Over the past few years, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) has accumulated quite a bit of cash on its balance sheet. At the end of the first quarter of 2018, Berkshire reported a total of $108.6 billion in cash — far more than the $30 billion CEO Warren Buffett recently said he would prefer.
This leaves almost $80 billion in excess capital, and Buffett has said that he’s having a tough time finding companies to acquire, which is by far his preferred way to use Berkshire’s money. This raises the question, “What is Warren Buffett looking for?” While some of Berkshire’s acquisition-evaluation process is a trade secret, we do have a pretty good idea of how Buffett determines what businesses he’s interested in.
Berkshire’s basic criteria
In Berkshire Hathaway’s 2017 annual report, there’s a list of six basic criteria that the company looks for in potential acquisition targets. And they need to meet all six.
- It must be a large business, which Berkshire defines as at least $75 million in pre-tax earnings. The exception is if the company will fit into one of Berkshire’s existing businesses. In other words, Berkshire could consider a small insurance operation if it fits nicely into one of its existing insurance businesses.
- The company’s earning power must be consistent. Berkshire doesn’t care about a company’s future projections — the past must be impressive.
- Good returns on equity with little or no debt. Buffett hates excessive debt and insists that Berkshire have billions of dollars in positive net cash at all times, so it makes sense that he wouldn’t want to acquire a business that reduced the company’s net cash position.
- A management team must be in place. It’s tough to emphasize how highly Buffett values good management. Berkshire loves acquiring companies that are already being run by great managers and bringing those managers along with the acquisition.
- A simple business. Buffett wants to be able to clearly understand the businesses he owns. If you look at Berkshire’s subsidiaries and its stock holdings, you can easily sum up what most of them do in a sentence. Even the most high-tech companies have fairly straightforward businesses.
- An offering price. Buffett doesn’t want to negotiate or entertain an acquisition opportunity if he doesn’t know how much the business owners want for their company.
The annual report goes on to say that the larger the company is, the greater Berkshire’s interest will be, mentioning a target acquisition range of $5 billion to $20 billion. Berkshire has become a massive company with a market cap of nearly $500 billion, and small acquisitions just don’t do much to move the needle.
Buffett’s five-minute test
One thing that may surprise shareholders is that Buffett doesn’t do very much research to determine whether he’s interested in a particular acquisition or not. In fact, Buffett says that it takes a very brief time for Berkshire’s management to determine whether it has any interest in pursuing an opportunity.
Buffett went on to say that he and Vice Chairman Charlie Munger are generally familiar with every American company that is large enough to meet its acquisition criteria, so it comes down to running each business through a few basic filters. While Buffett obviously doesn’t reveal his entire investment decision process, some of these filters are undoubtedly the acquisition criteria listed in the previous section.
Most of all, Buffett looks at the economic fundamentals of the business. Speaking about Berkshire’s 1996 acquisition of aviation training company FlightSafety, Buffett said that “before the purchase, and even for some time after … I had never set foot on [one of their training centers], never been to their headquarters, we never looked at a lease …”
This may be surprising considering Buffett had committed to spend $1.5 billion (which at the time was in Berkshire’s acceptable size range), but that’s just not part of Buffett’s process. As he puts it:
We don’t do all of those things, and to date that’s never cost us a penny. What costs us money is when we mis-assess the fundamental economic characteristics of the business, but that is something we would not learn by doing what people would generally call due diligence … That isn’t what makes a deal a good deal or bad deal.
In other words, Buffett doesn’t necessarily care about the underlying details of a business when deciding if he’s interested. He just cares about whether it’s a good business economically, and if Berkshire is getting a fair price.
Very high standards have resulted in a buildup of cash
After hearing that, you may think that there could be hundreds of potential acquisition targets Berkshire could pursue. And as far as the six criteria are concerned, you’d be right.
The major roadblock in recent years has been the requirement of a “fair price.” The stock market has gone up dramatically over the past few years, and the surge in private equity interest has pushed business valuations up to nosebleed levels. And Buffett has simply not been able to find any business whose price was compelling enough to pursue.
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