Motley Fool Hidden Gems Investing - What Will Make Buffett Spend?

Episode Date: November 6, 2023

With Treasury yields high, what will it take to get Berkshire Hathaway off the sidelines and back into the market? (00:21) Matt Frankel and Deidre Woollard discuss: - Berkshire Hathaway’s massive pile of cash. - If the NAR lawsuit damages Berkshire’s real estate prospects. - Why it has been a good year for insurance. (21:42) Mary Long and David Meier explore the big cybersecurity opportunity facing Palo Alto Networks. Claim your dividend report here: www.fool.com/dividends Companies discussed: BAM, BRK.A, BRK.B, PANW, Z, ZG, RDFN Host: Deidre Woollard Guests: Matt Frankel, Mary Long, David Meier Producer: Ricky Mulvey Engineer: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

You gotta try breakfast at A&W. You gotta try breakfast at A&W. And what better way than with the delicious Pret Organic Coffee. Starting with just one dollar, all day, every day, now until December 31st. You gotta try breakfast at A&W. At participating A&W locations in Ontario. When will Berkshire Hathaway be ready to spend? Motley Fool Money starts now. Welcome to Motley Fool Money. I'm Deidre Willard here with Motley Fool analyst, Matt Frankel.

Matt, good to see you today. Good to see you as well. Always fun. I work four Saturdays a year and they are Berkshire's earnings reports. So it doesn't even feel like a Monday. I worked over the weekend. Exactly. I mean, I think they're the only company that reports on a Saturday. Either way, it is always a special event, not as special as the big conference in the spring. But I think the headline for at least for most of the news reports I saw was that $157 billion number. So that's the amount of cash Berkshire has on hand. new record. I think about 126 million of it is sitting in short-term treasuries. Because we tend to respect Warren Buffett so much, we tend to look at his activity, and in this case, the lack

thereof, as a signal. Is this a signal? He's not buying. Should we be buying? There's three pieces of the cash hoard growing, right? There's the operating income from the businesses that gets put in the pile. There is how much Berkshire spent or did not spend on buying more stock for its portfolio, which it looks like it was a net seller of stocks. We don't know exactly what it bought and sold, but the cost basis of its portfolio declined quarter over quarter. That's usually the clue that it was a net seller. Berkshire isn't buying back as much stock. The company bought back $1.1 billion of stock in the quarter. it's a notable decline because during the first two quarters, they bought back a total

of $6 billion. Put all those three things together and the cash soared by about $10 billion this quarter and it's now sitting at a record. But like you said, it's mostly sitting in Treasuries. That means that Buffett doesn't really have to care about being able to find a deal as much as he did when the Treasury yields were 1%, because now that portfolios putting out $7 billion to $8 billion of interest income for Buffett every year. He needs to take that into consideration when assessing a potential deal. Would a potential deal definitely be able to do better than that? It wasn't that long ago where you could find any deal that would do better than Treasuries, but that's not really the case anymore. I'd

prefer Treasuries over certain real estate stocks that we talk about at the moment. It's interesting that the cash is getting that big. The market is down from its summer peak. The universe of companies that Buffett could potentially buy with that cash has gotten even larger than the number implies. Yeah. I think it's interesting you mentioned that $1 billion number. I love that everyone's like, oh, he's buying back less and the number is $1 billion in stock buybacks. But that also is a reflection of the fact that Berkshire stock has been up and he's savvy. He's not going to buy when the opportunity to buy isn't there. At the same time, you have to remember by definition, in order to buy back stock at all,

whether we're talking about one share or a billion shares, Buffett and Charlie Munger both have to agree that the stock is trading for below its intrinsic value. The lower buyback rate implies that Buffett doesn't like the stock as much as he did before, but thinks it's still a good value relative to the intrinsic value of the business. Well, and something he is buying sort of bite by bite by bite is the Pilot Travel Centers. That has been in the works for a long time. I think it's around 25% of the business left. But last week, it came to light that the founders of Pilots, the Haslam families, they sued Berkshire over a change in accounting methods that they say may have devalued their shares. This kind of seems to me like a battle

