During the weekend, Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) released its 2011 results as well as Warren Buffett’s annual letter.
Full-year earnings fell by 21% to $10.3 billion as Berkshire faced charges for large insurance payouts, such as for natural disasters, and saw continued weakness in its real estate businesses. Yet Berkshire was able to increase its book value by 4.6%, which was better than the S&P’s 2.1%. The company looks at this as a key metric of success.
Of course, investors are more focused on Berkshire’s -4.73% performance in 2011, as well as its average annual return of just 2.36% in the past five years.
Will 2012 be different? Can Buffett’s stockholders expect a return to strong returns? Let’s take a look at Berkshire Hathaway’s pros and cons:
Cash Machine: At the core of Berkshire is its highly lucrative insurance business, which includes the Berkshire Hathaway Reinsurance Group, Gen Re and GEICO. These companies generate huge amounts of cash flows because of the so-called float. This means they collect premiums from policy holders and do not have to make payments until many years later. Berkshire currently has $37.3 billion in the bank, and about $3 billion came in the last quarter.
With this cash, Buffett is in a great position to make investments. For example, during the financial crisis, he invested in companies like Goldman Sachs (NYSE:GS) and General Electric (NYSE:GS), which provided strong dividends. Even last year, Buffett invested in Bank of America (NYSE:BAC). In the deal, he snagged a juicy 6% dividend as well as a warrant to buy a 700 million additional shares at a strike price of $7.14.
Strong Non-Insurance Operations: Over the years, Buffett has made some mega-acquisitions that have had attractive payoffs. Consider that his five top non-insurance holdings — which include Lubrizol, BNSF, Iscar, Marmon Group and MidAmerican Energy — posted record operating income last year. Of course, Berkshire also has a high-quality portfolio of investments, which include Coca-Cola (NYSE:KO), Procter & Gamble (NYSE:PG) and IBM (NYSE:IBM).
Valuation: During the past two decades, Berkshire usually has traded at about 1.6 times book value, but it now trades at a multiple of just 1.1. Because of this, Buffett has been buying up some of the company’s shares.
Succession: Buffett appears to be in good health and still has passion for his work. But at 81 years old, there should be concerns about succession. According to the annual report, Buffett has indicated that he has selected a successor — but no name was given. He also has two backups in place. Buffett has brought on investment managers Todd Combs and Ted Weschler to get them familiar with Berkshire’s vast portfolio. Still, it seems impossible to replace someone like Buffett.
Real Estate: This business — which includes Clayton Homes, Acme Brick, Shaw and Johns Manville – continues to be a major drag on Berkshire. In the annual letter, Buffett admitted that he was wrong in his prediction that the market would see an upturn in 2011. While he still is bullish, Buffett thinks it still might take time for things to return to normal.
Losses: Berkshire insures for catastrophic losses, such as earthquakes and hurricanes. So long as the company still has strong risk management, the returns can be attractive. But Mother Nature can be brutal, as evidenced by the Japanese earthquake and tsunami.
While Berkshire is trading at a reasonable valuation, the company still has major issues. A big chunk of the company’s operating assets come from regulated industries like utilities and railroads. These businesses not only consume huge amounts of capital investments but also have fairly modest returns.
But still, the biggest issue seems to be succession. Buffett’s failure to disclose his successor has created lots of uncertainty. Can he find someone who has the strategic vision to manage the vast operations of Berkshire? Keep in mind that eight subsidiaries would be included in the Fortune 500 if they were independent operations.
So in light of all the challenges — as well as the difficulties of finding profit opportunities — the cons outweigh the pros on Berkshire Hathaway.
Tom Taulli runs the InvestorPlace blog IPO Playbook, a site dedicated to the hottest news and rumors about initial public offerings. He also is the author of “The Complete M&A Handbook, All About Short Selling and All About Commodities. Follow him on Twitter at @ttaulli or reach him via email. As of this writing, he did not own a position in any of the aforementioned securities.