Cash Happens: The Emergence of “MegaRealBuck$” at Berkshire Hathaway
Reflections on the Berkshire Hathaway 2004 Annual Shareholders Meeting
June, 2004

Berkshire Hathaway (“Berkshire”) remains in our view an anomaly in the investment landscape, continuing to stand as it has for some time as an operating embodiment of contradiction to efficient market theory. It is a large, well-known, diversified operating and financial company with a decades-long track record. Transparent finances and effective management operating strategy have allowed this company to prosper in a highly liquid financial system with informed, profit motivated participants. Berkshire produces a virtual mountain of cash at low cost, has a vast opportunity set for reinvestment, and houses highly skilled capital allocators among its senior management ranks and board of directors. The company nonetheless remains, in our opinion, poorly understood and commensurately undervalued.

Berkshire’s advantaged structural and market characteristics should continue to allow it to execute its capital allocation business model in a way that creates value for its owners. We note the following advantages embedded in ownership of Berkshire:

• A massive capital base represents an advantage of scale and stability for Berkshire’s skilled management to exploit in the markets for reinsurance, risk transfer and investments. Fortunately, Berkshire’s senior management has the discipline and skill set to pursue profitable growth and to intelligently allocate such massive amounts of capital.

• The management team’s candor, integrity and track record of practicing and championing those qualities provides a basis for credibility in its accounting representation and business dealings that stands demonstrably apart from the vast majority of corporate America today.

• The alignment of interests amongst employees and shareholders promotes, to the extent possible, proper incentives, rewards, and compensation that is fair, adequate, and even sizable but not random, mercurial, or without merit.

• Due in part to a sound system of values and a concentrated ownership structure, these attributes are offered with remarkably little “friction” or carrying cost, in the form of management compensation, between shareholders and the underlying businesses.

• The discount from intrinsic value which we believe persists in Berkshire’s shares presents all of these desirable qualities at a price which provides a margin of safety and very reasonable opportunity for capital-protected growth that is as comforting as it is rare.

BACKGROUND

The purpose of this commentary is to provide Oak Value Fund (“Fund”) shareholders with an update on our thoughts with regard to this significant investment we have made on their behalf. Though relatively straightforward, in our view, Berkshire’s business model and the attractiveness thereof remains misunderstood by the general investing populace. Fortunately, our target audience in these periodic commentaries is an informed and knowledgeable investor universe which has the context and perspective with which to utilize the information contained herein. Two years ago, we thought we might have completed our publishing about Berkshire, having reached what we called magnum opus proportions in 2002’s “Great White Shark” version. We found more to say in 2003, following up with last year’s “Cash is King” tome. “Back by popular demand” may be overstating the case some, but the continued flow of requests indicates there remains an ongoing level of interest in the topic (investment geeks, you know who you are). Additionally, we find we still have a few things left to say by way of update; we thus proffer “Cash Happens,” our fifth annual summary, roughly coinciding with a follow up to our attendance at Berkshire’s May 2004 annual meeting in Omaha. Five is a nice round number, so perhaps this will really be the last one. We’ll see.

As in the past, we encourage review of prior installments (particularly the 2003 version) for background and context on Berkshire and our historical thoughts on the company and its business model. While we have some additional thoughts to offer herein, we aren’t necessarily going to state the investment case for Berkshire any better than we have in those prior venues by simply attempting to say it differently here.

INTRODUCTION

“When my mother used to sing me songs about compound interest, there wasn’t any need to go any further.” - Warren Buffett (at the 2004 Berkshire Hathaway Annual Shareholders’ Meeting)

The Berkshire annual meeting is preceded by a company movie that for the past few years has included a humorous cartoon lampooning various aspects of Berkshire, the culture and icons which surround the company, and often society at large. This year’s version centered around a “Terminator” theme, complete with one of two hilarious Arnold Schwarzenegger cameo appearances, highlighting the meeting’s funniest line: “First I will terminate them, then I will run for Governor of Nebraska.” In the vignette, time travelers Buffett and Munger were charged with retroactively halting the fictitious merger of Microsoft, Wal-Mart, and Starbucks – “MicroWalBucks.”

A perhaps overlooked irony is that Berkshire, itself long ago the merger of two now forgotten textile manufacturers (as Mr. Buffett recently opined, “It was not a match made in heaven”), has in some ways become an inverse/parallel to the spoof entity, not quite its reciprocal. You might call it “MegaRealBuck$” since it is certainly large and, as we will indicate, is producing real cash at an amazing rate. (A semantic stretch you say?; in begging latitude we plead that we work in a university town, not on Madison Avenue. Still, it is catchier than last year’s “Reinvestment Reinsurance,” a moniker for which we did in fact receive a small royalty offer. Perhaps there’s a future in this name consulting thing. But we digress.)

