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Whitney Tilson on Why He Thinks Berkshire Hathaway Is Still Super-Cheap in March Letter to Investors

April 02, 2012 | About:
Holly LaFon

Holly LaFon

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Tilson clears up contentions related to his earlier estimation of Berkshire Hathaway's intrinsic value in this excerpt from his March letter to investors:

5) And speaking of Berkshire, my friend Doug Kass (who’s speaking for the first time at the Value Investing Congress in Omaha) posed two fair questions about our Berkshire valuation that I want to respond to:

Here are the two questions about BRK valuation that I would like to ask Whitney about Berkshire Hathaway (BRK.A)(BRK.B) at 10 AM block today :

Whit values Berkshire's intrinsic value at $178k vs. today's share price of $120k. In his email today he explains, as he has in the past, his methodology in determining his intrinsic value calculation:

FROM WHIT EMAIL 2) Attached is our updated slide deck, showing (on page 14) that we have increased our estimate of Berkshire’s intrinsic value to $178,366 ($98,366 in investments/share plus 10 x $8,000/share of pre-tax earnings of the operating businesses), nearly 50% above today’s price of $120,000. Page 15 shows that the stock trades at close to the largest discount to intrinsic value in two decades (despite the fact that we think the company has never been stronger, with fewer risks and a better mix of earnings drivers than ever).

But, Whit, why should we still pay full value of Berkshire's investment portfolio (or $98,366/share) given 1. Warren Buffet's age, 2. that he has begun to delegate investment portfolio selection to (two) others, 3. Berkshire's portfolio size makes it difficult to find that diamond in the rough (so he is basically buying what the other funds are buying) AND importantly (Given 1 and 2 and 3), 4. most closed end publicly traded investment funds trade at about an eight percent discount to net asset value.

Secondly, why do you value the non-investment businesses at a rich 10x pre-tax earnings ( or about 14x after tax earnings) when a large amount of those are in the financial sector (banking and insurance) which, in today's markets, are accorded a relatively low price earnings multiple well under 14x?

My answers:

A) Whether a haircut is warranted is a function of two things: the nature of the investment (cash, bonds, stocks, venture capital investments, etc.) and the capital allocation track record of the company. Let’s start with the facts: 51% of Berkshire’s investment portfolio is cash and bonds (nearly all cash equivalents: short-term, ultra-safe bonds) and the other half is stocks (57% of which was in four stocks at the end of 2011: Coke, IBM, Wells Fargo and Amex). The cash and bonds are easy to value and, as for the stocks, one can look at the major holdings and decide if they’re over- or undervalued (we only own one of the four, Wells Fargo, but think that overall the stocks Berkshire holds are moderately undervalued, along with many big-cap blue-chips).

If this was an average company run by an average CEO, I’d agree with Doug that a haircut was warranted – but it isn’t. For more than 50 years, Buffett have proven beyond a shadow of a doubt that he can consistently: a) take $1 of cash and invest it to create far more than $1 of value; and b) pick stocks that go up and beat the market. I’d bet a lot of money (in fact, we ARE betting a lot of money) that this continues as long as Buffett is running Berkshire.

Doug implicitly seems to agree when he highlights Buffett’s age and the fact that he’s begun to delegate to his two successors on the investment side – but Buffett is still going strong (see page 22 of our updated slide deck (www.tilsonfunds.com/BRK.pdf), the CNBC interview last month, as well as countless other data points), plus he’s only delegated a few percent of Berkshire’s investment portfolio. With all the talk about his age and succession, you’d think Buffett was on his death bed! In truth, Buffett is highly likely to be running Berkshire five years from now, and even money I think to be running it 10 years from now.

