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Investment

Increased stake in Berkshire Hathaway

5 Aug 2011 by Jim Fickett.

In February I put 3% of the portfolio in Berkshire Hathaway (BRK). This morning I raised the position to 5%. Most of the negative news about BRK is wrongheaded, however the negative comments have scared some investors and the price is down significantly. In my view value will continue to grow, and the current price makes it a bargain.

In February my reasoning was:

Berkshire Hathaway's growth has beaten that of the S&P 500, including dividends, in every 5-year period since inception. It is also a fairly safe investment, in that no 5-year period has given negative growth. Now may be a good entry point, as the price-to-book ratio is currently quite low compared to the last 25 years.

Well, a low price never means something can't go lower, and the stock is cheaper still now. Let's review some of the positives and negatives.

One of the greatest strengths of BRK is that Buffet understands how to reinvest profits to build long-term value. He very often speaks about the importance of cash, the large quantity of cash thrown off by his businesses, and the value of BRK taking excess cash from each business and deciding, from a very broad perspective, where best to invest it. Here is a graph of cash flow from operations over the last 18 years:

The strategy of reinvesting excess cash in strong businesses, in order to produce yet more cash, has paid off quite handsomely.

I would add that Buffet is also distinguished from many managers in that he understands how not to destroy a good thing. During my 10 years in pharma, I often saw small companies bought, absorbed, and then destroyed by the bureaucracy and internal turf wars of the buyer. I went through a number of mergers, and watched while productive work slowed drastically for months in the reorganizations, layoffs, and process changes that resulted. Buffet does extract a price when he buys a company – he retains final authority over large capital expenditures, and he takes the excess cash. But he leaves the business alone. Managers are not called to central strategy and coordination meetings, there is no BRK-wide HR or legal department, no single retirement plan, no uniform IT. Some would say this is very inefficient and ignores possible synergies. I would say he understands how not to destroy businesses.

Overall, I think BRK will continue to preserve and create real value, and will likely continue to grow significantly faster than inflation, and significantly faster than the S&P.

So why is the price down? There is, of course, never a really good answer to such a question. The market has many participants, and no one can ever know what most of them are thinking. But there are negative comments here and there, which may give some idea of various investor worries. I attempt to address some of these next.

Perhaps the best justification for negative sentiment is that insurance is an unpredictable business and, while most BRK insurance underwriting has been profitable in the long run, the last few months have been tough. Three major disasters in the first quarter cost the company perhaps $1.7bn. This has hit the stock psychologically, and it is indeed important for this year's results. But compared to the market value of BRK – $180bn – this is not overwhelming, and periods of high losses are typically followed by periods of higher premiums. The insurance business will return to profitability.

Mike Shedlock attacks the book value argument:

Take a look at Citigroup. Yahoo Finance reports Citigroup Trades at Price/Book of .64

Lovely. Had you bought at price to book of 1.0 (a tremendous “value” to many) you would be 36 percent in the hole.

Take a look Bank of America. Yahoo Finance reports Bank of America Trades at Price/Book of .50

Had you bought Bank of America at “book value” you would be down 50%. …

Does “book value” constitutes real value? How much of the book value of Citigroup and Bank of America is based on nonsensical not marked-to-market holdings? …

The second problem is book values may be overstated. Does anyone really believe the book value of Citigroup or Bank of America? On the same basis, why should anyone believe the book value of Berkshire?

Shedlock is a smart guy, but comparing BRK and Bank of America is wide of the mark. Unlike BofA, which made idiotic mortgage loans itself and was stupid enough to buy Countrywide, Buffett buys solid balance sheets – utility companies, a railroad, and stock in Coca Cola. No one ever knows completely what may be hiding in the accounts of a company, but there is no evidence of Buffet underwriting foolish insurance policies, investing in labyrinthine CDOs, or buying financials with inflated valuations. The worst thing I can find on BRK's balance sheet is a large position in the stock of Wells Fargo (a rare example where I disagree with Buffett's judgement). But Wells Fargo stock price has been much, much more stable than that of BofA or Citi, probably reflecting more confidence in its accounting and, even if Wells is hiding major problems, this represents only a tenth of BRK's book value.