of billionaires over price. Is that what this is, or is there something more profound here? Yeah. I just took a road trip this past weekend, and every time I stopped at a Pilots travel center, Warren Buffett got that much richer. So people need to realize that. You're a Berkshire customer if you're taking a road trip and you stop at a Pilot, especially if there's one with a Dairy Queen in it. But the accounting change happened earlier this year. I mentioned when I covered earnings for Motley Fool Live earlier that Berkshire's revenue was up 21% year over year. But most of that's due because Pilot is recognized differently on the balance sheet now that they have a majority stake. I think the initial investment Berkshire

bought a little over 40%. Now, they bought in the 35%-ish range more recently. The stake is close to 80% now. The Haslam family still owns a little more than 20% of it. Berkshire has already paid around $12 billion for the 80% that it owns. The second part of the investment was much more highly valued, like three times as highly valued as the first. This does seem like a pickiness between billionaires, how you account for revenue of an acquisition when you've already bought 80% of the company from the seller, and there's the other 20%. How much of a difference does it really make at that point? I've never had to deal with billion-dollar deals of selling my own family's business, so I can't really speak to how the

emotions involved in it. But the change in accounting methods, it had more to do with the fact that Berkshire is now the majority owner and can account for whoever it wants to. Warren Buffett's always thought of as a warm and fuzzy character, but he's a very smart businessman. If he could figure out how to get a better deal for a transaction within the terms of the transaction, because at first glance, and I'm not a CPA, but at first glance, he didn't violate any terms of the contract by changing the accounting method. It just didn't work out in the favor of the seller. So the question is, do they have the right to get a valuation under the old accounting methods or not? But we'll let the courts decide that. But Buffett's not

warm and fuzzy when it comes to his business dealings. No, he is not. Speaking of the courts deciding things, last week on the show, Dylan and Asa talked a little bit about the National Association of Realtors lawsuits. Home Services of America, that's Berkshire's real estate arm. That was one of the companies named in the suit. So they're going to be responsible for part of that multi-billion dollar judgment if appeals fail. We know there's going to be a lot of appeals. But thinking about this sort of change that we're seeing in real estate, is that sort of a long-term threat for Berkshire Hathaway? I mean, I know this part of the business did not do well for them. I think it was down 81% year over year, which is to be expected. I've been saying for years that the

real estate commission structure is very outdated, that the 6% standard commission structure needed to go. It was the last holdout of the antiquated fees era in general financial services. It turns out that might have been for a reason. It turns out that there might have been some, I don't want to say collusion. I don't want to say Berkshire was colluding with the National Association of realtors to keep prices high. But at the same time, you know, when you think of all the other financial service fees that we pay, that technology has disrupted and made it more efficient and easier. I don't know when the last time you paid a stock trading commission is, but I haven't paid one in years. And so I don't think that it's a long-term threat to the industry any more than

I thought that $0 stock commissions were a threat to companies like Schwab and Fidelity. They just find ways to adapt, figure out other ways to make money off the process. There's a lot more that goes on in a real estate transaction other than the sale and the purchase. There's title insurance, there's homeowners insurance, there's a mortgage that takes place. This is like the whole central thesis of Zillow right now, is the all-in-one nature of a real estate transaction. There are other ways to involve yourself. Generally speaking, the lawsuit, it has to do with the fact that the National Association of Realtors essentially pressures its users to have the seller pay both sides of the commission, pay the buyer's agent commission

and the seller's agent commission. There's a big argument to be made that if the buyer had to pay that part of the commission themselves, that it would create a lot more price competition and things like that, because the seller obviously has the money to pay any commission that they want, because they're the ones getting hundreds of thousands of dollars in the home sale, whereas the buyer, if they actually had to come up with money up front to pay a realtor's commission, might not put up with a 3% commission. The argument from the National Association of Realtors is, well, commissions have always been negotiable. I've bought and sold, including investment properties, eight properties in my lifetime. I have never been offered a total selling commission

below 5.5%. Maybe by Redfin. Redfin is the exception that wants to disrupt on price. But generally speaking, every realtor, no, this is what it is. This is what the commission is. I can bend a little bit. I'll do 2.5% on my selling commission, but you still have to pay the 3% buyer's agent or things like that. And my realtor friends hate it when I say this. I'm sure I'll get some nasty Facebook messages after this. Why is the commission for selling a home the same as it was 20 years ago when agents had a whole lot more they had to do? Think of the home selling process 20, 25, 30 years ago, agents had to physically drive around and find properties for their clients. They had to take them on 20 home tours because the internet hadn't evolved