B) We don’t think applying a 10 multiple to the pre-tax earnings of Berkshire’s 79 or so operating businesses is “rich.” That’s roughly a market multiple for a collection of businesses that’s far superior the average American business. As a group, they are market leaders, are superbly run, and most generate very high, unlevered (or low-levered) returns on equity. Only $1,000 of our $8,000/share estimate of Berkshire’s normalized pre-tax operating earnings are from the low-multiple insurance businesses (13%), vs. $5,500/share (68%) from these five higher-multiple businesses: BNSF, Iscar, Lubrizol, Marmon Group and MidAmerican Energy. We think a 10 multiple is conservative. Incidentally, as we show on slide 13, we think Buffett has used a 12 multiple historically.

The last point I’d make is that even if one agrees with Doug, Berkshire is STILL super-cheap. If we haircut investments/share by 8%, that's an $8,000 haircut to our estimate of $178,000, and then if we use 8 rather than 10 for the multiple on pre-tax operating earnings, that's a $16,000 haircut, so $178,000-$24,000=$154,000 vs. today’s price around $122,500 – it’s STILL at 80-cent dollar (vs. the 69-cent dollar we think it is) AND it’s super safe and growing at a healthy clip…

6) This Barron’s article (http://online.barrons.com/article/SB50001424052748704097904577251253784193654.html) highlights how safe and cheap Berkshire is – and speculates that Ajit Jain is likely Buffett’s successor:

Warren Buffett's towering stature among investors hasn't translated into big gains for Berkshire Hathaway stock.

That could change because Berkshire's class A shares (ticker: BRKA) look unusually attractive trading around $118,000, down 7% in the past 12 months, trailing the 5% gain in the Standard & Poor's 500 in that span and little changed over the past five years. The class B shares (BRKB)—each worth 1/1,500th of an A share—fetch 79.

The company's book value continues to grow and may hit $105,000 by the end of this quarter, boosted by earnings and gains in its big equity portfolio, which totaled $77 billion at year end. Book ended 2011 just below $100,000 a share.

Berkshire fetches little more than 1.1 times our estimate of current-quarter book value, which is the level at which it stands ready to buy back its stock, backed by $33.5 billion in cash. "Probably the last time the stock was such a laughingstock was in the spring of 2000," says David Rolfe, chief investment officer of Wedgewood Partners, a St. Louis firm that owns Berkshire. "You'd be hard-pressed now to find a more attractive blue chip." Back in 2000 at the height of the tech bubble, Berkshire briefly dipped to about $40,000.

Rolfe thinks Berkshire is worth at least $170,000 a share. Wall Street analysts Cliff Gallant of KBW and Jay Gelb of Barclays Capital are bullish, but have more conservative price targets of $133,000 and $127,500, respectively. Barron's has written favorably on Berkshire many times, including a cover story last year ("Mr. Moneybags," Jan. 24, 2011) when the shares were around $121,000.

"THE BUFFETT PREMIUM IS GONE from the stock," notes Gallant, referring to investors' former willingness to pay a big premium above book value for the shares. The stock's price has averaged 1.5 times book in the past decade, although that multiple has contracted in recent years. The current estimated price/book ratio near 1.1 is near the bottom of the decade-long range.

Berkshire arguably is one of the most defensive large-cap stocks because the company's diversified after-tax earnings power is running at about $12 billion annually. It comes from railroads, utilities, insurance outfits, investments and dozens of smaller businesses. Those profits should steadily boost book value, which could top $111,000 by the end of 2012 and $120,000 by the close of 2013.

Buffett reiterated in his annual shareholder letter this year that book value "considerably understates" what he considers to be Berkshire's intrinsic value. But the investment community seems unimpressed.

7) Jeff Matthews thinks Greg Abel is the successor (http://jeffmatthewsisnotmakingthisup.blogspot.com/2012/03/bill-gates-succeeds-warren-buffett-not.html):

So who’s The Guy?

Well, Barron’s—which a few years ago identified David Sokol in a cover story on the subject—now says it’s Ajit Jain, the reinsurance genius who has added more value to Berkshire Hathaway than anyone but Warren Buffett himself. (Barron’s keys off Buffett’s statement that the Board has had “a great deal of exposure” to the guy.)

