August 2010 Berkshire Hathaway Price: $78
Research Report by
Peter Hughes, Check Capital Management
INTRODUCTION
Berkshire Hathaway
(BRK) is Warren The Value of $1000 Invested in Berkshire Hathaway
Buffett’s investment Versus the S&P 500 (1965-2010)
vehicle. The firm has $10,000,000
over 100 different
subsidiaries, as well
as large investments $1,000,000
in several publicly
traded firms. Since $100,000
Buffett took control
of the company in
1965, BRK’s per- $10,000
share book value has
increased an average
$1,000
of 20.3% per year
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
versus 9.3% per year
for the S&P 500. In S&P 500 (Including Dividends) BRK
other words, Buffett
has beaten the market by 11% per year for 45 years. Although Buffett acknowledges that the
firm’s performance will diminish in the future because of its size, the company is still likely to
perform well for a long time. The graph above compares the value of $1000 invested in BRK
and the S&P 500 since 1965 (note that this is a logarithmic scale). In general, this report will use
the price of Berkshire “B” shares, which are 1/1500 the price of “A” shares.
BERKSHIRE’S STRATEGY
Berkshire’s strategy is much different than most other firms. Rather than having precise
quarterly or annual goals, Buffett’s approach has been to wait patiently for extraordinary
investment opportunities and then be prepared to act quickly when those opportunities arise. In
some cases he has waited years between investments. But the underlying strategy is to maximize
Berkshire’s value by investing in undervalued assets. It is useful to understand the key principles
which undergird Buffett’s philosophy:
Intrinsic Value: Buffett always estimates what a business is truly worth and bases his
investment decision on that value.
Margin of Safety: Particularly with publicly traded stocks, Buffett requires that the price
he pays be substantially less than his estimate of its intrinsic value. This greatly increases
the likelihood of the investment proving successful.
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Circle of Competence: Buffett only invests in companies that he understands well and
that he believes will not undergo significant change in the near future. Firms that fall
outside of his circle of competence are avoided.
Patience: Buffett is willing to wait years between investments if good opportunities
aren’t available.
Sustainable Competitive Advantage: Buffett seeks companies which enjoy a niche that
largely insulates them from competition.
With his earliest investments, Buffett favored stocks that were selling at a discount to their book
value. In the 1970s and 1980s, under the influence of his partner Charlie Munger, Buffett moved
towards buying stock in high-quality businesses, which would be able to generate high returns
for many years. Buffett also resisted the
Berkshire's Major Acquisitions (Since 1996)
temptation to over-diversify his portfolio, at
Company Year Price ($B)
times being willing to concentrate BRK’s net
GEICO (49%) 1996 2.3
worth in just a few investments. In 1988-89 FlightSafety 1996 1.5
Buffett put 25% of BRK’s entire worth into Dairy Queen 1997 0.6
Coca-Cola stock. General Re 1998 16.0
Mid-American Energy (76%) 1999-2003 4.0
In the past 15 years Buffett’s strategy shifted Shaw Industries (87%) 2000 2.0
again. Instead of investing primarily in Benjamin Moore Paint 2000 1.0
stocks, his chief aim now is to buy whole Johns Manville 2001 1.8
companies. Stock investments now make up Clayton Homes 2003 1.7
only 40% of BRK’s net worth, and the Pacificorp 2005 5.1
percentage attributable to its operating Iscar Metalworking (80%) 2006 5.0
companies has risen to over 30%, from 10% Marmon Holdings (60%) 2008 4.5
in 1995. The table at right shows BRK’s BNSF (77%) 2010 26.3
largest acquisitions since 1996, but there have been many smaller ones as well. Buffett usually
avoids issuing stock to make acquisitions, fearing that he will dilute the company’s value. He
does not buy companies expecting to change or restructure them, as do private-equity or
leveraged-buyout firms. In fact, he only buys companies where he believes management is
performing well and is willing to remain in place for the foreseeable future. BRK’s subsidiaries
function with near autonomy, except that profits flow to headquarters and are allocated by
Buffett. This probably makes Berkshire the most decentralized large company in the world, as
well as the most diversified. Buffett makes a point not to interject himself in the affairs of one of
his companies unless necessary.
Buffett has also showed a new willingness to invest in companies which produce lower returns-
on-capital than his previous criteria dictated, provided the returns are still reasonable and the
purchase price is low enough. This change of strategy can be seen in BRK’s entry into the
public-utility industry, a business renowned for its steady-but-unexceptional returns.
Insurance Float At End Of 2009 ($B)
OPERATING UNITS BH Reinsurance 26.2
General Re 21.0
Insurance In many ways this is the core of GEICO 9.6
Berkshire’s operations, because it supplies the money Other 5.1
that Buffett uses to invest elsewhere. There is a time Berkshire Total 61.9
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lag between when an insurance company collects a premium and when it pays a claim. During
this interval the insurer can invest the money, or “float.” Thus, even if an insurance company
pays out exactly as much in claims as it takes in with premiums, it can still be profitable as long
as it has use of the float and makes a reasonable rate of return on its investment. In fact, most
insurers pay out more in claims than they take in with premiums (thus operating at an
underwriting loss) but more than offset this loss by investment performance.
