With the U.S. market hitting new all-time highs again, we are back into a high-priced equity environment. That it has been a rollercoaster of a year is an understated cliché; the volatility has been extreme and so has the policy response by the Federal Reserve and other central banks. The drop in long-term interest rates has sent the ratio of the Wilshire 5000 over GDP, also known as the Buffett Indicator, to an all-time high. As Warren Buffett has said:
"Interest rates are like gravity in valuation. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that's a huge gravitational pull on value - and we had that in the early 1980s."
While the S&P 500 has bounced back sharply from the bear market earlier this year, Berkshire is still lagging behind, as can be seen in the chart below. The benchmark index is 10% ahead of the stock this year.
Looking at the long-term chart of Berkshire, one is struck by the consistent compounding of share price and book value. Both the book value and stock price have compounded at a 10% pace for 25 years. The chart below indicates that book value remains a decent proxy for Berkshire's prospects going forward.
I wrote about Berkshire earlier this year recommending that this was a good opportunity to take a position in the stock given that it was selling at close to book value, a very rare occurrence. Since then, while Class B shares have gained over 30%, the U.S. stock market has gone up even more and is almost certainly overvalued. Meanwhile, Berkshire is still about 10% undervalued based on the median price-book ratio.
The undervaluation becomes more apparent when using the GuruFocus two-stage discounted cash flow calculator. I used a discount rate of 8% (which I think is very generous given Berkshire's financial strength and less than 1% 10-year Treasury rate). I assume Berkshire can continue at a 10% per annum growth rate for the next 10 years and will then revert to a 4% growth in the following decade. This gives me a share value of $314 for the Class B stock, which is a significant margin of safety of about 29% from the current share price.
Conclusion
Charlie Munger (Trades, Portfolio), the vice-chairman of Berkshire, has said:
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent."
This makes me think, why take a chance on some overpriced hamburger in this market when you can still buy a filet mignon, like Berkshire, at a discount. You don't need to be a genius to understand the power of being "not stupid," whether you are in a melt-up or a melt-down situation.
Disclosure: The author owns shares of Berkshire Hathaway Inc.
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