Most value investors own some big stocks. I believe Berkshire will outperform those stocks. I also believe that Berkshire is cheap right now. I’m going to explain why in this article. But I’m not going to go to detailed discussion of how much I think Berkshire is worth.
I think the issue is simpler than that. When you look at any conglomerate, any holding company, a closed end fund, etc., you need to consider three things. You need to consider the assets that make up the value of the whole. You need to consider who is in charge and what kind of job they are doing of allocating capital. And you need to consider the price that you are paying. By price I mean the premium or discount you are paying to buy the assets as a bundled conglomerate rather than individual businesses.
If you are a long-term investor the idea of ignoring companies that trade at a discount because they are a group of different assets rather than a bunch of different stocks all treated separately does not make sense. A long-term investor does not just benefit from price appreciation. A long-term investor benefits from stock buybacks, dividends, extraordinary corporate events, and sales of the entire company.
Over time these can have a big effect on the compounding of your investment. The discount is an important part of your return. Some conglomerates and many, many closed-end funds do deserve to trade at a discount.
Some do not. In my view if you think you can achieve returns similar to the S&P 500 and you find a conglomerate that can match the S&P 500 you should be happy with any discount you can get. It is a question of the underlying assets and a question of management.
So you have to ask yourself if you like the assets as much as other things in the stock market. And if you like the manager or investor who is making all the decisions about capital allocation.
If you like the assets and you like the management team then you should treat a discount to those assets as a potential source of good returns for you.
The assets that Berkshire owns both in the form of common stocks and in the form of completely owned businesses are of a high quality. They would be worth considering if they were treated as individual public companies. In general they should not trade at discounts to where the stock market values a dollar of earnings right now.
Warren Buffett has historically generated excellent returns. He has used leverage at Berkshire. But if you look at his unleveraged returns in just stocks that he has bought and held over time, they are very similar to the leveraged compounding a book value that Berkshire has generated over the years. Berkshire has compounded book value at 20% a year over the last four decades.
Berkshire will not achieve anything like those returns in the future. However, you still have a better-than-average investor running the company. And you have a much better-than-average source of leverage in Berkshire’s insurance operations.
Berkshire’s insurance business has often had a combined ratio less than 100. And it is reasonable to expect that while the company will have some terrible years in insurance it will average a breakeven result. That means Berkshire is getting money for free.
This idea of free money is the basis for the way that I value Berkshire. It’s a very simple way. And it’s a way that Warren Buffett has hinted at in his annual reports.
Here is what Buffett said in last year’s annual letter: “I also included two tables last year that set forth the key quantitative ingredients that will help you estimates are per share intrinsic value… To update the table shown there, our per share investment in 2011 increased 4% to $98,366, and our pretax earnings from businesses other than insurance and investments increased 18% to $6,990 per share.”
I believe Buffett is laying out the best way to value Berkshire right there. Berkshire has two buckets of value. One is investments. And one is earnings from businesses. Berkshire’s businesses are generally quite good. They deserve to trade at a similar price-to-earnings ratio as the S&P 500. I believe that is equal to about 10 times pretax earnings. In other words I think that a fair not a conservative but a fair valuation for Berkshire’s owned businesses is 10 times the per-share earnings before taxes. Last year Berkshire’s earnings from businesses were $6,990 per class “A” share.
If Berkshire’s earnings were taxed at a 35% corporate rate that would turn into about $4543 a share after tax. And at 15 times earnings that would value Berkshire’s businesses at $68,145 a share.
I think that is right. And I think that if you split Berkshire into two companies that is about what the operating business assets should be worth. The other half is the investment portfolio. Last year that was worth $98,366.
Now those investments are obviously supported by the insurance business. A lot of people believe that you need to net out those investments against possible liabilities.I do not believe that is true.
Why not? The way Berkshire’s float works is similar to the way that a low cost deposit base for a bank like Wells Fargo (WFC) works. Berkshire’s assets are in many ways its liabilities. The ability to generate float at about a combined ratio of 100 over time drives Berkshire’s growth.
I do not believe it is right to put any positive value on purchase insurance operations apart from the assets that it finances. In other words I think it is best to take all Berkshire’s insurance operations and to treat them as simply a method of financing.
It is like having a 0% interest loan.
Some of Berkshire’s insurance businesses are actually worth more than that. The obvious ones are certain niche insurers of Berkshire no breaks out in detail. A few of these are definitely worth more than that. They generate underwriting profits. Not just float.
