Berkshire Hathaway: unique business at a discount price
August 29, 2021
Summary
Berkshire Hathaway has been my core holding for a few years. It is run by one of the world's best investors who keep over 90% of their net worth in this company, which makes it a perfect alignment of interests. Berkshire has a unique business model with leading insurance operations funding new investments (a rate advantage compared to most other businesses that have to pay interest for attracting new capital).
Berkshire has over 15% of assets in cash and has two leading businesses in regulated industries (Utilities and Railroads) which position it well for a possible correction and / or inflation. Historically, Berkshire has outperformed the market especially during crashes (e.g. in 2000 and 2008).
The company owns leading brands with a strong pricing power and returns on capital which ensures a strong future and minimises downside risks.
The current market price is c. 27% below my fair value estimate. Berkshire's private businesses have an implied market value of just $48bn despite generating $9.8bn of earnings in 1H21. The company has started to take advantage of this valuation discount and has bought over $30bn of own shares from the market over the past 12 months.
Berkshire has over 15% of assets in cash and has two leading businesses in regulated industries (Utilities and Railroads) which position it well for a possible correction and / or inflation. Historically, Berkshire has outperformed the market especially during crashes (e.g. in 2000 and 2008).
The company owns leading brands with a strong pricing power and returns on capital which ensures a strong future and minimises downside risks.
The current market price is c. 27% below my fair value estimate. Berkshire's private businesses have an implied market value of just $48bn despite generating $9.8bn of earnings in 1H21. The company has started to take advantage of this valuation discount and has bought over $30bn of own shares from the market over the past 12 months.
Introduction
Practically everyone would agree that Warren Buffett is one of the world's best investors ever. Yet, I find it quite surprising that few people pitch his company - Berkshire Hathaway - as their top stock idea at various investor forums. Berkshire may look too well-known, quite large and with few catalysts to appeal to smaller investors.
However, contrary to such unexciting views, I find Berkshire very attractive as a business model and on valuation grounds. Even if it is hard to surprise the audience by bringing Berkshire as a stock idea, I think this does not make it less attractive to own as long as business fundamentals remain attractive and price - reasonable.
Below, I provide my reasons for owning Berkshire and I try to address key concerns and potential risks.
However, contrary to such unexciting views, I find Berkshire very attractive as a business model and on valuation grounds. Even if it is hard to surprise the audience by bringing Berkshire as a stock idea, I think this does not make it less attractive to own as long as business fundamentals remain attractive and price - reasonable.
Below, I provide my reasons for owning Berkshire and I try to address key concerns and potential risks.
Partnering with great managers who have skin in the game
Firstly, by holding Berkshire stock I team up with the world's best capital allocator – Warren Buffett. His track record of growing market value per share by 20% over a 65-year period (for a total gain of 28,030 x) is hard to beat and serves as the best evidence of his superior investment skills.
Investing is Warren Buffett's biggest passion in life. His most favourite pastime is reading annual reports trying to find the next best investment opportunity. He has a great partner, Charlie Munger, and they both managed to bring together a great team of key executives including two other vice-chairmen – Greg Abel and Ajit Jain. All four of them have most of their net worth invested in just one stock, Berkshire Hathaway, which makes it a perfect alignment of interests.
Warren Buffett, Charlie Munger, Greg Abel, Ajit Jain
Succession at Berkshire is often one of the risks brought up by investors. But such concern often understates the role of Greg and Ajit. To understand the role of these two managers, please keep in mind that Greg Abel was one of the two key executives behind 28x growth of earnings at MidAmerican Energy (now Berkshire Hathaway Energy) from 2000 until 2020 (16% CAGR for a regulated business). In its 2020 annual letter to shareholders, Buffett wrote that the Energy business of Berkshire saw its earnings growing from $122mn to $3.4bn over a 21-year period when Berkshire owned this business.
Ajit Jain, an Indian-born executive who joined Berkshire in 1986 at the age of 35, has been praised by Buffett many times. During the 2020 annual meeting, he said that he "wrote to Jain's father after he worked for us for a few years, and said that 'if you've got another son like this, send him over from India because we'll own the world'".
In an earlier shareholder letter, Buffett also wrote that should he, his partner Charlie Munger and Ajit Jain be on a sinking boat, "and you can save only one of us – swim to Ajit".
It is harder to attribute a specific financial contribution of Ajit Jain to Berkshire's results, since he is in charge of Insurance operations which Buffett runs as well. But Buffett himself makes it clear that Jain has been instrumental in identifying risks and pricing them accordingly. This allowed Berkshire to grow its insurance float – a source of free funding for Berkshire's investment portfolio.
In the past 10 years, Berkshire's management team has been also strengthened by Todd Combs and Ted Weschler who joined as two co-portfolio managers in charge of company's stock investments. They currently run about $25bn of investment funds (c. 8% of total Berkshire portfolio) with more allocations from Buffett every year. You can read more about Ted and Tod here and here.
Ajit Jain, an Indian-born executive who joined Berkshire in 1986 at the age of 35, has been praised by Buffett many times. During the 2020 annual meeting, he said that he "wrote to Jain's father after he worked for us for a few years, and said that 'if you've got another son like this, send him over from India because we'll own the world'".
In an earlier shareholder letter, Buffett also wrote that should he, his partner Charlie Munger and Ajit Jain be on a sinking boat, "and you can save only one of us – swim to Ajit".
It is harder to attribute a specific financial contribution of Ajit Jain to Berkshire's results, since he is in charge of Insurance operations which Buffett runs as well. But Buffett himself makes it clear that Jain has been instrumental in identifying risks and pricing them accordingly. This allowed Berkshire to grow its insurance float – a source of free funding for Berkshire's investment portfolio.
In the past 10 years, Berkshire's management team has been also strengthened by Todd Combs and Ted Weschler who joined as two co-portfolio managers in charge of company's stock investments. They currently run about $25bn of investment funds (c. 8% of total Berkshire portfolio) with more allocations from Buffett every year. You can read more about Ted and Tod here and here.
Ted Weschler and Todd Combs
Unique business model with strong moat
Investment portfolio + Insurance = Exceptional combination
Berkshire Hathaway is a unique business because it is the world's leading investment fund, on the one hand, and one of the world's largest insurance companies, on the other. Combining two businesses under one umbrella creates a special type of business that is hard to match.
