, Charlie Munger joked about how after so many years shunning technology companies and airlines, suddenly Berkshire Hathaway was investing billions of dollars in each (emphasis mine):
In the old days, what we did was shoot fish in a barrel. It was so easy, we didn’t want to shoot fish while they were moving, so we waited until they slowed down and then we shot them with a shotgun. It was just that easy. It’s gotten harder and harder and harder. Now we get little edges. It isn’t any less interesting.
Remember when Warren bought Exxon as a cash substitute? He never would have done that in the old days. We had a lot of cash and he thought that Exxon was better than cash over the short term. That’s a different kind of thing from the way Warren came up. He’s changed. He’s changed when he buys airlines. He’s changed when he buys Apple. Think of the hooey we built up over the years: we don’t understand it, it’s outside our circle of competency, the worst business in the world is airlines—and what appears in the holdings? Apple and a bunch of airlines. Have we gone crazy? I think the answer is, we’re adapting reasonably to a business that’s gotten much more difficult. I don’t think we have a cinch. We have the odds a little bit in our favor. We have to live on the advantages we can get. I used to say you have to marry the best person who will have you. I’m afraid that’s a rule of life. Things have gotten so difficult in the investment world that we have to be satisfied with the type of advantage we can get.
Doing anything well in life means continuously pushing your boundaries as well as evolving to adapt to a world that is constantly changing around you. This is especially true with investing and allocating capital. Understanding why Berkshire Hathaway is now investing billions of dollars into Apple stock requires a deeper understanding of how Warren Buffett, Charlie Munger and Berkshire Hathaway have evolved over the decades.
In his early years, Warren Buffett was focused on “cigar butts”—typically a mediocre company that had very little going for it other than the fact that its stock price was trading well below liquidation value and maybe good for “one last puff.” It was actually Charlie Munger’s influence that pushed Warren Buffett to start investing in “great companies at good prices”.
Buffett and Munger talk about “circles of competence” i.e. focusing your investing in areas that you know extremely well. Both of them have also shown a capacity to expand their “circles of competence” over time. Warren Buffett started out as a huge fan of the insurance business. Some of you might remember him as a young stockbroker in 1951—now more commonly known as GEICO. But over time, he meticulously expanded his “circles of competence” into industrial companies, consumer goods businesses, power utilities, railroads and other sectors while also expanding outside the U.S. as the world economy globalized. Perhaps with and Apple, he has added the technology sector to the list as well.
Much of Berkshire Hathaway’s evolution has simply been the need to adapt to the realities of managing its massive girth. Managing a $100 million stock portfolio is very different from managing a. Part of the reason that Buffett moved on from “cigar butts” was simply that he had to—it becomes harder to find these sorts of opportunities as your minimum investment threshold increases. And even though the annualized IRR you might attain from investing in a “great company available at a good price” might not be as high as doubling your money on a “cigar butt” stock in 18 months, usually you are able to deploy far greater amounts of capital in the former as opposed to the latter. More importantly, you do not need to search for another “cigar butt” to replace it—great companies have the ability to compound returns over very long periods of time resulting in much higher multiples and absolute returns than “cigar butt” investing could ever generate. They are more scalable from a time and management perspective. This is why many of Berkshire Hathaway’s core equity positions—companies like Coca-Cola and Wells Fargo—have been held for multiple decades and have generated tens of billions of dollars of value for the conglomerate.
With such a massive balance sheet today, even “great companies available at good prices” are becoming harder and harder to find—the universe of companies with market caps over $10 billion is a small fraction of investable names (although a much bigger fraction of the market by weight of course). At the Daily Journal meeting, Charlie Munger went on to discuss how at some point you are managing so much capital that it becomes nearly impossible to beat the broad market indices. At some point, theoretical returns must converge with overall market returns. While Berkshire Hathaway is not quite there yet, Buffett and Munger have long warned investors that historical returns are simply not repeatable going forward. By this they mean that Berkshire Hathaway investors should not expect the percentage returns of the past—20%+ annualized over multiple decades—to be achievable on a consistent basis in the future.