Mr. Buffett’s fascination with a real, cash profit motive has remained unchanged since his early childhood experiences buying sodas by the six-pack and selling them individually for a markup, or fixing his investment in a pinball machine and counting quarters all the way to the bank. (Perhaps when the organized crime types of “Sopranos” fame took note of the value in the latter was when Mr. Buffett decided that investment markets might be a safer long-term strategy; Wall Street’s crooks don’t carry firearms.) There are more moving parts at today's Berkshire than in the average pinball machine, but the goal is a model of consistency: the production of cash begets more cash where adequate reinvestment opportunities can be executed. And in fact, as we have indicated in the past, such reinvestment activity and the cash they generate over time have been the “special sauce” on Berkshire’s Big Mac throughout its current management’s tenure.

A BRIEF HISTORY OF NEARLY EVERYTHING BERKSHIRE (WITH APOLOGIES TO BILL BRYSON)

Berkshire has sustained this virtuous circle of investing life over an amazing span of four decades through a mixture of focus, wisdom, opportunism, extreme investment discipline and structural foresight. Though Messrs. Buffett and Munger have made mistakes, the overall effect has been that the company has virtually minted money in investment transaction after transaction, seemingly conjuring capital over many decades by:

• founding its business on a pillar of profitable insurance and reinsurance, businesses that produce cash from insurance operations, investments, and float (money held but not owned by an insurer which it can use until claims are due);
• extracting “seed corn” for future profitable activities by growing and/or harvesting cash from profitable acquired businesses such as Sees Candies, Nebraska Furniture Mart, Blue Chip Stamps, and Borsheim’s;
• “bootstrapping” the advantageous growth of capital via cheap securities investments such as the Washington Post and other mid-70s bear market investments;
• allocating capital to high return investment opportunities before other investors, such as high quality consumer products, advertising, and publishing companies;
• comprehending the solid long-term advantages of and committing large investment dollars to entrenched consumer franchises and other competitive edges at companies such as GEICO, Coca-Cola, and Gillette;
• capitalizing on dislocations where knowledge and capital are decided advantages and where other investors periodically fear to tread (though they often eventually followed), such as the recent examples of energy/utility investments in 2000 and junk bonds in 2002; and
• plowing the resulting capital into new acquisitions of wholly-owned companies in a variety of industries (building products, retail, aviation services, apparel, and logistics & distribution) over time in increasing size but with consistently demanding return on investment hurdles.

WHAT HAVE YOU DONE FOR ME LATELY? (WITH APOLOGIES TO JANET JACKSON - AND HER WARDROBE)

Overall Results

“Thanks for the history lesson, but what is all this doing for today’s Berkshire shareholder?” you might ask. Repeat readers may recall our thesis last year that Berkshire’s growing cash earning power had been obscured over the series of years that opened the millennium. A variety of challenges masked the progress the company had otherwise made by pressing its advantages in insurance and allocating capital in a distressed environment. (See WHERE HAS BERKSHIRE BEEN, PART I? THE BAD AND THE UGLY OF 1999-2002 RESULTS from last year’s “Cash Is King” discussion for specific details.)

In essence, insurance losses, the 9/11 terrorist attacks and the bear market dug a $12 billion hole in Berkshire’s financial statements. Much of the company’s phenomenal operating progress was hidden as it developed because it was netted against the negative backdrop of 1999-2002’s insurance underwriting losses and equity market depreciation. We essentially asked a year ago “What happens when they go forward with the earnings power inherent in their business model and they don’t have the hole to fill in?” Cash happens, and we’re seeing it in action at Berkshire in a big way as the perpetual motion cash machine analogy we postulated a few years back churns out dollars.

The prodigious production of cash remains the business focus and is increasingly becoming the bottom line outcome at Berkshire after several difficult years from 1999-2002. However you slice it, its far flung activities are delivering cash by the bucketful, like a bunch of currency-focused sorcerer’s apprentice brooms. The figures demonstrate the outcome and speak for themselves. For obvious starters, the company reported net earnings in 2003 of over $8 BILLION dollars. Going somewhat further, a review of the company’s balance sheet reveals that Berkshire added nearly $9 BILLION dollars to its cash coffers in 2003, even after netting out the impact of a shift from intermediate term bonds to shorter maturities. (Those are digits followed by 9 zeroes. Such figures remind us of the old cereal commercials – “Honeycomb’s big. Yeah, yeah, yeah... It’s not small. No, no, no.”) Berkshire made $3.3 billion in payments to tax authorities. Realized investment gains were $4.1 billion. Operating results, exclusive of investment gains and the estimated tax associated with them, was a net of roughly $5 billion in 2003. First quarter results released subsequent to the Omaha meeting indicated an additional $1 billion was generated in the first three months of 2004 on the same basis. A billion here, a billion there, and pretty soon you’re talking real money.