to where you could have high-resolution home tours. There was a lot more phone work that had to be done, a lot more driving around to various offices to get papers signed. The job of a realtor has become so much more automated these days. They still are working hard. They still deserve some money. But 6% of the transaction, is that still the appropriate commission? And like I said, I'm not a realtor. My friends who are realtors tell me that, no, no, we earn our money. And of course, they're going to say that. I've never had any profession tell me they don't earn their money. But at the same time, it's not a long-term threat to the real estate business. I'm definitely getting off on a tangent here, but it's not a long-term threat to the real estate business

in general. Real estate is the largest industry in the world. Something like $6 trillion of transaction volume in an average year changes hands in the United States in real estate. And companies like Berkshire Hathaway Home Services that are an industry leader are going to figure out how to make money off of this, even if commissions are more left up to the market than the National Association of Realtors. Yeah. Yeah. I think that's absolutely true. The other part of the real estate business that Berkshire has that I find really interesting is manufactured housings, things like Clayton Homes. When I was looking through Berkshire's report, one of their only major financial receivables are the loans for both manufactured and site-built. So they said they've got around 96% of loans are current, but they are putting money away to protect against losses.

So, is that something? I'm sort of torn between wanting a lot of manufactured homes to be built and also seeing the potential for some risk there. How do you think about it? Well, manufactured homes today are filling an affordability gap. Absolutely. In a lot of ways. But there's a lot to unpack there. You're right. If we fall into a deep recession, for example, we could definitely see default rates start to tick upward. You mentioned 96% of their loans are current as of the end of the third quarter. Of the 4% that aren't, not all of those are going to turn into foreclosures. That includes loans that are like 30 days late, that people just might be behind

a payment or two on. The majority of loans that fall behind by a payment or two don't end up in foreclosure. That's one thing to unpack. The actual amount of net charge-offs they had during during the first nine months of this year, were about $52 million. They put away an additional $122 million to provide for future loan losses. As you mentioned, they're building up their reserves. They have a total of $856 million in reserves for loan losses compared to that $52 million over a nine-month period in actual loan defaults. So, my short answer is there's a lot of way to go before it would actually become a problem. They seem to be overplanning, which is a good thing. A smart bank will overplan for loan losses and release some of their

reserves when you see a coast is clear signal. The majority of these loans, I'm looking at it right now, about 85% of them were originated when mortgage rates were low. People are going do what they can to keep those. There are a lot of bills that if I were facing hard times that I would give up before my 3% mortgage rate. Because even if I got foreclosed on or whatever, I would still have to go rent a home at the current market price or something to that effect. The bulk of the loans are lower interest rate loans. The bulk are performing very well. Like I said, looking forward, Clayton Homes and other manufactured housing companies are filling a nice affordability gap in the United States. I don't think it's going to be

a big problem. It's definitely worth keeping an eye on. If we see a 2008-style recession, could it be a problem? Absolutely. But at the current rate, it looks like the company's overplanning for any downturn. Well, we can't talk Berkshire without talking insurance. Good quarter for them for insurance. Really a major driver of growth for them in the quarter. Smart underwriting is such an important consideration. I think especially now, I'm thinking about some of the climate change stuff. I've talked to a couple of insurance companies about what they're seeing. How do you think about that volatility and the need to underwrite smartly? I think Berkshire did have a great

insurance quarter. Natural disasters in 2023 weren't nearly as bad as they were in previous years. We've seen that throughout the insurance industry, that it's a more steady underwriting environment than it was a year ago. That could change at any time. The nature of the reinsurance business is you're going to absorb those big natural disaster losses. Reinsurance, if you're not familiar, is insurance for insurance companies. If an insurer has too much exposure to a certain market, they'll buy a reinsurance contract that will take care of any losses over a certain amount. and in natural disaster times, that could be a lot of money. Berkshire is one of the leading reinsurers. They're best known for GEICO, but General Re and a few other reinsurance

