Description

I am submitting BRK for a few reasons so shortly after Den1200 (sorry to come so quickly after yours):  (1) I am hoping to add to the BRK discussion with more than what is reasonable in a discussion thread, (2) I am not proposing an offsetting hedge and (3) good opportunities are very limited.  Also, note most figures are from year end 2015.

To fully appreciate how value creation cannot help but continue, we will discuss the power and uniqueness of the Berkshire model.  We will also discuss how the business has changed in recent years, making some multiple of book value an overly simplistic path to valuation.

“As everyone from Warren Buffett to his smallest investor knows, Berkshire Hathaway is worth more than the sum of its parts.  Is it time to cash in?”  asks a headline from Barron’s on November 14, 2015.  We will try to answer that question and will end up perplexed why we would cash in when today the prevailing stock price allows us to receive all of the currently in place value at Berkshire at a healthy discount while also receiving all expected future value creation for free.  While this future value cannot be quantified with precision, we can be certain it will continue in a meaningful way.    Thus, looking out as little as one year we are paying less than $0.70 for a very high quality dollar bill and the gap of what we pay versus what we receive will continue to grow over time.  The Berkshire model nearly guarantees continued and significant compounding of value.

As Buffett himself says, time is the friend of a wonderful business.  While investing in Berkshire can be likened to investing in the tortoise rather than the hare, let us not forget the tortoise ultimately wins.  And in this case, the tortoise gets a head start given its prevailing discount to intrinsic value.

Underappreciation (maybe not on VIC) for the Power and Uniqueness of the Berkshire Model:

The Power of Float, Flexibility, Internal Cash Generation and Deferral

Berkshire has compounded book value at nearly 20% annualized since 1965.  Berkshire’s shares have returned 1,826,163% over the 50 years ending in 2014 (think about that for a minute).  Since 1970, Berkshire has compounded its per share investments at 19% annually while earnings from businesses other than insurance and investments have compounded at 20.6% annually.  Those numbers are just astounding.  But how has it been possible?  While many focus on the man of Buffett, it is the power of the Berkshire model which has made these returns possible.  More importantly for today, it is the power of the Berkshire model that will persist into the future even when Buffett is no longer leading the company.  The real genius of Buffett has been in the construction of a business model that is an unstoppable compounding machine.  We will touch on four key aspects of the model:  (1) the power of float, (2) the power of flexibility, (3) the power of internal cash generation and (4) the power of deferral.

The Power of Float:  While Berkshire is widely known and even widely beloved, I think most investors underappreciate the power of the business model that underpins Berkshire.  The prominence and appeal of Warren Buffett has in some ways blinded people to the business he constructed.  While he has obviously created tremendous value in the last fifty years through his investing prowess, the far less discussed value he contributed was building Berkshire on a foundation of insurance businesses that provided the fuel for investing.  The growth from investing alone would have fallen far short of what was accomplished through the use of increasing levels of float from the insurance businesses.  It is nearly impossible to understate the importance that float has brought to growing the intrinsic value of Berkshire through time.

The Power of Flexibility:  Beyond insurance providing the fuel for decades of outsized value creation, the combination of decentralized operations paired with centralized capital allocation has enabled Berkshire to capture the highest return value creation opportunities regardless of business, asset class or industry. The most obvious example of this capital flexibility stems from Buffett’s start with Berkshire.  At the time of his initial investment, Berkshire was a struggling textile manufacturer with little ability to earn above average returns on capital.  Instead of plowing additional capital into the textile business, Berkshire ultimately bought National Indemnity which set the stage for the company’s remarkable run of value creation.  It is entirely accurate to say this step was paramount in building what Berkshire is today as it started the power of float generated investment returns.

That same degree of capital allocation flexibility exists today and insulates Berkshire from the institutional imperative of a business to keep throwing money at its own business, whether the prospects for future returns are high or low.  Berkshire can and has shown great aptitude to invest where the prospects for return are high and avoid committing new capital to those areas where the return prospects are low.  In addition, a team has been assembled in recent years with exclusive focus on investing to help ensure strong capital stewardship continues through the following decades.  

