Berkshire Hathaway Is a Three-Point Layup
There will be no high-flying heroics in my idea. Just standing under the bucket consistently and reliably hitting three point layups. Yes, three point layups. Buying a great company at a fair price that will grow over time is a two point layup and a reliable and consistent path to investment success. Buying a world class company run by one of best investors of all time at a significant discount to fair value is hitting a three point layup.
When done well, value investing is equivalent to hitting a three-point layup. Our goal is to acquire stakes in world-class companies well below a consistently increasing intrinsic value, allowing for strong future returns with little risk of permanent capital loss.
Our ideal investment would entail buying a 1) great business run by 2) superb management at a 3) low valuation. It should also be timeless, simple, understandable, and it should retain an ability to compound for years into decades with minimal tax drag.
Berkshire Hathaway (BRK.A)(BRK.B) is a collection of great businesses held both as fully owned operating businesses and as investments in publicly traded companies. The management at Berkshire carries a superb reputation for honest, reliably consistent and shareholder-focused actions. The company has the broadest of mandates that allows Warren Buffett, Charlie Munger and the rest of the management team the flexibility to invest wherever the best returns exist irrespective of industry or asset class. Most importantly, Berkshire is available for investment today at historically low valuations.
When we can invest in a great business run by world-class managers at low valuations, we invest aggressively and believe doing so is akin to hitting three-point layups. Such opportunities are rare but interestingly, are often associated with great simplicity in the thesis. Investing in a great business available at a significant discount to intrinsic value is our goal, and can be as simple as hitting layups.
As mentioned, Berkshire Hathaway is a collection of investments and operating businesses wrapped inside an insurance company that provides the predominant funding mechanism to continually and consistently grow its base of investments and operating companies’ earnings. Berkshire is truly a wonderful business with three distinct aspects: 1) investments, 2) controlled operating businesses and 3) insurance.
Berkshire’s investments comprise cash and cash equivalents, bonds, equities and other hybrid investments.
With today’s historically low interest rates, bonds, particularly those of long duration, carry heightened risk with an unfortunate corresponding low yield and return profile. With that in mind, Berkshire’s bond portfolio is of relative short duration and also of high quality. To highlight its short duration, over two-thirds of the highly rated portfolio matures in five years or less allowing for those investment dollars to be redeployed at likely higher rates and/or into future business acquisition and equity investment opportunities.
The historical foundation of Berkshire Hathaway has been its equity investments. Berkshire’s top three holdings are Coca-Cola (KO), Wells Fargo (WFC) and IBM (IBM). Coca Cola consistently posts high returns on capital and may carry the strongest combination of brand value and enduring business model of any company in the world. Coca Cola has been a strong foundational ownership stake for Berkshire and continues to grow its global business while returning significant amounts of cash to its shareholders including Berkshire.
Wells Fargo is one of, if not the most, well-respected and well-run banking franchises in the world. Buffett has been consistently adding to Berkshire’s stake in Wells Fargo as the continued overhang from the recent financial crisis weighs on bank valuations thereby allowing for opportunistic long term investments in the company. Berkshire’s stake in Wells should continue to grow in value as Wells trades at reasonably low valuations even against currently depressed earnings from a subpar economic environment, current low net interest margins and generally weak trading and capital markets environments. Wells’ earnings should increase as these aspects of their business normalize allowing them to capitalize on their best in class low cost deposit funding base leading to enhanced profitability and a return to more normal valuations. Wells has resumed stock buybacks and a more normalized level of dividends both of which should increase as they attain the higher capital levels being mandated by new regulatory standards.
IBM is a global technology company increasingly built upon a strong and recurring services business that now represents over 50% of annual revenue. IBM has also emphasized software which has eclipsed hardware as the second largest revenue source followed by hardware and financing. The global combination of having software, hardware and related services available under one roof allows IBM to fully differentiate itself with large global customers (no one ever got fired for going with IBM, as the saying goes).
As with most of Berkshire’s companies and investments, IBM has consistently grown its earnings while also returning significant amounts of its free cash flow to shareholders. As an indication of its ability to generate high amounts of free cash flow without having to heavily reinvest for future growth, IBM consistently posts extremely high returns on capital and equity and does so with a very conservative balance sheet.
One should note the commonalities of the investments above: industry leaders, high returns on capital, conservative balance sheets, strong free cash flow generation, strong management adherence to shareholder value with the stakes being acquired at attractive valuations. These dynamics ensure the long-term viability of the businesses which in turn support the long-term viability of the Berkshire business model and investment portfolio. The balance of the investments in the equity portfolio share these same dynamics including the recent additions by new investment team members.
