The Digest #18

Published on April 22, 2020

In Today’s Issue:

This week’s newsletter contains the introduction to an article published on The Rational Walk this week regarding Berkshire Hathaway’s large cash position. Berkshire’s $125 billion of cash has built up over a number of years and many shareholders assume that the bulk of it is available for deployment. The coronavirus bear market has increased expectations that Warren Buffett will find attractive opportunities, but Charlie Munger recently gave an interview in which he stated that Buffett’s phone has not been “ringing off the hook”. 

To read last week’s newsletter covering the earnings guidance trap, the pandemic of 1918, and the latest Howard Marks memo, please click here

Thoughts on Berkshire Hathaway’s Deployable Cash

“Berkshire will forever remain a financial fortress. In managing, I will make expensive mistakes of commission and will also miss many opportunities, some of which should have been obvious to me. At times, our stock will tumble as investors flee from equities. But I will never risk getting caught short of cash.”

— Warren Buffett, 2018 Annual Letter to Shareholders

Berkshire Hathaway has long been known for its culture of financial conservatism. Warren Buffett and Charlie Munger have, for decades, repeated the mantra of positioning Berkshire to always remain a financial fortress through all economic environments.

Although some investors may consider a large cash position to be “trash” in light of microscopic returns on cash equivalents such as treasury bills, Buffett and Munger consider cash to be an indispensable ingredient in the recipe that built Berkshire Hathaway. While the cash has always primarily been there to ensure the safety of the corporation, many have also regarded cash to be “ammunition” available for Buffett and Munger to deploy opportunistically at times of stress when few others have the ability to deploy capital. As of December 31, 2019, Berkshire held $125 billion of cash equivalents.

As Buffett likes to say, you can only tell who has been swimming naked when the tide goes out. Applied in a financial context, it is possible for businesses to operate in an unwise leveraged manner when times are good, credit is easy, and headlines about the death of the business cycle are appearing in respected newspapers. During such times, holding excess cash earning tiny returns is a lag on financial results. Doing nearly anything with excess cash, whether in the form of an acquisition or returning capital to shareholders, will boost return on equity in the short run.

During the nearly uninterrupted decade-long bull market that followed the financial crisis of 2008-09, Berkshire built up a formidable cash hoard while less far sighted managers decided to go skinny dipping in the ocean in the misguided belief that the tide would never go out and leave them exposed. Far from maintaining excess cash, many companies took on cheap debt for acquisitions or to finance a return of capital to shareholders leaving balance sheets in a leveraged state. For a while, actually for a long while, this type of approach worked wonders. Those who pursued leveraged strategies saw their stock prices rise and their equity-linked compensation enhanced. Holding excess cash was punished since, after all, the business cycle might be dead and the cash represented nothing but an anchor holding down return on equity.

It is unlikely that the business cycle will ever die, regardless of how stable a given period of history might seem to those living through it. The end of the long expansion of the 2010s came abruptly with the arrival of the coronavirus pandemic in early 2020. Much like when the tide goes out before an enormous tsunami comes ashore, executives found themselves exposed on an expanded beach with the surf well out in the distance. Suddenly, all of that leverage and risk taking appeared obviously unsustainable. Within weeks, many large businesses were in financial distress.

Berkshire Hathaway is in no way immune from the effects of the coronavirus pandemic. It is too broadly involved in the United States economy to escape unscathed. However, the presence of $125 billion of cash on the balance sheet at the end of 2019 makes it obvious that nothing that the virus can throw at the company will remotely threaten its solvency. Buffett’s fortress will not be exposed to the indignity of going to the government begging for bailouts.

However, the question that remains is whether the cash will position Berkshire to benefit from the current environment by making opportunistic investments. This has long been the hope of Buffett himself and many shareholders who have accepted the inherent lag of a large cash position in exchange for the optionality that it would provide when the tide goes out on everyone else.

Buffett’s fortress is like a lighthouse high above the ocean looking down on the naked executives exposed by the receding tide and looking for a lifeline. That’s a wonderful image for shareholders to hold in their thoughts but is it correct? Is the $125 billion of cash truly available for deployment at this time or has the economic situation deteriorated to the point where Berkshire’s risk aversion requires a large portion of these funds to be held in reserve?

To answer these questions, one must take a look at the history of Berkshire’s cash position and put it into the context of other investments held by the company. Then the resources on the asset side of the balance sheet must be weighed against the insurance claims on the liability side of the balance sheet.

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Copyright and Disclosures

Nothing in this newsletter constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. 

The Digest #18