Voting control will determine whether the company retains its unique culture
In the long run, entropy takes a merciless toll on all living things. Without dedicated effort, our health degrades over time, at first in imperceptible ways before the effects become undeniable. Almost no poor decision I make today is going to destroy my health tomorrow, whether I skip a workout or eat a fast food meal for dinner. But poor choices accumulate over time, allowing entropy to defeat us sooner than necessary.
The same forces of entropy will eventually erode and ultimately destroy institutions created by human beings, and the rate of decline can only be slowed down through constant vigilance and effort. When it comes to a business, the culture and ethos of the institution depends on the example and actions of key leaders, and the ability of the leaders to execute a long-proven strategy with support from the firm’s owners.
I’ve often written about Berkshire Hathaway over the past fourteen years because I find the company to be a beacon of rationality and integrity in a sea of dysfunction. All too often, public companies are run for the benefit of managers and other insiders who often have little skin in the game when it comes to actual ownership. Berkshire is different because it does not suffer from agency problems. Warren Buffett is both the largest shareholder of the company and effectively controls how it is managed.
As a longtime shareholder of Berkshire Hathaway, I have always regarded management succession to be a major concern. The announcement that Greg Abel has been designated as Berkshire’s next CEO alleviated many concerns, and his subsequent purchase of stock reinforced my positive assessment of the succession plan. Mr. Abel’s proven skills and his ownership interest are reasons for optimism.
We should keep in mind, however, that Mr. Abel’s ability to manage Berkshire will depend on the support of shareholders. Specifically, Class A shareholders will exert overwhelming influence over the direction of the company in the coming decades.
In March, I wrote Berkshire’s Future Depends on Voting Control in which I presented a lengthy and detailed explanation of the voting power of Class A and Class B shares, along with the necessary historical context. For those who are not inclined to read that article in its entirety, I will summarize the situation briefly:
- Berkshire Hathaway has two classes of common stock: Class A and Class B
- Each Class B share has 1/1500th of the economic rights of a Class A share.
- Each Class B share has 1/10,000th of the voting rights of a Class A share.
- Each Class A share can be converted to 1,500 Class B shares without triggering tax consequences, but Class B shares cannot be converted into Class A shares.
On Friday, November 18, 2022, Berkshire’s Class A shares closed at $468,290 while the Class B shares closed at $310.76. If we multiply the closing price of the Class B shares by 1,500, we arrive at $466,140 which is 0.46% less than where the Class A shares closed. This modest differential is the implied discount for the impaired voting power of the Class B shares. Historically, the discount has been relatively minor.
As I discuss in great detail in Berkshire’s Future Depends on Voting Control, the number of Class A shares outstanding is destined to decline over time. Class A shares will be converted to Class B shares because there are powerful incentives to do so.
Class A shareholders who have significant capital gains in the stock and need to raise less than $468,290 would prefer to convert Class A share to 1,500 Class B shares and sell only the number of Class B shares necessary. This minimizes the tax bill. Also, a Class A shareholder may wish to make gifts of stock without impacting the lifetime estate tax exemption. One may give away $16,000 per year to an unlimited number of recipients (rising to $17,000 per year in 2023) without impacting the estate tax exemption and the only way to do this is by giving away Class B shares.
The most important factor that will reduce the number of Class A shares is that Warren Buffett has stated that he will eventually convert all of his Class A shares to Class B shares prior to giving them away to charity. This process has been ongoing for several years as Mr. Buffett has given away more than half of his stock since 2006.
Hopefully, what I have described above provides enough of a high level overview and summary of the more detailed information provided in my earlier article. It should be clear that with the diminishing number of Class A shares in circulation, control of the company will depend on who eventually owns the remaining Class A shares.
Mr. Buffett is 92 years old, in apparently good health, and plans to run the company as long as he is able to. While it would be great to see Mr. Buffett running the company as a centenarian and beyond, the reality is that it is almost impossible to think that he will be running the company twenty years from now. Even Mr. Abel, currently 60 years old, may have turned over the reins to his successor by 2040.
This brings me to the suggestion that may have prompted you to read this article to begin with: Should Berkshire Hathaway consider splitting the Class A shares?