With only slightly more than 1.5 million equivalent “A” shares outstanding, each $1 billion represents $650 in earnings per Berkshire share. We also note that this display of financial pyrotechnics is occurring in what Mr. Buffett termed as an environment that is “pathetically low” for interest earnings on the company’s large holdings of cash and bonds, a circumstance he has also indicated he does not believe is permanent. The current rate environment is likely costing Berkshire hundreds of millions in investment income, perhaps as much as $1 billion a year with the current investment configuration (which is of course subject to change based on opportunities Berkshire finds and pursues).

Insurance

“Being the low cost producer of something people need is a good thing.”
- Warren Buffett

Insurance (primarily property and casualty reinsurance) is and will be the business that matters most at Berkshire; it is, as Mr. Buffett says, where the money is. We have therefore written extensively about Berkshire’s insurance operations in this space over the past four years, including a detailed review of challenges and improvements last year. In the spirit of Mr. Buffett’s quip in Omaha, “If we start confessing to stolen quotes we’ll be here all day,” we suggest reviewing our thoughts in those published reviews as a shorthand review of some of what we might not cover in the comments below.

Maintenance of a large pool of low or no cost capital provides the critical oil that lubricates the Berkshire business model. The key to making the various moving parts of insurance work well for Berkshire shareholders is underwriting profitability coming out of each individual insurance unit. Not just the aggregate, but the individual businesses, another example of Mr. Buffett’s “every tub on its own bottom” philosophy espoused in another context in this year’s annual report. Recent financial results indicate that this outcome has been achieved across the insurance portfolio of late. What can’t be predicted in advance is the amount of float generated or its growth rate; such outcomes are diametrically opposed to maintaining a low cost structure over time. Walking away from inappropriately priced business is a key discipline in insurance, and one which must be fostered through careful consideration of goals and incentives.

Mr. Buffett displayed several slides in Omaha that reviewed the National Indemnity subsidiary’s financial history to make this point clear. The company possessed no patents, natural resources, real estate, copyrights or other protected, obviously moat-creating intellectual property. Nonetheless, they prospered over several decades because they focused on the long-term and designed a system that did not work against them, recognizing that the industry’s worst challenges were self-inflicted. They did not reward the wrong behavior or set up unintended consequences. They tolerated volatile expense and growth metrics that Wall Street would likely have crucified them for were they a stand alone public company and focused on accepting only intelligent risks, whatever the short-term accounting consequences.

But National Indemnity achieved unparalleled success over time, and it’s clear that such a mindset is the operating focus for insurance operations across the board at Berkshire. Both senior management and the company’s consolidated financials can and will withstand volatility both in insurance operations’ growth rates and absolute levels of insurance revenue in a way few public companies can stomach. And they will do just that in order to avoid what the business model cannot long tolerate: insurance risk for which they are inadequately rewarded (as Mr. Buffett has pointed out before, “There is an unlimited market for badly priced insurance policies; insurance brokers will find you in the middle of the ocean if you are doing dumb things in pricing.”).

The company’s insurance operations appear to be corrected in the places where its most difficult challenges had arisen in the recent past. Messrs. Buffett and Munger’s comments about their insurance businesses, supported by review of 2003 and first quarter 2004 financial results, indicates that Berkshire’s insurance operations are very well positioned for long-term success. Insurance underwriting profits were $1.7 billion in 2003; investment income added another $3.2 billion. We note that while operating expenses related to an insurance operation are relatively straightforward, estimates of loss expenses are a much more uncertain undertaking. This makes an insurer’s cost of goods sold no more than a good faith estimate that will require adjustment to “true up” to economic reality over time. We recognize that Berkshire will not avoid large losses related to insurance in the future, and even some nasty surprises related to errors in estimation. Still, we believe that any mistakes will be honest ones of judgment made by people working hard and with a conservative mindset and where present, miscalculations will be dealt with expeditiously and honestly. In our experience as insurance investors, that’s saying a lot.

Notably, for all of his legendary and entirely appropriate conservatism, Mr. Buffett reiterated in Omaha recently that he believed that the overall goal of generating large amounts of low or no cost float remained “doable” over the course of several decades at Berkshire, likely indicating his confidence in the positive attributes of the insurance portfolio we have detailed herein. Both Messrs. Buffett and Munger have declared the problems at Gen Re fixed, and this business appears “ready for its close up.” Both the leadership of Joe Brandon and the value of the capital asset its business model represents to Berkshire may yet justify the financial pain it has inflicted in the first few years following its 1998 acquisition. Berkshire Re maintains its outright dominance of its field and the extreme efficiency (a staff of 23 people runs one of the world’s largest and most profitable reinsurance operations) of its business model. GEICO, as the cost leader for a product people are required to have and where price therefore matters greatly, is well positioned, with growth opportunities, discipline, and even some more rational industry competition of late.

