The big issues for Warren Buffett and Berkshire Hathaway remain unchanged.

• The latest earnings and Berkshire Hathaway's annual letter to shareholders are anticipated to be released this weekend.
• Despite the volatile stock market, Warren Buffett's company is performing well and investors are turning away from high-growth tech stocks towards safety.
• Berkshire continues to face some of its biggest challenges, including a large amount of cash on the balance sheet, a lack of significant M&A deals, and an Apple stake that rivals the size of Berkshire's operating companies.

In early 2022, the stock market has shown some indications of becoming more similar to the Berkshire Hathaway style, with Ark Invest's flagship Innovation ETF experiencing a complete reversal of its Covid outperformance and Warren Buffett's company surpassing Meta in market value.

James Shanahan, an Edward Jones analyst, stated that the recent run and rally in 2021 have been positive, with shares up roughly 5% this year. Despite a broader U.S. stock market dip into correction, the market has had a good year.

Berkshire's latest earnings and annual letter to shareholders reveal that some of the biggest challenges for the company's future have not changed, despite the market's recent tumult. The most significant issues can be illustrated through the largest numbers. At one point this year, before investors turned to Berkshire as a safe-haven trade, its stake in and cash on the balance sheet were both valued at approximately $150 billion - $160 billion each, which was comparable to the combined value of all Berkshire operating companies. Although this has changed, the underlying issues remain.

Apple and a stock concentration issue unlike any other

Warren Buffett's aversion to technology has changed, and Apple is now Berkshire Hathaway's biggest stock holding. Lawrence Cunningham, a Berkshire Hathaway expert and George Washington University professor, says that the bet on Apple should never have been much of a surprise, as it was clear how large a runway the company had for growth and scale. While certain technology themes might still be a bridge too far for Berkshire, such as pure-play EVs and AI, with Apple over the past decade, Cunningham says, what has been seen is a market leader similar to an auto company in the 1920s.

Although Apple has performed exceptionally well, it has resulted in a stock concentration issue that Berkshire has not experienced before. At one point this year, Apple's value in the Berkshire stock portfolio was equal to the combined value of all Berkshire's operating companies. Currently, the stake is valued at approximately $150 billion, and despite Berkshire's gains amid market volatility, Apple's relative value to the rest of Berkshire remains significant, accounting for about half of all the stock owned by Berkshire.

Cunningham advises investors to pay more attention to Buffett's history of holding a diversified stock portfolio, rather than focusing solely on Apple's weight in Berkshire. He emphasizes that Buffett has always been comfortable with having a large stake in a few select stocks. "Concentration has never bothered them," Cunningham said.

Instead of being concentrated in a few financial and consumer stocks like American Express, Wells Fargo, Gillette, and Coca-Cola, the market's largest company now holds the majority of its stock portfolio. If four companies in the past represented half of its portfolio, it is reasonable to assume that in today's technology-driven market, the largest company in the world may hold an even greater share.

Shanahan stated that no stock has ever been valued as high as the operating companies, but it's important to remember that the operating companies are primarily "old economy" and industrial-based, while the pivot to tech, specifically Apple, offers a balance to this investment.

Apple assisted Berkshire in resolving a longstanding issue related to underperforming financial stocks by providing exposure to technology. According to Shanahan, while Apple's exposure to technology is not particularly significant compared to other businesses, it was still necessary for Berkshire to diversify its portfolio.

Despite the market's shift away from growth stocks and concerns about free cash flow, Apple's cash generation is not a worry for any investor.

A new explanation for the role of Buffett’s cash

Berkshire's last reported cash value was close to the value of its Apple stake, at around $150 billion. Despite this, the company has been actively repurchasing its own shares as an alternative to high asset values across various industries, in a market with abundant liquidity and intense competition for deals from private equity and sovereign wealth funds.

"He finds the prices incomprehensible," Cunningham stated.

Cunningham stated that Berkshire is not capable of purchasing distressed properties and revitalizing them with new management to achieve a turnaround.

The partnership with 3G on Kraft Heinz was intended to be a cultural fit, but it has not been successful, indicating that Buffett's deal-making approach may not be as readily available as cash on the balance sheet as once thought.

In the last market downturn, the biggest challenge for dealmakers was the limited government support, which restricted Berkshire's ability to play a "lifeline" role. According to Shanahan, "You can't compete with the government cost of capital." However, if the economy weakens, it is not expected to see the same level of government support observed in either 2008 or 2020.

Cunningham believes Buffett should discuss the cash problem in a new way, rather than viewing it as a hoard that needs to be spent on M&A. He suggests that Berkshire should hold more cash on its balance sheet than it has historically due to the current world conditions. Cunningham notes that insurance is a significant part of Berkshire's operating business, and the potential calls on capital related to insurance are growing due to more frequent catastrophes such as hurricanes, floods, droughts, and tornadoes. Buffett and his long-time partner Charlie Munger have resisted discussing the impact of climate change on their business, but Cunningham believes Berkshire shareholders are due for an update on how Buffett thinks about the right level of cash to hold given the potential for catastrophes. Cunningham believes the cash held should be higher than it has been historically.

