Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B)
"We want to do business in times of pessimism, not because we like pessimism but because we like the prices it produces. It's optimism that’s the enemy of the rational buyer. We do not measure the progress of our investments by what their market prices do during any given year. Rather, we evaluate their performance by the two methods we apply to the businesses we own. The first test is improvement in earnings, with our making due allowance for industry conditions. The second test is whether their moats (competitive advantages) have widened during the year."
Warren Buffett (Trades, Portfolio)
We have owned shares of Berkshire Hathaway nearly continuously since the end of December 1998. (We exited the shares for a brief period after the share price spiked when the stock was added to the S&P 500 Index in early 2010.) Since our initial investment, the stock has meaningfully outperformed the S&P 500 Index by a factor of better than three- fold (+214% vs. +67%), buoyed by the tailwind of significant corporate growth. An aside: alert readers will note, if not recall, the significant underperformance of Berkshire stock during the first quarter of 2000 at the height of the dot-com bubble. Perhaps recalling too, the cover stories in the financial press then that the new new-world investing had laid waste to dinosaurs like Buffett. Well...Berkshire shares bottomed literally within days of the top in the NASDAQ. Since that seminal bottom 16 years ago, Berkshire shares have gained +292% versus a paltry gain of just +34%. (Cisco Systems has declined -65% since March 30, 2000.) Valuation matters.
Over the course of our decade and a half investment in Berkshire Hathaway, the most common question we have been asked on any stock we have owned – and continue to be asked to this day is – “Is Berkshire Hathaway a “growth" company?" We attempted to answer
this question back in early 2004 in a Client Letter titled, “Berkshire Hathaway: The Greatest Growth Company Wall Street Never Heard Of” (as excerpted):
“Even casual students of Buffett have long since learned that Berkshire Hathaway is quite a different entity than it was only ten years ago. Where once Berkshire was not much more than Buffett’s personal investment portfolio, the Company is now a conglomerate of mutually exclusive businesses, dominated by a core of insurance companies. Wall Street is not casual about anything. When it comes to Berkshire and Buffett, Wall Street has finally caught on to the reality that the Company is mainly a conglomerate of businesses. Wall Street does not slavishly follow every Buffett buy and sell as Holy Grail secrets any more.
“That said, we still think Wall Street once again remains behind Buffett’s learning curve.
We believe that the Street fails to realize that Buffett has slowly built Berkshire Hathaway into a true growth company. In fact, not only is Berkshire a growth company, but a remarkably rapid one considering the enormous asset base ($180 billion) and equity base ($78 billion). Would anyone believe that a conglomerate could grow operating earnings per-share by 28% compounded over the past five years? The key here is the term per-share. Wall Street worships the mantra of “growth.” Too many corporate executives are compensated far too largely for any type of growth – good growth or bad growth. Make no mistake about it: not every type of growth is good for shareholders.
“Growth via acquisition and mergers is the most prominent means of growth, and often the most fraught with abuse (Enron, Tyco, WorldCom, etc.). Investors must also be aware of managements’ claims of “record” growth. Buffett reminds us that even a simple passbook savings account generates “record” growth every year.
“This matter underscores a most underappreciated aspect of Berkshire: non-dilutive growth by acquisition. Buffett has a growing reputation, particularly among large family-owned private businesses, that Berkshire is a terrific home for them since Buffett will not dismantle what these families have built over the years. More to the point, mediocre businesses become good businesses under the Berkshire umbrella. Moreover, good businesses become great businesses. We cannot stress this point enough.
“The simple but powerful reason for this is that Buffett dramatically changes the reinvestment equation for Berkshire’s wholly-owned companies. Consider the capital reinvestment plight of a good -sized carpet or brick manufacturer. Now such a business may be considered a “good” business by measures such as profitability and market share, but unless the respective CEO can reinvest retained cash earnings accumulated in owner’s equity to earn future high returns, such businesses fail to be true “growth” companies. Of course, the carpet CEO or brick CEO can pay out all net earnings as dividends, but this is unlikely; since most CEOs are paid in part (in too many cases, in large part) on the size of the firm. Then the reinvestment of earnings becomes the paramount job of the CEO. So, what is the CEO to do if reinvestment opportunities back into the business are lackluster? Not much. This “lack of sustainable growth” is the simple reality facing the majority of Corporate America. Most businesses, by economic reality, cannot achieve growth much better than their underlying industry growth, or faster than the overall economy. We have stated for years that true growth companies are rare.