The other asset that is clearly worth more than just being a financing vehicle is GEICO. To understand GEICO you can look at a similar public competitor called Progressive (PGR).
GEICO and Progressive write car insurance. And they often get a combined ratio that is lower than 100. If GEICO was a public company it would trade at a large premium to book value. That is not true of some of Berkshire’s insurance operations. For example, Berkshire owns a big reinsurance operation. And the economics of the reinsurance business are very different from the economics of GEICO.
Instead of breaking all these things down, however, I think we can look at the overall insurance business as merely a method of financing Berkshire’s investments at a cost of essentially nothing.
So I believe the right way to value Berkshire is to treat the insurance businesses as a form of financing. And then put all insurance related earnings aside. And look at the investments independent of their financing. And look at the operating businesses independent of their financing.
If you do that I think you come to the conclusion that at the end of 2011 Berkshire’s intrinsic value was around $166,518 a share. Here I’m talking of course about the class "A" shares.
As I’m writing this Berkshire trades at $134,318 a share.
That means Berkshire is trading at about a 20% discount to its intrinsic value at the end of last year. Do I think that is right?
Yes. I believe that is pretty accurate. It is not a conservative valuation. I think it is a reasonable valuation. If you want to be conservative you would value Berkshire much closer to where the company is buying back stock.
That’s what I want to talk about now. Berkshire Hathaway has very rarely bought back stock. It spent $1.2 billion to buy back stock yesterday. And it did it at 120% of book value.
People look at book value a lot when analyzing Berkshire. I do not believe that book value is a very good gauge of Berkshire’s value. And it is dubious as a way of valuing the company any better than Warren Buffett’s own comments about the stock’s intrinsic value.
The book value that Berkshire has is largely the result of the price Buffett paid to buy companies in the past. GEICO is worth much more than book value. But GEICO is carried on Berkshire’s books at the price that Berkshire paid for GEICO. A lot of that came in the form of a buyout of the entire company that involved buying about half of the company all at once. The other part came from an investment Berkshire made in GEICO that was a minority investment for many years before that.
But the book value that you see for Nebraska Furniture Mart or for GEICO or for Burlington Northern reflects what Berkshire paid for those companies. I can tell you whether those companies are worth more than the tangible assets they use. But it is much harder to tell you if they are worth much more than what Buffett paid for them.
Unless you have faith that Buffett made the right decision. That brings us to the stock buyback. Berkshire is willing to pay up to 120% of book value. We have no idea if it will use that opportunity. So far it has bought back only about 1% of the company.
I believe that Buffett is willing to spend tens of billions of dollars buying back stock if Berkshire gets that opportunity. In the past whenever they’ve announced a buyback the stock has quickly risen to stay above the price where Berkshire would be comfortable buying back stock.
One of Buffett’s idols is Henry Singleton from Teledyne (TDY). Teledyne bought back a ton of stock in the 1970s. Teledyne often traded for a single-digit P/E ratio. And the buybacks created a lot of value for those company shareholders that chose not to sell their shares. Singleton was very aggressive in buying back stock. He made tenders for the stock at higher than the market price.
Berkshire has not shown any tendency to do that. They have not been aggressive in buyback a lot of stock. And they have not offered to make big buybacks above the current market price.
Will these buybacks benefit you? If the stock market really tanks Berkshire will have an opportunity to buy back stock. In fact I think that is one of the reasons why Berkshire announced the original buyback about a year ago. They saw the possibility that there might come a time when a lot of stock could be bought back at a good price.
That never happened. I don’t think Buffett will be rushed in this. So I don’t know if you can include any benefit from these buybacks in your estimate of the company’s value.
But I would suggest that you read a book called “The Outsiders.” It is a book about a group of CEOs including Henry Singleton of Teledyne and Tom Murphy of Capital Cities who created a lot of value for their shareholders. And they often did it with stock buybacks. I’m a big fan of stock buybacks when they are done by good businesses who know that the shares they are buying back are a better use of their capital than anything inside the business right now.
So there is the possibility that if the stock drops you will get a lot of bang for your buck from Berkshire’s buybacks. And the best argument for that is that Buffett has almost never bought back stock and is interested in buying back stock now.
Should you believe Warren? Or do you need to do your own research?
I don’t think you need to do your own research. I don’t think you need to know exactly what Berkshire’s intrinsic value is. I think it is better to have a reasonable guess of what you think intrinsic value is. And I think reasonable guess about $160,000 $170,000. And a 20% premium to book value is clearly an undervalued price. And so Berkshire is undervalued right now.
