Description

Time for the eye-rolling, this idea is as intellectually interesting as watching paint dry.  However, Buffett’s change in focus on book value made it worth a review, despite being on VIC in the past. 

Change in book value as a metric

In the 2018 annual letter, Buffett described three key reasons why change in book is no longer the relevant metric and the question is why.  The first reason is that Berkshire is moving away from the importance of securities.  Technically that’s true but it’s also not new information.  Berkshire started moving away from the importance of securities in the late ‘90s so I view that justification as a bit of a throwaway.  The second reason is that Berkshire’s wholly owned businesses aren’t marked to market.  This one seems like a partial issue- the operating earnings from those businesses are coming through the P&L into retained earnings so they are getting picked up in book value but I get the point that businesses purchased a number of years ago can be worth significantly more and those changes in value aren’t reflected in Berkshire’s balance sheet.  Third, Buffett specifically calls out that, “it is likely that – over time – Berkshire will be a significant repurchase of its shares…”  I don’t think he’s ever made this point so explicitly and this leads me to two conclusions.  If Berkshire does repurchase a significant number of shares, it’s a fair point that it will begin to distort book value as those shares become treasury stock.  I believe this third point is the key and effectively only reason why it makes sense to shift from evaluating Berkshire on a change in BV basis to a change in operating earnings/sum-of-the-parts basis. More importantly, the market is arguably pricing Berkshire as if it will never deploy its excess capital and therefore the ROEs are in permanent decline.  The emphasis that Buffett places on share repurchases in the 2018 letter leads me to lower the probability that Berkshire becomes a perennial cash hoarder and never mind the fact that calling the end of Berkshire’s ability to compound has been a fools’ game so far.

Sum-of-the-parts (five components of value)

Despite Buffett’s explicit definition, Berkshire has actually outlined a variation of these components necessary for valuing Berkshire since 1995, although it used to be described as securities per share and non-investment income per share.  As you’ll see below, the two key drivers of Berkshire’s value is how to value its operating businesses and whether or not Berkshire will ultimately deploy its excess capital.  On the former, I’m assuming the 10 year treasury goes back to 5% and then add 300bps for equity risk on top of that.  If the business can grow at 2%, that gives you a multiple of 17x fair value for their businesses.  We could debate all day where interest rates will go, and I’d take the under on 5% for the US 10yr, but the numbers get silly below 4% for the 10 year bond.  On Berkshire’s ability to reinvest its excess capital, call it $100B by subtracting Buffett’s stated minimum of $20B and give them a $10B buffer on that, I think the comment on share repurchases suggests that’s likely how they’ll deploy the majority of that.  Listening to Munger’s comments at the recent Daily Journal meeting, I think it’s likely that Berkshire will either make a couple of large operating business acquisitions during the next recession/major market decline or they’ll aggressively repurchase shares.

Kraft Heinz exposure

This has clearly gotten a lot of attention over the last year so here are two thoughts.  Kraft Heinz is immaterial in terms of Berkshire’s overall net worth.  As of 12/31/18, Berkshire’s portion of KHC was held at $13.8B and would be worth $10.7B at today’s price, immaterial in the context of Berkshire’s $348B book value.  The more relevant question is whether or not this suggests future Buffett investments and specifically Berkshire/3G deals will destroy capital.  Based on Buffett’s interview on CNBC 2/25/19, I think the odds are overwhelming against value destructive 3G deals.  Buffett clearly stated that they overpaid for the Kraft business as well as misjudged the amount of negotiating leverage that the branded goods companies have with retailers.  Interesting sidebar, Costco’s private label business called Kirklands is now doing $39b per year in revenue, which is more than KHC’s $26B.

Expected Returns

With Berkshire retaining 100% of its earnings, the $64k question is can they reinvest all of this capital.  Over the past 20, 10, and 5 years, Berkshire has grown book/share by the following annualized rates: 9.0%, 11.7%, and 9.5%.  Given the explicit mention of share repurchases as a justification for changing the metric away from book value and to stock price, this incrementally improves the odds that Berkshire will be able to reinvest their capital and compound at similar rates.  Given their explicit focus of buying operating businesses, the last five years have been quite difficult given private valuations and they’ve still been able to compound book value at HSDs.  The second question is valuation- over the past 20, 10 and 5 years, Berkshire has averaged 1.5xBV, 1.37xBV, and 1.44xBV.  Today, the stock trades at 1.43x BV so I assume no change in multiple over the next five years.  However, you could make an argument that the multiple increases back towards 1.5x if Berkshire is successful in reinvesting their excess liquidity.  Berkshire clearly will run out of revinestment opportunities in the medium term, I’ll take the under on 10 years, but given Buffett’s continued discussion of capital allocation, I expect the BoD will return the excess capital largely through share repurchases post Buffett. 

Taxes

For a family office or individual, an investment in Berkshire presents a material advantage relative to other strategies because it defer a shareholder’s gains for a long period of time.  As a thought experiment, I’ve compared Berkshire’s after-tax returns to an absolute return strategy that generates 100% ordinary income and to a single stock strategy where the stock is sold each year but all of the gains are taxed at long-term rates.  If, which is a big if, Berkshire compounds at 9%, a shareholder of 15 years would need almost 13% annualized in an A/R strategy or ~10% annualized in a single stock with 100% annual turnover strategy to match Berkshire’s after tax returns. 

Risks

Keyman risk- optically this is with Buffett but I actually think the bigger concern is keeping Ajit Jain and Greg Abel in their positions.  Clearly the promotion of each to Vice-Chairman is a step in that direction but I would be concerned about either of them leaving, given Buffett’s reduced involvement in the operating businesses.

Catalyst

Probably my favorite aspect of an investment in Berkshire is that the forward looking returns of Berkshire increase with both overall stock market declines as well as with a $400B cat event.  Berkshire’s stock will absolutely decline under either of these scenarios but the forward returns on its $100B of excess liquidity should increase from today’s paltry 2.4% T-bills yield to over 10% conservatively.  The second catalyst could be a meaningful acquisition to change the market’s perception of the value of the excess cash.