Because Buffett is an excellent investor, he has been able to earn far higher returns on the float
than other insurers. Furthermore, Buffett has assembled a group of insurance companies which
tend to show underwriting profits. Having an underwriting profit is tantamount to having an
interest-free loan which Berkshire can invest for further gain.
Berkshire’s specialty is reinsurance, which involves insuring other insurance companies, often
against catastrophic events such as hurricanes. It is not unusual for Berkshire to lose $1B or
more after a major hurricane strikes—but the company is well compensated for that expense.
Another advantage of Berkshire being a reinsurer is that the lag between when it receives a
premium and pays a claim often lasts years. Berkshire has several other insurance subsidiaries,
including vehicle-insurer GEICO. At the end of 2009 BRK had $61.9B in float.
Regulated Utility Business Buffett began to invest in Iowa-based MidAmerican Energy in
1999. Berkshire now owns 89% of the company, which contributed $1.1B in net earnings to
BRK in 2009. Mid-American has operations in Iowa, the U.K. and several western states. The
downside to the utility business is that rates are typically capped by regulators, making high
returns-on-capital virtually impossible. However, Buffett believes that he can deploy large
amounts of capital at “reasonable” returns, making the investment worthwhile. “Reasonable”
probably means a return of roughly 10% on invested capital.
Manufacturing, Service and Retailing (MSR) This segment encompasses a host of diverse
businesses, including furniture retailers, a flooring manufacturer, jewelers, a restaurant and a
candy maker. This unit is sensitive to the economy and sustained a 50% decline in earnings from
2008 to 2009. Although Berkshire owns dozens of businesses in the MSR category, each usually
occupies a particular market niche and has superior management, enabling it to earn returns
superior to those of its competitors.
BRK's Equity Portfolio at 3/31/2010 ($B)
Finance BRK has several subsidiaries whose Coca-Cola $ 11.0
business consists of leasing or lending some type of Wells Fargo $ 10.4
product, such as office furniture or containers hauled American Express $ 6.3
by trucks and trains. The largest company in this Procter & Gamble $ 4.7
group is Clayton Homes, which manufacturers and Kraft Foods $ 3.2
finances mobile homes. Wesco Financial $ 2.2
Wal-Mart $ 2.2
EQUITY INVESTMENTS U.S. Bancorp $ 1.8
ConocoPhillips $ 1.7
BRK has enormous stakes in several publicly traded Johnson & Johnson $ 1.6
companies. Although Buffett has signaled a greater Other $ 15.7
Total $ 60.8
interest in buying entire companies, he still buys
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stocks when exceptional opportunities arise. Berkshire’s larger holdings are shown in the table
on at right. The price of several key “permanent” holdings, notably Coke and Procter & Gamble,
has risen tenfold since Buffett bought them.
BRK DURING THE FINANCIAL CRISIS
Buffett had been criticized for holding a large amount of cash that was earning little interest. In
2008 his patience paid off. With the credit crisis, many financial institutions went bankrupt or
were forced to raise capital at very steep prices. BRK, on the other hand, remained in good
financial condition and was in a position to invest the money it held. During the financial crisis
Buffett invested $21.8B in long-term investments and was able
Long-term Investments
to command very good terms on several of them. The deals
Made During 2008 ($B)
with Goldman Sachs and GE provide BRK with 10% annual
Mars/Wrigley 6.5
interest, plus warrants to purchase each security at relatively
Goldman Sachs 5.0
low strike prices. Buffett also invested in municipal and General Electric 3.0
corporate bonds and some common stocks. Six of the Dow Chemical 3.0
investments are listed in the table at right. In retrospect, Buffett Swiss Re 2.8
wishes he had bought more during the market slide. However, Other 1.5
the fact that Berkshire was in a position to buy when virtually Total 21.8
all other companies were forced to sell is a testament to the
company’s strength.
RECENT EVENTS
On February 12, BRK acquired Burlington Northern Santa Fe Railway (BNSF), the largest
acquisition in Berkshire’s history. The company paid $26B for the 77% of BNSF that it did not
already own. BRKB also assumed $10B in debt. The $26B amounts to 19% of Berkshire’s
year-end net worth.
Buffett considers BNSF similar to a utility company, in the sense that the service provided is a
vital necessity for many customers and competition is relatively low. Both industries also
require larger ongoing capital expenditures than Buffett typically prefers. Railroads have a
substantial fuel-efficiency advantage over trucks, which will likely become more pronounced as
the price of oil rises. BNSF has averaged profits of $1.9B annually over the past four years.