Cunningham believes that Buffett's last figure for the right amount of cash to hold is outdated, with a current estimate of $20 billion being too low. He suggests that Buffett may have overestimated the need for cash, and that the figure may be closer to $150 billion. However, Cunningham acknowledges that some portion of the cash may be necessary for old-fashioned Berkshire prudence and not just a lack of opportunity.

If Berkshire had the chance to make a $150 billion deal tomorrow, it might be wise to consider the potential risks before making a decision.

Buffett believes that insurance companies should maintain reserves to cover claims, but he believes that even in the event of bankruptcy or government bailout, Berkshire's insurance businesses will not face such risks. Cunningham notes that Buffett believes that minimum capital statutory reserves are sufficient, but companies may still go bankrupt and be unable to pay claims even with those reserves.

Buybacks and the long argument over a dividend

In 2021, when the value of Apple and cash was close to the value of the operating companies, the buyback math was more attractive for undervalued shares, as the intrinsic value of Berkshire's businesses was worth more than the stock market value of Berkshire, which was driven by holdings like Apple. Additionally, Berkshire has been buying back more shares in recent years as the value of the operating companies decreased relative to cash and stock holdings.

As Buffett's stock price increases, the share buyback opportunity becomes more challenging. However, it will not completely disappear as an option for cash because Berkshire has become a steady stock, not a "glamorous stock hitting spectacular levels," according to Cunningham.

While it may not be as attractive as it has been in recent years, Berkshire still has some "modest upside" for buybacks, according to Shanahan. However, a more moderate case could mean that cash continues to grow on the balance sheet.

Buffett has long been averse to forcing a taxable event on shareholders, and despite speculation about other sources of cash, such as a Berkshire dividend, none have been forthcoming. It seems that if a dividend is to be issued, it may not occur until after Buffett's departure from Berkshire. However, Cunningham suggests that as the shareholder base evolves and new generations enter the company, it may be prudent to reconsider the idea of a dividend and present it to shareholders at an annual meeting. Berkshire has done this in the past.

The Berkshire board and the activists

Recently, two long-time directors, Tom Murphy and Walter Scott, resigned from Berkshire, and this has led to a critical management overhaul at the company. The board, which has been dominated by a group of older, mostly white male executives, is facing pressure to increase diversity. Recent replacements, including Christopher Davis and Buffett’s daughter Susan, suggest that there will be a push-pull tension between the need for greater diversity on the board and the need to preserve the Berkshire culture through board members who are familiar with Buffett.

Chris Davis, a long-time Berkshire investor and leader of value fund management firm Davis Selected Advisers, has joined the board at the age of 50, bringing down the average age. However, he does not address the growing calls for greater ethnic and racial diversity on the board. Berkshire insurance head Ajit Jain is of Indian descent, and former American Express CEO Kenneth Chenault became the first Black board member in 2020, replacing Bill Gates. Buffett's daughter has been added to the board, bringing gender diversity, but is his second child to serve. Cunningham stated that she knows Berkshire better than anyone and spends more time with him than anyone else, including his wife. When Buffett leaves, she will ensure that there are no exceptions, exemptions, or waivers around core principles and will speak up for them.

The tension between increasing board diversity and maintaining institutional knowledge is crucial to monitor because upcoming board changes at Berkshire will determine the company's future, which is significant for shareholders. This issue may become even more significant in a post-Buffett era, as there is a possibility of activist shareholders pushing for financial and structural changes on the company, especially if it continues to struggle with beating the index and has a large amount of cash. Additionally, there may be activists pushing for greater ESG focus from Berkshire, which has resisted such an approach due to issues such as climate and diversity reporting. Last year, more Berkshire shareholders than ever before voted in favor of climate and diversity proposals.

Cunningham stated that the power is approaching and Chris, Susan, and the rest must be ready to manage it. Berkshire has consistently acknowledged the dissenting shareholder perspective on ESG matters but believes its companies perform well and as an umbrella organization, Berkshire does not control the individual companies it owns.

Cunningham stated that with shareholder support for ESG measures reaching 25% at the annual meeting, it is likely to increase, not decrease.

Activists have not targeted Berkshire Hathaway because Warren Buffett controls a significant number of shares, but as he leaves and distributes more shares, those activists will take advantage of the situation by proposing strategic reviews, demanding a dividend payment, and selling off 10 companies.

Buffett requires board members who are ready to challenge him. "He wants them to say no," Cunningham stated. "They must assert that this business model is enduring and sustainable. However, it will be a different game when no one owns 20% of the stock, and no one is Warren."