Buffett often answers a question about a potential break-up of Berkshire suggesting that it does not make sense as his company is worth more when operating as a single entity than on a sum-of-the-parts basis. Let me try to explain why it is the case.
For the investment business to be successful, you need three key ingredients. You need 1) Size (asset under management) to be able to spread admin costs over a larger scale, you also need 2) 'right' capital, and, of course, 3) good investment decisions.
The second point is quite unique for Berkshire. Most funds suffer outflows during crisis when it is normally time to buy. As a result, fund managers try to avoid taking concentrated bets and prefer 'safer' options, not necessarily most undervalued. Some funds enjoy 'permanent' capital like family offices. But Berkshire enjoys a constant inflow of capital. Not only Buffett does not have to worry about capital outflow, but he can also rely on more money coming over time. This allows him to take a much longer perspective when making investment decisions and avoid the problem of market timing.
This naturally helps to make better investment decisions (the third factor). However, I should also mention the biggest challenge for Berkshire and all other successful money managers – size. So, the first and last points go into direct conflict after the portfolio size exceeds a certain level (probably $10bn or so).
Here is the direct quote from Buffett's 2018 shareholder letter:
"This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead".
Buffett often answers a question about a potential break-up of Berkshire suggesting that it does not make sense as his company is worth more when operating as a single entity than on a sum-of-the-parts basis. Let me try to explain why it is the case.
For the investment business to be successful, you need three key ingredients. You need 1) Size (asset under management) to be able to spread admin costs over a larger scale, you also need 2) 'right' capital, and, of course, 3) good investment decisions.
The second point is quite unique for Berkshire. Most funds suffer outflows during crisis when it is normally time to buy. As a result, fund managers try to avoid taking concentrated bets and prefer 'safer' options, not necessarily most undervalued. Some funds enjoy 'permanent' capital like family offices. But Berkshire enjoys a constant inflow of capital. Not only Buffett does not have to worry about capital outflow, but he can also rely on more money coming over time. This allows him to take a much longer perspective when making investment decisions and avoid the problem of market timing.
This naturally helps to make better investment decisions (the third factor). However, I should also mention the biggest challenge for Berkshire and all other successful money managers – size. So, the first and last points go into direct conflict after the portfolio size exceeds a certain level (probably $10bn or so).
Here is the direct quote from Buffett's 2018 shareholder letter:
"This arrangement allows us to seamlessly and objectively allocate major amounts of capital, eliminate enterprise risk, avoid insularity, fund assets at exceptionally low cost, occasionally take advantage of tax efficiencies, and minimize overhead".
Businesses with durable competitive advantages
Berkshire's owns a vast collection of businesses although the top 5 largest listed investments make up over 70% of the overall portfolio.
What makes practically all of those assets special is that they all have strong competitive advantages either through strong consumer brands or cost leadership. This adds stability to the overall business of Berkshire and reduces its risks. For example, key holdings within a publicly listed portfolio are Apple, Bank of America, Coca-Cola, American Express and Moody's.
These companies have above average ROE, larger-than-usual operating margins and very conservative balance sheets (Apple's net cash amounts to $87.9bn and accounts for 27% of total assets as of end 2Q21).
The largest private businesses owned by Berkshire have equally strong moats. Not all of them enjoy such high margins, mainly because two leading private assets operate in regulated sectors (Energy and Railroads).
Insurance – one of the key sources of capital for Berkshire – also creates an additional competitive advantage for the company which is not always appreciated. I discuss it separately in the following section.
What makes practically all of those assets special is that they all have strong competitive advantages either through strong consumer brands or cost leadership. This adds stability to the overall business of Berkshire and reduces its risks. For example, key holdings within a publicly listed portfolio are Apple, Bank of America, Coca-Cola, American Express and Moody's.
These companies have above average ROE, larger-than-usual operating margins and very conservative balance sheets (Apple's net cash amounts to $87.9bn and accounts for 27% of total assets as of end 2Q21).
The largest private businesses owned by Berkshire have equally strong moats. Not all of them enjoy such high margins, mainly because two leading private assets operate in regulated sectors (Energy and Railroads).
Insurance – one of the key sources of capital for Berkshire – also creates an additional competitive advantage for the company which is not always appreciated. I discuss it separately in the following section.
Insurance – the jewel in the crown
Few investors fully understand the sources of value in the Insurance business.
There are two main sources of income in Insurance: investment income and underwriting profits (the difference between the money collected from selling insurance policies and the money paid out on claims). Insurance can be viewed as a source of capital with negative interest. In contrast to bank loans, when you borrow money and pay interest as the price for using the money, in insurance you are paid in advance by policy holders and collect income from investing this money.
In reality, the insurance business is much more complex and few companies can be successful in this business especially over the long-term.
Insurance business is generally hard to analyse because you don't know the types of risks / policies that have been sold and you may not know the quality of investment portfolio. Often, it takes years to learn this.
Another factor complicating the analysis of insurance business is customer acquisition costs that are often booked in year one and the value the customer generates of years staying with the same insurance company (life time value). An insurance company may be reporting near-term losses even though it may be generating a long-term shareholder value by growing its customer base.
To compete in the insurance business, you have to lower your price for a policy, but then you run the risk of growing underwriting losses. You can also create problems if you invest policy proceeds (float) into low-quality bonds. Moreover, many insurance companies do not invest in equities at all, either due to the regulation applicable in the geography in which they are registered, or because they cannot afford to have temporary declines in assets.
Mohnish Pabrai had a good case study based on his own experience in insurance. Initially he was eager to have 'permanent capital' through insurance and was very happy when he launched his own insurance operations. But then he started facing the cruel reality of the industry and was happy when he sold the company. You can hear his story here.
Buffett put it well in one of his letters to shareholders:
"[Insurance] is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way".
The unique advantages of Berkshire relate to its ability to generate the best long-term returns from float as well as to best price potential risks and sell insurance policies on most favourable terms. Berkshire has additional advantages in re-insurance – an industry segment where traditional insurance companies want to hedge against rare, but potentially big disasters (catastrophes). Not only has the company proven its exceptional underwriting skills (thanks to Ajit Jain), but also it has scale and financial strengths.