Over time and when operated with underwriting discipline, Berkshire’s insurance portfolio should generate very satisfactory results. They appear to have come through a very trying period doing what they are designed to do: generate a sizable amount of low cost funds, via profitable underwriting, as fuel for the investing machine. In sum, Berkshire thrives on the delivery of underwriting profits over time, and its underling insurance subsidiaries have the capacity to deliver that outcome in a way most of its competitors do not. That capacity has great value to Berkshire shareholders, and will in our view remain an important advantage for many years to come.

Non-Insurance Operating Businesses

The specific performances of companies under Berkshire’s umbrella – finance activities, energy utilities, distribution, manufacturing, services, and retail operations – will fluctuate over the course of the years subject to various economic influences and company specific events. There are two essential items that tie them together as a group. First, while they aren’t all successful and some acquisition vintages have proven more successful and durable (Sees Candy, for instance) than others (say, shoes), they are all vetted according to Mr. Buffett’s exacting standards for competitive advantage and its corollaries: profitability and return on invested capital.

We walked through the return economics of several recent acquisitions last year and came away impressed with the results. This year Mr. Buffett shared a lesson about Shaw Carpet that was more qualitative (though the analysis is of course supported by the earnings figures), but equally instructive. He quickly noted the shifting economics of the floor covering industry over time, as the number of competitors dwindled over the decades from dozens to two, Shaw and Mohawk Industries. He observed that with ten competitors at 10% market share, profits would be elusive and occasional. With only two, the limitation of choice for the Lowes and Home Depots of the world presented a more predictable set of economics for the business owner.

Such a simple delineation of the most important facets influencing competition in an industry (which we’d bet dollars to donuts it took Mr. Buffett all of 30 seconds to compile and grasp) is a comforting indicator of the remarkable consistency of the capital allocation process at Berkshire over the years. We and other investors recognize Mr. Buffett’s focus on the essentials of competitive advantage as analogous to the highly useful “Porter Model” outlined by Harvard Professor Michael Porter, which considers the forces which dictate a company’s control of its profitability. This is the same “company with a moat around it” approach Mr. Buffett has been executing for years (“I call it a moat, Porter made a book out of it” he replied when we asked him about the comparison a few years back), and there are important implications for the future value of Berkshire embedded in reinvestments made with this focus intact.

The second important unifying factor about Berkshire’s non-insurance operating businesses is in one respect their very existence, as well as their diversity and growing influence on Berkshire’s financial outcome. As long as they meet Berkshire’s return hurdles (management has indicated they target 13% minimum returns, and aren’t interested in 7-8% opportunities), they present a nearly unlimited opportunity set for reinvestment of the gigantic cash we’ve indicated that the rest of Berkshire produces. Historically, most businesses simply “limited out” over time in terms of profitable capital deployment because they could not do so; beyond a certain point, industry-specific competitors reach a capacity level, i.e., the law of diminishing marginal returns.

If all Berkshire could do with all its money was look for more insurance business, returns there would long ago have turned decidedly negative. (Which hasn’t stopped many industry competitors over the years; to the man with a hammer, everything looks like a nail.) But Berkshire suffers no such limitation in either opportunity or ability, largely because of identity: Berkshire views itself in the capital allocation business. Its business model therefore revolves around a strategy of cash production and reallocation, across virtually the entire spectrum of capital opportunities – virtually any and all industries, geographies, and investment types. Berkshire is structurally designed to allocate capital to any industry where profits can be earned, at a time of its choosing, typically on a price-opportunistic basis, in whatever format it finds appropriate (securities, insurance contracts, whole companies, trading, etc.).

In point of fact, it is not solely the insurance or investment operations for which Berkshire is so well known that are producing Berkshire’s latest impressive financial showing. One of the most interesting shifts to have taken place at the company over the past decade is the move toward more visible cash flows produced by non-insurance business acquisitions. Berkshire has been acquiring earnings power outside its formidable insurance businesses for many years, and doing so at very reasonable rates of return on capital employed.

What has changed is the relative scale of insurance to investments and non-insurance operations over the passage of time and accumulation of dollars. This is not your uncle’s Berkshire Hathaway, in terms of the inscrutable insurance business as the sole source of the non-investment results. While pre-tax earnings attributable to non-insurance businesses produced roughly $800 million in pre-tax earnings at Berkshire in 1998, that figure more than tripled to over $3 billion in 2003. With a growing war chest measured in the tens of billions, it is not at all a stretch to envision Berkshire multiplying it by a (low) integer multiple again over the course of the next decade through various acquisitions.

