Description

Berkshire is not for everyone. I understand many investors consider it too big, boring, etc. I respect that opinion, and you can stop reading here. For the rest, if there are any, I will continue.

I am writing Berkshire now because in my opinion, the possibility of losing money from these prices is quite low. Upside could be substantial if things play out as expected. 

Berkshire was moderately attractive before earnings and this recent correction. Then the bottom fell off the market, Berkshire declined 10% from an already attractive point. The stock is now significantly undervalued and has a mountain of cash. 

What has been happening at Berkshire, is that the public has lost faith in the company´s ability to redeploy its cash. Investors have been disappointed for years: no acquisitions, repurchases have been minor, etc. 

In early 2018, the stock reached a price of $225, since then shares have declined roughly 10%. Over this period, a significant number of positive events have taken place including massive gains at Apple, change in repurchase policy, continued growth in Insurance and Energy, etc. A ton of value has accumulated.

Having said that, I understand where the doubts come from. These doubts have created a discount in the share price. You can look at any valuation metric and find that Berkshire is trading at the low end of its range.

My rationale: Berkshire is already trading at levels that assume cash won´t be deployed in an efficient manner. From current prices, returns should be decent even if this condition is maintained. Having said that, I believe this will change and returns could be in the mid-teens over the next 5 years.

Description

Berkshire in its current form has wholly-owned businesses (BNSF, Precision Castparts, Duracell, etc.) and a portfolio of cash, bonds, equities and other assets (preferred shares, etc.).

Wholly-Owned businesses: Berkshire has acquired many businesses throughout the years. For obvious reasons, most of these acquisitions have been done during times when credit markets dry up (2001, 2008, etc.). There are many businesses here, with a varying degree of profitability and attractiveness. However, the most valuable businesses and by a wide range are BNSF and Berkshire Hathaway Energy. BNSF was acquired in 2009, and has been a home run by any measure as rails have been able to raise prices with slight volume gains. BHE has also been a terrific investment as the company has reinvested every penny (no dividends) into attractive projects earning decent returns. The MSR segment contains all the other businesses which include: Precision Castparts, Shaw, IMC, Lubrizol, Clayton Homes, Marmon, etc. These businesses in general have decent economics.

Portfolio: Berkshire has a portfolio that is in partially financed by one of the best insurance operations in the world. The company has made an underwriting profit in 16 of the last 17 years. These funds have been better than cost -free. 

These are the 2 components of value. Since 2007, Operating earnings per share and portfolio assets per share have grown at a cagr of 12.5% and 8.5%, respectively. Fair value should follow the growth of these 2 segments, over time.

Investor Frustration

I think the 2 biggest concerns which are depressing the share price are the lack of aggressive repurchases and doubts if the company will be able to deploy cash.

Lack of repurchases: Since Berkshire changed its buyback policy, there have only been $6bn in repurchases. This has been a great disappointment to shareholders, since many thought that buybacks would be the solution to the cash problem.

• Buffett has been repurchasing, even if small amounts, at prices much higher than current levels. He executed repurchases in the high 220s. If at those prices he considered shares to be undervalued, then at current levels it is a bargain.

• There is a lack of volume in Berkshire shares, compared to other companies. It has been difficult to repurchase large amounts without affecting price. In the letter sent last week, Buffett offered a phone number for those interested in selling their shares could call the company directly. This might help.

• Since the 2018 ammendment to the repurchase policy, shares have rarely been significantly undervalued until now. They were quite cheap in late-2018, but Buffett said he was close to making a big acquisition that fell through and that slowed him down on repurchases. Some might not believe him, I do. 

• When the stock has been cheap, he has repurchased close to 10% of daily volume, which is aggressive. Problem is these periods have not been prolonged.

• I think he will be very aggressive under the right conditions, like right now. He has been so in the past with major investments (recent example, Apple). We will soon know.

Cash deployment: One big problem, is Berkshire has become a big free cash flow generator. In 2019, operating cash flow was $39bn and capex $16bn. That leaves $23bn that needs to be invested or cash will build up. We can expect free cash flow to grow over time. On top of that, there is a $125bn cash balance (roughly double from $60bn in 2015).

• Acquisitions have been difficult to execute in this environment with som much liquitdity chasing yield. PE will likely outbid Berkshire in any deal.

• Berkshire has been able to generate strong returns in the equity markets and through special deals. Recent examples include Apple, RBI prefs, etc.

• Aggressive repurchases or a dividend will need to occur. Buffett has mentioned he can´t justify a $150bn cash balance.

• Berkshire is prepared for a downturn, with a lot of dry powder.

I believe Buffett will prove skeptics wrong as he has done in the past. Given the right conditions he will be aggressive, return cash to shareholders through buybacks and make special deals. We just have had a difficult environment to deploy capital in the past 5 years or so. 

Valuation

There is a ton of valuation math on Berkshire out there. So most of you have seen this. We can go over some metrics just to show how undervalued and attractive this opportunity really is.

Book Value: As mentioned, for years Buffett thought that at 1.2x book value the stock was significantly undervalued and he would repurcashe at those prices. Since the repurchase policy of 1.2x BV was announced the stock never really traded below the leved (just on a couple of occasions and for a few days). The stock now sits below those levels, 1.18x BV to be exact. In the past decade or so, the average P/B has been 1.4x.

Two-Column: Here we just add the two components of value. Here I apply a 17x multiple to the earnings of the wholly owned businesses. Also, exclude earnings from the insurance operations just to be conservative. For the portfolio assets, just take current value and apply a haricut for deferred taxes and other.

Sum of the Parts: Similar to the two column method. Here I try to separate the two largest businesses (excluding insurance) and try to get a specific valuation for each. For MSR, I apply a 17x multiple to the earnings of these businesses.

• BNSF: I apply a 10% discount to the current market value of public competitor UNP. These are similar assets, with a comparable network. BNSF earns roughly 10% less than UNP. The $100bn valuation is close to 18x trailing earnings.

• BH Energy: Berkshire owns 91% of the company. BHE has been repurchasing shares from the other shareholders at what they consider “fair value”. In 2019, they repurchased shares at a valuation of $50bn, which gives us a value for Berkshire´s ownership fo $45bn. This equates to 17x trailing earnings and 1.5x book value.

As shown, under almost any metric, current prices are quite attractive.

Going Forward

It is clear Berkshire is cheap. You can buy into some first class businesses with a strong balance sheet at prices implying decent returns with little downside.

However, under current conditions I don´t think Berkshire re-rate to an estimate of fair value. Investors will continue applying a discount due to the cash build up, size, Buffett´s age, conglomerate discount, etc.

Having said that, I do not think the discount will widen, at least significantly, from current levels. Also, without any extraordinary investments, I calculate value to grow by 8% a year, even if there are no major new additions to the portfolio of assets. Since right before the crisis, I calculate earnings and portfolio assets have grown by close to 10% a year.

If we get some turbulence, like the recent Coronavirus correction, think Berkshire will be aggressive. This will alleviate some of the concerns and eventually shares will re-rate as they have done in the past.

Let´s imagine a scenario where free cash flow goes directly into buybacks and no additional investments. Think that would be something the market would like.

Using the same model as mentioned previously, we get to a fair value of $355 in less than 3 years. 

If Berkshire is able to show that it can deploy its cash flow in an efficient manner, stock will trade closer to the estimate of fair value.

My bet is they will be able to create value, as they have done in the past. Investors will be positively surprised.

Catalyst

Significant Buybacks

Additional investments, taking advantage of recent correction