For an insurer, who is worried about its exposure to various disasters, it is crucial that the re-insurer from which it purchases such policy (re-insurance) stays solvent when a catastrophe hits. So, the financial strength of a re-insurer is of critical importance and Berkshire stands out here due to its diversified business model and a very defensive balance sheet (over 15% of its assets are in cash).
Secondly, Berkshire can write policies for amounts that "no one else can even consider". The speed at which Berkshire can write such policies and the amount of such policies are important competitive advantages for the company.
I borrowed this from the Semper Augustus 2020 Shareholder 2020:
"Berkshire Hathaway Reinsurance Group, as the combined entity is now known, will write close to $20bn in premium volume in 2020 on surplus of more than $200bn. By comparison, the entire global reinsurance industry has combined surplus of roughly $600bn ($700bn when including alternative capital such as catastrophe bonds and insurance-linked securities). The industry will write roughly $300bn in premiums. Berkshire writes less than 10% of combined reinsurance industry premium volume but has more than one-third of industry equity capital".
Another legendary investor, Shelby Davis (see my book review of The Davis Dynasty) highlighted the defensive qualities of insurance operations: people hardly cut on their insurance policies during recession, but driving and consuming less often reduced claims. Falling rates boosted the value of insurance companies' bond holdings. Here is the quote from the book:
"Insurers offered a product that never went out of style. They profited from investing their customers' money. They didn't require expensive factories or research labs. They didn't pollute. They were recession-resistant. During hard times, consumers delayed expensive purchases (houses, cars, appliances, and so on), but they couldn't afford to let their home, auto, and life insurance policies lapse. When a sour economy forced them to economize, people drove fewer miles, caused fewer accidents, and filed fewer claims-a boon to auto insurers. Because interest rates tend to fall in hard times, insurance companies' bond portfolios become more valuable".
Berkshire's track record in growing its insurance float over time confirms the company's unique skills in identifying risks and pricing them better than the competition (see the following table).
There are two main sources of income in Insurance: investment income and underwriting profits (the difference between the money collected from selling insurance policies and the money paid out on claims). Insurance can be viewed as a source of capital with negative interest. In contrast to bank loans, when you borrow money and pay interest as the price for using the money, in insurance you are paid in advance by policy holders and collect income from investing this money.
In reality, the insurance business is much more complex and few companies can be successful in this business especially over the long-term.
Insurance business is generally hard to analyse because you don't know the types of risks / policies that have been sold and you may not know the quality of investment portfolio. Often, it takes years to learn this.
Another factor complicating the analysis of insurance business is customer acquisition costs that are often booked in year one and the value the customer generates of years staying with the same insurance company (life time value). An insurance company may be reporting near-term losses even though it may be generating a long-term shareholder value by growing its customer base.
To compete in the insurance business, you have to lower your price for a policy, but then you run the risk of growing underwriting losses. You can also create problems if you invest policy proceeds (float) into low-quality bonds. Moreover, many insurance companies do not invest in equities at all, either due to the regulation applicable in the geography in which they are registered, or because they cannot afford to have temporary declines in assets.
Mohnish Pabrai had a good case study based on his own experience in insurance. Initially he was eager to have 'permanent capital' through insurance and was very happy when he launched his own insurance operations. But then he started facing the cruel reality of the industry and was happy when he sold the company. You can hear his story here.
Buffett put it well in one of his letters to shareholders:
"[Insurance] is cursed with a set of dismal economic characteristics that make for a poor long-term outlook: hundreds of competitors, ease of entry, and a product that cannot be differentiated in any meaningful way".
The unique advantages of Berkshire relate to its ability to generate the best long-term returns from float as well as to best price potential risks and sell insurance policies on most favourable terms. Berkshire has additional advantages in re-insurance – an industry segment where traditional insurance companies want to hedge against rare, but potentially big disasters (catastrophes). Not only has the company proven its exceptional underwriting skills (thanks to Ajit Jain), but also it has scale and financial strengths.
For an insurer, who is worried about its exposure to various disasters, it is crucial that the re-insurer from which it purchases such policy (re-insurance) stays solvent when a catastrophe hits. So, the financial strength of a re-insurer is of critical importance and Berkshire stands out here due to its diversified business model and a very defensive balance sheet (over 15% of its assets are in cash).
Secondly, Berkshire can write policies for amounts that "no one else can even consider". The speed at which Berkshire can write such policies and the amount of such policies are important competitive advantages for the company.
I borrowed this from the Semper Augustus 2020 Shareholder 2020:
"Berkshire Hathaway Reinsurance Group, as the combined entity is now known, will write close to $20bn in premium volume in 2020 on surplus of more than $200bn. By comparison, the entire global reinsurance industry has combined surplus of roughly $600bn ($700bn when including alternative capital such as catastrophe bonds and insurance-linked securities). The industry will write roughly $300bn in premiums. Berkshire writes less than 10% of combined reinsurance industry premium volume but has more than one-third of industry equity capital".
Another legendary investor, Shelby Davis (see my book review of The Davis Dynasty) highlighted the defensive qualities of insurance operations: people hardly cut on their insurance policies during recession, but driving and consuming less often reduced claims. Falling rates boosted the value of insurance companies' bond holdings. Here is the quote from the book:
"Insurers offered a product that never went out of style. They profited from investing their customers' money. They didn't require expensive factories or research labs. They didn't pollute. They were recession-resistant. During hard times, consumers delayed expensive purchases (houses, cars, appliances, and so on), but they couldn't afford to let their home, auto, and life insurance policies lapse. When a sour economy forced them to economize, people drove fewer miles, caused fewer accidents, and filed fewer claims-a boon to auto insurers. Because interest rates tend to fall in hard times, insurance companies' bond portfolios become more valuable".
Berkshire's track record in growing its insurance float over time confirms the company's unique skills in identifying risks and pricing them better than the competition (see the following table).
It is also worth highlighting that Buffett has numerously praised the importance and value of Berkshire's float. For example, in a 1997 letter to shareholders he wrote:
"Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had".
