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Buffett and Watsa’s IBM and Berkshire Appear Undervalued

December 09, 2013 | About:
Holly LaFon

Holly LaFon

250 followers
Cautious investor and businessman Prem Watsa built the Canadian insurance conglomerate Fairfax Financial (TSX:FFH), compounding its book value per share by 23% annually since he began it in 1985. His investment portfolio, containing 42 stocks, is valued at almost $1.6 billion. Right now he has 100% hedged it because of the risk he sees in the markets – risks which he has expounded on in several consecutive shareholder letters.

Watsa seeks undervalued investments, and around May of 2013, he was 31% in cash and cash equivalents giving his team “great options for long term gain whenever the opportunity becomes available,” he said in his investor letter. He calls his investment approach a “long term value-oriented investment philosophy.”

Watsa often draws comparisons to Warren Buffett, who also built a behemoth insurance conglomerate – Berkshire Hathaway (BRK.A)(BRK.B) – at a prodigious rate and who has value-oriented philosophy.

On the basis of GuruFocus’ discounted cash flow (DCF) calculator, Watsa and Buffett’s common holding IBM appears undervalued. Buffett’s company, Berkshire Hathaway, also appears cheaply valued by the market currently.

A note on the DCF Calculator – it uses a formula involving growth rate, discount rate, growth rate at terminal state, years at terminal growth, and earnings per share to determine a fair price for a stock.

The Stocks

International Business Machines Corp. (IBM)

Watsa bought just 1,200 shares of IBM in the second quarter this year, a small trace of the overall portfolio. Watsa’s average buy price was $204.

Warren Buffett also bought IBM, amassing from the first quarter of 2011 to the first quarter of 2013 a total of 68,121,984 shares, sized at 13.7% of his portfolio. His average buy price was $173.

The stock on Monday trades for $190.12; the DCF calculator assigns it a fair value of $301.88. This equals a 41% margin of safety.

Calculation: The DCF calculator used the following figures for IBM: $14.37 fiscal 2012 EPS, 15.4% next 10-year growth rate, five-star business predictability, 4% terminal growth rate, 10 years of terminal growth rate and 12% discount rate.

IBM, the global IT company with a $192.7 billion market cap, reported in the third quarter a year-over-year net income increase of 6% to $4.0 billion, and a revenue decline of 4% to $23.7 billion. Its weakest segment was Systems and Technology falling 17%, while its Cloud business revenue increased by 70%. The company is currently chasing the high-growth markets of cloud, mobile, analytics and security. For the full year management is aiming for $20 in operating EPS by 2015, compared to its expectation of at least $16.90 for full-year 2013.

IBM bears another marker of undervaluation on the Peter Lynch chart. This chart shows the price of the stock at a PE of 15 compared to its actual price. The best time to buy, according to investing legend Peter Lynch, is when the green line is below the blue line. This is how the chart appears for IBM:

1386625646561.png

IBM trades near its three-year low P/E ratio at 12.3, and near its two-year low P/B ratio of 9.7. It has a P/S of 1.96, and dividend yield of 2.08%.

Berkshire Hathaway (BRK.B)

Over the past several years, Watsa has frequently bought shares of Warren Buffett’s company Berkshire Hathaway, as the chart below reflects. At the end of the third quarter he held 21,100 shares, sized at 0.15% of his portfolio. Watsa’s average share price for Berkshire is $74.5; the share price on Monday is $117.17; and the DCF calculator assigns it a worth of $128.84, for a 9% margin of safety.

Calculation: The DCF calculation uses $6.28 fiscal 2012 EPS, 4% next 10-year growth rate, business predictability rank of 2.5 stars, 4% terminal growth rate, 10 years of terminal growth and 12% discount rate.

The Peter Lynch chart also indicates that Berkshire became undervalued as recently as October. This marks one of the first times the company has appeared undervalued by the market since 2007:

1386625989260.png

Berkshire Hathaway has a $287.5 billion market cap. It has, over the past five years, grown at a rate of 9.2% for revenue, 13.8% for EBITDA, 16.1% for free cash flow and 12.1% for book value, on a per-share basis.

In the third quarter, Berkshire’s revenue increased to $46.5 billion from $41.05 billion the previous year, and net earnings increased to $5.15 billion from $4.05 billion. Through the first three quarters of the year, Berkshire’s book value increased by 11.0% to $126,766 per class A share.

Berkshire is currently trading near its 10-year high share price, and five-year high P/S ratio of 1.52. Its P/E ratio has almost reduced to a three-year low at 14.4, and it has a P/B ratio of 1.3.

For more of Prem Watsa’s undervalued stocks, go here. Also check out the Undervalued Stocks, Top Growth Companies and High Yield stocks of Prem Watsa.

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Rating: 3.4/5 (20 votes)

Comments

tomxiao
Tomxiao premium member - 7 months ago
To get a more accurate estimate, you may have to slice the big portfolio into different sectors to evaluate these stocks' price. At least, insurance, operating income from subsidiary companies and lastly investment portfolio.

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