The New Investors Guide to Holding Companies

Berkshire Hathaway is the most famous holding company in the world. Warren Buffett grew it from $8 per share to more than $150,000 per share over the 40+ years he ran the company, making his stockholders extremely rich in the process.

When you begin investing for the first time, you are going to encounter something known as a holding company. In fact, many of the most successful companies in the world are really holding companies. This basic introduction the holding company will explain what holding companies are, why you need to understand how they work, and some things to consider before investing in one.

The Basics – What Is a Holding Company?

A Sample Holding Company

To understand the concept better, imagine that you and I decided we wanted to invest together. We, and members of our family, create a new company called Blue Sky Holding Company, Inc. We file the paperwork with the secretary of state and pay the fees. Then, we issue 1 million shares of stock at $10 per share, raising $10 million in fresh cash. We vote on a Board of Directors. hire one of us as CEO, and build an office.

The next day, we show up and start investing the money. We (meaning Blue Sky Holding Company) do several things:

• We incorporate a new business called Frozen Treats of America, LLC. It is 100% owned by Blue Sky Holding Company. We contribute $1,500,000 in cash to the business, hire a manager to run it, and open a Dairy Queen franchise that we expect to earn $170,000 in profit before taxes.
• We have Blue Sky Holding Company open a brokerage account with Charles Schwab or another major institution. We deposit $3,000,000 in cash into the account and buy a collection of high quality blue chip stocks. We expect these stocks to generate $150,000 in pre-tax dividends each year.
• We start a new company called Southworth Hospitality, LLC that is 100% owned by Blue Sky Holding Company. We contribute $2,000,000 of our cash and have this new subsidiary borrow $2,000,000 from a bank, giving it a capitalization structure of $4,000,000 in assets, $2,000,000 in liabilities. and $2,000,000 in book value. We use the $4,000,000 in cash to buy a Hampton Inn hotel franchise, which we expect to generate $320,000 in pre-tax profits for us after interest expense and all other costs. The debt is not guaranteed by the holding company because we decided to only allow non-recourse liabilities in case the hotel isn’t successful.
• We buy $2,000,000 worth of tax-free municipal bonds. which we believe will generate $100,000 in annual interest income.
• We use $500,000 to buy gold and silver bullion.
• We park the last remaining $1,000,000 in cash at our local bank in institutional money market funds that pay 6% interest, generating $60,000 in pre-tax interest income each year.

Holding Company Financial Statements

The consolidated balance sheet of our holding company is going to show $12,000,000 in assets, $2,000,000 in debt, and a $10,000,000 net worth, or book value. Other than an office, which we will ignore for now for the sake of simplicity, our balance sheet appears as follows:

Blue Sky Holding Company, Inc.

• Frozen Treats of America, LLC – 100% ownership ($1,500,000 assets, no liabilities)
• Southworth Hospitality, LLC – 100% ownership ($4,000,000 assets, $2,000,000 liabilities, $2,000,000 net worth )
• Tax-Free Municipal Bonds ($2,000,000 assets, no liabilities)
• Blue Chip Common Stocks in Brokerage Account ($3,000,000 assets, no liabilities)
• Bank Balances ($1,000,000 assets, no liabilities).
• Gold and Silver Reserves ($500,000 assets, no liabilities).

The holding company income statement is going to show $800,000 in operating income (profit before taxes). That would be an 8% return on equity because $800,000 divided by $10,000,000 in net worth is 8%. It would be a 6.7% return on assets because $800,000 divided by $12,000,000 in assets is 6.7%.

How to Think About a Holding Company

Imagine you were the CEO of our fake company, Blue Sky Holding Company, Inc. When you show up to the office each morning, turn on the lights, grab a cup of coffee, and go sit at your desk, what do you actually do.

As you can tell, he thing that makes us a holding company is that we have no day-to-day role in any of the investments! Each is run by its own management team. In other words, as a holding company, our job is executive oversight and / or passive investing. depending upon our corporate strategy. Our job is to put the money to work and determine if management is doing a good job. If we own enough stock to control an investment, we can fire the managers and replace them at our own discretion.

In other words, you aren’t going to be making ice cream cones at our Dairy Queen franchise. That is the job of Frozen Treats of America, LLC, a 100% owned subsidiary with its own employees, managers, financial statements. contracts, bank loans, etc.

The Benefits of the Holding Company Model

The holding company model protected our other assets from this one subsidiary. We didn’t lose our Dairy Queen franchise. or our stocks, or our bonds, gold, silver, or bank balances. We only lost the money we invested into that one subsidiary.

This is how large corporations protect themselves. Procter & Gamble, for example, is effectively a holding company because it has different subsidiaries for different purposes. Some subsidiaries own the brand names such as Tide detergent. Other, totally separate subsidiaries own the manufacturing plants that make Tide and pay the company that owns the brand name a licensing royalty. That way, if the firm is sued, Procter & Gamble could never lose the Tide brand name, the factory would go bankrupt.