During the meeting with shareholders held the same year, Buffett explained why the float (reported as liability) was worth more than equity. If Berkshire were to raise $7bn (the amount of float in 1997) as equity, this would increase the number of shares and reduce interest of each shareholder proportionately. Even though Berkshire could have earned more with additional funds, divided over more shares such a higher absolute profit would not differ much from the previous earnings on a per share basis (earned without additional funds).
On the other hand, earned as insurance premiums float does not change interests of existing shareholders as share count stays the same. Yet, as long as Berkshire avoids large scale losses, such float generates moderate profits. In other words, float has a negative cost to Berkshire, unlike debt or equity which have a positive cost (Berkshire has to pay to capital providers through interest or shared profits).
importantly, just being in the insurance business does not guarantee cost-free funding. To finish this part of my thesis on the insurance, I would use the following quote from Buffett's talk during 1996 shareholder meeting:
"Float, per se, is not a blessing. We can show you many insurance companies that thought it was wonderful to generate float. And they have lost so much money in underwriting that they'd be better off if they'd never heard of the insurance business".
"Though our float is shown on our balance sheet as a liability, it has had a value to Berkshire greater than an equal amount of net worth would have had".
During the meeting with shareholders held the same year, Buffett explained why the float (reported as liability) was worth more than equity. If Berkshire were to raise $7bn (the amount of float in 1997) as equity, this would increase the number of shares and reduce interest of each shareholder proportionately. Even though Berkshire could have earned more with additional funds, divided over more shares such a higher absolute profit would not differ much from the previous earnings on a per share basis (earned without additional funds).
On the other hand, earned as insurance premiums float does not change interests of existing shareholders as share count stays the same. Yet, as long as Berkshire avoids large scale losses, such float generates moderate profits. In other words, float has a negative cost to Berkshire, unlike debt or equity which have a positive cost (Berkshire has to pay to capital providers through interest or shared profits).
importantly, just being in the insurance business does not guarantee cost-free funding. To finish this part of my thesis on the insurance, I would use the following quote from Buffett's talk during 1996 shareholder meeting:
"Float, per se, is not a blessing. We can show you many insurance companies that thought it was wonderful to generate float. And they have lost so much money in underwriting that they'd be better off if they'd never heard of the insurance business".
Focus on downside protection
Another factor that is very important to me in any investment decision is downside risks. I wrote about an overlooked concept of the geometric mean applied to probabilities and returns here. In summary, if you invest $100 and can either win $55 or lose $45 (50/50 chance), then after two rounds you can only be up in 1 out of 4 possible scenarios. In other words, in 3 out of 4 cases you lose money!
Yet, your gain in only one scenario is so large relative to losses in the other 3 cases, that your mean outcome is positive (your original $100 investment could be worth $240.25 if you win two times in a row and your average value in 4 scenarios is $110.25). This can be said about the overall stock market which rises over time increasing the total wealth of stock market participants but these gains are spread very unevenly with very few collecting most of the wealth at the expense of the majority of participants.
This simple math example shows that avoiding losses is often more important than achieving short-term gains. Another example is this: if you earn 50% on $100, you are worth $150. But if you lose 50%, you would then need to earn 100% to just break even.
One of the key principles of value investing is Margin of Safety introduced by Ben Graham (see my review of his book here and my article on Value Investing here).
Using this principle, I think it is important to have the biggest weight in your portfolio in positions with the highest margin of safety (lowest risk). This principle was mentioned by Joel Greenblatt in the 2020 interview when he attributed his long-term success to his position sizing based on downside potential, whereas most people put most money in stocks with the highest upside.
Buffett has highlighted many times his focus on quality of the underlying business, integrity of management and generally minimising risks to Berkshire by maintaining a very conservative capital structure. Almost all of his and his family net worth is in just one stock – Berkshire Hathaway. Charlie Munger's portfolio is equally concentrated.
Moreover, by being very open about his investment strategy Buffett has managed to bring investors with a similar mindset into Berkshire. Unlike a typical corporation, most of Berkshire shares are held by individual investors, not professional money managers. I don't think you can find many speculators among Berkshire shareholders or investors with a short-term horizon. Other companies may have to choose options with short-term gains at the expense of long-term success due to pressure from shareholders.
This defensiveness and long-term focus can be seen in Buffett's patience with spending cash (over $161bn in 2Q21). Facing competition from a wave of money raised by Private Equity funds, Hedge Funds, SPACs and others as well as indirectly from the Fed, Buffett is willing to step aside and keep waiting for the 'fat pitch' rather than invest in a market that is expensive, yet continues to rise.
Berkshire's cash position accounts for over 15% of its total assets – one of the highest among large companies. I don't want to say that having a huge cash pile is an advantage and I would much rather see it invested in a productive and growing asset, but what is important is that Buffett is not affected by the Fear-of-Missing-Out syndrome.
During a 2021 annual meeting, Buffett said that Berkshire would never go below $20bn, although he raised this estimate to $30bn in a quarterly report for 2Q21 period. As Buffett explained, this cash position is needed to allow Berkshire to withstand any calamity and never have to tap emergency funds.
Such focus on protecting downside risks is quite rare. Most executives are willing to borrow to expand their operations or reduce share count which allows them to report better results almost immediately. This can last for a while until some emergency takes place, which sometimes wipes out all the equity (think of airlines in 2020 or banks in 2008).
But great companies can enjoy support of shareholders in their pursuit of long-term value creation at the expense of short-term losses or underperformance. Amazon is probably the best example, but so is Berkshire Hathaway.
By owning Berkshire shares you join the group of like-minded partners with controlling shareholders treating everyone as a partner regardless of their stake, on fair terms.
In his 2018 shareholder letter Buffett wrote:
"A Russian roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company's upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don't risk what they have and need for what they don't have and don't need".
Yet, your gain in only one scenario is so large relative to losses in the other 3 cases, that your mean outcome is positive (your original $100 investment could be worth $240.25 if you win two times in a row and your average value in 4 scenarios is $110.25). This can be said about the overall stock market which rises over time increasing the total wealth of stock market participants but these gains are spread very unevenly with very few collecting most of the wealth at the expense of the majority of participants.
This simple math example shows that avoiding losses is often more important than achieving short-term gains. Another example is this: if you earn 50% on $100, you are worth $150. But if you lose 50%, you would then need to earn 100% to just break even.