It would be fruitless to detail all the new investments that have been made in recent years, whether in traditional investments or through the acquisition of entire businesses.  But as one example, four of Berkshire’s five largest non-insurance operating businesses have been bought in the last ten years and this does not consider the massive investments made in smaller acquisitions and more traditional investments, including well over $40 billion in 2008 alone.  The scale of the growth in investments and operating businesses will be apparent in the next section but the important aspect to keep in mind will be our consideration of their respective values in per share amounts which exemplifies how this growth has been internally generated.

The Power of Internal Cash Generation:  The cash generation of the enterprise in totality is enormous and enables a continuous flow of new capital for investments and to acquire new operating businesses.  Some liken Berkshire to other companies posting growth through acquisition, or roll up, strategies.  But this misses the most important distinction of Berkshire relative to most businesses.  Its growth in value through new investments and acquired companies has been achieved through internal capital generation and was not done with large amounts of external debt or equity capital.  While most acquisitive companies would falter without regular access to the capital markets, Berkshire’s growth is self-generated and thus more sustainable than appreciated.  The snowball cannot help but to keep rolling down the hill.

Returning to decentralization, it goes without saying that Berkshire’s investments in publicly traded companies operate on their own accord and have value independent of Berkshire.  The same can also be said for its non-insurance operating businesses.  This extreme operational decentralization has led many to call for Berkshire to break apart in various pieces.  And it is true they operate independently and thus can stand on their own apart from Berkshire.  But the ability of all freely available capital to return to headquarters and be sent to the highest possible returns, its home not needing to bear any relation to where it came from, is a unique advantage that allows for long term durability.  As any one business or industry in the portfolio falters over the longer term, its capital can be sent to where it can continue to create value, even if outside and away from its own business.

Many current forms of platform or acquisitive companies are likened to Berkshire but I believe most fall short in at least one very critical way.  Their acquisition led growth is fueled by access to the capital markets rather than Berkshire’s continued growth through investments and acquisitions which are predominately funded through internal cash generation.  As with the power of float, it is hard to understand the difference and the importance of being able to grow organically rather than through a reliance of accommodative financing markets.  Internal cash generation fueled growth is durable and sustainable.  Berkshire is not prone to hiccups in the financing markets.  Berkshire always has enormous levels of cash on hand for both durability and opportunism. The additions to the growing piles of investments and owned operating businesses will continue in good times and bad times and thus the growth in Berkshire’s intrinsic value can grow sustainably for the foreseeable future.

The Power of Deferral:  Berkshire’s model of funneling generated capital back to headquarters to most effectively redeploy also has the benefit of the frictional costs of taxes often associated with companies moving cash out of the business.  The below section from Buffett’s 2014 annual letter highlights (1) the power of flexibility in capital allocation toward the highest available returns even if in another business, (2) the power of internal cash generation from a myriad of sources and (3) the power of deferral as these movements of capital occur within Berkshire free from the tax and other frictional costs that would be associated with the various businesses being standalone entities.  The example highlighted is See’s Candy which generates great free cash flow but in amounts beyond the level it can profitably reinvest.  Given See’s sits inside the larger Berkshire, it can keep generating very high returns on its own capital while allowing the cash to move within Berkshire to other businesses and investments where the prospects are much better for the incremental capital invested.  And all of this occurs without the usual friction prevalent in most businesses and investments.

“At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise.  Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo.  That’s important:  If horses had controlled investment decisions, there would have never been an auto industry.

Another major advantage we possess is the ability to buy pieces of wonderful businesses – a.k.a common stocks.  That’s not a course of action open to most managements.  Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making.  The businesses we are offered by the stock market every day – in small pieces, to be sure – are often far more attractive than the businesses we are concurrently being offered in their entirety.  Additionally, the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would otherwise have been beyond our financial capabilities.

In effect, the world is Berkshire’s oyster – a world offering us a range of opportunities far beyond those realistically open to most companies.  We are limited, of course, to businesses whose economic prospects we can evaluate.  And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now.  But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry.  On top of that,, we can profitably scale to a far larger size than the many businesses that are constrained by large taxes, and almost always, by frictional and agency costs.

I mentioned earlier that See’s Candy had produced huge earnings compared to its modest capital requirements.  We would have loved, of course, to intelligently use those funds to expand our candy operation.  But our many attempts to do so were largely futile.  So, without incurring tax inefficiencies or frictional costs, we have used the excess funds generated by See’s to help purchase other businesses.  If See’s had remained a stand-alone company, its earnings would have had to be distributed to investors to redeploy, sometimes after being heavily depleted by large taxes and, almost always, by significant frictional and agency costs.”