subsidiaries of theirs are very big businesses. There's a lot of reinsurance exposure there. Natural disasters could play a big part of it. I think Berkshire plans really well. They have a history of excellent underwriting. Berkshire handpicks all of its insurance businesses for a reason. It's because they're good at predicting losses. Berkshire has the capital to absorb short-term losses on its balance sheet. One of the reasons Buffett insists on keeping at least $30 billion of cash on the balance sheet at all time is specifically to absorb any kind of losses or volatility that take place. But the insurance business had a great quarter. You can't deny that. Well, I want to take us away from Berkshire before we wrap up, because Brookfield Asset

Management, they reported this morning, not over the weekend, and they've got about $102 billion in dry powder to deploy. So, talk about cash hordes. We've got a different one here because they really have to spend it. The interesting thing I thought was in their shareholder letter, they said they really feel like next year is going to be this robust deal-making time because interest rates stabilize, valuations become clearer. I want to see them spend. Sometimes I hear dry powder and then I hear nothing happen, but Brookfield pretty much has to. So it looks like they're going to be spending on renewables. They're going to be spending on infrastructure. What are you thinking about Brookfield Asset Management right now? And

How fast do you think that dry powder comes into use? Well, there's a little bit to unpack there. Next year, yes. I've been hearing that the interest rate environment was going to stabilize for a while. Now, I think 2023 was supposed to be the year that we saw interest rates stabilize and valuations become clearer, as you just said. I think that was actually one of my bold predictions in my 2022 year-end article. So far, it really hasn't come into fruition.

Mortgage rates kind of went the opposite way of what most people, including me, thought. But at the same time, it's not a bad time to have dry powder, especially to put to work in real assets whose valuations have come down quite a bit lately. It's not a great time to necessarily own office properties, but it's not the worst time. If you have billions of dollars and someone says you have to buy office properties, you're going to get a good deal compared to a year or two ago. We're seeing cap rates come down all across the real estate industry. Stag Industrial is one that I recently did on The Earnings Show. They put more money to work in the third quarter than the first two combined by a significant margin. One of the reasons

is they're starting to see cap rates really come down and catch up to the market and see opportunities emerge. Right now, you're absolutely right, the interest rate environment and the valuation environment is not what I would call stable. But it's definitely more attractive than it was a couple of years ago for the type of assets that Brookfield, as you put it, has to invest in. You know, they can't raise $50 billion for an infrastructure fund and then not spend that money. They don't have to, you know, I wouldn't use the word have to, to the point where they have to take on bad deals, but they have to, to the point where their investors expect them to to deploy that capital in a business-like timeframe. In infrastructure, in energy,

in real estate, there are some impressive valuations right now compared to a couple years ago. It's a situation where to buy those kind of assets right now, you have to be willing to look stupid in the short-term. If I buy a property today, I could look like an idiot two months from now. If mortgage rates continue to go up and I can't sell it and things like that, but in a couple of years from now, eventually, interest rates and valuations are going to stabilize. I don't know if it happens in 2024, like Brookfield just said. I thought it was going to happen this year. It didn't. But it's going to be really interesting to see them put that capital to work, because it's a really good time to have that type of war chest of investor capital,

because you're not seeing that everywhere. Yeah, I think that's sort of been the theme of today's show is that the people who have the most money to spend are poised at the starting line. Not necessarily ready to go, but hopefully more next year. Well, Matt, thanks for your time today. Yeah, thanks for having me. You just found out that your sales team is at risk of missing quota. Don't panic. Just ask Rippling AI. Since it's built on your real-time people and business data, Rippling AI can pull metrics from Rippling and Salesforce into a meeting-ready dashboard showing quota attainment, headcount plan, and monthly revenue to quota by region. In seconds, you'll see exactly what's behind your quota risk and fix it before it's missed. Question answered,