One of the key principles of value investing is Margin of Safety introduced by Ben Graham (see my review of his book here and my article on Value Investing here).
Using this principle, I think it is important to have the biggest weight in your portfolio in positions with the highest margin of safety (lowest risk). This principle was mentioned by Joel Greenblatt in the 2020 interview when he attributed his long-term success to his position sizing based on downside potential, whereas most people put most money in stocks with the highest upside.
Buffett has highlighted many times his focus on quality of the underlying business, integrity of management and generally minimising risks to Berkshire by maintaining a very conservative capital structure. Almost all of his and his family net worth is in just one stock – Berkshire Hathaway. Charlie Munger's portfolio is equally concentrated.
Moreover, by being very open about his investment strategy Buffett has managed to bring investors with a similar mindset into Berkshire. Unlike a typical corporation, most of Berkshire shares are held by individual investors, not professional money managers. I don't think you can find many speculators among Berkshire shareholders or investors with a short-term horizon. Other companies may have to choose options with short-term gains at the expense of long-term success due to pressure from shareholders.
This defensiveness and long-term focus can be seen in Buffett's patience with spending cash (over $161bn in 2Q21). Facing competition from a wave of money raised by Private Equity funds, Hedge Funds, SPACs and others as well as indirectly from the Fed, Buffett is willing to step aside and keep waiting for the 'fat pitch' rather than invest in a market that is expensive, yet continues to rise.
Berkshire's cash position accounts for over 15% of its total assets – one of the highest among large companies. I don't want to say that having a huge cash pile is an advantage and I would much rather see it invested in a productive and growing asset, but what is important is that Buffett is not affected by the Fear-of-Missing-Out syndrome.
During a 2021 annual meeting, Buffett said that Berkshire would never go below $20bn, although he raised this estimate to $30bn in a quarterly report for 2Q21 period. As Buffett explained, this cash position is needed to allow Berkshire to withstand any calamity and never have to tap emergency funds.
Such focus on protecting downside risks is quite rare. Most executives are willing to borrow to expand their operations or reduce share count which allows them to report better results almost immediately. This can last for a while until some emergency takes place, which sometimes wipes out all the equity (think of airlines in 2020 or banks in 2008).
But great companies can enjoy support of shareholders in their pursuit of long-term value creation at the expense of short-term losses or underperformance. Amazon is probably the best example, but so is Berkshire Hathaway.
By owning Berkshire shares you join the group of like-minded partners with controlling shareholders treating everyone as a partner regardless of their stake, on fair terms.
In his 2018 shareholder letter Buffett wrote:
"A Russian roulette equation – usually win, occasionally die – may make financial sense for someone who gets a piece of a company's upside but does not share in its downside. But that strategy would be madness for Berkshire. Rational people don't risk what they have and need for what they don't have and don't need".
Capital allocation
I mentioned the importance of capital allocation for generating shareholder returns in my theses on Loews and Exor. In a world where most financial metrics can be downloaded with one click in less than a second, having a low PE multiple or high dividend yield may not be a sufficient reason to own the stock. Since this information is available to most investors, there is probably a serious issue with the company trading on extremely low PE multiple.
What the company does with excess capital is much harder to quantify and requires judgement which computers cannot easily make. Often, the business reaches the critical size in its main industry which then requires the management to make a decision on future direction. Normally, it is this time when returns start to fall rapidly as the company runs out of attractive re-investment opportunities. The main risk is that in pursuit of growth, the management undertakes expensive acquisition especially in a much less known area like a new geographic market or industry. This can be quite harmful for shareholder value.
Berkshire is not immune to this problem. Its book value per share used to grow at 25-30% annual rate during the 1970-1980s, but gradually declined to 10-15%.
However, I still think that by owning Berkshire you automatically benefit from exceptional capital allocation skills of Buffett and his team. I thinks it is a significant advantage that I don't have to decide on whether macro conditions are sound and justify paying X for business Y or should I be trimming my position Z because the rates are going to rise and so on. Not that Buffett operates in such mode, but at least if there is a major correction and many businesses become vulnerable, not only do I know that Berkshire would survive, but I can also expect it to take advantage of the crisis.
Over the past 2 years another important change in capital allocation happened. Buffett decided to be more active in buyback. His previous criterion was for market price to be less than 1.2x of book value for buyback to take place. In 2019, he removed this condition mainly because many private businesses (32% of total assets) have increased their intrinsic value over time but were still shown at old acquisition prices. So over time, the gap between the book value of equity and fair value of Berkshire has widened.
Over the past 12 months Berkshire has spent $30.5bn on buyback reducing its share count by 7%. Importantly, Berkshire's buyback is price sensitive. The company buys more of its stock when the price is low and slows down the pace of buyback when the share price rises. This provides additional downside protection. From a purely technical perspective, shareholders of Berkshire Hathaway should wish for the stock to go down so that the company would spend more in absolute terms and pay less per share (retire more shares). The lower the market price drops, the more NAV per share growth the company can deliver.
What the company does with excess capital is much harder to quantify and requires judgement which computers cannot easily make. Often, the business reaches the critical size in its main industry which then requires the management to make a decision on future direction. Normally, it is this time when returns start to fall rapidly as the company runs out of attractive re-investment opportunities. The main risk is that in pursuit of growth, the management undertakes expensive acquisition especially in a much less known area like a new geographic market or industry. This can be quite harmful for shareholder value.
Berkshire is not immune to this problem. Its book value per share used to grow at 25-30% annual rate during the 1970-1980s, but gradually declined to 10-15%.
However, I still think that by owning Berkshire you automatically benefit from exceptional capital allocation skills of Buffett and his team. I thinks it is a significant advantage that I don't have to decide on whether macro conditions are sound and justify paying X for business Y or should I be trimming my position Z because the rates are going to rise and so on. Not that Buffett operates in such mode, but at least if there is a major correction and many businesses become vulnerable, not only do I know that Berkshire would survive, but I can also expect it to take advantage of the crisis.