Some of this is just based on pure math and the “law of large numbers”. Generating a 25% return on $100 million of capital means achieving a $25 million gain. Generating a 15% return on a $200 billion portfolio means having to generate $30 billion of gains. Which one do you think is harder or more impressive?
It also means being more willing to consider opportunities that offer lower potential returns than you would have considered in the past. In the ’70s and ’80s, Berkshire Hathaway tended to focus on buying businesses that could generate fantastic returns on capital—typically capital-light businesses that needed very little capital to expand. A prime example of this was See’s Candy, which was purchased for $25 million in 1972—at around three times book value and a six to seven times multiple of earnings…implying returns on capital of well over 40 percent. Buffett loves to talk about how over the decades See’s Candy has generated over $1 billion of cash flow for Berkshire Hathaway—most of which did not need to be invested back into the business but could be deployed into new securities or acquisitions of new operating companies. See’s Candy could grow revenue mainly by using its pricing power to raise prices year after year after year.
By the early 2000s, Berkshire Hathaway had grown to the point where a $25 million acquisition would have been a rounding error on its balance sheet. Its operating businesses were also starting to throw off significant cash flow that needed to be intelligently re-invested. So after having largely avoided capex-intensive businesses for the first three decades of running Berkshire Hathaway, Warren Buffett purchased a small regulated utility in the Midwest called Mid-American Energy. While the percentage returns from regulated businesses are never going to match those of a “great” capital-light business like See’s Candy, it does have the advantage of allowing you to reinvest large amounts of cash flow at a decent return through the large capex requirements of the business. Today, through a combination of acquisition and organic capex-driven expansion, Mid-American is one of the largest energy companies in the country and helps Berkshire Hathaway—which means over $10 billion of operating earnings across $90 billion of invested capital in its “regulated businesses” division (which includes its railroad, BNSF).
Today, Berkshire Hathaway generates over $30 billion of operating cash flow per year, which means that in the five or so minutes that you’ve been reading this (admittedly long-winded) answer, an additional quarter million dollars will have flowed into Berkshire’s coffers that needs to be re-deployed. I know…high-class problem if there ever was one! Capex-intensive regulated businesses help absorb some of this incoming cash flow—by Buffett™, if you will.
Finally, the most recent example of how Berkshire Hathaway has evolved: After managing most of the investment portfolio for over four decades, in 2010 and 2012 Warren Buffett invited two new managers to help manage the portfolio—Todd Combs and Ted Weschler. As the equity portfolio had gotten larger and larger, it was harder for one man—even the Oracle of Omaha himself—to dedicate the necessary time and effort to cover the entire stock market. Over the past several years, we have started to see new names pop up in Berkshire Hathaway’s portfolio and it is safe to assume that many of the smaller new positions are the handiwork of these two new managers. Meanwhile, a position like Apple—which at close to $8 billion means that it definitely needs Warren Buffett’s seal of approval—was likely originally initiated by one of Berkshire Hathaway’s new managers.
Which finally brings me to Apple itself. First, let me start by mentioning that Apple has been a large “core” position in my portfolio and fund since 2013—not to mention Berkshire Hathaway itself since 2006—and also that none of this should be construed as financial or investment advice.
For most of his career, Warren Buffett stayed away from the technology sector, preferring instead to. In fact, one of his more memorable moments was getting up on stage at Sun Valley in 1999 in front of hundreds of venture capitalists, technology entrepreneurs and investors to essentially .
So I do remember being a bit surprised when Berkshire Hathaway started buying shares of IBM in 2011. While I never quite agreed with this investment thesis it definitely made me think about how Warren Buffett constantly evolves and pushes his boundaries. But I also think another major reason why he eventually invested over ten billion dollars in IBM stock was that the business itself had changed dramatically—to the point where it wasn’t really a technology company anymore, at least in the sense that its business model was no longer subject to the volatility that haunts many technology businesses. As I wrote in another answer ():
Very simply, IBM has evolved to the point where Mr. Buffett is a lot more comfortable with his ability to peer five or more years into the future and see what IBM looks like and what the economics of its business will be.