Berkshire’s reputation, financial prowess and ability to make quick decisions allows for unique investment opportunities most currently represented by a series of hybrid investments made in the throes of the recent financial crisis. Examples include current pay debt and preferred equity investments in Bank of America, GE, Goldman Sachs, Dow Chemical and The Wrigley Company, often with attractively priced long-term warrants.
To highlight one example of an investment unique to Berkshire, in the fall of 2011, Berkshire invested $5 million in a Bank of America (BAC) 6% Cumulative Preferred Stock position which also included warrants to purchase 700 million shares of BAC expiring in 2021 with an exercise price of roughly $7.14 per share. So, between now and 2021, Berkshire has the right to buy BAC stock at $7.14 per share. Current book value for BAC is $20.16 and current tangible book value for BAC is $13.22. Tangible book value has consistently increased in recent years through a highly challenging environment for banks in general and Bank of America in particular. There is tremendous upside potential in this particular investment along with the other hybrid investments that Berkshire invested in through the recent financial crisis.
Berkshire consistently carries significant cash balances positioning the company for unknown events (a fortress balance sheet to use the increasingly popular term) and opportunistic investments.
While the foundation of Berkshire has historically been its investment portfolio and insurance businesses, Berkshire has become increasingly reliant on the success of its growing portfolio of operating businesses. These businesses include large, well-known and valuable companies such as: Burlington Northern, MidAmerican Energy Holdings, Lubrizol, The Marmon Group, See’s Candy, NetJets and McLane, amongst many others.
As can be seen in the valuation section below, the pre-tax earnings of these operating businesses has increased dramatically in even just the last 10 years. Berkshire’s increased emphasis on owned businesses makes them an increasingly important piece of the company’s value. The combined businesses posted strong growth in 2011 and continue to do so through the first six months of 2012. The addition of strong companies like Lubrizol in the fall of 2011 imply more and more of Berkshire’s value will reside in fully owned and controlled businesses.
It should also be noted that many of the businesses are housing related and thus have been a drag on performance. A return to a more normalized housing market should augment the growth inherent in the other operating businesses. All that said, the combined operating businesses have grown and continue to grow even in the face of housing and general economic headwinds.
To understand the value of Berkshire is to first understand a more commonly run insurance company and then understand how Berkshire differs.
Most insurance companies take in premiums and invest such premiums hoping and planning their investment returns outpace the traditionally recurring underwriting losses prevalent with most insurance companies. They in essence price policies to most commonly incur annualized losses that are an offset to the investment income the management of such premium income allows.
In contrast, Berkshire historically operates with reasonably consistent underwriting profits (on average over extended periods of time). There are some years with underwriting losses but those have tended to be the exception rather than the rule. To support such a claim, the insurance operations have shown an underwriting profit for nine consecutive years with profit over those years totaling $17 billion.
One important note is that Berkshire is subject to large catastrophic risk through its super cat and reinsurance businesses. This is the predominant reason for retaining a very significant cash balance at all times (in excess of $20 billion). This business is mitigated by Berkshire’s incredibly strong balance sheet and the strong management teams in place including Ajit Jain, but this is still a risk nonetheless.
Simple Investment Thesis: Berkshire Hathaway is a growing pile of investment portfolio value and operating business earnings augmented by consistent cash build through a profitable insurance operation that can all be acquired at significantly less than its intrinsic value.
Understandable: Berkshire Hathaway is a collection of investments and businesses that are enduring in value while being run by a chairman who articulates and presents the company in a straightforward and understandable manner.
Elements of Value:
1. High-quality investment portfolio
2. Stable of owned businesses that continue to generate cash and grow in value
3. Insurance business that, while I have valued at zero for purposes of conservative analysis, have a long history of profitable operations that generate cash flow for new investments
4. Corporate capital allocation from consistent cash generation deployed to most optimal uses by supreme capital allocators: Warren Buffett, Charlie Munger and the investment team they have assembled
5. Consistently increasing intrinsic value through the acquisition and ownership world class companies
Warren Buffett is transparent in how he thinks about the value of his own company. In other words, one of the best investors of all time nearly walks us through how to arrive at his company’s intrinsic value.
A conservative current estimate of intrinsic value comprises the combined value of Berkshire’s investments and operating businesses per the playbook laid out by Buffett himself.
