiration, however noble, of helping to solve America’s housing crisis.
Notably, Buffett had no other calling than churning out profits for Berkshire’s shareholders.
Meanwhile, Abel’s other big deal is a US$10bil investment in Alphabet Inc to help fund the company’s development of artificial intelligence.
It adds to Berkshire’s existing US$17bil stake in Alphabet acquired beginning last year.
Alphabet is undeniably wonderful, with gross margins regularly exceeding 50% and improving ROE that broke above 35% last year.
But at 25 times next year’s earnings, it’s also well more expensive than Buffett likes, particularly for a bet on a new and yet untested technology.
I wrote as much late last year, when the initial purchases were disclosed.
Buffett would be the first to acknowledge that his taste for quality at a fair price has been hard to satisfy in a years-long runaway bull market.
It explains why Buffett handed Abel nearly US$400bil in cash, which amount to more than four times Berkshire’s cash balance in 2016.
That leaves Abel plenty of flexibility to chart his own path, and he appears to be doing just that. — Bloomberg
Nir Kaissar is a Bloomberg Opinion columnist covering markets. The views expressed here are the writer’s own.