Over the past 2 years another important change in capital allocation happened. Buffett decided to be more active in buyback. His previous criterion was for market price to be less than 1.2x of book value for buyback to take place. In 2019, he removed this condition mainly because many private businesses (32% of total assets) have increased their intrinsic value over time but were still shown at old acquisition prices. So over time, the gap between the book value of equity and fair value of Berkshire has widened.
Over the past 12 months Berkshire has spent $30.5bn on buyback reducing its share count by 7%. Importantly, Berkshire's buyback is price sensitive. The company buys more of its stock when the price is low and slows down the pace of buyback when the share price rises. This provides additional downside protection. From a purely technical perspective, shareholders of Berkshire Hathaway should wish for the stock to go down so that the company would spend more in absolute terms and pay less per share (retire more shares). The lower the market price drops, the more NAV per share growth the company can deliver.
Finally, I think it is also worth adding an information advantage of Berkshire which is critical for successful capital allocation decisions, which offsets the disadvantage arising from size. Not only is Buffett a 'learning machine' and has accumulated more knowledge than I by being a more intensive learner and spending over 70 years learning (about a 50-year advantage), but also he is in a much better position to learn new information.
He had lunch with Apple CEO, Tim Cook, before buying Apple shares, for example. Not that it is absolutely necessary to make sound decisions, but having such option definitely helps and this is the option that 90% of regular investors (myself included) simply lack. He also receives hundreds of data points on US economy from a collection of private businesses that Berkshire owns and can tap into the knowledge of their executives (if he wants to learn about a particular sector, product or consumer trend, for example).
He had lunch with Apple CEO, Tim Cook, before buying Apple shares, for example. Not that it is absolutely necessary to make sound decisions, but having such option definitely helps and this is the option that 90% of regular investors (myself included) simply lack. He also receives hundreds of data points on US economy from a collection of private businesses that Berkshire owns and can tap into the knowledge of their executives (if he wants to learn about a particular sector, product or consumer trend, for example).
Partnering with great managers who have skin in the game
I also like Berkshire for its positive exposure to potential inflation risks. If the current pick up in global inflation turns out to be permanent rather than transitory, then owning Berkshire shares can be quite helpful.
Berkshire benefits from rising inflation in a number of ways:
1. Its insurance float can be reinvested at higher rates and generate more income for shareholders.
2. Insurance premiums normally rise with inflation as this is something consumers do not try to save on regardless of macro conditions. During economic recessions, people tend to travel less, so the amount of various insurance claims drops benefiting insurance companies.
3. Berkshire owns two large, regulated businesses – Energy and Railroads. Their tariffs are adjusted for inflation to allow a reasonable return on capital. BNSF (railroad business) carries about 15% (1 out of 7) of all non-local goods in the US regardless of the means of transportation (whether by rail, truck, pipeline, barge or aircraft). This makes BNSF by far the largest carrier in the US.
Berkshire Hathaway Energy (BHE) is also a leading company in its sector with 29 GW of generation capacity, serving 5.2mn retail customers, operating 21,300 miles of gas pipelines with design capacity of 21 bcf/d. Importantly, BHE has committed to invest $18bn until 2030 in upgrade and re-design of outdated transmission lines in the West of US. $5bn has already been spent, leaving $10bn to be invested in the next 10 years.
During the latest annual meeting held in May 2021, Berkshire's Vice Chairman, Greg Abel, announced that the company has already spent over $30bn in renewable business.
4. Berkshire's other businesses (including minority stakes in publicly listed companies like Apple and Coca-Cola) have a strong pricing power through well-known brands. As a result, they have no problem raising prices for customers and enjoy above-average operating margins which protect their earnings from sharp increases in costs.
As for a possible market correction, I have already mentioned that with an active buyback programme in place, shareholders would benefit if Berkshire's share price declines as the company can buy more shares with the amount of dollars and increase NAV per share more. The same logic applies to company's investment operations.
When there is plenty of capital around and prices are high, Berkshire faces steep competition for quality assets and normally remains on the side lines. As a result, in strong market environments Berkshire shareholders have to sit on a large pile of cash which earns close to zero returns. However, when things turn sour like in 2008 and liquidity dries up, Berkshire can take full advantage and use its dry powder to the full benefit.
In fact, Berkshire has outperformed the broader market during the 2020 and 2008 crises (see charts below):
Berkshire benefits from rising inflation in a number of ways:
1. Its insurance float can be reinvested at higher rates and generate more income for shareholders.
2. Insurance premiums normally rise with inflation as this is something consumers do not try to save on regardless of macro conditions. During economic recessions, people tend to travel less, so the amount of various insurance claims drops benefiting insurance companies.
3. Berkshire owns two large, regulated businesses – Energy and Railroads. Their tariffs are adjusted for inflation to allow a reasonable return on capital. BNSF (railroad business) carries about 15% (1 out of 7) of all non-local goods in the US regardless of the means of transportation (whether by rail, truck, pipeline, barge or aircraft). This makes BNSF by far the largest carrier in the US.
Berkshire Hathaway Energy (BHE) is also a leading company in its sector with 29 GW of generation capacity, serving 5.2mn retail customers, operating 21,300 miles of gas pipelines with design capacity of 21 bcf/d. Importantly, BHE has committed to invest $18bn until 2030 in upgrade and re-design of outdated transmission lines in the West of US. $5bn has already been spent, leaving $10bn to be invested in the next 10 years.
During the latest annual meeting held in May 2021, Berkshire's Vice Chairman, Greg Abel, announced that the company has already spent over $30bn in renewable business.
4. Berkshire's other businesses (including minority stakes in publicly listed companies like Apple and Coca-Cola) have a strong pricing power through well-known brands. As a result, they have no problem raising prices for customers and enjoy above-average operating margins which protect their earnings from sharp increases in costs.
As for a possible market correction, I have already mentioned that with an active buyback programme in place, shareholders would benefit if Berkshire's share price declines as the company can buy more shares with the amount of dollars and increase NAV per share more. The same logic applies to company's investment operations.
When there is plenty of capital around and prices are high, Berkshire faces steep competition for quality assets and normally remains on the side lines. As a result, in strong market environments Berkshire shareholders have to sit on a large pile of cash which earns close to zero returns. However, when things turn sour like in 2008 and liquidity dries up, Berkshire can take full advantage and use its dry powder to the full benefit.