And while it’s true Jain is familiar to everyone at Berkshire (he’s been making money for Buffett for 25 years) it ignores the fact that Jains runs the reinsurance business out of a small office in Stamford, Connecticut, without as much exposure to the Berkshire businesses that now drive the company’s growth (energy, railroads and manufacturing) as others.

So while we’d bet Jain is one of the two back-ups, since he can step into Buffett’s shoes easily, if need be, the “managerial” aspect cited by Buffett suggests somebody running actual businesses, which leads to Tony Nicely, who has run GEICO brilliantly—and to big props from Buffett along the way—for decades, as well as Tad Montross of GenRe, Matt Rose of Burlington Northern, and Kevin Clayton of Clayton Homes—all of whom excel at what they do, and (except Nicely) are young enough to fit the bill…but may lack the broad experience of our pick: Greg Abel, the dealmaker and ace manager of Berkshire’s immensely important MidAmerican Energy unit.

Well-liked, and presumably with plenty of exposure to the Berkshire Board since Buffett bought MidAmerican over ten years ago (back when MidAmerican’s executive offices were across the street from Berkshire’s in Omaha), Abel has the experience of operating regulated, multi-national businesses plus a healthy deal-making background that Berkshire will need over the long run.

8) Glenn was interviewed by PBS’s Nightly Business Report at the end of February about Berkshire’s future. The transcript and video are posted at: www.nbr.com/videos/video?id=1478927572001. Here’s an excerpt:

TONGUE: If you look at each and every one of the operating businesses, whether it's the utilities or the railroads or manufacturing businesses, they were all up year over year. They were all up quarter over quarter in terms of operations. So the underlying businesses are doing terrifically well. There's some accounting conventions that are required, certain write offs and write downs, that made the earnings go down, but the cash flow of the company certainly went up and the operating performance has never been stronger.

GHARIB: But what Berkshire stock? The A shares have been trading at around $120,000 for two years now. What do you think?

TONGUE: We value Berkshire stock and we think it's worth about $180,000 per share. We were buying Berkshire stock today very aggressively in the marketplace. It's got the most powerful balance sheet of any company in America and it's got earnings power that is growing very, very rapidly.


9) A great story (below) by Buffett in the latest issue of ForbesLife about how he got started (with some wonderful old pictures of him and his family from the 1950s). Here’s an excerpt:

I did no solicitation, but more checks began coming from people I didn’t know. Back in New York, Graham-Newman was being liquidated. There was a college president up in Vermont, Homer Dodge, who had been invested with Graham, and he asked, “Ben, what should I do with my money?” Ben said, “Well, there’s this kid who used to work for me.…” So Dodge drove out to Omaha, to this rented house I lived in. I was 25, looked about 17, and acted like 12. He said, “What are you doing?” I said, “Here’s what I’m doing with my family, and I’ll do it with you.”

Although I had no idea, age 25 was a turning point. I was changing my life, setting up something that would turn into a fairly good-size partnership called Berkshire Hathaway. I wasn’t scared. I was doing something I liked, and I’m still doing it.


Rating: 3.1/5 (9 votes)

Comments

AlbertaSunwapta
AlbertaSunwapta - 2 years ago
I own some BRK.

I imagine the fact that Berkshire's shares haven't risen "significantly" over the past number of years means to many, many investors that Buffett has lost his ability. That's the EMH at work, probably unconsciously, in the minds of those investors. Furthermore, he's an old guy and most people would have trouble hiring anyone in their 50s, let alone someone in their 80s.

Further 'reasoning' will be that Buffett could die overnight and the shares would take a significant tumble. Following that, doubts would arise over its ability to grow and the possibility that the new management would make major value destroying errors - all during a time when America's own ability to survive debt and demographics raises a lot of fears in those investors hearts.

Then there's the fact that it's an insurance company with insurance risk and derivatives with risk... (never say never).

Well, I've talked myself into it. I think I'll go buy a few more shares as these really are foolish times.