And speaking of cash accumulation, Berkshire’s balance sheet at March 31, 2004 listed $34.7 billion, nearly equal to the equity investments that so often gave rise to Berkshire’s mislabeling as an investment vehicle or closed-end fund. (What will pundits call it if cash surpasses equities? A money market fund? A bank?) Some of that cash hoard is no more than a place marker, a temporary holding spot for the intermediate bonds Berkshire would prefer to hold but which are unattractive at current interest rates and low premiums above cash. But much of the cash is also ready, willing and available for investments, particularly in the wholly owned business arena that is Berkshire management’s expressed preference. We’ll take up this idea of Berkshire’s capacious coffers again in a bit, after a brief detour to review Berkshire’s balance sheet investments.

Investments

Berkshire’s recent motion, or lack thereof, in securities’ investment recalls Mr. Buffett’s past self-description of “inactivity bordering on sloth” in making investment selections, though it’s more like determined disinterest. Nothing in the overall stock or bond markets currently appears compelling enough to move away from their default safety position of short-term U.S. Treasuries, which have the dual desirable characteristics of not being overpriced and maintaining their dollar value. That description does not, in Mr. Buffett’s view, apparently fit the major asset classes of stocks and bonds.

Berkshire’s relative quiet on the investment front does not surprise us, and is in fact consistent with a case we’ve been making about Berkshire for years. It’s not that balance sheet investments don’t matter at Berkshire. That would be like saying that operating systems don’t matter at Microsoft. It’s just that marketable securities, for the foreseeable future, are not where the action is likely to be at Berkshire. It is a giant part of yesterday’s value creation story for sure, but probably not the driver going forward. Traditional bonds earn income and provide a relative store of value to offset insurance liabilities. While stocks offer growth, the size of Berkshire’s available investment pool limits its meaningful opportunities in the public equity markets.

The last sizable activity Berkshire undertook with balance sheet capital was its $8 billion foray into the junk bond market in 2002. There may be occasional similar dislocation opportunities, but trust us, we do not want to see an analogous situation for the equity market where Berkshire would be similarly motivated. Absent any significant break in the equity market and exclusive of allocations that are small relative to the total available, Berkshire is essentially out of the business of investing in public marketable equities in any way that is truly meaningful to its future financial results. We expect Berkshire management will remain opportunistic in specific areas that will vary over time (like the viaticals they discussed briefly at the annual meeting), but will likely be things that happen at the margins.

As we indicated, Berkshire continues to generate gobs of low cost capital to invest and a significant determining factor in its value going forward will be what happens to the unprecedented monster cash the company is accumulating. We turn our attention now to this critical issue: when cash happens, then what?

SO, WHAT DOES ONE DO WITH $30 BILLION?

“Tomorrow, tomorrow… you’re only a day away.”
- Annie

Though Berkshire’s management has a long and enviable track record of reinvestment, Mr. Buffett has acknowledged that finding, and executing, good investment opportunities for all those dollars being created remains Berkshire’s biggest challenge. The undeniable difference in investing for Berkshire relative to years past is one of scale; Berkshire must do more and/or bigger things now. The Berkshire system is awash with liquidity, probably north of $30 billion after accounting for all insurance and other liabilities (except deferred taxes). As we’ve indicated, the current low rate environment is costing Berkshire hundreds of millions in interest on its existing positions, partly prompting Mr. Buffett’s description of Berkshire’s capital as underutilized.

Even with a conservative viewpoint on future potential, in our view piling up such a sizable stash of cash is an awfully high grade “problem” to have. As we have heard Mr. Munger observe on more than one occasion, “There are worse outcomes than being left with a lovely pile of money.” There is for instance the minimum comfort of Mr. Buffett’s reminder that the painful condition of temporarily earning low returns on cash is preferred to “doing something stupid” with it. While we are certain that not every future capital allocation will work well, in general we believe shareholders will be well served in the aggregate by Mr. Buffett’s patience with, careful approach to, and ultimate disposition of cash.

We can’t predict what the specific prospective investments will be that will offer better uses for Berkshire’s massive capital. Which puts us in pretty good company, since both Mr. Buffett and Mr. Munger indicated in Omaha that they didn’t know either. “You will occasionally see something obvious and can load up on it, but you can’t know what it will be in advance.” Berkshire’s ability and willingness to commit large amounts of capital, and quickly, is a leg up on competition in a way that is impossible to quantify but nonetheless very real. We remain confident that Berkshire has the means, motive, and opportunity to vet whatever investment alternatives are proffered. As they have demonstrated across a broad spectrum of investment types, their abilities in standing up to such a challenge stands quite apart from peers.

