Why is Buffett Buying Utilities?

by JT McGee

It’s JT reporting live from Financial Management 461. All classes should be in a computer lab.

Anyway, I received a few emails about Warren Buffett’s latest acquisition of NV Energy, a regulated Nevada utility business.

This isn’t Buffett’s typical style. In his younger years, he would have never purchased part or whole of a utility.

Utilities, especially regulated utilities, are very predictable cash flow generators that sell for high multiples of cash flow.

Returns are generally low.

Young Buffett vs. Older Buffett

In his younger years, Buffett bought securities in companies that flew under the radar. This meant buying up illiquid net-net “cigar butts” (I call these Pawn Star stocks), usually at prices less than the company’s net cash. His returns in those years were nothing short of remarkable – 30-40% annually in names that no one had ever heard of.

Back then Buffett had a much smaller portfolio to manage. Buying smaller companies under the radar was a workable strategy. Now he has significantly more capital to manage. Not only does Berkshire Hathaway spin off a boatload of earnings ($16.4 billion in the last twelve months) it also manages a monstrous $73 billion insurance “float,” money that may or may not be paid out to insurance customers in the future.

Since the insurance business is growing each year, and because it delivers and underwriting profit (paying out less in claims than it receives in premiums), this $73 billion is not really a liability. It’s a liability on the balance sheet, but as policies are renewed and policy growth goes on into the future, Berkshire can essentially claim that $73 billion as its own.

What is a “debt” really worth if it is never repaid?

Utilities as a low-return opportunity

So why would Berkshire dabble in the low-return business of utilities? Is it just that he has no better ideas? I think not.

Instead, I’m of the opinion that Berkshire wants safe alternatives to corporate debt. Insurance companies generally hold a 90-95% fixed-income and 5-10% equity portfolio to generate a return. Given that interest rates should rise in the future, holding fixed-income securities is “riskier” than holding a quality, regulated utility.

Not to mention, regulated utilities offer much higher returns than short-term corporate debt. Considering that the insurance float is interest free capital, and the insurance subsidiaries generate an underwriting profit, an acquisition of NV Energy can be paid-for with capital that has a negative cost to Berkshire.

As a control owner of a utility, Buffett has every right to take every dollar of free cash from the business each year. As a noncontrol owner, you have only the opportunity to enjoy dividends, which are generally smoothed and do not match the year to year cash flows. This provides some upside, since Berkshire can squeeze more value out of each cash flow.

A Berkshire without Buffett

Most importantly, Buffett is firming up a future without Buffett. Capital intensive railroads (BNSF) and utilities (MidAmerican and NV Energy) remove some of the questions surrounding capital allocation going forward. Remember, a business is only so good as the investments inside the company. Capital allocation is the difference between the world’s best stocks and the world’s worst. Buffett’s acquisition of capital intensive companies says to the market “hey, the next guy will have some commitments on where to put shareholders’ money.” Markets like certainty.

All in, Buffett’s move is one to replicate for a fixed-income portfolio. I regard Chubb (CB) insurance as one of the highest quality insurance operators, and I would have no pause about substituting it for a fixed-income portion of my portfolio. Likewise, high-quality regulated utilities like Vectren (VVC) fit as a quality alternative to bonds. That said, I would never, ever expect full-on equity performance from a utility. Rather, it’s just a better alternative to fixed-income products.

{ 3 comments… read them below or add one }

krantcents June 6, 2013 at 13:09

I believe Buffett is doing what every good investor does! He is diversifying his investments.

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Your Daily Finance June 10, 2013 at 10:24

Diversify diversity is what Mr. Buffett in my opinion is doing and who better to follow the then the Triple O. Of course I do think he is planning for the future without him at the helm.

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The College Investor June 10, 2013 at 23:26

I’m always a fan of utilities – there’s a nice feeling about a government monopoly and good dividends.

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