:-)



P.S. BRK's governance has been a 'public' issue for a while now. See below for an activist letter. I'm surprised that someone hasn't raised these critical and important issues before. BRK frequently challenges 'common sense' and it took until this past April 1st, ;-) for concerned shareholders to finally bring forth such deviant behaviour, behaviour that I'm sure will disturb many in the 'public' and possibly the media too. :-)


Baker Street Capital Writes Activist Letter To Berkshire Hathaway

April 1, 2012

The Board of Directors

Berkshire Hathaway Inc.

3555 Farnam Street, Suite 1440

Omaha, NE 68131

Dear Members of the Board:

..."Compensation:

We believe that the board has conveniently chosen to maintain the status quo and ignore these critical issues in order to preserve the directors’ generous board fees, ranging from $3,300 to $7,300 annually. Equally disturbing is the fact that this compensation package is not tied to quarterly or annual share price performance. As a result, the board has stood by idly as the stock price has lagged the general market during the past three months... Given the directors’ excessive board fees and lack of economic ownershipin the business, it is not surprising that the Berkshire board has fought for years to maintain a dual-classstock structure, a corporate maneuver used frequently by deeply entrenched and self-interested boards.Any criticism of Berkshire is incomplete without a discussion of egregious executivecompensation practices at the company. As disclosed in the most recent proxy, Warren Buffett received asalary of $100,000 for his services as Chairman and CEO in 2011. By his own admission, Mr. Buffett hasdelegated management responsibilities to more talented subsidiary company executives. More recently, hehas hired investment managers to direct many of Berkshire’s public market investments. In mediainterviews Mr. Buffett has admitted to spending a significant amount of time pursuing his bridgegambling interests. In the absence of more comprehensive disclosures, shareholders are left to wonder exactly what role Mr. Buffett really plays at Berkshire. We believe that compensation of one hundredthousand dollars represents a significant transfer of wealth from shareholders to Mr. Buffett. We urge the board to retain professional compensation consultants to perform a thorough benchmarking study of executive remuneration at Berkshire.

Succession Planning:..."


http://www.valuewalk.com/2012/04/baker-street-capital-management-writes-activist-letter-to-berkshire-hathaway-inc-brk-a-brk-b/


For anyone that wants some reference material...

http://money.cnn.com/2011/10/26/news/companies/board_of_directors_pay/index.htm

http://www.forbes.com/sites/francinemckenna/2011/04/11/corporate-governance-at-berkshire-hathaway-maybe-its-not-all-that/

http://www.theracetothebottom.org/executive-comp/director-compensation-project-berkshire-hathaway.html
coda
Coda - 2 years ago
This is ridiculous if I was Buffett I would be really pissed about these questions about Berkshire future.

It doesn't matter how good a capital allocator you are in this market, you can be the best in the world as Buffett certainly is, but still if you don't give any detail about what you gonna do with those money, if you don't give to the fools some news to trade they won't be satisfied.

The fact that Berkshire's portfolio should trade at a discount is ridiculous,that is a far better portfolio than any individual investor could ever build,and the two new managers are outstanding...still they don't care....like if Buffett couldn't recognize a good investor when he sees one.

About the fact that Buffett can't find the diamond in the rough anymore....I don't think so, consider BNSF, Greenwald considered it an insane deal, everybody thought it was a mistake...

Well BNSF was a diamond, a bet on the cleaner transportation solution and on the coming energy crisis ,Greenwald is a professor, he couldn't understand BNSF' moat cause he hadn't seen it in the past. Buffett understood that with higher oil prices and environmental problems things would have changed forever and trains would have had a leg up on trucks....a sustainable competitive advantage. Not even a Professor, a man that is considered a guru like Greenwald was able to see this coming...isn't it a diamond? Buffett is one of those few people who can see things 10 years from now...

alysomji
Alysomji - 2 years ago
I remember those comments from Greenwald.

Buffett really did a number with BNSF. Mighty impressive.

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