2014 Chairman’s Letter, Berkshire Hathaway

The Building Blocks of Value

Berkshire Hathaway is a collection of great businesses held both as owned and controlled operating businesses and as investments in publicly traded companies built on a foundation of a world class and profitable insurance business.  The management at Berkshire carries a reputation for honest, reliably consistent and shareholder focused actions.  The Company has the broadest of mandates, which allows the flexibility to invest wherever the best returns exist, irrespective of industry or asset class.  Most importantly, Berkshire remains available for investment today at attractive valuations.  

There are three core buckets of value in Berkshire: (1) the insurance operations, (2) owned and controlled non-insurance businesses and (3) investments predominately in publicly traded companies.  The foundation of Berkshire is insurance.  Insurance creates both float and cash flow that is the fuel for buying both owned and controlled businesses and stakes in publicly traded companies.  When an insurance company writes policies to underwriting profitability, float becomes the best form of financial leverage available.  When an insurance operation is profitable, the company enjoys the use of free money while getting paid to hold it.  This form of financial leverage is cash generative without any timeline for repayment, assuming there is no decline in the aggregate value of float outstanding through time.

Flat or increasing float in the aggregate precludes any need for net cash outflows whereas declining float brings about a need for net cash outflows.  Given that critical distinction, has float increased or decreased through the years at Berkshire?  The chart below answers this question in striking form.  And while the future is not likely to bring the same level of increasing float, we should also not expect dramatic declines in float either.  This makes float, for a profitable insurer like Berkshire, long enduring without any repayment obligation on a net basis (inflows equal or exceed outflows) and profit generating, all of which makes it enormously valuable.

Increasing levels of float along with sustainably profitable insurance operations have provided much of the fuel for Berkshire’s gains in value over the years and will continue to do so going forward.

Value Today

As described above, insurance drives and provides the foundation for Berkshire but there is great value in its collection of controlled businesses and investments, so let’s summarize those two buckets of value.  

Berkshire owns a growing collection of controlled business including the Burlington Northern Railroad, a sprawling utility operation called Berkshire Hathaway Energy, IMC, Lubrizol and The Marmon Group.  These five companies generated $13.1 billion in pre-tax earnings in 2015, an increase of $650 million over 2014.  To accentuate how Berkshire has grown even in recent years, only of these five, Berkshire Hathaway Energy then called MidAmerican Energy, was owned by Berkshire ten years ago and produced pretax earnings of just under $400 million at that time.  

Part of our valuation exercise will be discussing what future value can be created by the cash generation of Berkshire in total.  This one data point of four new companies and over $12 billion of new pre-tax earnings coming almost exclusively from internal cash generation (a small amount of stock was issued in the Burlington Northern acquisition) is remarkable and points to what lies ahead.  You cannot overstate the power of the internal cash generated and how it has enabled additions to Berkshire’s constantly growing buckets of investments and businesses without the need for issuing additional equity.

Berkshire also owns scores of smaller non-insurance businesses that in aggregate produced another $5.7 billion in pre-tax earnings in 2015, up from $5.1 billion in 2014.  There are over 80 businesses that contribute the $5.7 billion in pre-tax earnings.  In fact, much of the premise of the Barron’s article referenced above is how significant value could be created if Berkshire were to deconglomerate and spin off a great number of these businesses (they are actually over 200 entities that could be spun out).  Part of the challenge in this strategy is it devalues the strong benefit today that the cash generated by all the Berkshire businesses can be brought back to corporate and allocated to the best opportunities wherever they may exist rather than in just one business silo.  The far bigger challenge is the “value” that may be created through spinning out many businesses is stock market value, not true business value.  So the deconglomeration may create a bump in the stock price but not fundamentally alter the value inherent in the business (and in fact is more likely to degrade existing value).