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That's fool.com slash dividends to claim your five dividend stock recommendations now. Curious about cybersecurity? Mary Long and David Meyer dive into Palo Alto Networks. This was recorded before its most recent acquisition of Talon, but gives insights into why it's time for the company to be making bold moves. So regular listeners may be familiar with the name Palo Alto Networks, but for those who aren't deep into the world of cybersecurity, can you explain in layman's terms what this company does and how they do it? In layman's terms, yes, cybersecurity is definitely a complicated issue with

all sorts of technical jargon and whatnot. But essentially, Palo Alto does three things. It does what's called network security, which is, if you own a network, if you own computers that talk to each other, you as a business want to make sure that you understand what's coming into your network. And if something gets into your network, what might be going out of it? Palo Alto built its reputation on the firewall, which stands in between your network and whoever is accessing it or trying to get stuff, data from it. So it built essentially its reputation on network security. But today, right, we don't just have networks. We have the ability to do computing and the cloud. So network security is actually now a subset of cloud security.

So in cloud security, you do, again, it's accessing a network, making sure that who gets into the network is supposed to be there. And if they get in, making sure that they don't take something you don't want them to take. But what cloud does is it says, okay, I know that now I'm using Amazon web services in addition to the network that I have. I have to be able to protect my business, my customers, my employees, and frankly, my proprietary technology that's in my software from anybody accessing the cloud part of my business as well. So, it's all the same things, it's just across a different ecosystem. And then the last thing is they have security operations. So, the best way to think of this is, this is the operating system. With so many different ways I'm

trying to protect myself, how do I manage this? And that's what security operations does. It basically gives the operators a way to look into all the things that are happening, whether it's outside devices, whether it's on my current network, whether it's in my cloud network. I need to be able, or the operator needs to be able to look at all that, assess, hey, maybe I have a weakness here. I need to do something about it. Oh my goodness, I have a threat vector coming in here. I need to do something about it. So the operations piece of it gives you the look and to be able to control all of the security that is protecting your business. So it sounds like based on that, that cloud security might be kind of where the world is

going if it's not already there. But are most companies, most enterprise customers getting some combination of all three of these different security services, or are they focused mostly on one offering? At the enterprise level, they're big enough where they're mostly focusing on all three, which is exactly what Palo Alto wants. They've built their business to be able to to cater to the enterprise customer. They started with smaller customers, just with the firewall, and then expanded over time to the larger enterprise-level customers. Let's talk about that expansion and growth a little bit. The current CEO of Palo Alto, Nikesh Arora, he came to the helm in June 2018. Since then, Palo Alto's market cap has gone from

$18 billion to about $73.7 billion today. I would say that that's quite the jump. How did that happen? Let's establish something right off the bat. It didn't happen smoothly. Nikesh Arora had a huge task on his hands when he came to Palo Alto. Basically, he was going to take it from the firewall expert into the current cybersecurity as a whole expert. And the way he did that was, he looked and said, okay, our platform needs this security technology and that security technology and another security technology. And he went out, and frankly, if he couldn't develop them in-house, he bought them. And if the technology wasn't mature, he would do what's called an acqui-hire, meaning I want to buy a business, even though its

technology is still nascent, but I think it's going to be important, or we think it's going to be important, and we want to be ready to put that on our platform. So the other thing that he had to do, and this is where there were, this is what caused some bumps along the road, is he had to change the way his Salesforce operated. If you're good at selling one thing, a specific product and service, it doesn't necessarily mean you're good at selling a solution or Palo Alto as now a one-stop shop, if you will. They had to change the incentives. They had to change the management structure of the sales organization. Quite frankly, there were some bumps along the way. If you look at the stock chart from 2018 to about 2020, you'll see some pretty big

drawdowns where, again, they had some problems. But again, it wasn't smooth. But to his credit, he has proven himself to be a fantastic leader, bringing all these technologies together, making sure the platform works, making sure the sales and marketing teams know how to sell the product to these enterprise customers. Quite frankly, the proof that he's done well is in the results. You mentioned changing up the sales force. I'm curious about how, in this business, you actually go about taking and growing market share. It's not easy. Let's put it that way. There are a very large number of competitors. This is a very fragmented industry. Despite being an enormous one, there's no what you would call winner-take-all

