Buffett's a Genius Again

Berkshire shares clear $100,000. Time to bail?
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On Oct. 23, Warren Buffett's Berkshire Hathaway (BRK.A) - Get Report hit a price of $100,000 a share. As far as I can discover, that's the highest price ever for shares of a publicly traded company. The A shares are up about 5,555 times since May 1965, when Buffett took control of what was then a modest textile company.

With that milestone behind the shares, of course, the question now is, will Berkshire Hathaway A become the first $200,000 stock?

Yes. Not a doubt. Remember that you heard it here first: Berkshire Hathaway A will be the first $200,000-per-share stock.

That doesn't mean the stock is a good investment now, however

Why Dump a Winner?

So why sell what is almost certainly going to be the world's first $200,000-a-share stock? Because time is money. The actual value to an investor of that increase from $100,000 to $200,000 a share depends on how long it will take the stock to get there. And quite frankly, the next year or so -- and maybe even longer -- doesn't look especially favorable to Buffett's company.

Simple math tells me Berkshire Hathaway will get to $200,000 a share before any other stock does. Getting to that astronomical price, after all, requires only two things.

First requirement: a steadfast refusal to split the stock. Most companies declare 2-for-1 or 3-for-1 splits whenever they think the share price is getting high enough to discourage investors from buying. Nothing actually changes, of course, since instead of one share worth $100, investors after a 2-for-1 split have two shares worth $50 each.

Not Buffett. He's on record as saying he doesn't believe in stock splits, since a high stock price, he insists, discourages buying by short-term traders. The high price and the limited number of unsplit shares certainly do limit trading. Typically, fewer than 1,000 A shares trade a day.

For the past 10 years investors have also been able to buy B shares in

Berkshire Hathaway New

(BRK.B) - Get Report

that represent 1/30 of an A share and carry no voting rights in the company.

So it's unlikely that any other stock would climb anywhere near Berkshire Hathaway's price before management announced a stock split.

Second requirement: years of appreciation in the price of the stock. Buffett has guided Berkshire Hathaway to an average annual gain of 11% for the past 10 years. If Buffett or his successors could deliver that same appreciation in the years ahead, Berkshire Hathaway A shares would break $200,000 sometime in late 2012 or early 2013.

Gosh, even if the shares gained just 5% a year, the stock would break $200,000 in about 13 years, in 2019. With inflation likely to contribute at least half that rate of appreciation, I think $200,000 by 2019 at the worst is a lock.

Nobody Likes to Wait

To an investor, though, there's a huge difference between $200,000 a share in six years and $200,000 in 13 years. I suspect that investors in Berkshire Hathaway would be very unhappy with a 5% annual return over the next 10 years. Look at the kind of squawking that Buffett's sluggish performance in 2004 (4.2%), 2005 (0.82%) and the first half of 2006 (3% through June 30) elicited.

As I noted in my March 28, 2006, column, "

OK, Bash Buffett -- but Buy His Stock," writers such as Pulitzer Prize winner James Stewart and Jon Markman wondered if Buffett had lost his touch.

To understand why Buffett looked like he'd lost it in March and now looks like a genius again -- and why I'm selling my shares of Berkshire Hathaway today -- you've got to look at how Berkshire Hathaway makes its money.

I'd break down the company's earnings stream into three parts. First and foremost in investors' minds, there are the earnings from investing the huge amounts of cash thrown off by the company's insurance business. Second, there are the earnings from the insurance business itself. And, third, there are the earnings from Berkshire Hathaway's non-insurance operating businesses, such as clothing maker Russell or carpet maker Shaw Industries.

The problem recently hasn't been in that third segment, the non-insurance operating businesses, where 2005 was a good year. Earnings before taxes climbed by 27% from the third quarter of 2004 to the third quarter of 2005. And 2006 has so far been even better, with earnings before taxes from this part of Berkshire Hathaway climbing by 55% from the third quarter of 2005 to the third quarter of 2006.

To be completely fair, part of the growth in the earnings of this segment comes from Berkshire Hathaway's acquisition of new operating companies with cash from its insurance operation. But I think these numbers give you an idea of where the problem isn't.

Insurance Segment Rebounded

Berkshire Hathaway's insurance business was one of the places, on the other hand, where the problem

was

in 2005. From a profit before taxes of $387 million in the third quarter of 2004, the insurance group swung to a loss of $897 million in the third quarter, sometimes called the hurricane quarter, of 2005.

And the rebound in 2006 was remarkable. That $897 million loss turned into a $2.5 billion profit.

Buffett has attributed the turnaround to good luck. Well, partly, since the stunningly good results in the third quarter of 2006 were due to an absence of hurricanes, just as the stunning losses of 2005 had been the result of an overabundance of big storms, including Katrina. That shift reduced the losses that Berkshire Hathaway's insurance businesses had to cover, and, as is typical in the insurance business, the huge losses of one year led to a huge increase in premiums in the next.