The more widely recognized component of Berkshire is its portfolio of publicly traded companies and other investments.  Core holdings include Wells Fargo, Kraft Heinz, Coca Cola, Bank of America, American Express and IBM.  Recent years have also brought a number of preferred equity investments to Berkshire include preferred stakes in Wrigley from the Mars acquisition, Dow Chemical, Bank of America and Restaurant Brands (the parent of Burger King and Tim Horton’s).  In addition to these and other meaningful stakes in publicly traded companies, Berkshire over $61 billion in cash and cash equivalents as of year end 2015.

Two of the listed core holdings require further discussion: Bank of America and Kraft Heinz.  The stake in Bank of America is not listed on quarterly filings as it is derived from Berkshire’s ownership of 700,000,000 warrants exercisable to common shares in 2021.  While the warrants will not be exercised until that time, Berkshire’s economic stake in Bank of America is very real and very material.  The warrants were part of the $5 billion preferred investment from 2011 (the preferred equity investment has not yet been repaid and may not be redeemed until 2019).  So, while an investment in the common shares of Bank of America is not found on Berkshire’s current filings, it is a material holding for Berkshire.  My own past investment summaries of Bank of America express its own undervaluation which should create value for Bank of America and Berkshire shareholders alike.

Berkshire’s investment in Kraft Heinz was also a two pronged with both an investment in preferred stock and common stock.  The nuance with the Kraft Heinz stake stems from its equity method accounting resulting from the size of Berkshire’s ownership.  In short, the common shares owned by Berkshire were reported at year end 2015 at $15.7 billion but its actual value exceeds $28 billion as the stake is not marked to the current market price each quarter.  Berkshire’s also had a preferred stake of $8 billion at year end 2015, although it is able to redeemed beginning in June of 2016.  

Discount on Today

If a certain multiple of book value is too simplistic, how should we think about valuation?  We will consider it in three parts:  (1) the current value of the operating businesses, (2) the current value of the investment portfolio and (3) the value creation we can expect going forward.  

In thinking about the value in place today, we will reference the chart below.

The investments are marked to market and thus we have a fairly easy to determine source of value for them.  Of course, if Berkshire’s holdings were significantly overvalued by the market we would need to make an offsetting adjustment but as you work through the list of holdings I consider them to be in the neighborhood of fairly valued or in some cases undervalued.

In considering the value of the operating businesses, we have ascribed a 10x multiple of pre tax earnings.  This is a below market multiple for a collection of well above average businesses with decent growth prospects ahead.  

By ascribing a multiple to these pre tax earnings we can approximate a combined number (nearly $282,000 per share) of value as if all the investments and businesses owned by Berkshire were publicly traded.  

This $282,000 compares to a current price of around $220,000.  So we can invest today at a price that is meaningfully lower than just the current value of Berkshire’s investments and businesses.

But more significant than that, the $282,000 gives little value to the business of Berkshire as a going concern.  It is clear and obvious Berkshire will continue to grow in value over time as its massive internal cash generation will ultimately be put to work through new investments or buying new businesses.  Additionally, and just as important, the existing businesses will continue to grow in value.  While it may be challenging to paint a precise figure for the value of the going concern, it is certainly real, tangible and significant.

Tomorrow For Free – The Value of the Going Concern

The combined cash flow from controlled businesses and insurance operations and the income from investments can be thought of as a water hose that continues to pour water/new capital, building larger and larger buckets of value across both operating businesses and investments.  New water coming into the two buckets does not degrade or reduce the value of the water already there.  The new value is only additive to the current value that remains.  This will be relevant as we consider the intrinsic value of Berkshire as it nearly guarantees increases in our two components of value over time.  Cash cannot help but build inside Berkshire and that cash is an immediate add to value before even accounting for how the newly created cash is ultimately invested.

This is also where another common misunderstanding of Berkshire occurs:  the value of the buckets of businesses and investments relative to Buffett’s role in the company.  A common problem associated with investing in Berkshire is its reliance on Warren Buffett and the related question of what the company will be worth once he is gone.  But think about those businesses and investments using a couple examples:  If Buffett is gone tomorrow, what will happen to Burlington Northern Railroad?  And what will happen to Wells Fargo?  They will both continue to generate cash flow just as the day before.  There will be no change.  And the same can be said for all the other businesses inside of Berkshire.  These great businesses have a permanence of value regardless of Buffett’s presence.

