BERKSHIRE HATHAWAY IN 2011
Berkshire Hathaway of 2011 is a very different beast than the textile mill business of half a century ago. The operations of the holding company are split up into three distinct units: investments, insurance, and non-insurance companies. The investment portfolio is the most well known part of Berkshire Hathaway, and includes sizable stakes in some of the best companies in the world, including American Express (12.6% ownership), Procter & Gamble (2.6%), and of course, The Coca-Cola Company(8.6%). As of yearend 2010, investments were worth $158 billion at market value.
While Warren Buffett is known in the general public for his investing, the other two pieces of the pie are also fundamentally important to Berkshire. The insurance business accounts for nearly $66 billion in float (included in the $158B above), which is “free” money as long as insurance underwriting breaks even. For clarification, Berkshire has operated at an underwriting profit for the past eight years, with a total underwriting gain of $17 billion during that period. In essence, float has been better than “free” during that time period. As noted by Warren in the 2010 shareholder letter, there is no reason for this to change anytime soon: “I believe it likely that we will continue to underwrite profitably in most – though certainly not all – future years.”
The non-insurance companies are also any important part of Berkshire Hathaway. As noted in the annual letter, “During the past two decades we’ve increasingly emphasized the development of earnings from non-insurance businesses, a practice that will continue.” Some of the well known names in this 68 company category include Fruit of the Loom, Business Wire, NetJets, and Dairy Queen (my personal favorite). In 2010, the non-insurance businesses accounted for $5,926.04/share in pretax earnings, which compounded at a rate of 20.5% over the last decade (compared to 21% over the last 40 years). The continued increase in earnings at the non-insurance businesses are a testament to the diversification across sectors, the competitive advantages of the individual firms, and the business quality of the acquired companies that have become a part of Berkshire Hathaway over the past 46 years.
Increasing per-share earnings of the non-insurance business at a decent rate over the coming years will be largely dependent on new additions to the Berkshire family. As noted in the annual letter, “We will need both good performance from our current businesses and more major acquisitions. We’re prepared. Our elephant gun has been reloaded, and my trigger finger is itchy.” The big acquisition from last year was the railroad company Burlington Northern (BNSF), which brought questions in regards to both price and an uncharacteristic purchase of a capital intensive business. However, the results to date have left all concerns in the dust. Based on 2010 pretax earnings of nearly $4B, Buffett paid roughly 8x for BNSF; on top of that, as pointed out in the shareholder letter, the earnings from BNSF increased normal earning power by nearly 40% pretax, and well over 30% after tax.
Considering how quickly Buffett replenished the cash from the BNSF acquisition, he was ready to shoot when the next opportunity appeared, which happened earlier this week. On Monday, March 14th, Berkshire Hathaway announced that they would acquire Lubrizol ( LZ), a specialty chemical company in the global transportation, industrial, and consumer markets, for $135/share in an all-cash deal ($9 billion for the company). Based on consensus 2011 estimates of $11.35/share, the price tag on LZ comes in at less than 12x earnings, and is equal to an earnings yield of 8.4%; this is for a company that has increased EPS by more than 25% per annum over the past five years. Again, it appears that Warren has found a strong addition to the non-insurance business portfolio.
The success of each of these three pieces has been the driving force behind consistently strong gains in book value year after year. From 1965 to 2010, book value per share at Berkshire increased 20.2% per annum (from $46 to $95,453), compared to 9.4% for the S&P 500; over 46 years, that works out to a 6,262% increase for the S&P 500, compared to 490,409% gain for Berkshire Hathaway. Much of this success is attributed to superior capital allocation by Warren Buffett and Charlie Munger, who are no doubt well deserving of the praise they have received. However, it is important to realize that the tradition and people they have built around them are essential to both the current and future success of Berkshire Hathaway. As an investor in Berkshire, one must realize that the story doesn’t end with Warren Buffett.
THE PEOPLE OF BERKSHIRE HATHAWAY
Most discussions about the future of Berkshire only ask one thing: what will life be like without Warren and Charlie? Despite the calls for a clear succession plan, the majority of the future leaders of Berkshire are already in place. The first are the operating managers of Berkshire’s insurance and non-insurance businesses. As Warren Buffett has always said, he has interest in acquisitions without the incumbent management team, and keeps his hands out of other people’s business; managers like Ajit Jain (Berkshire Hathaway Reinsurance Group), Matt Rose (BNSF), and Tad Montross (General Re) run their own operations at Berkshire, and their business results will not be affected by who they send their excess capital to at the end of the year. The Board of Directors is another star studded cast, with names like Bill Gates (Microsoft founder ( MSFT)), Tom Murphy (former CEO, Cap Cities/ABC), and Don Keough (former COO, Coca-Cola ( KO)) filing the ranks. Much like with the operating managers, these gentlemen have proven their merit outside of Berkshire, and will step up to make sure things run smoothly when change does happen.