In fact, Berkshire has outperformed the broader market during the 2020 and 2008 crises (see charts below):
I would like to finish this point by quoting Warren Buffett's speech said during a 1994 shareholder meeting:
"We're not wishing it on anybody. But if you asked us next month whether Berkshire would be better off if the whole stock market were down 50 percent or where it is now, we would be better off if it was down 50 percent, whether we had any cash on hand now or not, because we would be generating cash to buy things".
"We're not wishing it on anybody. But if you asked us next month whether Berkshire would be better off if the whole stock market were down 50 percent or where it is now, we would be better off if it was down 50 percent, whether we had any cash on hand now or not, because we would be generating cash to buy things".
Hedge against inflation and against market correction
As in any business valuation, I think it is important to understand what returns this business will generate in the future and what price you are paying for it (mainly to make sure you are not overpaying for it). Another important point to remember, of course, is that there is no precise math, rather some reasonable ranges of potential outcomes.
I think the most realistic range of returns that Berkshire's businesses can generate in the future is about 10-12%. In an optimistic scenario, returns could be higher, but there is also a possibility of losses, recessions and most importantly, with growing size ($912bn in total assets as of 30 June 2021) returns would naturally converge to long-term average returns in the economy.
Insurance float (when Berkshire is paid to hold other people's money) can add a further 2-5%, depending on the overall level of interest rates and insurance discipline.
So combined, Berkshire Hathaway could generate 12-17% returns on its capital over the long-term.
Its NAV per share has increased 19.1% since 1964 and its share price has grown by 20.0% annually, on average. So, 12-17% returns going forward seem reasonable.
The second question is what price we are paying for Berkshire's shares and especially whether we are overpaying for them (if the price more than reflects a good growth potential of Berkshire).
To answer this question, I try to evaluate company's NAV in fairly simple and conservative terms and compare it with market valuation. My conclusion is that the current price (c. $430,000 for A shares and $285 for B shares) is about 28% below NAV per share (providing 39% upside).
Here is the summary table of NAV estimate.
I think the most realistic range of returns that Berkshire's businesses can generate in the future is about 10-12%. In an optimistic scenario, returns could be higher, but there is also a possibility of losses, recessions and most importantly, with growing size ($912bn in total assets as of 30 June 2021) returns would naturally converge to long-term average returns in the economy.
Insurance float (when Berkshire is paid to hold other people's money) can add a further 2-5%, depending on the overall level of interest rates and insurance discipline.
So combined, Berkshire Hathaway could generate 12-17% returns on its capital over the long-term.
Its NAV per share has increased 19.1% since 1964 and its share price has grown by 20.0% annually, on average. So, 12-17% returns going forward seem reasonable.
The second question is what price we are paying for Berkshire's shares and especially whether we are overpaying for them (if the price more than reflects a good growth potential of Berkshire).
To answer this question, I try to evaluate company's NAV in fairly simple and conservative terms and compare it with market valuation. My conclusion is that the current price (c. $430,000 for A shares and $285 for B shares) is about 28% below NAV per share (providing 39% upside).
Here is the summary table of NAV estimate.
I break down Berkshire into 4 segments as Buffett himself suggested in his 2018 annual letter. In essence, Berkshire's business has four key segments: 1) Cash; 2) Public securities; 3) Private businesses; 4) Insurance operations.
1) Cash. Berkshire has about $141bn in cash and cash equivalents (Treasury bills) as well as $20bn of fixed income securities (medium-term bonds). I use the book value of $161bn for this segment.
2) Public securities. I also use the book value for this segment which is reported by based on market prices. Berkshire's stock portfolio was worth $308bn as of 30 June 2021. I add the value of equity investments (businesses in which Berkshire owns more than 10%, but does not have full control, like Heinz, Berkadia and a few others). The combined value of Listed investments stands at $324bn.
Obviously, the value of this segment would fluctuate based on market conditions: specifically, it would decline during market correction. But since I take a long-term approach, I don't think this portfolio would be worth less than the current market prices. In fact, one can argue that investors should pay a premium to this portfolio because they benefit from Buffett's portfolio management skills. He can trim positions when markets are too high and buy more shares during corrections. This portfolio would probably be worth less if held by a normal person.
3) Private businesses. I value this segment at $295bn applying 15x PE multiple (c. 25% below current S&P 500 multiple) to $19.7bn annualised profits from this segment. I should note that 2021 earnings will probably be one of the highest in Berkshire's history, so there is some risk that I use an elevated earnings base. However, I am sure that over 3-5 years, Berkshire's earnings from private businesses would be higher. Besides, 15x multiple is fairly conservative given that we deal mostly with industry leaders enjoying strong moats and high returns on capital.
4) Insurance. This is a less straightforward segment. The main value of the business comes from the underwriting profit of insurance which is the difference between all premiums collected and claims paid out over time. As long as Berkshire remains disciplined and can continue to assess risks better than a typical insurance company, it should earn positive underwriting profits over time. Buffett has answered a question on the value of its insurance operations during annual meetings several times. Each time he said that he would not sell this business for the value of the 'float'. The reason is that this float allows Berkshire to generate higher returns in other segments and also because the float keeps rising over time (it was just $23mn in 1970 and is now around $142bn).
Derived NAV per share values of $593 (for Class A) and $396 (for Class B) can be viewed as Base Case valuation. In the near term, if economy falls into recession and asset values depreciate, Berkshire's value (linked to market prices) will decline as well. However, if you use a long-term investment horizon and especially if your personal circumstances are such that you don't have to sell stocks, then short-term declines can be viewed just as signs of volatility and you can comfortably wait until market prices reflect the intrinsic value of the company.
The upside case for Berkshire's valuation could be estimated in very simple terms by applying a 20% premium to the valuation of Listed and Private businesses. This 20% premium can reflect a potential increase in value over time as companies reinvest profits to expand their operations and also distribute dividends / buy back their shares. For Private businesses, this premium implies 18x PE multiple (instead of 15x applied in the Base case).
The value of Class A and Class B shares rises to $672,000 and $448 respectively, which offers 56% and 57%, upside to current market prices.