The relevant question as it pertains to his effect on value is the value of tomorrow.  As mentioned, the insurance businesses, along with cash flow from both controlled companies and investments, continue to add capital that is available for new investments.  How will that capital be treated?  The value that already exists is protected given the decentralized management approach to all operations excluding capital allocation.  Responsibility for the allocation of new capital resides at headquarters.  Again, we will return to this topic when discussing valuation but we can comfortably say that the current collection of businesses is not reliant on Buffett.  So the question of Buffett becomes a question of how intrinsic value can grow in the future.  

But what can we see in the relative near term for value creation?  There are two primary sources: (1) cash generation to expand the current roster of investments and businesses (2) continued growth in the underlying value of the existing operating businesses and investments.

As mentioned, the cash generation of Berkshire cannot be slowed down and will consistently and reliably add incremental value to the company, quarter to quarter and year to year, as time goes on.  There is significant, organic new value creation every day through internal cash generation alone.

Additionally, the underlying earnings power of the myriad of businesses under the Berkshire umbrella will continue to grow through time.  This is not to say there will not be some businesses in the fold that do degrade over time, but taken as a whole, underlying earnings power will continue to grow above and beyond cash generation.

Studying the past helps put perspective on what the future may hold.  Since 1970, Berkshire’s per share investments have grown at 18.9% compounded annually, while the per share amount of pre-tax operating earnings has compounded at a 23.7% clip.  While not expecting this amount of growth in the coming years, it would be foolish to believe Berkshire’s ability to grow has reached a ceiling considering its cash generation alone.

In 2015, Berkshire generated just shy of $32 billion in cash flow from operations after generating $32 billion in 2014.  That cash was then used in growing our two sources of value by making new investments, buying new businesses and growth capital expenditures for existing businesses.  

Value creation will continue unabated at Berkshire for years to come.

“The next to last task on my list was: Predict whether abnormally good results would continue at Berkshire if Buffett were soon to depart.

The answer is yes.  Berkshire has in place in its subsidiaries much business momentum grounded in much durable competitive advantage.

Moreover, its railroad and utility subsidiaries now provide much desirable opportunity to invest large sums in new fixed assets.  And many subsidiaries are now engaged in making wise “bolt-on” acquisitions.

Provided that most of the Berkshire system remains in place, the combined momentum and opportunity is so great that Berkshire would almost surely remain a better-than-normal company for a very long time even if (1) Buffett left tomorrow, (2) his successors were persons of only moderate ability and (3) Berkshire never again purchased a large business.

But, under this Buffett-soon-leaves assumption, his successors would not be “of only moderate ability.”  For instance, Ajit Jain and Greb Abel are proven performers who would probably be under-described as “world-class.”  “World-leading” would be the description I would choose.  In some important ways, each is a better business executive than Buffett.

And I believe neither Jain nor Able would (1) leave Berkshire, no matter what someone else offered or (2) desire much change in the Berkshire system.

Nor do I think that desirable purchases of new businesses would end with Buffett’s departure.  With Berkshire now so large and the age of activism upon us, I think some desirable acquisition opportunities will come and that Berkshire’s $60 billion in cash will constructively decrease.”

Charles T. Munger, Berkshire Hathaway Vice Chairman, 2014 Letter

The Same, Old Berkshire?

While much of Berkshire remains the same from decades ago, much has also changed.  The most striking change has been the accumulation of owned operating businesses that stand alongside a large portfolio of predominately publicly traded businesses.  We will discuss this shift towards more owned and controlled businesses as it has important valuation implications requiring a move beyond trying to understand the value of Berkshire relative to its book value.

The preference for adding to the collection of owned operating businesses has accelerated in recent years both through purchases of new businesses and bolt-on acquisitions for existing businesses.  As discussed above, four of the five largest non-insurance operating businesses have been newly acquired in the last ten years (Burlington Northern, The Marmon Group, IMC and Lubrizol).  For the full year 2015, Berkshire subsidiaries contracted for 29 bolt-on acquisitions for a total of $634 million, after completing $7.8 billion of bolt-on acquisitions in 2014.

Berkshire entered a new line of business in the first quarter of 2015 acquiring The Van Tuyl Group automotive dealership business for $4.1 billion.  The Van Tuyl Group, now named Berkshire Hathaway Automotive, is positioned and seeking additional acquisitions in the auto dealer industry while also building out related businesses around insurance, extended warranty and other automotive protection plans.  Berkshire also completed an acquisition of Precision Castparts for roughly $32 billion in 2016 which will substantially increase its portfolio of owned and controlled businesses.