But Berkshire Hathaway also took conscious risks in 2006 that led to maximum returns from that "luck." The company decided to aggressively use its financial strength -- Berkshire Hathaway is one of the few companies left with a top credit rating from Standard & Poor's -- to write more business at a time when financially weaker insurers were pulling out of the market.

In some cases, Berkshire Hathaway became the insurer of "only resort" after all other companies refused to underwrite a risk. That let the company reap the maximum advantage from the post-Katrina increase in insurance premiums.

Too Much of a Good Thing

The environment for the company's third leg, investing, has remained a tough one in 2006. Oh, investment gains went up. As you'd expect, the rally in big-company stocks was good to Buffett's portfolio. The increase in unrealized appreciation of investments climbed to $2.7 billion in the September 2006 quarter from $1.2 billion in the third quarter of 2005.

But the real problem for Buffett and Berkshire in recent years hasn't been making money on investments, but finding enough investments to put money into. Despite an active year for Buffett on the investment front, with deals like the acquisition of Internet corporate news outlet Business Wire, Berkshire Hathaway still finished the third quarter of 2006 with $42.2 billion in cash and cash equivalents. That's down only slightly from the $46 billion in cash at the end of the third quarter of 2005.

All that cash is a huge drag on Berkshire Hathaway's performance. It's hard to grow earnings by 10% when you've got $40 billion in cash sitting around earning 4%.

Blame Competition

I'd chalk up Buffett's problem in this segment of Berkshire Hathaway's business not to any diminution of his investing smarts but to too much competition from cheap money. This part of Berkshire Hathaway's business is in essence an investment pool that competes with all the other investment pools interested in buying public companies and taking them private or in providing cash to a public company for a seat on its board and a share of the profits from any turnaround.

Hedge funds and private-equity funds set a record for money raised in 2005, only to easily break it in 2006. The competition among all that money for good deals drives down the returns to investors -- something that is clearly happening right now in commercial real estate.

Disciplined investors like Buffett refuse to play when the potential profit isn't high enough. He's got a major advantage over the funds that raised money on Wall Street for buyouts: He doesn't have a hoard of outside investors clamoring for above-market, short-term returns on their money and forcing the managers of these funds to invest in deals, whether profitable or not, rather than keep their money on the sideline.

That discipline will help Buffett and Berkshire Hathaway investors in the long run. But it sure doesn't do much to solve his excessive-cash problem right now.

Adding up the prospects for these three parts of Berkshire Hathaway, I don't see a good reason to hold onto these shares -- up 20% in 2006 -- and wait for a repeat performance in 2007. The operating companies will continue to do well and expand their revenue despite the exposure of companies such as Shaw Industries to the slumping housing market.

But insurance, as Buffett himself reminded shareholders in the company's third-quarter earnings report, is a cyclical business. Attracted by increased premiums, some of the companies that fled the underwriting market in 2006 will re-enter in 2007. At the least, that will restrain premium increases to less than the jump in 2006. And, of course, there's no guarantee that 2007 will turn out to be as free of natural disasters as 2006 has been to date.

Cheap and Getting Cheaper

I'd swallow my worries about the ebbing of big increases in insurance earnings in 2007 -- if the financial environment looked friendlier for Buffett. The

Federal Reserve

doesn't look likely to raise interest rates in a major way in 2007 or to do much to slow the growth of the money supply. Money, already cheap, might actually get cheaper in the short term, in 2007. Managers of private equity funds with even more money to invest are likely to drive potential returns even lower in their search for deals.

In the past year, Buffett has widened his scope to include more overseas deals, in part to find better opportunities and in part to put on another play on a falling U.S. dollar. But the flood of money seeking deals and driving deal profits lower isn't confined to the U.S.

So I'm going to take my 2006 profits here and patiently wait to see what 2007 will bring. There's a good chance, in my opinion, that by the end of next year I'll be reading new articles arguing that Buffett has lost his touch. At that point, I'll think about jumping on again for the ride to $200,000 a share.Long-term investors -- long term being anything longer than the 12- to 18-month time horizon -- can just hang on through any doldrums.

New Developments on Past Columns

"

Five Buys for a Fourth-Quarter Rally": Fourth-quarter sales momentum looks good for

Garmin

(GRMN) - Get Report

. Store advertising and promotions for the big-shopping Friday after Thanksgiving gave Garmin 32.3% of the ad space devoted to GPS units in store circulars, according to brokerage company Thomas Weisel. Garmin has added distribution of its personal-navigation devices through

Target

(TGT) - Get Report

,

Wal-Mart

(WMT) - Get Report

and

Costco Wholesale

(COST) - Get Report

this year.

That same source notes that their checks of store sales channels show that GPS devices being heavily featured for the holiday season. And it looks like promotional discounting is relatively modest with average discounts of around 20%.

Looking ahead to 2007, Garmin's new marine products are ready to hit stores in January through March, in time for boating season in the northern hemisphere. The company has only 22% or so of the global marine GPS market -- its lowest share of major GPS markets -- and the new products are likely to let the company pick up share.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Berkshire Hathaway and Garmin. He does not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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