A very strong business producing a lot of cash can be wonderful to own, but it comes with a key tradeoff.
As a general rule, the more you can hope to potentially earn from an investment, the higher the risk of loss you face when putting your money in it. This is a key reason why people choose to split their money between stocks, bonds, and cash depending on how much they need, when they need it, and what their particular risk tolerance looks like. Of those asset classes, stocks tend to be the riskiest, and even within stocks, the risks you face can vary wildly depending on the company and how it operates.
With that framework in mind, Berkshire Hathaway (NYSE: BRK.A)(NYSE: BRK.B) just might be among the most defensive stocks around. As with any stock investment, investors do face risks, but the way the company is structured and operates makes Berkshire Hathaway fairly unique and fortress-like.
Just how strong is it?
Well, during the global financial crisis when banks themselves were so cash-strapped they needed bailouts, Berkshire Hathaway actually provided some of the cash to bail them out. Think about that for a second -- at a time when even banks had trouble coming up with cash, Berkshire Hathaway had enough excess cash to keep those banks afloat, on top of running its own business.
What makes the company so strong?
Indeed, if there’s a common complaint that people have about Berkshire Hathaway, it’s that the company often finds itself with more cash generated from its operations than it knows what to do with. This has its foundation in the fact that it is primarily an insurance company. As a result, it is in the business of modeling (and charging for) risks.
On that front, it tends to follow a conservative philosophy when underwriting and pricing out those risks. That helps it a great deal. On a day-by-day basis, it means that the company has a reasonable shot of earning a profit off the premiums it charges for insurance. That gives it more access to float — the money it holds from its premiums in order to pay for its expected claims. The more float it has available, the more it can invest that float in a way to potentially make money for itself and its shareholders.
In addition, the more conservative an insurance company’s underwriting standards, the more aggressive it can be in investing that float. In Berkshire Hathaway’s case, it has tied together conservative underwriting with the investing skills of one of the greatest stock picker of all time — Warren Buffett. That combination has added up to some incredible investments in and outright acquisitions of companies that generate even more cash for the business.
Berkshire Hathaway’s wholly owned subsidiaries include BNSF Railroad, Duracell Batteries, Dairy Queen, GEICO, NetJets, and See’s Candies. On top of that, it has investments in large, cash-generating public companies like Apple, Coca-Cola, American Express, and Bank of America. Berkshire Hathaway collects cash from the operations of its subsidiaries, as well as dividends from the shares of many of the companies it owns.
All those sources of money add to the war chest it has available and contributes to the “problem” of having too much cash that it often finds itself facing. Of course, as far as problems go, generating too much cash is a relatively good one to have, and it’s a key reason why Berkshire Hathaway is considered a defensive stock.
All that cash comes with a tradeoff of its own
The upside of generating all that cash is that, as long as Berkshire Hathaway continues to operate the same way, it is incredibly unlikely that it will run into substantial troubles of its own. After all, even if its insurance business faces higher than expected losses, it typically has plenty of cash to cover those costs, thus allowing it to survive despite those temporary tough times.
The downside, however, is that when a company gets as big as Berkshire Hathaway does, it gets much tougher for it to grow at a fast rate. To deliver a 10% growth rate on a $1 billion company only requires $100 million of new revenue, while a 10% growth rate on a $250 billion company like Berkshire Hathaway requires $25 billion of new sales. That kind of growth in absolute terms is very tough to achieve, and with slower growth comes a lower potential for stock price appreciation over time.
As a result, while Berkshire Hathaway is likely able to survive even in really tough economic times, it’s not likely to consistently grow faster than the stock market while the economy is growing strong. Still, for long term investors, it can play a role as a stock capable of providing more growth than bonds, even though it likely will not grow as fast as smaller companies.
While that tradeoff is very real, it’s that combination that puts Berkshire Hathaway in contention for the spot of the ultimate defensive stock.
At the time of publication, Chuck Saletta owned Bank of America bonds maturing in July 2024 and American Express bonds maturing in August 2023.
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