· Berkshire has roughly $107,000 of per-share investments at the end of the second quarter of 2012
· Berkshire has a per-share earnings run rate from its operating businesses of roughly $7,600, and this run rate is increasing on a year-to-year basis including in 2012
· Buffet has historically implied (through discussions and annual reports) a fair value multiple for such earnings of 11x to 13x · I have used a 10x multiple to further the conservative nature of the calculation ascribing roughly $76,000 per share for the operating businesses
· I have conservatively ascribed no value to the insurance business even though it historically averages profitable operations
· Current estimate of intrinsic value is $183,000 per share which should continue to increase over time
o Cash levels continue to build quarter to quarter increasing the base of investments and/or dollars available for future full business acquisitions
o Existing businesses continue to grow in value The current conservatively estimated intrinsic value of Berkshire Hathaway is significantly less than where Berkshire is available for investment today (roughly $127,000 per A share). In addition to the current significant value gap, intrinsic value will continue to increase as time progresses. The insurance businesses will continue to add cash available to grow the base of investments and fully owned operating businesses. The existing investments and businesses will continue to grow in value.
To put valuation in another perspective, let’s assume the investments are valued on a dollar-for-dollar basis. So, of the roughly $127,000 in today’s Class A share price, there is $107,000 in per share investments. The remaining operating businesses can then be acquired for well under 3x earnings (paying $20,000 for roughly $7,600 in per-share pre-tax operating earnings).
An investment is available today to sit alongside one of the greatest investors of all time at a value well below intrinsic value in a company with a growing base of strong value investments and operating businesses.
World-class company. World-class management. Low valuation. A three-point layup.
Age: Warren Buffett is old. Charlie Munger is old. Let’s assume for a moment Warren Buffett is hit by the proverbial bus tomorrow. Coca-Cola will still be the leading carbonated beverage company in the world. Wells Fargo will still be banking its customers. Burlington Northern’s trains will keep running. In short, the show will go on.
I do understand and appreciate there is some concern regarding future capital allocation. Charlie Munger would still have his hands on the capital wheel in my hit-by-the-bus scenario. The board will have appointed leaders for oversight of both the operating businesses and of the investment portfolio. The beauty of Berkshire is in its enduring management structure. The businesses largely are left to be run by their own management. There is little control from Omaha. The company has in place a stable of managers that have been ably managing the operating companies for decades. The investment portfolio is largely in place. So, we are largely talking about what will happen with new investments. A team is being assembled to address those concerns. They are being tested as we speak. The cash generating insurance businesses (arguably the most important component to future value as they generate the cash to fund future investments) are run by some of the best insurance managers in the world.
Maybe the investment growth profile diminishes to some degree. There however is still a world-class collection of investments and companies that are growing at an admirable pace. And, most importantly, they can be acquired for a significant discount today.
Boring: Berkshire may be boring but that is fine with me.
No Catalyst: I don’t know what, if any, singular catalyst there will be to prompt a share price move towards fair value. However, my long-term horizon does not require such a move in any narrowly defined period of time. In fact, a continued divergence from fair value only allows me time to build a larger position leading to enhanced long-term profitability.
No Growth: Some associate the old-economy nature of the Berkshire businesses with a slow-growth model. I however don’t find that to be true. Using just one set of recent data points will dispel some notions of an old slow grower. From year-end 2011 to the end of June of this year, book value increased roughly 7.5% equating to a 15% annualized growth rate in book value. Berkshire may no longer grow its book value at the greater than 20% of years and decades past, but it can still grow. And it can be bought at a significant discount to intrinsic value thereby augmenting the growth for current shareholders from today’s valuations.
Cost of Float: A balance sheet account that, on average over multiple years, generates positive earnings has value and is not a value reducer in the same sense as debt is for most companies. Some would argue that Berkshire’s float from the insurance business of roughly $70 billion should be deducted in part or in full from the value of Berkshire. Berkshire’s profit generating float is unique and does not reduce intrinsic value.
Derivatives: Berkshire’s derivative positions have been much talked about of late. They subject Berkshire to some level of increased earnings volatility. Importantly, the impact is to earnings, not cash flow. In fact, the equity index options have carried the most press and those entailed Berkshire receiving a large sum of cash to effectively insure against a market with no price appreciation for over a decade. In the meantime, Berkshire can profitability invest the premium. I am concerned with the cash Berkshire generates as opposed to its GAAP earnings. Additionally, Berkshire is scaling back other derivative activities as collateral rules change, requiring the posting of collateral, where in the past Berkshire would not have been required to post such collateral.
Have people ever talked about this idea? Absolutely. Is it heroic? Not even close. Is there real value in this investment? Without a doubt.
Buying Berkshire Hathaway today may seem too easy. It may not seem “smart” enough.
But those are bad reasons to look past the opportunity in search of a more heroic investment. Berkshire Hathaway should be bought today. In large amounts. And it can and should be held for years.
World-class company. World-class management. Low valuation. A three-point layup.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.