August 2010 Berkshire Hathaway Price: $78 Research Report by Peter Hughes, Check Capital Management INTRODUCTION Berkshire Hathaway (BRK) is Warren Buffett s investment vehicle. The firm has over 100 different subsidiaries, as well as large investments in several publicly traded firms. Since Buffett took control of the company in 1965, BRK s pershare book value has increased an average of 20.3% per year versus 9.3% per year for the S&P 500. In other words, Buffett $10,000,000 $1,000,000 The Value of $1000 Invested in Berkshire Hathaway Versus the S&P 500 (1965-2010) $100,000 $10,000 $1,000 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 S&P 500 (Including Dividends) 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: BRK 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. 1 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
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 temptation to over-diversify his portfolio, at times being willing to concentrate BRK s net worth in just a few investments. In 1988-89 Buffett put 25% of BRK s entire worth into Coca-Cola stock. In the past 15 years Buffett s strategy shifted again. Instead of investing primarily in stocks, his chief aim now is to buy whole companies. Stock investments now make up only 40% of BRK s net worth, and the percentage attributable to its operating companies has risen to over 30%, from 10% in 1995. The table at right shows BRK s Berkshire's Major Acquisitions (Since 1996) Company Year Price ($B) GEICO (49%) 1996 2.3 FlightSafety 1996 1.5 Dairy Queen 1997 0.6 General Re 1998 16.0 Mid-American Energy (76%) 1999-2003 4.0 Shaw Industries (87%) 2000 2.0 Benjamin Moore Paint 2000 1.0 Johns Manville 2001 1.8 Clayton Homes 2003 1.7 Pacificorp 2005 5.1 Iscar Metalworking (80%) 2006 5.0 Marmon Holdings (60%) 2008 4.5 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 returnson-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. OPERATING UNITS Insurance In many ways this is the core of Berkshire s operations, because it supplies the money that Buffett uses to invest elsewhere. There is a time Insurance Float At End Of 2009 ($B) BH Reinsurance 26.2 General Re 21.0 GEICO 9.6 Other 5.1 Berkshire Total 61.9 2 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
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 $1.1B in net earnings to BRK in 2009. Mid-American has operations in Iowa, the U.K. and several western states. The downside to the utility business is that rates are typically capped by regulators, making high returns-on-capital virtually impossible. However, Buffett believes that he can deploy large amounts of capital at reasonable returns, making the investment worthwhile. Reasonable probably means a return of roughly 10% on invested capital. Manufacturing, Service and Retailing (MSR) This segment encompasses a host of diverse businesses, including furniture retailers, a flooring manufacturer, jewelers, a restaurant and a candy maker. This unit is sensitive to the economy and sustained a 50% decline in earnings from 2008 to 2009. Although Berkshire owns dozens of businesses in the MSR category, each usually occupies a particular market niche and has superior management, enabling it to earn returns superior to those of its competitors. Finance BRK has several subsidiaries whose business consists of leasing or lending some type of product, such as office furniture or containers hauled by trucks and trains. The largest company in this group is Clayton Homes, which manufacturers and finances mobile homes. EQUITY INVESTMENTS BRK has enormous stakes in several publicly traded companies. Although Buffett has signaled a greater interest in buying entire companies, he still buys BRK's Equity Portfolio at 3/31/2010 ($B) Coca-Cola $ 11.0 Wells Fargo $ 10.4 American Express $ 6.3 Procter & Gamble $ 4.7 Kraft Foods $ 3.2 Wesco Financial $ 2.2 Wal-Mart $ 2.2 U.S. Bancorp $ 1.8 ConocoPhillips $ 1.7 Johnson & Johnson $ 1.6 Other $ 15.7 Total $ 60.8 3 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
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 $21.8B in long-term investments and was able to command very good terms on several of them. The deals with Goldman Sachs and GE provide BRK with 10% annual interest, plus warrants to purchase each security at relatively low strike prices. Buffett also invested in municipal and corporate bonds and some common stocks. Six of the investments are listed in the table at right. In retrospect, Buffett wishes he had bought more during the market slide. However, the fact that Berkshire was in a position to buy when virtually all other companies were forced to sell is a testament to the company s strength. RECENT EVENTS Long-term Investments Made During 2008 ($B) Mars/Wrigley 6.5 Goldman Sachs 5.0 General Electric 3.0 Dow Chemical 3.0 Swiss Re 2.8 Other 1.5 Total 21.8 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 earningsper-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. 4 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
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 to be excellent by comparison. Berkshire has several derivatives contracts which can also cause reported results to swing wildly. The firm s derivatives portfolio must be marked-to-market each quarter. In 2009 these accounting adjustments caused reported earnings to fluctuate by more than $1B each quarter, obscuring real operating results. Although BRK has entered into several kinds of derivatives contracts, the largest type is equity puts on major Key Statistics ($B) 2009 Revenue Book Value Market Cap. 2009 Reported Income $112B $147B $178B $8.1B $100 $80 $60 $40 $20 Price 1.5 times Book Value $0 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 2.5 world stock indexes. The contracts expire between 2019 and 2028. 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 would have to pay. Despite generating bad press for BRK, the realistic loss exposure on these contracts is low. Price / Book Value 90 92 94 96 98 00 02 04 06 08 10 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. 5 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777
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 earnings and thus intrinsic value would be substantially higher. The table at right shows the growth of Berkshire s intrinsic value. The operating component is clearly contributing far more to Berkshire s total value than it did 15 years ago. Estimate of Berkshire's Intrinsic Value Value of Intrinsic Investments Operating Earnings Op. Income Value Year Per Share Per Share (P/E = 15) Per Share 1995 $14 $0.12 $2 $16 2005 $50 $1.56 $23 $73 2007 $61 $2.43 $36 $97 2009 $63 $2.19 $33 $96 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. 6 Check Capital Management Inc. Costa Mesa, CA. (714) 641-3579 (800) 710-5777