“Consider the capital reinvestment options if our carpet/brick company is wholly-owned under the conglomerate of Berkshire. Buffett solves the reinvestment conundrum unlike almost any other business we know of. Sure, Buffett can allow CEOs to reinvest in carpets or bricks – but only if the CEO can convince Buffett that these reinvestment opportunities are superior to Buffett’s exceptionally wide canvas of reinvestment opportunities. This is highly unlikely since Buffett can invest in any asset, stock or bond, private or public company, or do nothing and just sit on wads of cash. Rare is the CEO who sits on stacks of idle cash. Too many CEOs view any and all activity as progress.
“This is why businesses become better as a wholly-owned subsidiary of Berkshire. Buffett solves the ever-present capital reinvestment dilemma: this is the unique essence that too many investors fail to appreciate about Buffett and Berkshire Hathaway.
“Now back to that pesky matter of “per-share” growth. Berkshire’s growth has been driven in large part by acquisition. However, Buffett – unlike most companies –rarely uses Berkshire stock to fund an acquisition. Therefore, as Buffett reinvests Berkshire’s many billions of cash into seemingly boring, but profitable businesses, revenues grow, earnings grow and cash flow grows. But since outstanding shares do not grow, per-share growth explodes. Per-share earnings have compounded at 28% for the past five years and 24% for the past ten years.
“So, make no mistake about it –Buffett has masterfully built Berkshire Hathaway into an outstanding growth company.
We would change little in that Letter. However, we did miss a few key elements. We failed to mention the evolving, solidifying culture of management redundancy and independence at each wholly owned business. Buffett ain’t making chocolates at See’s Candies, and he ain’t driving locomotives at Burlington Northern (though he probably wouldn’t mind such gigs from time to time). We failed to mention too the swiftness and tax efficiency with which billions can move throughout the Company’s conglomerate structure. A huge, and hugely underappreciated, element of Berkshire’s key enduring competitive advantages particularly the durability of the Company’s + $87 billion of insurance float. We would also add, after another decade of Buffett and Munger adding new diverse streams of revenues, earnings, and cash flow in very long-lived assets via acquisitions, plus significant organic growth within the Company’s best-in -class insurance operations, that Berkshire Hathaway has become what capitalism may have never contemplated, a perpetual growing cash flow machine. Notable acquisitions over the past decade ISCAR, PacifiCorp, Burlington Northern, Marmon, Lubrizol, Bank of America, Heinz, and, most recently, Precision Castparts. We do not type such words lightly, but as long as the Company retains all of their earnings (no dividends) for additional future acquisitions, the compounding will continue.
The 50 - year compounding of Berkshire Hathaway on a per-share basis is without peer in the annals of capitalism. Many have tried to build conglomerate empires over the many years, but few have survived. Fewer still that might have the lights still on are but a shell of their former short-term glory selves. Wall Street has a long history of feeding and promoting faux empire builders who ultimately choke on too much dilutive common stock, too much easy debt, too many accounting schemes, too many lousy businesses acquired – and far too much fraud. Inevitably, the investment bankers stop calling (or returning calls) and the empire-builder CEO now must try to manage their colossus for organic growth and some semblance of true cash flow generation. At best, the colossus has morphed into a colossal mess (envision herding cats). At worst, the jig is up and the lawyers start calling. Berkshire Hathaway is the antithesis of this litany of conglomerate woe.
The table below outlines the growth of a number of fundamental metrics since we first began investing in Berkshire, as well as more recent growth.
