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The hidden value of Berkshire Hathaway

Warren Buffett’s performance has been lagging the last decade. He has not been able to beat the market the same way he did it in the 1970s and 80s. But has he lost his touch? Far from it. Hidden gems dwell behind the moat surrounding Berkshire Hathaway.

People who have kept their stocks in Berkshire Hathaway through thick and thin, and invested in Berkshire Hathaway for the long term, have been very well rewarded. The overall return for the stock between 1964 and 2016 was 1,972,595%, compared to only about 2 500 percent for the S&P 500 index. In other words Buffett crushed the market during this time period.

When I write this, Berkshire’s A-shares are selling for around 275 000 USD, which means the gains are now over two million percent counting from 1964. If you had invested 1 000 dollars in Berkshire Hathaway in 1964, it would be worth over ten million dollars today. A 10 000 percent return on the initial investment(!).

From 1980 onwards the returns have been a bit more modest, but still dwarfs the overall return of the market. From 1980 to 2016, the A-shares of Berkshire Hathaway had an annual return of about 20,2%. 1 000 dollars invested with Buffett in 1980 returned about 500 times the initial investment up until 2016. One share bought in 1990 has returned around 40 times the initial investment.

When analysts and experts claim that Buffett has lost his touch this is nothing new. People said the same thing about Buffett during the tech bubble, in the late 1990s. Today experts critique him of buying Precision Castparts, Kraft Heinz and sticking to the investment in Coca Cola for too long. But in the past when people have underestimated Buffett, that has usually been followed by great leaps upward in Berkshire’s share price and earnings. Buffett has always been at his wisest when the euphoric stages of a bull market is coming to an end, avoiding many of the pitfalls, that lures in the rest of the crowd, towards the end of a business cycle. Then to later make some of his biggest investments ever, a few years later, when the markets have bottomed. Or as he wrote in one of his recent letters to shareholders:

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons.”

Fundamentals

The growth rate of Berkshire Hathaway has actually been quite high even in recent years, especially considering the size of the company. The book value of Berkshire has been rising at a rate of about 11 %, for the last 15 years. The earnings have been increasing at a rate of around ten percent annually. The free cash flow though, has been even higher than this, at around 12-13% per year. And the last few years, these growth rates have actually been ramping up. For the last twelve months the cash flows have been growing at around 82% on an annual basis. The average return on equity and return on capital have been a bit lower, at around 10% for the last fifteen years, which is quite high for a giant conglomerate like Berkshire, but also hard to calculate. Earlier this year Buffet wrote a few interesting paragraphs, in his annual letter to shareholders, where he first talks about some mistakes of the past, paying too much for businesses. But then he goes on to mention some of Berkshire’s winners:

”We’ve also had some winners among the businesses we’ve purchased, ‘a few of the winners very big’ but have not written those up by a penny.”

Buffett has no quarrel with the current accounting rules but points out that they give a misguided view of value:

“But over time it necessarily widens the gap between Berkshire’s intrinsic value and its book value. Today, the large ‘and growing’ unrecorded gains at our winners produce an intrinsic value for Berkshire’s shares that far exceeds their book value. The overage is truly huge in our property/casualty insurance business and significant also in many other operations.”

Generally accepted accounting rules is the foremost reason why Berkshire is Hathaway is so undervalued at these levels. Because of GAAP-rules, the private businesses have not been marked up to their intrinsic values, on the balance sheet. According to GAAP-rules, companies are not allowed to mark up their winners. In contrast, the losers have to be marked down to zero. A strange rule one might think, and it makes Berkshire interesting, because its whole business model is based on buying undervalued companies and holding them for decades.

That makes the value of Berkshire very hard to calculate. For example Buffett bought a company called See’s Candy in 1972, which is now a wholly owned subsidiary, where his initial purchase price was around 25 million dollars. We don’t know what See’s would sell for today, since Buffett is the main, and sole, owner of the business. But we do know that See’s sends him a check, well over 65 million dollars worth of dividends, every single year. That is about three times the purchase price he put up for the business in 1972. But on the books it is still marked at 25 million dollars. In reality it is probably worth at least 700 million dollars.

