Activist Bill Ackman (Trades, Portfolio) is having a banner year. His firm, Pershing Square, returned 48.8% in the first half of the year. The interim financial statement can be found here.
What really jumped out at me is Ackman invested 11% of the fund into Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) and he is also motivated about this new investment. It is surprising because Ackman returned to focus on his activist strategy after a debacle with Valeant Pharmaceuticals. This investment can't have an activist component, or can it? In addition, neither insurance nor industrial companies are usually Ackman's favorite targets, as he seems to do best with food companies and real estate. I've highlighted the most interesting parts of his analysis and will provide context.
"The catalyst for our current investment in Berkshire is our view that the company is currently trading at one of the widest discounts to its intrinsic value in many years, at a time when we expect the operating performance of its subsidiaries to improve as a result of certain managerial and organizational changes at the company."
Ackman starts off by laying out the Berkshire case extremely succinctly and clearly: wide discount and operating improvements. Note the operating improvements because we'll get into these later. As it turns out, Ackman found a way to apply his activist knowledge here.
"Mr. Buffett has clearly designed the company to succeed decades after he is no longer running the company. As a result, we believe that Berkshire should continue to generate high returns for shareholders from the current stock price even if the investment returns from the company’s large cash holdings and marketable securities portfolio are similar to that of the broad market indices."
This could be true, but I think Ackman is glossing over the risk of Buffett leaving. An event like that would likely have a big impact on the stock.
"Furthermore, we believe that Berkshire’s cost of float will remain stable or even decline as its fastest growing insurance businesses (GEICO and BH Primary) have a lower cost of float than the company’s overall average."
This seems a bit optimistic to me as it should become progressively harder with more float to realize low costs on said float. That's because, by definition, as you scale up, you become less picky what you're insuring. Of course, if the company grows without lowering underwriting standards, that's a great outcome.
"Berkshire has been able to produce investment returns that significantly exceed its insurance company peers as the combination of the company’s long-duration float and significant shareholders’ equity allow it to invest the substantial majority of its insurance assets in publicly traded equities, while its peers are limited to invest primarily in fixed-income securities. We believe these structural competitive advantages of Berkshire’s insurance business are enduring and will likely further expand."
Ackman estimates Berkshire has averaged a nearly 7% annual rate of return in the insurance investment portfolio even with a large slice of cash of around 20%.
We estimate the portfolio derives more than 50% of its earnings from its largest three businesses: Burlington Northern (more than 30%), Precision Castparts (approximately 10%), and regulated utilities (approximately 10%).
Valuation
"...We believe that Berkshire currently trades at only 14 times our estimate of next 12 months’ economic earnings per share (excluding the amortization of acquired intangibles), assuming a normalized rate of return of 7% on its insurance investment portfolio. While generating a 7% return on such a large amount of investment assets is not a given—particularly in an extraordinarily low-rate environment—we believe that Berkshire’s ability to invest the substantial majority of its insurance assets in equity and equity-like instruments and hold them for the long term makes this a reasonable assumption."
Ackman believes Berkshire trades at 12 times next year's earnings net of cash. That's a very low multiple in today's market. It seems a stretch to expect Berkshire to achieve 7% on its insurance investment portfolio. There could be tax issues here and Berkshire's scale will make this challenging. Not to mention the $100 billion in cash it holds. How is Buffett going to get that deployed effectively?
Ackman also believes Berkshire is undervalued because the company doesn't get credit for its cash hoard. He thinks the low interest rates disadvantage the conglomerate. Low interest rates are fairly horrible if you are an insurer or bank. Likely, Berkshire is not going to like this in any instance.
"We believe that Berkshire should be valued at a large premium to its current valuation."
I think he can forget about that. That's likely not going to work.
"Moreover, we believe an investor’s downside is limited due to the company’s fortress balance sheet, highly diversified business portfolio and significant earnings contribution from recession-resistant businesses such as insurance and regulated utilities. Furthermore, we expect that certain recent positive developments will highlight and enhance the per-share value of Berkshire’s business over the next several years."
Ackman believes Greg Abel and Ajit Jain, who've recently been promoted to co-managers and could potentially succeed in turning around all these restaurant retailers.
"First, we believe that it is likely that management will intelligently deploy some of its $100billion of excess cash into value-enhancing large-scale business acquisitions and/or a greater than historical amounts of share repurchases."
In the immediate future, my bet is on stock buybacks.
"We believe that this can be achieved because Mr. Buffett has built a deep bench of managerial and investment talent and a durable culture of character and performance. Second, Berkshire created a new managerial structure in 2018 to elevate two long-time managers,Ă‚ Ajit Jain and Greg Abel ,who now directly oversee the insurance and non-insurance businesses."
Ă‚ Ackman continued:
"Both managers have a track record of improving operations under their purview. We expect this new management structure will empower them to enhance the operational performance of Berkshire’s businesses that have underperformed their peers. For example, Burlington Northern’s current operating profit margins are nearly 500 basis points below the average of its North American peers, and nearly 800 basis points below that of its best-in-class peer despite BNSF’s industry-leading scale."
The guru has a good point here. It is also interesting to note that he has been a railroad investor for years, starting with Canadian Pacific (CP, Financial). Ackman has had most success with precision railroading and specifically raised a focused fund to have Hunter Harrison do the same thing at CSX (CSX, Financial). Both campaigns were hugely successful. Ackman sees more potential to put his playbook into practice.
"In light of the company’s currently depressed valuation, understated near-term earnings, and the potential for significant future earnings per share growth, we believe that Berkshire’s share price is likely to increase substantially over the coming years."
If the company gets rated at a substantially higher ratio, that's very favorable, especially if it can also grow earnings. With Pershing Square trading at a 30% discount, you get a double discount if they are really discounted.
Disclosure: No positions.
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