A couple of observations hopefully stand out in the table above, but first a few notes. Assets, Revenues, Pre-tax Operating Earnings and Insurance Float are in millions. The shares outstanding are A- share equivalents. All per-share figures have been converted to 1/1500 B share equivalents.
Observations since 1998:
The 25X increase in pre-tax operating earnings per share illustrates the dramatic transformation of Berkshire from a “closed-end stock fund” into the mighty conglomerate it is today. Over the past 17 years, shares outstanding have only increased 8%.
Insurance float increased a terrific +285%, but the change in float during 1998 was substantially increased by roughly $15 billion with the acquisition of Gen Re. Growth in float from year-end 1997 was +1,137%. Also of considerable note in June of 1998, Buffett swapped shares of Berkshire for shares in the purchase of Gen Re. At the time when the stock of Coca-Cola was valued at an incredibly rich +40X earnings and the Company’s equity portfolio alone made up 115% of book value, Buffett swapped Berkshire stock valued then at 3.0X book value, which tripled the Company’s float and “sold” stocks and “bought” a very huge fixed income portfolio. One of the greatest tax-free market-timing and asset allocation moves of all time.
Investments per share “only” grew at a rate of 235%, yet this is far below the other conglomerate-related metrics.
Observations since 2011:
In an environment where the GAAP earnings of the S&P 500 Index companies was flat (see graphic below), Berkshire increased their pre-tax operating earnings per share by +63%, as well as reloading Buffett’s elephant gun (investments per share) by +62%.
Growth in shares outstanding that included the following acquisitions: Bank of America warrants ($5 billion), Heinz ($12 billion), and Precision Castparts ($32 billion)? Zip. Zero.
While not shown, sourcing the Company’s Statement of Cash Flows, specifically cash flows from investing activities less depreciation has collectively amounted to $101billion since 2011. Post-Precision Castparts, Buffett's annual cash for elephant and gazelle hunting should now exceed $25 billion per annum.
When we consider the current weak economic environment, and the concomitant weakening environment for corporate earnings, we expect Berkshire’s enduring earnings growth to be a standout among the largest market cap companies. Bloomberg reports that U.S. corporate EPS growth has been falling since the second quarter of 2014 and has been increasingly negative for the past twelve months. In addition, factor in, that, according to Standard & Poor’s, Apple alone has contributed 22% of the S&P 500’s margin expansion. Remember, too, that these earnings per share fiqures are populated with plenty of convenient measures such as “adjusted net income,” “adjusted sales,” and “adjusted EBITDA.” Berkshire is quite unique too within their aforementioned long-lived assets. Utilities, pipelines and railroad assets consume many billons in annual capex expeditures. Accelerated depreciation is in effect a “tax-free loan.” As Berkshire continues to grow Property, Plant and Equipment faster than depreciation, deferred tax liabilites will continue to grow too. Over the past dozen years the Company’s defferred tax liability for PP&E has grown 30X from about $1.2 billion to over $36 billion. Said another way, Berkshire’s GAAP earnings are meaingfully understated. If you want earnings clarity, just follow the money – i.e., cash. The cleanest, most conservative accounting is routinely found in Omaha.
Over time, this asymmetrical accounting treatment (with which we agree) necessarily widens the gap between intrinsic value and book value. Today, the large – and growing – unrecorded gains at our “winners” make it clear that Berkshire’s intrinsic value far exceeds its book value. That’s why we would be delighted to repurchase our shares should they sell as low as 120% of book value. At that level, purchases would instantly and meaningfully increase per-share intrinsic value for Berkshire’s continuing shareholders.
Warren Buffett (Trades, Portfolio)
2015 Chairman’s Letter to Shareholders
We have also put together a table to track the growth in the intrinsic value of Berkshire’s stock since the 9/11 terrorist attacks in 2011; Berkshire recorded over a $2 billion loss that year. Working backwards, the last column is the pre-tax earnings of the Company’s various and numerous non- insurance subsidaries. The second to last column is the pre-tax earnings of Berkshire’s Ft. Knox-like insurance companies. Total Insurance is simply the sum of the prior two columns – Underwriting Profit plus Investment Income. Float and Float Growth are self-explanatory.