Another way of proving that you do not overpay for Berkshire at the current market prices is to work out the implied value of Private businesses. If we deduct from Berkshire's market cap ($650bn) its Cash at nominal value ($161bn), Listed investments at market prices ($324bn) and $25bn of possible tax on realised gains (discounted at 30% to reflect time value of tax liability), Insurance float also at nominal value ($142bn), then the implied value of Private businesses would be just $48bn.
This price looks too low for businesses which generated $9.8bn in 1H21 alone (just 2.4x PE based on annualised 1H21 earnings). Even if we forget about the Insurance business for a second, and just take into account Berkshire's Cash and Listed investments, then we are left with $165bn value for Private businesses (or $190/bn if we add potential Tax liability). Even this value looks low for Berkshire's Private assets (less than 10x PE multiple).
One final thought on valuation. I already mentioned that there is no precise math and values can change depending on market conditions. But what is very important and why I particularly like Berkshire in current markets is that this company can increase its NAV during correction. Since it has excess cash, its returns are sub-optimal as cash generates close to zero return. If economy enters recession and asset prices decline, this cash can be deployed quite attractively. Moreover, with $30.5bn of cash spent on buyback in the past 12 months, Berkshire can generate more value if its share price declines as the same amount of capital can buy more shares at lower prices. If and when Berkshire's share price drops, its shareholders should expect a faster decline in share count and consequently a faster growth of NAV per share.
1) Cash. Berkshire has about $141bn in cash and cash equivalents (Treasury bills) as well as $20bn of fixed income securities (medium-term bonds). I use the book value of $161bn for this segment.
2) Public securities. I also use the book value for this segment which is reported by based on market prices. Berkshire's stock portfolio was worth $308bn as of 30 June 2021. I add the value of equity investments (businesses in which Berkshire owns more than 10%, but does not have full control, like Heinz, Berkadia and a few others). The combined value of Listed investments stands at $324bn.
Obviously, the value of this segment would fluctuate based on market conditions: specifically, it would decline during market correction. But since I take a long-term approach, I don't think this portfolio would be worth less than the current market prices. In fact, one can argue that investors should pay a premium to this portfolio because they benefit from Buffett's portfolio management skills. He can trim positions when markets are too high and buy more shares during corrections. This portfolio would probably be worth less if held by a normal person.
3) Private businesses. I value this segment at $295bn applying 15x PE multiple (c. 25% below current S&P 500 multiple) to $19.7bn annualised profits from this segment. I should note that 2021 earnings will probably be one of the highest in Berkshire's history, so there is some risk that I use an elevated earnings base. However, I am sure that over 3-5 years, Berkshire's earnings from private businesses would be higher. Besides, 15x multiple is fairly conservative given that we deal mostly with industry leaders enjoying strong moats and high returns on capital.
4) Insurance. This is a less straightforward segment. The main value of the business comes from the underwriting profit of insurance which is the difference between all premiums collected and claims paid out over time. As long as Berkshire remains disciplined and can continue to assess risks better than a typical insurance company, it should earn positive underwriting profits over time. Buffett has answered a question on the value of its insurance operations during annual meetings several times. Each time he said that he would not sell this business for the value of the 'float'. The reason is that this float allows Berkshire to generate higher returns in other segments and also because the float keeps rising over time (it was just $23mn in 1970 and is now around $142bn).
Derived NAV per share values of $593 (for Class A) and $396 (for Class B) can be viewed as Base Case valuation. In the near term, if economy falls into recession and asset values depreciate, Berkshire's value (linked to market prices) will decline as well. However, if you use a long-term investment horizon and especially if your personal circumstances are such that you don't have to sell stocks, then short-term declines can be viewed just as signs of volatility and you can comfortably wait until market prices reflect the intrinsic value of the company.
The upside case for Berkshire's valuation could be estimated in very simple terms by applying a 20% premium to the valuation of Listed and Private businesses. This 20% premium can reflect a potential increase in value over time as companies reinvest profits to expand their operations and also distribute dividends / buy back their shares. For Private businesses, this premium implies 18x PE multiple (instead of 15x applied in the Base case).
The value of Class A and Class B shares rises to $672,000 and $448 respectively, which offers 56% and 57%, upside to current market prices.
Another way of proving that you do not overpay for Berkshire at the current market prices is to work out the implied value of Private businesses. If we deduct from Berkshire's market cap ($650bn) its Cash at nominal value ($161bn), Listed investments at market prices ($324bn) and $25bn of possible tax on realised gains (discounted at 30% to reflect time value of tax liability), Insurance float also at nominal value ($142bn), then the implied value of Private businesses would be just $48bn.
This price looks too low for businesses which generated $9.8bn in 1H21 alone (just 2.4x PE based on annualised 1H21 earnings). Even if we forget about the Insurance business for a second, and just take into account Berkshire's Cash and Listed investments, then we are left with $165bn value for Private businesses (or $190/bn if we add potential Tax liability). Even this value looks low for Berkshire's Private assets (less than 10x PE multiple).
One final thought on valuation. I already mentioned that there is no precise math and values can change depending on market conditions. But what is very important and why I particularly like Berkshire in current markets is that this company can increase its NAV during correction. Since it has excess cash, its returns are sub-optimal as cash generates close to zero return. If economy enters recession and asset prices decline, this cash can be deployed quite attractively. Moreover, with $30.5bn of cash spent on buyback in the past 12 months, Berkshire can generate more value if its share price declines as the same amount of capital can buy more shares at lower prices. If and when Berkshire's share price drops, its shareholders should expect a faster decline in share count and consequently a faster growth of NAV per share.
Thank you for reading this piece. I hope it was useful. Please consider sharing it with your friends who may also benefit from this.
I would love to hear your thoughts. Feel free to leave your comment in the discussion section below (you will need to register with Disqus, a platform that handles comments, it is free).
I would love to hear your thoughts. Feel free to leave your comment in the discussion section below (you will need to register with Disqus, a platform that handles comments, it is free).
DISCLAIMER: this publication is not investment advice. The main purpose of this publication is to keep track of my thought process to better assess future information and improve my decision making process. Readers should do their own research before making decisions. Information provided here may have become outdated by the time you read it. All content in this document is subject to the copyright of Hidden Value Gems. The author held a position in the stock discussed above at the time of writing. Please read the full version of Disclaimer here.