The name Warren Buffett has become a household name. Many may realize that Buffett is the CEO and Chairman of Berkshire Hathaway, but few really understand what Berkshire Hathaway really is. Because Buffett is known as the world’s best investor, people may incorrectly think that his company is a mutual fund, hedge fund, or some kind of partnership. After Buffett graduated from Columbia University, he went to work for Benjamin Graham, who was his most influential professor. A few years later, Buffett moved back to Omaha to start his own investment partnership. He employed a strategy that he called “cigar butt” investing which involved finding companies without regard to quality as long as the shares were at bargain prices.
After meeting the current vice chairman of Berkshire Hathaway, Charlie T. Munger, Buffett changed his investment style and started investing in quality companies with moats at discounted or fairly valued prices. He realized that quality companies with moats can enrich investors handsomely if held for long periods of time because they have competitive positions that allow them to generate high returns on capital. Weak companies, even if bought at cheap prices, can turn into can turn into bad investments, and ironically, this is exactly what his purchase of Berkshire Hathaway turned out be. While running his investment partnership, he purchased Berkshire Hathaway, which, at the time, was a textile company. He bought it because it was cheap on a quantitative basis. However, the company did not possess any competitive advantage over its competitors. On the contrary, it possessed competitive disadvantages because overseas companies were able to undercut it on cost, which is key in commodity-type businesses. As a result, it turned out that Berkshire Hathaway was selling at a cheap price for a reason.
Buffett kept the company and its name and used its capital to reinvest in other businesses. In other words, Berkshire Hathaway became a holding company. Today, it owns equity investments such as American Express and Wells Fargo, and entire businesses such as GEICO, an automobile insurance company; See’s Candies, a manufacturer and distributor of candy; and Clayton Homes, a company that builds, sells, finances and insures manufactured homes. Because the company is a collection of businesses, it is more difficult to analyze and value. While there are many books written about Buffett’s investment style, life, and career, there is not as much written on Berkshire Hathaway itself. On February 28, 2010, Ravi Nagarajan, the author of The Rational Walk blog, published a report on Berkshire Hathaway that includes the background, analysis, and valuation of the company. Some of you might remember that I interviewed Ravi at the beginning of the year. I was very impressed by his 67-page report on Berkshire Hathaway. While valuation is more of an art than a science, Ravi values the company by using three valuation methods: the float-based, “two-column,” and multiple of book value approaches.
In Ravi’s view, the float-based approach is the main driver of value. Insurance companies, such as the ones that are part of Berkshire Hathaway, generate float, which is policyholders’ money. When an insurance company issues a policy, it collects the premium upfront and does not have to pay out claims until later down the road. Therefore, float refers to money that is temporarily held by an insurance company before it is paid out. During that time, it can be invested, and the profits can be pocketed by the insurance company. Float is listed on the balance sheet as a liability, but it has tremendous value for Berkshire Hathaway. In his report, Ravi shows readers how to analyze float in order to establish an intrinsic value of the company.
The “Two-Column” approach was actually recommended by Warren Buffett to be used in valuing Berkshire Hathaway by analyzing two major “areas of value.” One area of value includes Berkshire’s investments in stocks, bonds, and cash equivalents, not including investments held in the finance and utility operations. The second area of value is derived from earnings that come from sources other than investments and insurance. The reason why Buffett does not include earnings from investment and insurance is because he believes that they are already included in the first area of value.
The third approach to value used by Ravi is the traditional multiple of book value approach. He believes that this approach has limitations because it employs the historical cost of the subsidiaries and does not reflect their true values. Even though this approach has limitations, it is useful because changes in value signal changes in intrinsic value.
Conclusion
If you own Berkshire Hathaway stock, plan to own it in the future, or just want to learn about the company, I would recommend reading Ravi’s report. Because it was published on February 28, 2010, it is the most up-to-date analysis of the company.
by: Mariusz Skonieczny
Disclosure: I, or persons whose account I manage, do no own shares of Berkshire Hathaway.
After meeting the current vice chairman of Berkshire Hathaway, Charlie T. Munger, Buffett changed his investment style and started investing in quality companies with moats at discounted or fairly valued prices. He realized that quality companies with moats can enrich investors handsomely if held for long periods of time because they have competitive positions that allow them to generate high returns on capital. Weak companies, even if bought at cheap prices, can turn into can turn into bad investments, and ironically, this is exactly what his purchase of Berkshire Hathaway turned out be. While running his investment partnership, he purchased Berkshire Hathaway, which, at the time, was a textile company. He bought it because it was cheap on a quantitative basis. However, the company did not possess any competitive advantage over its competitors. On the contrary, it possessed competitive disadvantages because overseas companies were able to undercut it on cost, which is key in commodity-type businesses. As a result, it turned out that Berkshire Hathaway was selling at a cheap price for a reason.
Buffett kept the company and its name and used its capital to reinvest in other businesses. In other words, Berkshire Hathaway became a holding company. Today, it owns equity investments such as American Express and Wells Fargo, and entire businesses such as GEICO, an automobile insurance company; See’s Candies, a manufacturer and distributor of candy; and Clayton Homes, a company that builds, sells, finances and insures manufactured homes. Because the company is a collection of businesses, it is more difficult to analyze and value. While there are many books written about Buffett’s investment style, life, and career, there is not as much written on Berkshire Hathaway itself. On February 28, 2010, Ravi Nagarajan, the author of The Rational Walk blog, published a report on Berkshire Hathaway that includes the background, analysis, and valuation of the company. Some of you might remember that I interviewed Ravi at the beginning of the year. I was very impressed by his 67-page report on Berkshire Hathaway. While valuation is more of an art than a science, Ravi values the company by using three valuation methods: the float-based, “two-column,” and multiple of book value approaches.
In Ravi’s view, the float-based approach is the main driver of value. Insurance companies, such as the ones that are part of Berkshire Hathaway, generate float, which is policyholders’ money. When an insurance company issues a policy, it collects the premium upfront and does not have to pay out claims until later down the road. Therefore, float refers to money that is temporarily held by an insurance company before it is paid out. During that time, it can be invested, and the profits can be pocketed by the insurance company. Float is listed on the balance sheet as a liability, but it has tremendous value for Berkshire Hathaway. In his report, Ravi shows readers how to analyze float in order to establish an intrinsic value of the company.
The “Two-Column” approach was actually recommended by Warren Buffett to be used in valuing Berkshire Hathaway by analyzing two major “areas of value.” One area of value includes Berkshire’s investments in stocks, bonds, and cash equivalents, not including investments held in the finance and utility operations. The second area of value is derived from earnings that come from sources other than investments and insurance. The reason why Buffett does not include earnings from investment and insurance is because he believes that they are already included in the first area of value.
The third approach to value used by Ravi is the traditional multiple of book value approach. He believes that this approach has limitations because it employs the historical cost of the subsidiaries and does not reflect their true values. Even though this approach has limitations, it is useful because changes in value signal changes in intrinsic value.
Conclusion
If you own Berkshire Hathaway stock, plan to own it in the future, or just want to learn about the company, I would recommend reading Ravi’s report. Because it was published on February 28, 2010, it is the most up-to-date analysis of the company.
by: Mariusz Skonieczny
Disclosure: I, or persons whose account I manage, do no own shares of Berkshire Hathaway.