Two people that will play key roles in the future of Berkshire Hathaway are David Sokol and Todd Combs. Mr. Sokol, who runs Berkshire subsidiary MidAmerican with Greg Abel, was moved to the leadership position at NetJets, the leading provider of fractional ownership of jet airplanes, in August 2009. NetJets was acquired by Berkshire in 1998, and had accumulated an aggregate pre-tax loss of $157 million in the 11 years prior to Mr. Sokol’s rein. Like magic, David spun the business around to a pre-tax profit of $207 million in 2010, compared to a loss of $711 million in 2009. As noted by Warren in the annual letter, “I can’t overstate the breadth and importance of Dave Sokol’s achievements at this company.” Many people expect that Mr. Sokol will likely become the next CEO of Berkshire Hathaway; based on his past operating success, shareholders should be more than happy to have him.
Todd Combs, who appeared to drop out of the sky, was hired to handle a “significant portion of Berkshire’s investment portfolio” in October 2010. Mr. Combs was the portfolio manager of Castle Point Capital Management, which gained 28% since its inception in 2005, compared to a 49% decline against the benchmark. While I could talk about Mr. Combs and what I think it means for the future of Berkshire Hathaway, I would rather let Warren: “When Charlie and I met Todd Combs, we knew he fit our requirements. Todd, as was the case with Lou [Simpson], will be paid a salary plus a contingent payment based on his performance relative to the S&P. We have arrangements in place for deferrals and carry forwards that will prevent see-saw performance being met by undeserved payments… Todd initially will manage funds in the range of one to three billion dollars, an amount he can reset annually. His focus will be equities but he is not restricted to that form of investment. Over time, we may add one or two investment managers if we find the right individuals. Should we do that, we will probably have 80% of each manager’s performance compensation be dependent on his or her own portfolio and 20% on that of the other manager(s). We want a compensation system that pays off big for individual success but that also fosters cooperation, not competition.”
In the future, power will be split between the CEO, CIO, and the board of directors: “When Charlie and I are no longer around, our investment manager(s) will have responsibility for the entire portfolio in a manner then set by the CEO and Board of Directors. Because good investors bring a useful perspective to the purchase of businesses, we would expect them to be consulted – but not to have a vote – on the wisdom of possible acquisitions. In the end, of course, the Board will make the call on any major acquisition.”
As usual, Warren has the best analogies to explain his logic: “One footnote: When we issued a press release about Todd’s joining us, a number of commentators pointed out that he was “little-known” and expressed puzzlement that we didn’t seek a “big-name.” I wonder how many of them would have known of Lou in 1979, Ajit in 1985, or, for that matter, Charlie in 1959. Our goal was to find a 2-year-old Secretariat, not a 10-year-old Seabiscuit.”
So what does that all mean? There is no way of knowing what the future will bring. But I have seen the success of Warren’s investments in Lou, Ajit, and David; and I have no doubt that Warren has found people who are capable of picking up where he will leave off in Todd Combs, David Sokol, and all the other people that have made Berkshire Hathaway what it is today.
For Berkshire Hathaway, I think the best way to estimate intrinsic value is by splitting up the respective business segments. As noted above, the investment portfolio is worth $158 billion, or $94,730/share; since these are market values and are essentially liquid, they are valued at face.
The second component of this value is from the earnings in the non-insurance businesses, which was equal to $5,926/share in 2010. Considering an increase in per share earnings of 20.5% per annum over the past decade, I think a multiple in the high teens is justified. However, as noted by Warren above, these growth rates are harder to attain as size increases, and will likely decrease over time. In order to be conservative, I will use multiples of 8-12x pretax earnings, which are equal to a range between $47,408/share and $71,112/share.
In aggregate, my calculation of intrinsic value for Berkshire Hathaway is from $142,138 (B share equivalent = $94.76) to $165,842 ($110.56) per share. Based on a current stock price of $126,400/share, I believe that BRK.A is undervalued by anywhere between 12-31%.
The financial strength of Berkshire is a testament to Warren’s focus on creating shareholder value over time. As noted in the annual report, “Charlie and I have no interest in any activity that could pose the slightest threat to Berkshire’s wellbeing. (With our having a combined age of 167, starting over is not on our bucket list.) We are forever conscious of the fact that you, our partners, have entrusted us with what in many cases is a major portion of your savings.” This strategy also presents another advantage: cash when everyone else is running dry. The investments made in Swiss Re notes, along with General Electric ( GE) and Goldman Sachs ( GS) preferred are an example of this strategy, and a key tenet of Buffett’s investment philosophy: “Be fearful when others are greedy and greedy when others are fearful.”
For years, Berkshire Hathaway was said to carry a “Buffett Premium”, the price to pay in order to be in business with one of the greatest investors and businessmen in history. As noted by Alice Schroder in a recent article, the market is concerned with the future at Berkshire, and has turned the “Buffett premium” into a “Buffett discount”. On top of this, investors caught up on short term mark-to-market accounting on derivative positions are missing the bigger picture. For long term investors who trust Warren’s ability to find businesses and managers that will maintain the legacy of Berkshire Hathaway, now is a great time to acquire shares of BRK.B.