The Berkshire Hathaway (BRK.A) - Get BRK.A Report annual meeting was a few months ago and many of you probably got your fill of reading about " Warren Buffett this and Warren Buffett that." I know I did.
But I think enough time has gone by to share some thoughts on Berkshire, especially since I would like to stop lugging around the annual report and
"seminal" analyst report on Berkshire that has been weighing down my briefcase for the past three months.
That report pegs the value of a share of Berkshire -- an A share -- at a lofty $91,000. The problem is I'm still coming up with numbers a good deal lower than even the stock's current value, which is only $69,000 per share. Given that we only own Berkshire in some of our clients' taxable accounts where the cost base is very low, I realize that, once again, I have spent way too much time obsessing over this discrepancy.
So why bother you with the issue? Well, for one thing, the stock is closer to reasonable than it was a year ago. The "buy-and-die" attitude of many Berkshire holders, Buffet's infrequent use of investment bankers and his refusal to play analyst earnings games all make Berkshire a woefully underfollowed and a conceptually misunderstood equity worthy of our attention at least once a year.
Add to that the fact that Buffet has also put together one of the world's most stunning records of wealth creation in the postwar era. So unless you have your investing head buried in
discussion groups for hours at a time, it is worth taking a half hour to consider the activities of arguably the best investor of the 20th century.
Despite Buffet's decent and welcome attempts to present a fair picture of what is really happening under the cover of Berkshire, the fact still remains that this is an insurance company, a closed-end mutual fund and a
Kohlberg Kravis Roberts
operating fund sans leverage all wrapped in Buffet's highly effective personality cult. In other words, there is not a clean way to value Berkshire.
Despite these hurdles, analyst Alice Schroeder of Paine Webber put together a 55-page tome in reverence to Berkshire and Buffet at the end of last year. Interestingly, she allegedly had and continues to have access to The Great One in a way that few on Wall Street have. Her conclusion was that Berkshire was worth about $91,000 per share and therefore was, and still is, a bargain.
I would like to note that this is somewhat complicated stuff and it is not necessarily fair to critique Ms. Schroeder and Paine Webber in a mere 900 words. It is also impossible for me to go into huge depth with my own numbers, so you must take a little on faith. But I think there were two key flaws in Schroeder's analysis that caused our valuations to vary so widely.
Discrepancy No. 1
The first and biggest issue is the discount rate. While Schroeder and I used five different valuation analyses between us to come up with a value for Berkshire, the main driver was a discounted cash flow model driven by the amount of "float" generated by Berkshire's insurance operations. As noted previously in these columns, float is a massaged number representing a rough estimate of excess cash that is "kept" by an insurer reporting an underwriting profit. If you generate positive float, you are in effect being paid to be in business. If you are negative, you are paying for the right to be there. Berkshire's ability to generate huge amounts of positive float -- i.e. free money -- over a long period is the key to its investment results -- and thus, arguably, its value.
So at what rate do you discount an estimate of the future value of the float? Schroeder used 5.3%, which was, at the time, the yield to maturity on the 30-year Treasury bond. Not so coincidentally, it is also the basis allegedly used by Buffett, when he asks why should
be considered riskier than T-bonds?
Nevertheless, many practitioners, both academic and otherwise, advocate using a discount rate that reflects the possibility that most stocks do have more risk than a fixed-income security -- thus the T-bond plus some sort of equity risk premium. As we all know, the higher the discount rate used, the lower the value in your valuation.
In my humble opinion, using 5.3% is neither accurate nor provides a "margin of safety." First off, it is now 6%, which knocks $10,000 or so Berkshire's price. Secondly, an insurance company is not Coca Cola: It's not a bullet-proof franchise with highly visible estimates of cash flow but a risk-and-probability business. Things can go wrong in a big way and for a few years in a row, even if you run three of the six best insurance companies in the world as Berkshire does.
If you reflect this by adding a modest 200 basis points to the T-bond yield, thus using a discount rate of 8% today instead of 6%, that is the difference between the $91,000 per share Schroeder calculates and the $60,000-ish that I come up with.
Discrepancy No. 2
The other big issue is somewhat related. Schroeder takes the current amount of the float, assumes it grows in a straight line for the next 10 years and then discounts it back to the present. Why is that a problem? Once again, this is not Coca-Cola, this is the insurance business.
Despite Berkshire's excellent fortune over the past few years avoiding catastrophic losses, the odds are highly in favor of at least one bad year over the next 10 years. In other words, it is certainly not inconceivable to have an earthquake, a few floods, a satellite crash, a bond default or even some nationalized industries all in one year -- any of which could produce a large underwriting loss and negative float. Buffet admits to even higher chances of a few rotten years. So it is overly optimistic in my view to value Berkshire's insurance business on the base case of having 10 years in a row of perfect, disaster-free numbers.
Using these figures, I can't come near Paine Webber's estimate of $91,000 per share, nor do I even come that close to the current price of $70,000. What I do attempt to do is to come up with some hard numbers for the value of the business, and (forgetting for a moment who runs Berkshire), see if the "Buffett/Munger" premium can be justified on the basis of investing smarts. Here are three ways to do this:
Method No. 1:
Pretend Berkshire is just another collection of insurance companies. Take the value of the Berkshire equity holdings, assuming liquidation and payment of capital-gains taxes and reinvest this sum in fixed income as is generally common for most insurers. Calculate the present value of the investment cash flow and underwriting profit for the next 10 years (but include one rotten year of losses in the fifth year). Add to this the discounted cash flow value of the operating businesses, which we estimate to be $7,700 per share. Total appraised value for Berkshire: $52,000 per A share, making the premium that the market places on the Buffet/Munger gray matter $17,000 per share, or $25.5 billion.
Method No. 2:
Spin off the untaxed equity portfolio to shareholders, and add to that the discounted cash-flow value of the remaining "normal" insurance company and the operating companies. Total appraised value for Berkshire: $59,000 per A share, making the premium that the market places on the Buffet/Munger gray matter $9,500 per share, or $14.2 billion.
Method No. 3:
Very simple book value analysis. (You get what you pay for, but it's a decent reality check sometimes.)
- Current book value per share: $38,105
- 5-year estimated book value growth: 15%
- Current price to book value: 1.9
- Projected price to book value: 2.5
- Present value price per share: $79,000.
Take a rough average of the three methods at current interest rates,
a 200-basis-point risk premium, and you get about $63,300, which I think is generous.
The bigger picture is that Buffett has been able to acquire on very favorable terms (too favorable in the opinion of a former
shareholder!) some of the world's best insurance assets. He's got a stellar reputation to do acquisitions of operating businesses at prices where others can't, because ... well ... he's Warren Buffett.
Nevertheless, he's got a boatload of cash in what I still consider to be a dangerous market. To say that "it's over" because he is in the middle of a couple of poor investment years due to the poor value on his big-five holdings is ridiculous. If you disagree, send your 10-year performance numbers to
me and see if they compare.
Still, I think the "big" days are over. Not that 15% annualized is anything to sneeze over -- I'll take it. But shareholders can't have it both ways: A bearish chairman can't grow a portfolio with a $100 billion market capitalization at 23%. And if he can't, then shareholders really have to question whether the Buffett/Munger premium is worth it, after all.
Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with about $1 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value fund. At time of publication, RCB held a position in Berkshire Hathaway, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at