You see, IBM is not really as much a “technology company” these days as it is a “highly competent advisor to Fortune 1000 companies around the world with complex IT needs” that happens to also be very profitable in that role. Because he’s made it such a large investment, Mr. Buffett must believe that IBM’s place in the business world is unlikely to change in the medium to long-term, or that it will change in a way that he is comfortable predicting.
In the same way, Apple is not your typical technology company where the future can often be extremely unpredictable and volatile. I was a technology investor for many years and one of the first questions I always asked myself when evaluating a new investment opportunity was “how is Moore’s Law going to affect this company and its industry?” More often than not potential opportunities went straight into the “Too Hard” bucket because I simply had no idea of how to comfortably predict the future even twelve months out at times.
Apple has incredible brand value and this manifests itself financially in an extremely sticky customer base (90%+ customer retention rate, almost unheard of for a consumer product). It has a massive ecosystem of content creators and app developers that is makingfrom Apple’s customers. And it has dominant market share of a product platform that billions of people around the world can take advantage of and one that seems to grow in importance every year.
Apple is a tollbooth for consumption in the modern global economy—and Buffett has a particular fondness for toll-collecting businesses. There are some reports that Apple generates over 100 percent of the profits of the smartphone industry—meaning that the rest of the industry might actually collectively lose money trying to compete. Its domination of the industry is akin to Microsoft’s near-monopoly of PC operating systems and application software in the 1990s and 2000s or Google’s dominance in the world of digital advertising.
And one big difference between Microsoft in the 1990s and Google today that is sure to pique Warren Buffett’s interest is that Apple stock can still be purchased at less than 10x operating earnings. At the latest share price of $135 (as of February 2017), Apple has an implied enterprise value of $550 billion against 2016 operating earnings of $58 billion.
Apple’s market capitalization has gotten so large—it representsand an even higher percentage of its profits—that not owning any Apple shares essentially means you are betting against it. So for Berkshire Hathaway and its $600+ billion balance sheet, owning $8 billion in Apple stock is almost the minimum the conglomerate needs to own so that they are essentially not betting against it.
The thing that finally pushed me over the edge on Apple back in 2013—I was a staunch “PC guy” for my entire life (much to the chagrin of my IRA)—was that the new management team led by Tim Cook  appeared to be a lot more shareholder-friendly and willing to return more of Apple’s rapidly increasing cash flow to its shareholders. After returning almost no cash to shareholders for the first three decades of life as a public company, Apple initiated a capital return program in 2012 and has sincethrough dividends and buybacks—the largest capital return program ever in the history of the stock market. Warren Buffett generally likes when companies buy back their own shares at discounts to their underlying intrinsic value so I am pretty sure he saw this in a positive light.
Finally, I want to say that beyond the unadulterated capitalism of it all, Apple is very good for America, not only enriching shareholders but its employees, the communities they belong to and society at large. Americaand it is always a nice bonus to invest in a company that you admire.
Investing in Apple is not without its risks. It still needs to navigate the rapidly changing nature of the technology industry, Moore’s Law and perhaps increased protectionism. Management still needs to execute—and there are concerns over its recent struggles with Apple TV and allowing Alexa to somehow push Siri out of the way. Like Berkshire Hathaway, it has to deal with the problem of figuring out how to grow from such a massive base.
There is no guarantee that Berkshire Hathaway will ultimately generate a positive return on its investment in Apple. Investing in Apple is not like the “shooting fish in a barrel” type opportunities that Buffett and Munger saw in their earlier years. But as Munger remarked above, “the odds are a little bit in our favor” and in my experience betting against Apple, Berkshire Hathaway and/or Warren Buffett has never really been a wise move.