Since Berkshire owns 50 or 60 of these types of businesses, it is likely that it has a lot more value under the hood than what first meets the eye. The book value was 119 dollars a share at the end of 2016, which is way understated. And Buffett knows this. He has even stated that he will be a buyer of the stock if it goes below 120 percent of book value. So does that mean that Buffett will buy back stock if it goes below 140 dollars? Actually not. Buffett has stated that he will take a decision, along with the board, to see where the best purchase price is for buybacks, which means that he prefers the stock to go even lower. As a value investor, Buffett is willing to wait until the very best opportunity presents itself.

Making the castle float

Buffett also mentions Berkshire’s insurance operations in the letter. The fact that Buffett is a genius insurance-operator, is widely known by Buffett-fans, but not as widely understood by outsiders to the value investing community. Berkshire produces outsized gains through the use of interest free loans, or so called float. Buffett is able to invest these funds before paying them back in customer-claims, at a later point. Float is actually a liability on the balance sheet of insurance companies. They are funds that are required for satisfying policy holder’s claims at a future point in time. A lot of insurance companies actually have negative returns on their float. But Buffett invests these funds into financial securities of low risk, and high return businesses, fixed income and different types of debt instruments. He makes high returns on these funds and has previously pointed out the advantages of this:

“Float is wonderful. If it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an insurer earns an underwriting profit – as has been the case at Berkshire in about half of the 39 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money.”

Quality float is the main reason behind Berkshire’s extreme growth in combination with the skill and investment skills of Warren Buffett. It is why Berkshire makes higher annualized returns than many significantly smaller hedge-funds, despite its greater size and therefor limited investment landscape. The cash on Berkshire’s balance sheet is now enormous, because of dividends and continual streams of float, and that makes the value compelling. Buffett is sitting on around 100 billion dollars in cash, which could be deployed into new investments in the future. But Buffett is waiting for a better opportunity to strike.

Hidden assets

Another thing that makes the value hard to calculate are the companies that are just owned partially by Berkshire. Take Coca Cola for example. It is easy to just stare at the dividend stream going from Coca Cola into Berkshire Hathaway. But that excludes the rest of the earnings and cash flows that goes into Coca Cola itself. The cash flows are frequently not calculated for, when people analyze Berkshire. Mostly earnings and book value are used. If we calculate the earnings from these businesses, the price earnings ratio of Berkshire Hathaway comes down from today’s P/E of around 20-25, to the low teens.

Buffett thinks it will be harder to outperform the market in the future. But that should not be confused a prediction of bad returns in the future. In the past Buffett, and his partner Charlie Munger, have usually been very conservative in their estimates for Berkshire’s growth, so this is nothing new. They often outperform these estimates. And that bodes well in a time when a lot of uncertainty is surrounding the company. It is also interesting that Buffett thinks that Berkshire can withstand any “coming economic storm”, calamity or financial disaster, like for example something similar to the 2008 financial crisis.

Maybe what makes him so sure about Berkshire’s robustness is the large accumulation of hard assets they have been doing in recent years. For example one of its biggest subsidiaries, Burlington Northern Santa Fe, the second largest railway in North America, transports more commodities and hard assets than any other railway in America. Grains, coal, automobiles and oil is shipped on its rails in enormous quantities. And according to the company financial literature, it ships enough fertilizers to cover the whole state of Kansas.

These hard assets hedges Berkshire against high inflation. The equity of Burlington Northern, which is in the range of 50 billion, is also a lot larger than the equity of other similar railway giants in the United States. The equity that has been stated for Burlington Northern Santa Fe recently, actually comes close to what Berkshire paid for the whole company back in 2009.

Conclusion

Buffett himself has stated that he will buy back the stock, if it goes below 120% of book value. That is around 100-150 dollars per B-share. Personally I might be a buyer if it hits 150 dollars. Anyhow, a revaluation and reversion to the mean is looming. If it happens before or after a financial storm remains to be seen.

Disclaimer: I do not hold any stock in Berkshire Hathaway at the moment. All information found on this site ideas, opinions, predictions, commentaries are my own views that are for informational, entertainment or educational purposes only and should not be construed as personal investment advice. While the information provided is believed to be accurate, it may include errors or inaccuracies. I will not and cannot be held accountable for any actions you take as a result of what you read in here. I am not your investment adviser. Consult a licensed financial adviser before making any investment decisions.

See also:

Berkshire Hathaway Annual Meeting, Timesaver Edit, 2019:

https://www.youtube.com/watch?v=NkxvUV1wbdM

Why you should keep believing in Warren Buffett even though the stock market is crushing Berkshire Hathaway

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