We can make a few broad inferences from our knowledge of Berkshire’s context and public comments. As we have indicated, marketable equity securities are unlikely to make any meaningful dent in Berkshire’s investable cash. They can’t buy enough of any single company to really move the needle. Moreover, nothing in Mr. Buffett’s past suggests he will lower the bar on the few good stock market ideas he really likes and somehow find thirty one billion dollar ideas, all of which would have to be $15 billion market cap companies; not likely in our view. (The one exception would be a significant break in the equity market, where Berkshire’s long time horizon, huge capital and analytical abilities could be put to work in the phenomenal discount environments that liquid markets sometimes offer that private markets almost never do. It’s a possible outcome, but hopefully not terribly likely, since the precipitating circumstances of such an outcome would likely mean bigger problems for most of us to think about.)

There will also be a fairly constant rotation of investment activities at the margin (which for Berkshire can be measured in billions of dollars) in various liquid markets, such as Mr. Buffett’s fixed income trading and the occasional dislocation à la 2002’s junk bond move. We recall that Berkshire would have been a logical private market alternative to the Long Term Capital Management near-failure in 1998 as well as their early-mover status in the uncertain environment for energy assets in 2000-2001 as examples of the sizable deployments that chance will periodically place in Berkshire’s path.

We believe this leaves the most likely use of capital in Berkshire’s expressed preference for its deployment: entire acquisitions of cash-generating businesses that earn above average returns on capital (see Berkshire’s “Owner’s Manual,” published in its annual report, Principle #4). And its capacity for acquisitions in this arena is truly stupendous. While purely in the realm of conjecture but interesting for illustrative purposes, we believe Berkshire could fund a $50 billion acquisition. With a 10% return on investment assumption, this would add $5 billion dollars in income annually.

More likely is a series of transactions (as we recall it, management a few years back indicated a 3-4 per year average expectation summing to 40 or so over a decade) of the type we’ve seen over the past four years. Berkshire has and will continue to operate across a wide latitude in making acquisitions and has done deals of all types over the past few years, including wholly private market transactions (Pampered Chef), tender offers for public companies (Shaw, Clayton Homes), purchases of divisions from public entities (McLane) and special situations (gas pipelines, Johns Mansville).

Making hay of the great promise of all Berkshire’s cash is of course no slam dunk. We both applaud and echo Messrs. Buffett and Munger’s frequent assertions, most recently in the 2003 annual report, that the future track record with enormous sums will in no way approach their past results. We take comfort in one of history’s greatest investors indicating that he can’t do as well in the future with a much larger pool of capital as he did in the past with a smaller one. That outlook is realistic. We also note, however, that Mr. Buffett also said “Charlie and I remain hopeful that we can deliver results that are modestly above average.” That the five or ten year hence record won’t compare to Berkshire’s earlier results is probably close to guaranteed based on the size handicap, but it isn’t necessarily relevant in our view to Berkshire earning very healthy profits and growing its intrinsic value from here. Because make no mistake, the opportunity created by Berkshire’s unprecedented nest egg is a pretty phenomenal one. Given the non-dilutive, non-leveraged way it has been amassed, it’s probably unprecedented in the history of capitalism.

We’re pretty sure Messrs. Buffett and Munger see that opportunity as well, because they notably have not decided to return the capital to shareholders. They aren't spending future royalty checks either (these are managers for whom conservatism is a way of life, not a political slogan), but they likely believe the odds favor finding value-adding uses for the capital. Otherwise, everything about their history, temperament, and published philosophy indicates they would return that capital to shareholders (on this front, see Berkshire’s “Owner’s Manual,” published in its annual report, Principles #8 and #9).

We take heart that we heard over and over this year from both Mr. Buffett and Mr. Munger, in response to questions that were not per se related to the issue of capital utilization, that they believe they can make intelligent use of Berkshire’s cash over time. In discussing asset allocation targets they indicated that they respond to opportunity rather than try to predict it, and that they still believed similar opportunities would be offered up. In addressing the competition for ideas from private equity funds they indicated they had done fine for many years with that competition and expected they would do so prospectively as well. In responding to a question about dividend policy, they offered that they had a reasonable expectation (and they are known for reasonable expectations) that they could put $30 billion to work.

Finally, in answering a (torturously specific) question about a particular valuation model for Berkshire, Mr. Buffett perfectly framed the “movie, not snapshot” aspect of considering Berkshire’s ultimate value. “The key issue is how well we can do with $30 billion in cash,” he said, then added “we hope to be able to deploy it in similar businesses.” This is another of those oh-so-small, almost throwaway comments you can hear at the annual meeting that in our view loom amazingly large in considering a long-term intrinsic value range for Berkshire if you have the context to frame them appropriately.