aspect to this industry. That's because, frankly, there's a lot of great competing technologies. For a company like Palo Alto, there's a few big players that try to make themselves into a one-stop shop. But there are also a lot of smaller competitors that say, hey, my niche in cybersecurity is here or here or here. Quite frankly, if they're able to say, hey, I can do a better job and I can price it right, you know, they can create their own little niche that can be very profitable. So, it's not an easy market because there are so many different types of competitors, both big and that try to do the one-stop shop approach, and there's a lot of price competition as well, as well as on the technology side. There's constantly, you know, that's the one

thing about innovation, it never stops. It just never does. And so, you know, new technologies are being created all the time. And if they catch hold in the marketplace, you know, they can create a nice little niche for themselves. And that innovation piece just seems so true in this sector, especially. Like, at any business, you're constantly trying to innovate, right, and stay ahead. But in cybersecurity specifically, you're not just competing against other business competitors. You're competing against cyber criminals. It's like a constant cat and mouse game in which they're trying to outsmart you always. That is the perfect summation of what the situation is in cybersecurity. Yes, that's exactly right. Not only are you competing against,

again, your competitors for someone's business, but you're competing against very, very smart hackers that have a huge incentive. People don't necessarily realize this, but there can be big, big, big payoffs in terms of money if you can hack into somebody's business and essentially hold them for ransom. That is an enormous incentive to be innovative in how you create an attack vector. And so, what Palo Alto and competitors have done as well, Palo Alto actually has a unit within its business called Unit 42. All they do is look for and study emerging attack vectors. What they want to do is to say, hey, yes, I got to be competitive on the business side of things, but I have to be even more competitive on the technology side of things because someone

is out there, a bad actor is out there trying to do harm, and my job is to protect my customers from harm. So, yes, they spend a lot of money on research and development in there to try to get ahead of the problems. And because of all that, I think it's pretty hard to bet against this industry. It's easy to imagine a world in which it just only gets bigger, right? The threats only become greater. The payoffs that you mentioned for hacking into a company only become greater. So, with all that said, what do you see the next 10 years looking like for Palo Alto Network specifically? I see them continuing to run as fast as they can on the treadmill to keep innovating. One of the underappreciated things in business is if you have the ability

to integrate an acquisition, that is an enormous advantage. When I went to business school and we'd studied cases, integrating acquisitions is something that's very difficult to do. And so, the fact that they have a playbook based on their past success of how to take a technology at whatever maturity level it's at, integrate it into its platform, integrate it into its sales organization, and sell it profitably into the marketplaces trying to serve, they're going to continue to do that. Um, in addition, like I said, with unit 42, they're going to look at attack vectors and if they can develop technologies in house, they'll continue to do that. And getting back to my, you know, they're going to run as fast as they can. They're, they're just never going to stop this. This is pretty interesting when you think about how unique this industry is.

And again, not only is there business competition, but there's outside competition ratcheting up the competition level. I would be very, very surprised if the cybersecurity market was ever smaller on a year-over-year basis. It can't be because the incentives drive the behaviors of everyone to, hey, the cost of doing this is just more and more, so we got to figure out ways to do it. Let's play devil's advocate for a second. Maybe not with the shrinking of the cybersecurity business, but with Palo Alto in particular, what could go wrong? In what ways might this investing thesis not be intact? A perfect question, because there's always risk in every investment that we make. If there was a major attack vector that Palo Alto's

platform just missed and it really caused harm to one of its larger customers reputation you know they're they're they're hard to build but if you really mess up like completely drop the ball type of a situation you know you you can ruin your reputation and if and if you're serving big customers with a one-stop shop uh type of approach um you know word can get around very quickly that hey, we had a problem here. The ramifications could be twofold. One, your customers might say, hey, if you want us to stick with us, you're going to have to give us an X percent discount right now. Or they could go to somebody else. That's the other risk, is that the things unravel. So from that standpoint, again, Palo Alto, as well as its competitors, have a huge incentive

to make sure they get this right as often as they can and to the right magnitude. Breaches are going to happen, but you don't want to have a bad actor get into an enterprise and really cause damage. Like that's, that's the big risk. And that's why Palo Alto spends hundreds of millions of dollars every year on research and development. Yeah. To say that the stakes are high feels like an understatement, but the, but the opportunity is large as well. Absolutely. As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Deidre Willard. Thanks for listening. We'll see you tomorrow.