The Bargain in Berkshire

So we're buying Berkshire Hathaway (BRK.A Quote). Whether or not it was sheer luck, brilliant intuition, hard-nosed financial analysis or some combination thereof, we were in print on the reasons why did not we want to own Berkshire near its highs. I would like to postulate that we will now be in print on buying Berkshire near its lows.

We feel differently now for no other reason than price. As usual, we try to evaluate the operating characteristics of a business, take a reasonable assessment of its prospects in the intermediate future, understand management's game plan and, finally, compare our estimate of the value of the business to its current price. If there is a significant discount, and we can construct a reasonable scenario for why this discount could or should narrow -- ideally while the underlying value is growing -- then we think we have a winner.

Since the only thing that has changed in my opinion of Berkshire Hathaway since I last wrote about it is price, little more needs to be said. Berkshire has changed from a investment company run by a smart guy that happens to own insurance companies to one of the premier financial-service companies in the world that happens to have a very smart guy running the investments.

Investors are paying roughly 1.2 times book value for the premier name in insurance during a bear market for insurance. They are buying perhaps the world's greatest value manager in a bear market for value. I think a conservative re-estimate of fair value is $54,000 per A share, a number which abysmally understates the after-tax value of compounding the current portfolio even at Neanderthalean rates in the low double-digits, as was pointed out in some detail by TSC subscribers. I think the stock sits tight in a rotten market and has a double in it over four years -- if the insurance/reinsurance markets at least don't get any worse.

I realize, of course, that a nice, boring, 20% tax-deferred annualized return is of no interest to anyone but the most stubborn and thick-headed investor, but I think I can make a living out of it. And yes, it would be nice if Warren manages to disappoint cynics and stick around for a few more years. But I think people are grossly underestimating the estate planning accomplished by taking in both Geico and General Re -- even though, in the short run, the insurance operations are acting as a depressant on the value of the company.

In other words, investors are buying a stock with a real business behind it, not the "Warren-is-God" cult. They are starting to get the "obvious" headlines like "Tech Phobia May Topple Buffett," and "Why Everyone's Beating Warren Buffett" -- which are clear signs of the critics piling on near a bottom. At current prices, I would suggest that many of same people buying JDS Uniphase (JDSU Quote) at current prices have officially dumped their "must-own" Berkshire Hathaway bought at $80,000.

I would also suggest that the same must be true of the institutional players who owned General Re -- and thus became unwitting Berkshire shareholders when Buffett bought it. Most holders were value managers, most value managers are doing poorly, ergo most value managers are selling nonperformers in the face of client redemptions, or to save face.

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Which brings us to -- there is no other word for it -- the ridiculous back-and-forth between Mr. Cramer and David Dreman on the topic of value investing. I know the beauty of the Internet is that it does not kill trees to produce such drivel, but watching two investment professionals, each with a long history of success, flail around like drunk shadow boxers is barely even funny. I have tried not to get involved since I have bored enough people over the last few months with why the concept of value makes sense, but one can only stand so much.

Since there has already been lots of verbiage, I will once again turn to some numbers to try to frame the debate. Look at the Frank Russell Company's take on dividing the world into value and growth camps, which they began doing more than 15 years ago. The the Russell 1000 refers to the company's large-cap index composition.

First a few words on index composition: Russell's stinks like nearly everyone else's. What is "growth" and what is "value" has become convoluted beyond recognition. I agree with Cramer that many "value" managers have fallen into the trap of using one tool -- i.e. low P/E or low price-to-book -- to define an entire universe. This can lead to an unhealthy bias towards slowly failing companies and it often misses great discounted cash-flow stories in communications, media, etc.

Accepting Russell's faults as our own for the moment, I looked at the annual performance for each index, a running cumulative-performance number and then a series of rolling five-year returns for value and growth. I highlighted which side was "winning" in blue. As someone thinking rationally might intuitively infer, value and growth trade places -- often for extended periods of time before rolling after. What is also clear is that a dollar invested in value cumulatively outperformed growth for 16 years in a row. It has taken two stupendous years of stomping value for growth to take back the lead.

The point is that "growth" as it is currently defined -- i.e. ignore all valuation considerations and get in on the new, new thing -- is not a forgone conclusion of success. Even with the stomping over the past two years, growth is still within hailing distance of value. It is ridiculous to suggest that because 20 stocks have appreciated a 1,000-fold over the past three years, all or most "growth" stocks will or should. It is also folly to suggest that a manager up 130% in one year is not capable of being down 35% the following year.

It then follows, as numerous studies have shown, that chasing last year's winners, whether they be stocks or money managers, usually leads to poor performance in the ensuing years and vice versa. If Dreman should return shareholder money today, then why shouldn't Cramer's investors have requested theirs after a poor 1998?

And why is David Dreman the god of all value-based managers -- other than the fact that he made the foolish decision to go head-to-head with a fiercely competitive guy who writes four times a day and is coming off a great year when Dreman himself is coming off a rotten year and writes weekly at best? What about Mario Gabelli, Wally Weitz, Bill Miller and the other value greats?

Enough of this. My parting shot is to refer you to the shareholder's letter from the Longleaf Partners funds. While I am clearly not in the business of promoting my competitors, this is an outstanding example of rational, value-based thinking that simply does not go out of style. While I am glad I did not have the year they had, I wish I had written it. Dreman probably does too.