This “tomorrow, tomorrow” aspect of Berkshire’s current standing versus potential has been and will remain in our view key to maintaining proper perspective on the company’s long-term value. More important than the short-term interest income Berkshire is forgoing in a low rate environment, a good portion of its cash has a current opportunity cost that is much higher, as the ultimate goal is to allocate it to even higher returning investments. We think this may well be a specific example that Mr. Buffett had in mind in issuing an admonition in the 2003 annual report. “When analyzing Berkshire, remember that the company should be viewed as an unfolding movie, not as a still photograph. Those who focused in the past on only the snapshot of the day sometimes reached erroneous conclusions.” The $30 billion in excess capital at Berkshire is “worth,” ipso facto, $30 billion. The question for Berkshire shareholders (and its outcome makes the $64,000 question look like change found in the couch cushions) is what the deployment of that $30 billion will turn into over time. Given whose hands it is in, and the structural elements surrounding the company’s attitude toward capital, we like the odds. We note that at full deployment and a 10% target earnings return, the $30 billion pool would generate an additional $3 billion in annual income. Think movie, not snapshot.

MANAGEMENT SUCCESSION AND OTHER RISK FACTORS

There are a handful of risks that are germane to an evaluation of Berkshire that we have delineated in our past summaries that remain relevant today. We believe the largest one remains the inevitable psychological blow - and we suspect follow-on stock price weakness - that would accompany Mr. Buffett’s death or incapacity, the outcomes he has indicated would precipitate his departure from Berkshire. We’re sure that the stock price would suffer immediately, but as we’ve said before, we think one growing attraction of Berkshire is that Mr. Buffett has “Buffett-proofed” the company from an operating perspective and ensured its long-term success in his absence.

We have heard only increasingly encouraging thoughts related to succession over the past few years. Mr. Buffett indicated this year that he thought Berkshire was in far better shape than ever before, with four qualified internal candidates to succeed him and potentially more to come over time from future acquisitions. It has also become increasingly clear that this item is getting a high level of attention and frequent discussion among Berkshire’s board of directors. Mr. Munger opined at the Wesco meeting that while the acquisition strength of Berkshire would probably decline under a successor, the rest of the company would continue to do well. And that in his view the acquisitions side would be fine, if diminished from Mr. Buffett’s rarefied gifts in that area. And he then summed up the pretty solid position Berkshire shareholders find themselves in with a signature hilarious and blunt one-liner. “But it’s silly to complain, ‘what kind of world is this that gives me Warren Buffett for 40 years and then [someone] comes along who’s worse?’”

Moreover, the Berkshire board has only gotten stronger in our view, and we particularly note the capital allocation credentials of its recently added members. A year ago, in response to one of our questions on another topic at the Wesco meeting, Charlie Munger reminded shareholders that should sizable deviations of stock price from intrinsic value occur and persist, he knew “of ‘someone’ (i.e., Berkshire itself) with a little cash on hand.” His comment has only gotten more true over time. Berkshire currently maintains a cash balance that is a sizable percentage of its total equity market capitalization (and nearly as large as the equities it holds), providing Berkshire’s succeeding management and board ample liquidity in the event of stock price to intrinsic value dislocations. Conversely, investing that cash in operating companies in a fashion consistent with past practice prior to Mr. Buffett’s departure will help insulate the company from senior management dependence. Either they have the cash or they get in exchange an increasing volume of operating earnings that have nothing to do on a day-to-day basis with headquarters in Omaha. In any event, we think Berkshire’s position has been augmented relative to its past from both an appearance and reality standpoint.

At the same time, we are also cognizant of the sizable potential for short-term price dislocations, and know the havoc that can play on investor emotions. We would place stock price weakness related to Mr. Buffett’s death or serious illness in the category of a short-term price shock, rather than a permanent impairment of fundamental business value. There would be initial price risk in our view, but little or no long-term risk of real capital destruction (relative to the prices paid for Berkshire shares in the Fund portfolio) to Berkshire shareowners over the long-term. The upside would probably be truncated, but that represents opportunity cost rather than capital impairment risk. Nonetheless, we remain aware that this opinion might be in the minority on the matter, especially in the uncertainty in the short-term, and would be little consolation for those who might need to sell into potential price weakness. Therefore, in our view, Berkshire remains an investment for long time horizon (greater than five years) investors.