Berkshire has also completed tax efficient asset swaps with companies where it has a significant common stock investment.  Just last year, Berkshire swapped its shares in Philips 66 for one of its chemicals business which has since been folded into Lubrizol and also tax efficiently swapped long held shares with in Graham Holdings (formerly The Washington Post Co.) for cash, Berkshire shares and a Miami-based TV station.  Berkshire had essentially no cost basis in the Graham shares but was able to effectively sell the shares through the transfer on a tax free basis.  Berkshire will also exchange its shares in P&G for full ownership of Duracell this year and in the process avoid roughly $1 billion in taxes that would have been due if selling the P&G shares outright.  In each of these cases, Berkshire has gained control of sought after businesses while using existing investments as the deal currency in a tax efficient manner including effectively buying back its own shares in one case.  Taxes are avoided and Berkshire adds to its growing pile of controlled operating businesses.  It should also be noted that Berkshire has rebuilt its Philips 66 stake to a much larger size than before its exchange for the chemicals business through recent investments.

The relatively recent moves described above highlight the dramatic change occurring at Berkshire as it seeks to own and control entire businesses compared to its historic practice of focusing more on making minority investments in the public markets.

Increasing Gap Between Book Value and Intrinsic Value

Book value per share as a yardstick of intrinsic value per share for Berkshire is increasingly too simplistic.

When Berkshire was largely an insurance operation paired with a collection of investments, book value was a decent yardstick for conservatively assessing value.  This is not to say that book value was the right value but rather that the relationship of book value to intrinsic value stayed consistent which allowed for using the growth in book value as a proxy for the growth in intrinsic value.

As Berkshire has evolved to where more and more of its value comes from controlled businesses rather than investments, the relationship of intrinsic value to book value is changing. There is an increasing gap between intrinsic value and book value and this gap is likely to widen going forward.  A constant multiple of book value is too simplistic a method of valuation for Berkshire, largely as a result in the dramatic growth in the value of operating earnings relative to the value in investments.

“In our early decades, the relationship between book value and intrinsic value was much closer than it is now.  That was true because Berkshire’s assets were then largely securities whose values were continuously restated to reflect their current market prices.  In Wall Street parlance, most of the assets involved in the calculation of book value were “marked to market.”

Today, our emphasis has shifted in a major way to owning and operating large businesses.  Many of these businesses are worth far more than their cost-based carrying value.  But that amount is never revalued upward no matter how much the value of these companies has increased.  Consequently, the gap between Berkshire’s intrinsic value and its book value has materially widened.”

                2014 Chairman’s Letter, Berkshire Hathaway

In another sign of the increasing gap between intrinsic value and book value, we can look to Berkshire’s share repurchase program.  In addition to the current repurchase program, there has only been one other time when Buffett has offered to buy back stock.  The current program was initiated in 2011 at a price to book of 1.1x or below but was subsequently increased to 1.2x or below in 2012 mirroring statements that the gap between intrinsic value and book value is expanding.  

It should also be noted that Buffett has repeatedly stated he will only buy back shares at a level that is substantially below intrinsic value.  He would not buy back shares for a discount of $1.20 relative to $1.35 of value.  He is inferring that intrinsic value is materially above today’s levels.  Also, in the 2015 annual letter Buffett states that Berkshire’s intrinsic value far exceeds book value (his emphasis, not mine).

This can also be seen in the valuation chart below adding together the two pieces of current value: per share investments and the value of current operating earnings.  As can be seen, the ratio of these combined values to book value has increased in recent years as the company has rapidly accumulated larger operating businesses.

The above chart details the moving yardstick of what is the appropriate multiple of book value for the value in place today, before even considering how to value the going concern.  It is likely the gap will continue to increase as the amount of operating businesses grows in importance so we need our slightly more nuanced picture of valuation.

What is the Number?

Valuation is not precise to the penny and is best thought of as ranges where investment is likely to be productive or not.  That being said, I will work to accumulate our sources of value to a number but will leave open the important consideration of the value creation beyond the next year.  If we can invest well below this conservative measure of value, we can invest comfortably and aggressively.