If you don’t trust Buffett’s investment judgment you should not invest in Berkshire. It’s not an issue of Buffett’s view of the intrinsic value of his company. Either you believe his judgment as an investor is good. And then you can benefit from his investments. Or you don’t know if you can trust his judgment right now. If you don’t know if you can trust his judgment then you don’t know both about his capital allocation and about his judgment that the stock is cheap right now.
So it’s really a question that you have to answer that takes care of two issues at once. It takes care of the key issue of how good capital allocation will be at Berkshire. And it takes care of the issue of whether Berkshire’s cheap right now.
Unless you have complete faith in Buffett as an investor I don’t think it makes any sense to buy Berkshire Hathaway shares right now. But I know that some people reading this do have complete faith in Buffett. And for them I think it makes perfect sense to sell their big holdings and buy Berkshire.
I think there’s a very good chance Berkshire Hathaway will with less risk than most big caps return more than those big caps. When you get down to whether Berkshire will outperform all investments I’m not so sure.
I think the people who have investments in smaller stocks may not want to go rush out and buy Berkshire. It makes perfect sense to sell other S&P 500 companies and buy Berkshire right now. It is a better bet than most companies in the S&P 500. But it is a very big company. And it will not grow anything like the rate it had in the past.
So you cannot buy Berkshire with expectations of matching past returns. But you can buy Berkshire with expectations returns that are better than the S&P 500. I personally am very skeptical of the ability of the S&P 500 to achieve high returns in the years ahead. And I think it is not reasonable for most people to expect returns better than 7% a year from their stocks.
The justification for high stock prices may be valid. But that does not remove the result of high stock prices. High stock prices even if they are fully justified by low interest rates still result in low future rates of return. So when I am endorsing Berkshire Hathaway as a buy right now I am saying this is a stock that can return low double digits. And the S&P 500 cannot do that.
And if the discount to intrinsic value is close you will get a boost to your returns.
To give you an idea, consider a 10-year investment in Berkshire Hathaway. Imagine Berkshire is able to earn returns of about 7% a year. If Berkshire’s intrinsic value increases by just 7% a year over the next 10 years but the discount to its intrinsic value vanishes over those 10 years, the stock will return more like 9.5% a year. In other words you can get a return of about 2.5% a year just from the discount to intrinsic value closing over time.
This is a big deal. And it’s something that I think people miss with holding company discounts. A holding company discount is often viewed in static terms. The idea is to buy a stock and hope to take advantage of a gap closing. But it is better to think of it as in essence a higher yield.
If you buy Berkshire at its intrinsic value and Berkshire achieves intrinsic value growth of 7% a year you’re buying a Buffett bond that yields 7%. But if you pay just 80 cents on the dollar for that same Buffett bond you are getting a 9.5% yield. That is the right way to think about a holding company discount. At least it’s the right way when you expect holding company to continue to exist for many years.
It’s definitely the right way to think about Berkshire Hathaway. For that reason I think now is a great time to buy Berkshire Hathaway.
Will I be buying Berkshire Hathaway? Not right now. Right now I have 25% my portfolio in stocks. And I have 75% in cash. I’ve laid out the case for Berkshire conservatively gaining close to 10% a year. I try not to buy stocks where I am not yet convinced the company will earn at least 10% a year. Right now I think Berkshire falls a bit short of that.
I do not think that is Berkshire’s own fault. I think it is a case of the stocks that Berkshire owns not being especially cheap right now. I just don’t expect Berkshire’s stock portfolio to compound value very fast. Most people are much more bullish on stocks long-term than I am. I look at something like the S&P 500 and I see a collection of assets that will have a hard time returning more than 7% a year. So I look at Berkshire Hathaway with about two-thirds of its value in things like common stocks and some bonds I find it hard to expect returns will be very high when those asset classes as a whole simply are not going to achieve high returns over the next 10 years.
So for me it’s a choice between holding cash or buying Berkshire Hathaway. And in that situation I tend to prefer cash. Most people reading this probably have nowhere near 75% of their portfolio in cash. I think it makes perfect sense to sell some stocks you own right now and buy Berkshire. I’m not sure it makes sense to buy Berkshire right now if you're thinking about it in terms of absolute returns. I think the absolute returns available in Berkshire are okay but not great. I think the relative returns possible in Berkshire are great.
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