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Is Berkshire Hathaway Still a Buy After Sokol's Departure?

May 03, 2011 | About:
Street Authority

Street Authority

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The Berkshire Hathaway (BRK.A) (BRK.B) shareholder meeting takes place each year during the first weekend in May in Omaha, Neb. The 2010 meeting, held this past weekend, was attended by an estimated 40,000 loyal shareholders, many of which have held shares of Berkshire for decades and have become wealthy due to Warren Buffett's ability to grow money at one of the most rapid rates in history.

Since Berkshire's start in 1965 and running through 2010, Berkshire has experienced a 20.2% annual growth rate in book value. This is more than double the 9.4% annual growth rate in the stock market, as measured by the return of the S&P 500 Index. Over this period, this means that Berkshire has returned 490,409% -- while the market is up 6,262%. Both rates of growth have been impressive, but Berkshire's qualifies as spectacular.

Buffett has relayed numerous times that future growth rates at Berkshire will fall below its historical growth trends, but there is still potential for investors to earn above-average returns by investing in the stock. Just take the past two years as an example -- book value grew 19.8% in 2009 and 13% in 2010.

This suggests Berkshire is still likely to be able to compound wealth at a double-digit rate going forward. The meeting this past weekend indicated there are a few near-term hurdles for the company to overcome, but there were also a number of positives for shareholders to take home and mull over.

Two major uncertainties relate to Berkshire's corporate culture and succession plans for Buffett and Vice Chairman Charlie Munger, Buffett's sidekick who sits by Buffett and fields questions from 9:30 a.m. to 3:30 p.m. at the shareholder meeting each year. Berkshire's culture took a serious hit when news broke that David Sokol, a former trusted Buffett lieutenant thought to be Buffett's successor, personally purchased shares of chemical giant Lubrizol (LZ) before recommending it to Buffett and Berkshire as a potential acquisition candidate.

On March 14, Berkshire did in fact announce it would be purchasing Lubrizol, and on March 30 it issued a press release announcing that Sokol was resigning from Berkshire Hathaway. A number of facts have been uncovered since, and the basic conclusion from Berkshire's audit committee, which was released on April 26 just before the shareholder meeting, was that Sokol violated Berkshire's code of business conduct as well as its insider-trading policies and procedures.

Buffett went into the matter in great detail at the start of the meeting and fielded a number of questions after. He summed it up as both inexplicable and inexcusable. He found it inexplicable, as Sokol made an estimated $3 million by trading the Lubrizol shares, a small fraction of the $24 million he earned last year and an even smaller proportion of his total net worth. He also found it inexcusable for not informing Berkshire that Sokol learned of Lubrizol from a Citigroup investment banker when he was officially representing Berkshire Hathaway and should have acted in the best interest of the company.

Despite the drama, the actions represented the mistake of Sokol as one individual. Berkshire's 260,000 employees are overwhelmingly honest and ethical individuals, thanks to Buffett's insistence on stellar ethics and placing a high value on reputation. As for Sokol as a once-potential successor, Buffett stated there is a much stronger candidate. He has also asked Berkshire's individual company managers for their input on a future replacement and expects to hire multiple individuals to manage its $60 billion stock portfolio.

The discussion at the meeting should have left shareholders comfortable with Berkshire's corporate culture and succession plans, given the company has dozens of capable managers and former business owners whom Buffett has described as "truly skilled managers who have an unusual commitment to their own operations and to Berkshire Hathaway."

Berkshire is a very well-run company and a leader in a wide array of industries. It owns what is arguably the best insurance operation on the planet, led by Geico, as well as a reinsurance business run by Ajit Jain, who could be on the top of the list as Buffett's successor. Berkshire's collection of manufacturing, service and retailing operations, including Dairy Queen, Fruit of the Loom, NetJets and Justin Boots, just to name a few -- qualify the company as a conglomerate in every sense of the word. All operations are impressively profitable and among the strongest players in their industries and, for the most part, are growing briskly.

Action to Take --> Berkshire's growth rate is far from slowing down. In the past decade, its non-insurance businesses have grown earnings at 20.5% on average each year. Earthquake disasters in Japan and New Zealand, along with tornadoes in Alabama could dent near-term insurance profits, but it should allow for higher pricing in the next couple of years. An improving global economy will allow most of its operations, including those related to home building, such as Shaw carpets, to grow sales and profits robustly for at least the next couple of years.

Berkshire could be capable of growing book value in the low double digits for at least the next five years. The "A" shares currently trade at $123,000 each and at 1.3 times book value, which is a common valuation metric for insurance companies. Of course, Berkshire is unique given its other non-insurance businesses, and combined, it is arguably worth closer to 1.5 times book value, or more than 15% above the current stock price.

In other words, the current stock price is at a reasonable discount from intrinsic value of closer to $150,000 per share and represents a decent entry point to jump on board and participate in the double-digit growth rates that are still possible from Berkshire's many leading business units.

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-- Ryan Fuhrmann

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Street Authority
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Comments

dew_nay
Dew_nay - 3 years ago
BRK sure looks priced for future gain, probably that will exceed the average index performance. In the latest annual report. Buffett laid out how he & Charlie think about BRK's intrinsic value. It consists of 3 components. Two of it are laid out in numbers: 1) per-share investment of $94,730; 2) per-share in pre-tax operating earnings of $5,900.

Assuming tax rate of 35%, after-tax per share in operating earnings is $3,800. At current share price $122,000, after netting off the per-share investment, current buyers are paying only $27,000 for the operating business, which translates to about 7x of operating earnings. That's a pretty ridiculous valuation, in a cheap way.

Going forward, with the addition of LZ, LZ will contributes somewhere north of another $400 per share in operating earnings after tax.

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