In conjunction with the Burlington Northern acquisition, Berkshire announced that it would split
its “B” shares 50-for-1, making it practical for BNSF shareholders to receive BRK-B shares in
exchange for their railroad shares to facilitate the acquisition. This stock split made BRK stock
liquid enough to be added to the S&P 500 Index, which happened in February 2010. Berkshire
had been by far the largest U.S. company not included in the index.
FINANCIAL METRICS & VALUATION
Normal financial metrics such as return-on-capital, net-income margin and growth in earnings-
per-share are of limited use in measuring Berkshire as a whole. Furthermore, because of its
reinsurance operations, the company’s reported earnings can fluctuate greatly from year to year.
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If several devastating hurricanes occur in the same year, as in 2005, BRK’s results will seem
poor even if the underlying businesses are performing well. If the next hurricane season is mild,
company results will appear
Key Statistics ($B)
to be excellent by comparison. 2009 Revenue Book Value Market Cap. 2009 Reported Income
$112B $147B $178B $8.1B
Berkshire has several
derivatives contracts which can also $100
cause reported results to swing wildly. $80 Price
The firm’s derivatives portfolio must 1.5 times Book Value
be marked-to-market each quarter. In $60
2009 these accounting adjustments
caused reported earnings to fluctuate $40
by more than $1B each quarter, $20
obscuring real operating results.
Although BRK has entered into several $0
kinds of derivatives contracts, the 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09
largest type is equity puts on major 2.5
world stock indexes. The contracts
expire between 2019 and 2028. Price / Book Value
Berkshire would be forced to pay on the 2
contracts if, on their expiration date, the
indexes are trading below where they
were when the contract was created 1.5
(around 2008). Given the long period
before expiration, even slight growth in
the stock indexes would place them well
1
above the point at which Berkshire
90 92 94 96 98 00 02 04 06 08 10
would have to pay. Despite generating
bad press for BRK, the realistic loss exposure on these contracts is low.
Berkshire’s diversity causes it to defy easy measurement and valuation. The best single metric
for assessing BRK’s performance and intrinsic value is book value. The extent to which book
value changes over a period of years is the foremost indicator of the firm's performance.
Likewise, book value at any juncture provides guidance about what the stock is worth. BRK’s
book value has declined in only two years (2001 and 2008) since Buffett became CEO in 1965.
With Berkshire becoming more of an operating company, especially with its recent acquisition of
Burlington Northern, the chance of book value falling in any one year has been reduced
substantially.
Buffett has long stated that Berkshire’s intrinsic value is higher than its book value.
Furthermore, the stock has not traded below book value for at least 30 years. Because Berkshire
is composed of a number of high-return businesses, it is reasonable for the stock to trade at a
significant premium to book value, which is now $60 per B share. Over the past 10 years
Berkshire has typically traded at between 1.3 and 1.7 times its book value, averaging 1.5.
Currently the stock trades at 1.3 times its book value. The graphs on the previous page show that
Berkshire’s price relative to book value is near the low end of its valuation range since 1990.
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An alternate method of valuing Berkshire also suggests the stock is undervalued. In this
analysis, the company is divided into an investment component and an operating component. To
arrive at this valuation, Berkshire’s investment portfolio is divided by the number of outstanding
shares. For the operational component, the firm’s operating-earnings-per-share are given a
moderate market multiple (P/E of 15). This analysis suggests an intrinsic value of $96 per B
share, suggesting the stock is close to 20% undervalued. It is noteworthy that this analysis is
calculated using 2009 earnings, which were depressed for many of Berkshire’s businesses. In a
more typical year, operating
Estimate of Berkshire's Intrinsic Value
earnings—and thus intrinsic
Value of Intrinsic
value—would be substan-
Investments Operating Earnings Op. Income Value
tially higher. The table at
Year Per Share Per Share (P/E = 15) Per Share
right shows the growth of
Berkshire’s intrinsic value. 1995 $14 $0.12 $2 $16
The operating component is 2005 $50 $1.56 $23 $73
clearly contributing far more 2007 $61 $2.43 $36 $97
to Berkshire’s total value than 2009 $63 $2.19 $33 $96
it did 15 years ago.
In summary, Berkshire is an extremely diversified, conservatively managed company led by the
greatest investor of all time. Warren Buffett has consciously designed the company to succeed
long after his death. The company’s ability to prosper during the recent stock market crash and
credit crisis demonstrates its strength. The current stock price is below reasonable estimates of
the firm’s intrinsic value. Based on these factors, the stock price at the time of this writing
appears to represent a good entry point for long-term investors.
CCM Research Reports are for informational purposes only and are not an offer to sell or a solicitation to buy.
They are not personal recommendations for any particular investor and do not take into account the financial
circumstances of any individual investor. Check Capital, or one of its officers, may have a position in the securities
discussed and may purchase or sell such securities from time to time. CCM Research Reports are created using
third-party data. While Check Capital believes such third-party information is reliable, we do not guarantee its
accuracy, timeliness or completeness.
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