Buffett solves his cash crisis
Good deals are scarce and the billions are piling up, so Berkshire will look to private outfits abroad to put its war chest to work.
OMAHA (MONEY Magazine) - If every year you had more cash than the year before, would you have a problem with that? If every year you had a lot more cash than the year before, would you have a problem with that? And if, at last count, your cash had piled up to $37 billion, would you have a problem with that?
That's why his announcement this week that he is spending $4 billion in cash to buy Iscar, an Israeli-based machine-tool maker, is so important. "It's the first business we've purchased that's based outside the US," Buffett said on Saturday in his remarks to 24,000 shareholders assembled at Berkshire's annual meeting in Omaha. "I think we'll look back on this in five or ten years and see this as a very significant event in Berkshire's history."
A turning point
The Iscar purchase is a sign that Buffett and his vice chairman, Charles Munger, may be finding a way out of Berkshire's unique kind of cash crisis. Most companies struggle to produce excess cash after paying all their costs. Buffett's investments are so lucrative that he struggles to find ways to put all their excess cash to work.
Those billions in cash are a problem for Buffett because:
• Interest rates are low, so idle money earns meager returns.
• He believes the value of the US dollar will decline for years to come, making cash a wasting asset that may be worth less with each passing year.
• At Berkshire's current market capitalization of roughly $130 billion, it's hard for Buffett to find publicly traded stocks both cheap enough and big enough to make a difference in his company's overall results.
• The hundreds of billions of dollars pouring into hedge funds and private equity funds have made it difficult to buy private businesses in the US at fair prices.
All these factors combine to make Buffett's original game – buying small, publicly traded US companies – next to impossible. And they make it almost as hard to buy bigger US stocks, too. At Saturday's annual meeting, Buffett revealed that Berkshire – which as of March had $37 billion in cash – is looking at one acquisition for about $15 billion in cash. (He, Bill Gates, and the royal family of Saudi Arabia may be the only people alive who could consider such a thing.) But he warned sternly that this particular deal has a "low probability" of occurring.
"We don't like excess cash," said Buffett, "but we like dumb deals even less. It's likely, but far from certain, that three years from now we will have significantly less cash." And how much less is "significantly" less? "We don't need anything remotely like $40 billion [in cash]," explained Buffett. "We would be much happier if we had $10 billion." (Hey, who wouldn't?)
So how will Buffett get rid of all that extra cash? To me, the most interesting thing about his remarks at this year's meeting was the word he never uttered: dividend. In years past, Buffett has admitted that if he could not find a better use for the mountain of cash that his shareholders have entrusted him with, then he would have to consider paying out a special dividend, much as Microsoft (Research) did in 2004. This year he never spoke the D-word, which suggests to me that the Iscar deal may be a template for a new solution to his cash problem. Iscar has several advantages:
• Based in Israel and operating mainly outside the US, it generates most of its cash in foreign currency.
• It was a private transaction, so Buffett did not have to outbid competitors in a public auction.
• It was a sizable deal, enabling him to put a good chunk of cash to work at once.
• And, most importantly, it will send a signal to major family-owned businesses around the world that Buffett is now a buyer of choice beyond the borders of the US. By turning the Wertheimer family, the main owners of Iscar, into instant billionaires, Buffett has sent out a wake-up call to similar potential partners everywhere.
It's important to realize what's going on inside Buffett and Munger's heads. They view capital allocation – how the cash should be redirected among the dozens of different businesses that make up Berkshire Hathaway – as their single most important responsibility. They also think they can add at least as much value with smart capital allocation as they can with smart stock picking. After all, inside a conglomerate like Berkshire, even a business with only marginal profits can be valuable if Buffett and Munger can redirect its excess cash to a faster-growing division that has a better use for the capital.
With each passing year, they seem to become a little less interested in buying small stakes of companies that trade in the stock market – and more interested in buying majority holdings in private businesses. That, they believe, is how they can now get the biggest bang for their big bucks.
Buffett and Munger are more thoughtful about what to do with cash than any other business leaders in America. That's because they know that cash is like most good things in life: It takes only a tiny bit too much to turn it from a blessing into a curse.
As Buffett's mentor, Benjamin Graham, explained in Chapter 19 of his book The Intelligent Investor, the better a boss is at managing the operations of his business, the worse he is likely to be at managing its finances. That's because a well-managed business mints money – and those piles of cash lead to temptation.
Most corporate managers could find 37 billion ways to spend $37 billion – nearly all of them bad. They might go on an acquisition binge, paying any cost and bearing any burden to buy any company they came across. They might build a 60-story skyscraper with their name on it, expand their product lines into markets they knew nothing about, or spend a fortune on research and development for goods that nobody wanted.
Even more likely, they would pay themselves hundreds of millions of dollars in stock options, then spend even more money to buy back the company's shares on the open market. They would call this "enhancing shareholder value," since it would supposedly keep the new stock options from "diluting" the stake of existing shareholders.
For several years Buffett seems to have been casting about, trying to find a way to solve his peculiar cash crisis without having to admit defeat and pay out a big (and taxable) dividend. The Iscar deal is a strong hint that he may have largely solved this problem. Of the $25 billion to $30 billion that Buffett hopes to invest over the next few years, it wouldn't surprise me a bit if the lion's share of it went into private companies based outside the U.S.
Welcome to Warren's World.