We know at a minimum there is value of roughly $282,000 per share in place today.  Value continues to accrue day by day.  We can comfortably expect cash to build and underlying earnings power to increase.  While not expecting growth of 20% or even 15% as in years past, it is not at all unreasonable to expect growth in value of 10% per year over the medium term.  As we discussed, much of this growth is in place solely from reasonably certain internal cash generation before giving credence to the uses of such cash including incremental investments, buying new businesses, bolt-on acquisitions, high return capital expenditures and growth in the underlying earnings power of the investments and businesses already in place at Berkshire.

Berkshire Hathaway is a consistently growing amalgamation of businesses and investments augmented by consistent cash generation from profitable insurance operations.  The additional cash generation from those same investments and businesses further add to the base of businesses and investments in an enviable cycle of value creation.  As important, the business can be acquired today at materially less than a conservative estimate of its intrinsic value.

Pushing this 10% growth in value out one year brings value over $310,000, a marked discount from today’s price around $220,000.  Buying at a discount to current value in a compounding machine provides an enormous opportunity and one that longer term investors should not look past.

Thought of in a slightly different way, if we compare the per share value of Berkshire’s investments to its current stock price, we are left paying less than 5x pre-tax operating earnings for Berkshire’s non-insurance businesses while retaining future value creation for free.

Why Does the Opportunity Exist?

As widely known as Berkshire is, how can this opportunity exist?  The same question could have been asked about our earlier summary in 2012 and many other points of time through its history.  The reality is I cannot know with certainty why a company is undervalued by the market.  Speculation is dangerous, even with words.  That being said, I will point out a few hurdles others may have investing in Berkshire.

Time/No Catalyst:  There is no near or medium term catalyst that can be seen to dramatically alter the stock market valuation of Berkshire.  The lack of catalyst is enough for many investors to avoid a particular company.  With a compounder like Berkshire, time is often the only catalyst you can find.

Underappreciation of Compounders:  Several have commented about the market’s underappreciation for platforms, or long term compounders.  I am not certain all the platforms of today are truly long term compounders but Berkshire unequivocally is a long term compounder.  And I continue believe the relative short or medium term focus of most market participants does not allow for a full appreciation of the longer term compounding power made possible through its unique operating model.  The short term returns may not seem high enough and the long term returns may feel too distant.  As a related point about the longer term power of a compounder, consider the chart from earlier in the report showing the increasing gap of current value to book value.  In roughly fifteen years, the multiple changed by two tenths.  While that may not seem like a large amount, it is a powerful additive over long periods of time and it should continue given the changes in relative preferences for owned business to minority investments.

Boring/Not Smart Enough:  It is often way more compelling to find a highly complex, misunderstood idea than to invest in the broad daylight.  The stories that can be told are so much more compelling.  But investing should be about long term returns rather than compelling story telling.  And I believe many market participants think it is just too simplistic to invest in a well-known business like Berkshire.  This apathy creates our opportunity.  We do not need to be the smartest in the room, but we do hope to have the most value creation twenty years from now.  Our willingness to invest with a very long term perspective helps us move on opportunities that others tend to look past.

Buffett/Key Man Risk:  While we touched on this topic above, Warren Buffett is inexorably tied to Berkshire.  And much will be lost when he is no longer running the company.  But, as we described above, the wonder of the business is the structure he devised as much as the capital allocation decisions he made.  The two large buckets of investments and businesses that comprise our calculation of current value will continue to create value in current form with or without Buffett in place.  Additionally, Charlie Munger remains a source of cultural and intellectual capital at the company should he surpass Buffett’s stay with the company.  Berkshire has also built a highly capable team of insurance leaders including Ajit Jain, capital allocators and business managers.

Overreliance on Book Value/New Emphasis on Owned Businesses:  We touched on this above as well but the gap between intrinsic value and book value has increased in recent years based in large part on the increasing amount of owned operating businesses.  Opportunities can arise when you combine this change from a historically simple valuation metric because of slow moving changes in the underlying structure of the business with a degree of apathy preventing investors from diving anew into Berkshire.