The fun starts with columns 2 through 4. Regular readers of Buffett’s Chairman’s Letter will recognize the variables that Buffett regularly publishes on how he and Charlie Munger (Trades,Portfolio) determine the Company’s intrinsic value (IV). Buffett breaks down the Berkshire conglomerate into just two parts. The first (column 4) is the Pre- Tax Operating Earnings of the Company’s non-insurance businesses. The third column represents the Company’s Investments Per Share. Since most of the Company’s investments reside on the books of the Company’s insurance companies, In vestments Per Share is a very good, but arguably conservative measure if the compostion of the investment portolio is largely made up of higher-quality, growing businesses. However, this measure could be aggressive if the portfolio is excessively valued at any given time.
The most important element for an investor is to try to fiqure out the most fair multiple to capitalize the non-insurance part of Berkshire. We have chosen a pre- tax multiple of 10X, so the IV math for 2015 looks like this: 10 X $8.38 = $83.80, then add the insurance side + $107 = $190.8. With the stock at $142, the shares seem like a bargin relative to IV of prospectively $191.
However, IV calculations are inherently imprecise. If we thought a fairer pre-tax multiple was, say, 12X – given what we believe are the Company’s significant and enduring competitive advantages – the IV would be a robust $208 per share. On the other hand, we must also recognize that we should be as conservative as possible in such calculations, so if we capitalize the non-insurance subsidiaries at, say, a 8X multiple, then IV is only $174.
We do take significant clues from the words of Buffett on this critcal topic to help us determine a conservative – but not too conservative – calculation of fair value. Specifically, Buffett has stated that he would like to buy back billions in Berkshire stock at a minimum price-to-book value of 1.2X. Furthermore, and quite significant, Buffett has noted, without equivocation, the rewards to shareholders of such actions.
Share buybacks are only advantageous to existing shareholders if they are executed below IV. In classic Benjamin Graham style and discipline, Buffett will only buy back Berkshire stock at a significant margin of safety. Book value at year-end sits at $104 per share. 1.2 X $104 comes to $125, so, $125 is Buffett’s fat pitch. If, say, IV is $174 (8X), then Buffett’s margin of safety is 28%. In our view, this is not fat enough. At $208 (12X) the discount is 40% - maybe on the high side for Buffet, perhaps not. At $191 (10X) the discount is 35% - a minimum margin of safety discount for Buffett in our view.
Here are a few other observations to consider:
For the first time, Buffett included insurance underwriting results in the calculation of non-insuranceoperating results. His decision, after 12 years of annual underwriting profits, speaks to his expectation of continued insurance profitability in the years ahead. This decision, well past due in our humble view, underscores the amazing insurance business that Buffett and Ajit Jain have built over the years. There is no comparison anywhere in the world in terms of size, sticky float, and profitability.
When Buffett states that the largest IV value over book resides in the insurance companies, believe him.
We have added underwriting profits in the calculation of PTOE/share for all years. The profits of the non-insurance subs eclipsed the insurance side for the first time in 2010 after the sizable acquisition of Burlington Northern. (The purchase of BNSF alone immediately increased the Company's pre-tax earnings by almost 40%, while only increasing the share float by just 6%.)
Note the underwriting profits in 2006 and 2007, post-Katrina. If Berkshire could ever achieve such results on their current base of float, underwriting profits would approach $5.5 billion.
In a world of zero to negative interest rates, investment income in excess of $4 billion is remarkable.
What will Berkshire Hathaway look like at the end of the next 10 years? Well, if the Company continues to retain all earnings, and redeploys capital with the same demonstrated success and discipline, shareholder's equity could reach $650 billion and the stock's market capitalization could reach $1 trillion. We'll take such growth...
From David Rolfe (Trades, Portfolio)'s Wedgewood Partners 1st Quarter 2016 Client Letter.