Probably the biggest worry I have about BRK is that Buffett sometimes puts himself above his own rules. An example of this that many people called him on was that after sharply criticizing derivatives in general, he took some derivative bets himself, and then assured his fans it was all ok because he had seen to the solidity of the bets himself. In this case, it probably was ok, and a hint of arrogance now and then is hardly a surprise in someone this successful. Still, the issues with David Sokol suggest that the tendency to overlook the rules might be catching, and could lead to serious trouble. I did, like many others, find the episode with Sokol's insider trading troubling, and was unhappy that it took Buffett quite a while to come around and handle the problem transparently. But in the end the issue with Sokol was resolved fairly cleanly, and I do not see any other serious problems with this side of Buffett's personality.

The issue of succession worries many investors. The many businesses within BRK are solidly run now, with relatively little oversight from Buffett and Munger. I suspect that when the duo are gone, the culture will continue to exert an influence for a long time, and the various businesses will continue to be well run. Where the magic touch will be missed is in new investments. The quality of new investments will be good, but not as good as before, and results will slowly move closer to average. That will, though, take a long time.

Over the years 2004-2008, Buffett insured unnamed counterparties against the possibility of stock markets being lower at certain dates ranging from 2019 to 2028. The bets say nothing about intervening values, and only insure against markets being lower at the end of the contract term than at the beginning. In the interim, though, mark-to-market accounting does cause these bets to impact earnings negatively at times, and these paper losses worry some people:

Berkshire’s equity-index derivatives, tied to the S&P 500, Japan’s Nikkei 225 Stock Average, the Eurostoxx 50 Index, the U.K.’s FTSE 100, were recorded as a $6.5 billion liability as of March 31. The liability was $7.1 billion a year earlier.

Nevertheless, these are quite safe bets for the long-term, for two reasons: first that inflation and world economic growth raise the nominal numbers over time, and second that Buffett gets large premiums to invest in the meantime, so that even if some of the bets turn out badly, he will be ahead. The Globe and Mail explains concisely that the drop in earnings is all on paper, while the positive cash flow is large and real. It really will be very surprising if BRK loses money.

This summer, Stifel, Nicolaus & Co. analyst Meyer Shields put an almost-unheard-of sell recommendation on Berkshire, largely because of the derivatives. “I don’t know that any investors that I’ve spoken to think that this is the best use of capital,” he said. Keefe, Bruyette & Woods also criticized the strategy. “It brings an element of volatility to quarterly results that I think people don’t like,” said insurance analyst Clifford Gallant.

Buffett’s response: guilty as charged, with a Cheshire cat grin. As he’s explained in annual report after annual report, the puts are supposed to deliver short-term earnings volatility. It’s the whole point of the trade. Buffett is renting out earnings stability to other companies—and being paid ridiculously large cash premiums for the service. In exchange, he’s accepting higher volatility in Berkshire’s short-term earnings, in the form of non-cash accounting charges brought on by fluctuations in the value of the long-dated contracts. But the premiums are so fat that they will boost Berkshire’s real, long-term returns. …

Berkshire was paid about $5 billion in premiums up front. Let’s assume that Berkshire can earn an 8.3% annual return on that money. (That’s the average annual increase in Berkshire’s book value per share over the past 10 years—its least successful decade ever.) Also assume that the contracts have an average maturity of 17.5 years. (They were written with maturities of between 15 and 20 years.) For Berkshire to lose money, stock markets in 2019-’28 would have to be down more than 50% from 2004-’08 levels.

What if the indexes are 25% below their pre-2008-crash peaks? Berkshire’s profit will exceed $10 billion—on an initial investment of zero. Every cent invested was somebody else’s money.

The long-dated equity puts are classic Buffett: a patient, low-risk strategy that exploits mispricing and market irrationality, and that’s brave when others are fearful.

Given that results have come down from spectacular in the early days, to very good recently, the stock should probably not command a large premium. In fact, the current price reflects no premium at all, or a negative one. Today the (current)-price-to-(end-of-2010)-book ratio is about 1.08, extremely low (1) by historical standards, (2) by comparison with the S&P 500, whose price-to-book is over 2, and (3) low by comparison with the insurance industry (since BRK's biggest business is insurance), where the historical price-to-book in the neighborhood of 1.4.