Feeling the Pain

This column originally appeared on Real Money Pro at 8:38 a.m. EDT on April 18.

NEW YORK ( Real Money) -- Amid a bunch of routine first-quarter 2012 earnings releases from Intel ( INTC), IBM ( IBM) and others and after the close of trading, Berkshire Hathaway's ( BRK.A)/ ( BRK.B)Warren Buffett announced that he had stage-one prostate cancer. He noted that he "was told by his doctors that his condition "is not remotely life-threatening or even debilitating in any meaningful way."

Here is the company's press release.

My initial response was that I was shocked, and I recognized that this was potentially a very sad and sobering event for Buffett and his family.

I was also shaken, for my mind wandered to some personal memories of my dear (and far-too-young) friends who lost their lives to cancer over the past couple of years: my best pal Petie Lane, TheStreet's own David Morrow, Sanford Bernstein's Jonathan Gray and, most recently, my horse partner and my buddy Andy Grant.

My first thought was that I wanted Warren Buffett to be healthy and to beat the cancer. After all, the avuncular Oracle is an investment icon to me and legions of investors. Moreover, he is enormously charitable and is often a rational voice in a sometimes irrational world (on economics, politics and business). For four decades, I have enjoyed and cherished his annual letters -- especially his quotes (Mae West, Woody Allen, etc.) and sports metaphors (in particular his ample use of Yogi Berra-isms).

Though obviously saddened by the surprise announcement, quite frankly in short order, as I suppose was the reaction of many other Berkshire Hathaway shareholders, my next order of business was to figure out the consequences of the report on Buffett's health on the company's share price. (I had just discussed why Berkshire Hathaway was among my favorite stocks and largest holdings in Monday's "Fast Money Halftime Report.")

I detached myself from the emotional impact of Buffett's announcement and found myself grappling with tables from the U.S. Census Bureau, indicating that a white man in his early 80s in America has about a seven- to eight-year life expectancy (Table 107. Expectation of Life and Expected Deaths by Race, Sex, and Age: 2008).

As Whitney Tilson reminded me in an email, "Buffett isn't average -- he is active (mentally and to a lesser extent physically) and he is surrounded by loved ones, he has low stress, wears a seat belt, etc., etc., etc." Plug those factors into this website, and Whitney argued that "you'll see that the average person with Buffett's characteristics has a 12-year life expectancy."

As I mentioned on "Fast Money" and as I have repeatedly written in columns on Berkshire on Real Money Pro, Berkshire's valuation has declined as:

  • Warren Buffett has aged;
  • Buffett had already began to delegate investment portfolio responsibility to two others;
  • Berkshire Hathaway's size increased (making finding a needle in the haystack and ever more sizeable deals needed to move the needle more difficult); and
  • there was more competition in the M&A arena compared to decades ago, when Buffett effected some of his most important transactions and investments (e.g., Geico and Coca-Cola (KO)).

Reflecting the above concerns, the current valuation of about 1.15x book value is well below its 20-year average of approximately 1.6x and near the lowest price-to-book in years.

From my perch, the cheap valuation reflects that no one can replace Buffett. It is not an easy task to replace the greatest investor of all time. I felt and still feel that a replacement would not be seen in the same light as The Oracle of Omaha (who currently has the imprimatur of being the investment community's white knight), nor would a replacement's accomplishments be anywhere near those of Buffett. Nor would a new executive at the top see the sort of unusual deals that Buffett saw during periods of economic stress ( Goldman Sachs ( GS), General Electric ( GE), Bank of America ( BAC), Marmon, etc.) Buffett has already delegated some of his investment decisions to two other individuals, and The Oracle has chosen (but not disclosed to anyone but Berkshire's Board of Directors) a successor.

In essence, after Buffett, Berkshire Hathaway will likely be run well but not likely as well as over the past five decades.

It was in the context of the difficulty in replacing Buffett as well as his advanced age and other factors (above) that has caused me to have a lower intrinsic value calculation than the valuations arrived at by other analysts and money managers, including Whitney Tilson, who I respect immensely and feel has the best analytical grasp of Berkshire Hathaway. Whitney's analysis takes the full value of the company's cash and investments and adds 10x pretax profits of the noninvestment holdings to produce a $178,000 value per Berkshire A share. By contrast, I have taken an 8% percent haircut to cash and investments, and I use a 7.5 multiplier to noninvestment income and come up with a $151,000 per share value (relative to the share price of approximately $119,000 a share).

Yesterday's announcement has made me increase the haircut modestly to Berkshire's cash and investments and to slightly lower the multiplier to noninvestment profits, leading to a reduced intrinsic value of $140,000- $145,000 per share. This has reduced the appeal of reward vs. risk in Berkshire as an investment.

Bottom line: The appeal of Berkshire's common shares has become more common (to me) with yesterday's news.

Within minutes of Buffett's announcement, the media calls came through to my office, and I appeared (separately) with Whitney Tilson on CNBC's "Fast Money" to explain my above analysis of the situation and further discussed the rationale for my investment response in reducing my holdings in Berkshire Hathaway shares -- I am long the B shares -- in after-hours trading.

I wanted to close today's opening missive with a personal thought.

On May 7, the Monday after Berkshire Hathaway's annual meeting, I will be making a presentation and speaking at Whitney Tilson's Value Investing Congress in the same convention center in Omaha where Warren Buffett will be talking to his shareholders two days earlier. To be honest, I will be taking my pilgrimage to Omaha in three weeks with a heavy heart and a pit in my stomach.

At the time of publication, Kass and/or his funds were long BRK.B and BAC, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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