I Don’t Know/But I Do Know:  The reality is it is impossible to know with any precision why a company trades at a certain price at a certain point in time.  The above details a few possible reasons for Berkshire’s undervaluation but they border on speculation more than true knowledge.  I do know however that Berkshire is a great company, with durable long term advantages and is available at a very attractive valuation.  Investment in Berkshire may require a longer term perspective than those looking for near term catalysts, but that longer term perspective suits our investing style and temperament quite well.  We can invest and patiently wait while value continues to accrue.

There are risks to investing in Berkshire (significant insurance losses, economic contractions, market volatility, unforeseen natural or geopolitical events, amongst many others) but those risks are managed through the ownership of great businesses, a strong, liquid and stable balance sheet and a corporate philosophy with a unwavering eye towards thoughtful capital allocation.  

No investment should be passive so what are the key aspects of the company that should be monitored through time?  Much of the power of Berkshire and its ability to create value is described above and this structure must be maintained including its highly decentralized operations paired with a centralized, invest anywhere capital allocation operation.  More specifically, we can focus of two broad categories to monitor while recognizing that investing requires constant learning, studying and vigilance.  Those two categories are:  insurance underwriting discipline and capital allocation discipline.  

The business is built on a foundation of underwriting profitability so that the insurance business creates, rather than destroys, capital.  Any longer term path to sustained underwriting losses would create a significant downward change in the company’s value.  Berkshire has also allocated capital with incredible proficiency through time but if future capital allocation degrades rather than creates value then the expected path of future value creation would be compromised.

There will certainly be bumps in the road across its businesses but Berkshire has the assets and the balance sheet to withstand shorter term challenges.  Berkshire has constructed an incredibly resilient array of businesses and investments paired with an unbelievably strong balance sheet full of cash and devoid of any short term obligations.  So while short term pain will certainly occur at different points in time, the overall business is well positioned for long term success.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment adviser as to the suitability of such investments for his specific situation. A comprehensive due diligence effort is recommended.

Appendix - Highlights from 2012 Summary

I thought it would be constructive to revisit the price and value relationship as described in 2012.  Immediately below is a summary of the estimate of value at that time compared to the then prevailing share price.

From the Summer of 2012:

A conservative current estimate of intrinsic value comprises the combined value of Berkshire’s investments and operating businesses per the playbook laid out by Buffett himself.

• Berkshire has roughly $107,000 of per share investments at the end of Q2 2012

• Berkshire has a per share earnings run rate from its operating businesses of roughly $7,600 and this run rate is increasing on a year to year basis including in 2012

• Buffet has historically implied (through discussions and annual reports) a fair value multiple for such earnings of 11x to 13x

• I have used a 10x multiple to further the conservative nature of the calculation ascribing roughly $76,000 per share for the operating businesses

• I have conservatively ascribed no value to the insurance business even though it historically averages profitable operations

• Current estimate of intrinsic value is $183,000 per share which should continue to increase over time

• Cash levels continue to build quarter to quarter increasing the base of investments and/or dollars available for future full business acquisitions

• Existing businesses continue to grow in value

The current conservatively estimated intrinsic value of Berkshire Hathaway is significantly less than where Berkshire is available for investment today (roughly $127,000 per A share).  In addition to the current significant value gap, intrinsic value will continue to increase as time progresses.  The insurance businesses will continue to add cash available to grow the base of investments and fully owned operating businesses.  The existing investments and businesses will continue to grow in value.

To put valuation in another perspective, let’s assume the investments are valued on a dollar for dollar basis.  So, of the roughly $127,000 in today’s Class A share price, there is $107,000 in per share investments.  The remaining operating businesses can then be acquired for well under 3x earnings (paying $20,000 for roughly $7,600 in per share pre tax operating earnings).

An investment is available today to sit alongside one of the greatest investors of all time at a value well below intrinsic value in a company with a growing base of strong value investments and operating businesses.

Key Elements of Value:

1. High quality investment portfolio

2. Stable of owned businesses that continue to generate cash and grow in value

3. Insurance businesses that have a long history of profitable operations and generate significant cash flow for new investments

4. Corporate capital allocation from consistent cash generation deployed to most optimal uses by first class capital allocators: Warren Buffett, Charlie Munger and the investment team they have assembled

5. Consistently increasing intrinsic value through the acquisition and ownership of world class companies

Catalyst

There are no likely catalysts other than time.