I am fully aware of the fact that splitting a stock is economically meaningless, so let’s put that objection to rest. There is absolutely no compelling reason to split the Class A shares to create underlying economic value. Furthermore, I do not believe there is any compelling case to split the stock to “increase liquidity”. Both Class A and Class B shares are liquid enough from any long term investor’s perspective, and there is no reason to increase liquidity for the benefit of short term traders.
So, why split the Class A stock?
I believe a split should be considered because the current price is certain to “shake out” longtime individual investors who will feel compelled to convert their Class A shares to Class B for several reasons:
- Berkshire does not pay a dividend, justifiably so in my view, but this means that the only way shareholders can obtain liquidity is to periodically sell shares.
- A longtime Class A shareholder who needs a modest amount of liquidity will not want to sell a Class A share because doing so will incur a capital gains tax on the entire amount of the gain. As a result, the Class A shareholder will opt to convert to 1,500 Class B shares and sell only the number of Class B shares required.
- A longtime Class A shareholder who wants to take advantage of the $16,000 annual gift tax exemption has no choice but to convert his Class A share to 1,500 Class B shares and give away Class B shares.
- A Class A shareholder who owns stock in a traditional IRA account may be compelled to convert to 1,500 Class B shares in order to take annual required minimum distributions.
Over time, the effect of these factors will be that longtime Class A shareholders will convert to Class B and lose voting influence in the process. The dwindling number of Class A shares will increasingly fall into the hands of institutional investors over time. Although the process will be gradual, it will also be inexorable especially as the stock price advances in the future. I’m not making any predictions, but the combination of increases in business value and the effect of repurchases could conceivably cause the Class A stock price to breach a million dollars by Mr. Buffett’s 100th birthday.
Is it a good idea for Berkshire’s longtime Class A shareholders to convert to Class B and lose voting control? I think the answer to this question is an unequivocal no.
As Mr. Buffett has said on many occasions, Berkshire has a long-established base of shareholders who are committed to the culture and ethos of the company, and he does not wish to see this change. The best way, indeed, the only way, for such shareholders to retain influence is to retain as much voting control as possible over time.
A potential solution to this problem is to split the Class A stock, but to keep the price relatively high in order to discourage purchases by short-term traders and others who are not aligned with the long-term prospects of the company. In 2010, Berkshire split the Class B stock 50:1 in order to facilitate the BNSF acquisition which required the use of Class B shares for part of the consideration.
What if Berkshire were to split the Class A stock at the same 50:1 ratio that was applied to the Class B stock in 2010?
- The Class A shares would trade at around $9,400 based on recent market prices
- Each Class B share would have 1/30th of the economic rights of a Class A share.
- Each Class B share would have 1/200th of the voting rights of a Class A share.
- Each Class A share would be convertible to 30 Class B shares without triggering tax consequences, but Class B shares will not be convertible into Class A shares.
A price tag of $9,400 per Class A share would still be considered “very high” for investors who do not understand the company or have a short-term mindset. Each Class A share would be convertible to 30 Class B shares, so those who wish to convert will still be able to do so, but fewer shareholders will opt to do so. It will be easy enough to liquidate individual Class A shares without triggering an enormous tax bill, and one could give away single Class A shares within the $16,000 gift tax limit. Shareholders will retain voting control over the remainder of their Class A shares.
While this idea might seem heretical to some shareholders (and possibly to Mr. Buffett himself), I think it deserves serious consideration. Ultimately, voting control will likely fall into the hands of large institutions anyway, but that day could be pushed further into the distant future if longtime individual shareholders have less of an incentive to give up their voting power prematurely by converting to B shares.
Over the past decade, institutional investors have increasingly come to embrace the “ESG” movement that seeks to turn public corporations into activist agents of social change regardless of the impact on the financial future of shareholders who have entrusted their savings to people who are supposed to be their fiduciaries.
Warren Buffett and Charlie Munger have created a great shareholder-centric culture, but they will be powerless to do anything about it if institutions exert their will in the 2030s or 2040s. One step they could take is to encourage individuals aligned with the company to continue owning Class A shares or to purchase Class A shares. In my opinion, individuals who are planning to put a large amount of money into Berkshire should strongly prefer Class A shares, and this would be easier to do at a lower price.
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