Doug Kass, president of Seabreeze Partners Management Inc., wrote an article at the end of February titled “Buffett's Letter Shows Berkshire Hathaway Faces Many Headwinds.” For those who don’t remember, Kass was the “credentialed bear” invited to ask questions at the Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting in May 2013.
While the article has a number of areas worth discussing, this part in particular grabbed my attention because I’ve seen similar sentiment elsewhere:
“Berkshire's annual book-value increase has failed to beat the S&P 500's price performance in five of the last seven years. And in 2011, one of the two years of outperformance, Berkshire only did so by a scant amount, returning 4.6% vs. 2.1% for the S&P 500.
Berkshire's share price also fell 12.4% in 2015, the third year in seven that the stock has underperformed the S&P 500. And given that the stock only outperformed the S&P 500 by about 0.2% in both 2013 and 2014, Berkshire has finished basically in line or worse than the S&P 500 in five of the past seven years.”
When you read that, you might notice something: When Kass talks about Berkshire, he mentions book value per share, as well as Berkshire’s stock price performance. However, when discussing the S&P 500, there’s no mention of fundamentals - just price performance.
I think that’s a flawed view – particularly over a period like the last seven years. I’ll try and show this by examining the data in a bit more detail, which I think will speak for itself.
Here’s why this is important: If you own Berkshire, I think you’re mistaken if you expected a different result based on what has happened since 2009. It’s worth taking the time to explain why that’s the case. (We should also have a discussion about the calculation of book value, which is relevant as well. For the sake of keeping this relatively brief, I’ll do that another time.)
Berkshire Hathaway
Let’s start with Berkshire Hathaway’s book value.
Over the past seven years, book value per “A” share has increased from $70,530 to $155,500. That’s a cumulative increase of roughly 120% and a compounded growth rate of 12%.
If you go back seven years (March 6, 2009), which is within spitting distance of the market bottom during the financial crisis, you’ll see that Berkshire traded at roughly 1.05x book value. Seven years later, the shares trade at roughly 1.35x book – a cumulative increase of 30% (compounded growth rate of less than 4%). As we can see, the underlying performance of the business has driven the majority of the gains over the past seven years; the changing opinion of Mr. Market, by comparison, has played a relatively small role.
Now let’s take a look at the S&P 500.
Over the past seven years, book value for the S&P 500 has increased from about $450 per share to about $740 per share – a cumulative gain of roughly 65% (compounded growth rate of 7.4%).
The market valuation has had a big move as well: The S&P 500 traded at roughly 1.5x book near the lows of March 2009, compared to roughly 2.7x book as of early March 2016. The roughly 80% increase in the multiple Mr. Market is willing to pay relative to book value for the S&P 500 has been a significant driver of returns (compounded growth rate of 8.8%).
We see a similar (though less extreme) result if we look at earnings: In 2009, the S&P reported earnings of about $60 per share (according to data from FactSet - here); with the S&P 500 trading at about 700 in early March 2009, the forward P/E for the S&P 500 was roughly 11.6x.
By comparison, the S&P 500 is expected to earn about $117 per share in 2016. Overall, EPS for the S&P 500 nearly doubled over the past seven years (compounded growth rate of 10%). With the index trading around 2,000, the market is valued at a forward P/E of 17.1x – an increase of roughly 50% from seven years ago (I think the gap between the changes in P/B and P/E reflects the impact of wider net profit margins on ROE; whether that's sustainable is another question).
Overall, the S&P 500 has increased at a roughly 16% CAGR since March 2009.
Conclusion
As we can see, changes in valuation played a material role in the performance of the S&P 500 relative to Berkshire Hathaway from the lows of 2009. So with what we know now, here’s a different perspective on the data Kass presented in his article.
In five of the past seven years, the S&P has increased by more than 10%. In three of those five years, the price increase in the index exceeded the increase in earnings per share by a wide margin; in 2013, for example, the index climbed four times faster than earnings per share.
When the S&P moves higher in a big way, Berkshire Hathaway investors shouldn’t be surprised that book value lags the price performance of the index. Because of Berkshire’s wholly owned businesses, as well as the type of companies that are found in the company’s equity portfolio (among other investments), this is an all but certain outcome. When Mr. Market is optimistic, the gains from higher valuations will likely outpace those recorded from underlying business results.
Here’s how Buffett explained it on the first page of the 2013 shareholder letter:
“Charlie Munger (Trades, Portfolio), Berkshire’s vice chairman and my partner, and I believe both Berkshire’s book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%. Over the stock market cycle between yearends 2007 and 2013, we overperformed the S&P. Through full cycles in future years, we expect to do that again.”
The key words: “through full cycles.” The last seven years simply do not meet that test.
When the S&P 500 moves higher and higher, year after year, Berkshire’s book value will not keep up. On the other hand, when markets tumble, Berkshire Hathaway will look good by comparison. (When the S&P 500 fell 37% in 2008, Berkshire’s book value declined single digits.)
I’d make one other point: While its importance is diminished over long periods of time, changes in valuation over a market cycle can play an important role as well. If you’re going to look at Berkshire’s performance from the end of 2007 to today, you’re missing an important factor if you don’t consider the contraction in valuation from 1.80x book in late 2007 to 1.35x book currently (a headwind to the annualized return of roughly three percentage points).
The S&P 500 has had a good run from the lows in 2009; whether or not that will continue is anybody’s guess. What we do know is that Mr. Market is willing to pay much more for those businesses – measured relative to shareholder’s equity or net income – than he was seven years ago. Anybody who expects that trend to continue indefinitely will likely end up disappointed.