THOUGHTS ON VALUATION

“Most men would rather die than think. Many do.”
- Bertrand Russell

We recognize that its already vast scale precludes a repetition of Berkshire’s legendary success of past decades. We note too, in one important and noteworthy change from years past, Berkshire’s stock has appreciated nicely since we began this exercise of writing about it back in 2000. Therefore, it isn’t as cheap, on a relative basis, as it was in those long ago bubble-market days when we first published this piece. Still, in our view the company remains undervalued, in spite of the greater than 22% price appreciation (July 2003 – May 2004) over the past year since our last communication. Because something has gone up a lot is no reason to sell it; price to intrinsic value, not price now to price a year ago is the relevant ratio for intelligent investors. In that regard, we do not expect the significant progress we have summarized herein will remain unrecognized forever, either in Berkshire’s financial results or by investors. In our view, it does not in fact need to repeat (and almost certainly will not) its four decade track record in order to represent a profitable investment based on recent prices. We believe Berkshire is an allocation of Fund shareholders’ capital that will comfortably outpace broad market average results, inflation, and other alternative uses of capital over a reasonable prospective time frame, and will do so with less risk of real, permanent impairment of principal.

Our math on valuing Berkshire essentially runs in this fashion. First, we value the cash flows generated by insurance float by making various assumptions about the float’s size, growth rate, cost, and return characteristics. We also value the existing businesses and assets according to their relevant comparable metrics and valuation methodologies. We then allow for required insurance capital, make some assumptions about tax liabilities, and aggregate these sums to total an intrinsic value estimate for the company.

As in all valuations, we of course consider a range of possibilities and compute the discount or premium at which the company’s stock trades from the lower end of the range. We have run various scenarios/models and recognize that none of them will in fact match the reality of exactly how the Berkshire movie unfolds over time. We believe that our long history building a solid understanding of the company’s advantages qualifies us to make reasonable assumptions about the critical business levers that influence Berkshire’s financial performance. For many of the reasons we’ve outlined herein, we’re therefore quite comfortable that if we are approximately right about Berkshire, lack of precision will not preclude profits going forward. Knowledge of and insight into the company are the base on which we stand to help us derive a target for what Berkshire is worth today. All reasonable assumptions we can make lead us to a much higher value than current stock price indicates.

CONCLUSION

“You should be so lucky.”
- Charlie Munger

Berkshire Hathaway has been and remains the largest position, in the Oak Value Fund portfolio, largely because it so clearly meets all of our investment criteria of a good business, with good management, at an attractive price. In brief, Berkshire has created an immense capacity to generate low cost funds from insurance for reinvestment as well as internally generated cash from reinvesting. The business model is working as intended, with a “Cash Happens” outcome manifesting itself more and more at Berkshire.

As long as its management team can profitably retain and reinvest those dollars, as they have for decades, the exercise will result in growing intrinsic value of the business over time. At the end of the day, we think Mr. Munger’s quote above, proffered in reference to an unrelated matter, applies equally well to the excess cash accumulating at Berkshire Hathaway. As investors, we should be so lucky to have such high grade problems in all our investments.

IMPORTANT INFORMATION

This commentary seeks to describe Oak Value Capital Management, Inc. (“Oak Value,” “we,” “us,” the “Fund’s Investment Adviser” or “our”)’s and the Oak Value Fund (the “Fund”) Investment Adviser’s, current view of the market and analysis of Berkshire Hathaway. This discussion is intended to help readers understand Oak Value’s investment management style, and should not be regarded as a recommendation of Berkshire Hathaway or any other security referenced in this commentary. Where shown or quoted, recent company returns are stock price changes only. Information concerning the performance of the Fund and Oak Value’s recommendations over the last year is available on request. Past performance is no indication of future performance. You should not assume that future recommendations will be as profitable or will equal the performance of past recommendations.

Statements referring to future actions or events, such as the future financial performance or ongoing business strategies of the companies in which the Fund invests, are based on the current expectations and projections about future events provided by various sources, including company management. These statements are not guarantees of future performance, and actual events may differ materially from those discussed herein. References to securities purchased or held are only as of the date of this commentary. Although the Fund focuses on long-term investments, holdings are subject to change.

This commentary may include statistical and other factual information obtained from third-party sources. We believe those sources to be accurate and reliable; however, we are not responsible for errors by them on which we reasonably rely. In some cases, the quantitative data presented above has been prepared by Oak Value based on our analysis of financial data and other information disclosed by Berkshire Hathaway in public filings as well as that obtained through our research efforts. The views and data included in this commentary also are influenced by our analysis of information from a wide variety of sources and may contain syntheses, synopses, or excerpts of ideas from written or oral viewpoints provided to us by investment industry, press and other public sources about the companies in which we invest on behalf of Fund shareholders as well as various economic, political, central bank, and other suspected influences on investment markets.

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