Berkshire Hathaway’s Retained Earnings Test

Published on June 28, 2023

This is the third and final article in response to questions from readers.

The first two articles, published on June 21 and 23, covered performance disclosures for Berkshire’s investment managers, the reinsurance outlook, inflation, insider ownership, and worst case scenarios:

Should Berkshire Hathaway Disclose Performance for Investment Managers?, June 21, 2023

Berkshire Hathaway: Reinsurance, Inflation, Insider Ownership, and Worst Case Scenarios, June 23, 2023

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The Owner’s Manual

Berkshire Hathaway’s shareholders have an unusually long term perspective and are typically well aligned with management’s unique style of operations. The company’s corporate ethos first developed when Warren Buffett took control in 1965 and was reinforced when Berkshire shares were distributed to limited partners as Mr. Buffett wound down his investment partnership at the end of 1969. 

Berkshire’s shares historically turn over less than other companies but there have been occasions when the shareholder base has changed materially in a short period of time. Berkshire’s merger with Blue Chip Stamps in 1983 caused the shareholder base to grow and Mr. Buffett considered it important to communicate Berkshire’s operating principles to new owners.1 He set down thirteen owner-related business principles intended to help new shareholders understand Berkshire’s approach. 

When Berkshire issued Class B stock in 1996, this resulted in an influx of new shareholders, many of whom were previously “priced out” due to the high price of Class A stock. This presented Mr. Buffett with the challenge of welcoming a large number of new owners who may have purchased shares without fully understanding his approach.2 In June 1996, the thirteen owner-related principles communicated to Blue Chip shareholders in 1983 were republished as An Owner’s Manual in a booklet sent to all Berkshire shareholders. The manual was reprinted in Berkshire’s annual reports until 2017 and the latest version is still available on the company’s website.

The Owner’s Manual remains relevant to shareholders even though it is no longer included in annual reports. Our focus today is on Principle #9 which has to do with the question of whether or not management should retain earnings.

Deploying Free Cash Flow

Before getting into Berkshire’s retained earnings test, it is important to understand that we are referring to “owner earnings”, a concept that is closely related to free cash flow and almost never identical to net income defined by generally accepted accounting principles (GAAP). Warren Buffett explained owner earnings in his 1986 letter to shareholders as part of his discussion of the Scott Fetzer acquisition. 

Owner earnings is calculated as reported earnings plus depreciation, depletion, and amortization minus the average annual capitalized expenditures for plant and equipment required to maintain the company’s competitive position and unit volume. In addition to these items, we should also recognize that Berkshire’s reported earnings are distorted, especially over short periods of time, due to the inclusion of unrealized gains and losses on the company’s large portfolio of equity securities.

Five years ago, I wrote Thoughts on Share Repurchases and Capital Allocation which describes the options for management to deploy free cash flow. I came up with the following possible options which are more fully described in the article:

  • Expand current business operations.
  • Pursue business opportunities in adjacent or unrelated areas.
  • Pursue acquisitions.
  • Accumulate cash.
  • Return capital to shareholders. 

Berkshire Hathaway is a conglomerate made up of hundreds of business units, each of which have unique economic characteristics. The conglomerate structure allows free cash flow to move between business units in a tax efficient manner. This is a major advantage. For example, despite management’s many attempts, See’s Candies has been unable to reinvest its prodigious free cash flow to expand the business. Similarly, BNSF has been a provider of cash for Mr. Buffett to allocate to other opportunities. In contrast, Berkshire Hathaway Energy has been able to redeploy all of its free cash flow.

Despite Warren Buffett’s desire to bag “elephants”, opportunities to acquire businesses of a size large enough to “move the needle” have been few and far between in recent years. As a result, cash has accumulated on Berkshire’s balance sheet. In 2018, Berkshire changed its repurchase policy and began to buy back shares and the pace picked up significantly starting in 2020. Between August 2018 and March 2023, Berkshire used $70.5 billion to repurchase shares.

The rest of this article is a discussion of Berkshire’s retained earnings test, as originally formulated in 1983 and as amended in 2010. As we go through this discussion, we should be cognizant of the fact that Berkshire has been returning a significant amount of cash to shareholders over the past five years, an implicit recognition that management has found it difficult to deploy capital in other ways. The fact that Berkshire has accomplished this return of capital via repurchases rather than dividends is an expression of Warren Buffett and Charlie Munger’s view that shares have been trading below intrinsic value, “conservatively determined”.3

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Berkshire Hathaway’s Retained Earnings Test
  1. For some background on Blue Chip Stamps, I recommend reading my book review of Damn Right! — Behind the Scenes with Berkshire Hathaway Billionaire Charlie Munger. I also discussed Blue Chip in my book review of The Buffalo News: From Butler to Buffett. []
  2. When the Class B shares were offered, Berkshire issued a remarkable statement in a prospectus dated May 9, 1996 indicating that “Mr. Buffett and Mr. Munger believe that Berkshire’s Class A Common Stock is not undervalued at the market price stated above [$33,400]. Neither Mr. Buffett nor Mr. Munger would currently buy Berkshire shares at that price, nor would they recommend that their families or friends do so.” []
  3. See the 2022 annual report, page K-32: “Berkshire’s common stock repurchase program permits Berkshire to repurchase its Class A and Class B shares at any time that Warren Buffett, Berkshire’s Chairman of the Board and Chief Executive Officer, and Charles Munger, Vice Chairman of the Board, believe that the repurchase price is below Berkshire’s intrinsic value, conservatively determined. Repurchases may be in the open market or through privately negotiated transactions.” []
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