The Guide to Investing in Stocks and Shares

Berkshire Hathaway

Dan Tebbutt - A Shareworld Contributor

I've recently been looking for some US-based companies to invest in. Until recently I had a large amount of cash tied up in dollars, and I've been wary of having my share portfolio weighted towards the US as well – but now my dollars have now become pounds, with the happy result that I have plenty of cash to invest and the US market is my oyster.

Less happily, my search for fruitful US-based investments has not gone particularly well. I'm looking for reasonably priced shares in safe companies that will do well over the long term. I want an investment that I can put away and forget about for 10 years – trading in and out isn't my style, and particularly not in an unfamiliar market. This leads me on to a number of criteria that I'd ideally like to fulfil:

1. The company has strong cash flows.

2. The company is not too heavily leveraged.

3. The company will not suffer too badly in a high-inflation environment.

4. The management can be trusted.

5. The company provides some diversity to my portfolio.

6. The shares are cheap. I don't mind paying for quality, but I don't want to overpay.

Now, if it wasn't for point 6, I'd have plenty of choice. Coca-Cola, McDonalds, Microsoft, Google and Amazon are a few that spring to mind, and I'm sure I could find dozens of others. Some are cheaper than others - Amazon trades on a breathtaking P/E ratio of 75, McDonalds on only 16 - but I don't consider any of them cheap.

But before I go looking too far, I need to reassess the one US share I already own: Berkshire Hathaway. I bought some B shares at $2400, and they've since risen to $3300 (although the dollar has weakened against the pound, so in sterling terms the rise is less impressive). Perhaps I should increase my stake in Berkshire – or perhaps it has already risen to its fair value, and I should be selling up.

In early March 2009, when I bought my shares in Berkshire, I said “I think fair value is around $3500, possibly more if Berkshire is now holding a substantial number of undervalued securities.” My full reasoning is here: http://dansinvestments.blogspot.com/2009/03/berkshire-annual-report.html. So how did I reach that conclusion? And valuing it again in January 2010, what price will I come to?

Corporate Structure

Although Berkshire is a sprawling conglomerate, it can be neatly divided into two parts: insurance and non-insurance. The insurance operations include a US vehicle insurer (GEICO) and two of the world's largest re-insurers: Berkshire Reinsurance and General Re. The other parts of Berkshire include utilities, retailers, manufacturers and service companies. With its forthcoming purchase of Burlington Northern Santa Fe, it will add a major US railroad to its collection.

The main purpose of the insurance operations within Berkshire is to generate “float”. An insurance company charges premiums up front, and then pays them out over time as claims arise. In the meantime the insurance company holds a bunch of money that it can invest for the benefit of its shareholders – this is its float. Of course if the company continues taking in premiums, then it can maintain or grow that float indefinitely. The difference between the amount the company takes in premiums and the amount it pays in claims is its underwriting profit or loss. Many insurance companies make an underwriting loss, but accept this as the cost of their float. On the whole, Berkshire makes an underwriting profit through it's greater discipline in writing business, and therefore it obtains its float at negative cost.

Berkshire invests its float in equities, bonds, gilts and cash. It owns big chunks of Coca-Cola, American Express, Wells Fargo, Kraft, Proctor & Gamble and many others. It holds preference shares issued during the financial crisis by General Electric, Goldman Sachs and Swiss Re. And Berkshire is rarely without a few tens of billions of dollars of cash, just waiting for the next buying opportunity.

Berkshire's non-insurance operations are a collection of businesses that Buffett has bought because they were reasonably priced, have a sustainable competitive advantage and offer a high return on capital employed. Those are the sorts of companies you want to own. The advantage of having all of these companies under one corporate umbrella is that Buffett can allocate capital amongst them to derive the best return. If one subsidiary earns plenty of cash, but has low growth prospects, then Buffett might divert that cash to a subsidiary which needs funds to expand, or to acquiring another company, or buying bonds. In this way a collection of companies can operate together in a more efficient way than the same companies would on their own.

Share structure

Berkshire Hathaway has 2 classes of share: A and B. At the time of writing (January 2010) an A share was worth 30 times a B share, and there were the equivalent of 1.55m A shares outstanding. That is about to change with the purchase of BNSF, where some new shares will be issued, and the B shares will be split. In this article, for the avoidance of confusion, I'm going to talk only about the A shares.

Valuation #1: Divide and conquer

Now that we understand the structure of Berkshire, we come to the hard part – giving it a value. In my opinion the best way to do this is to divide it into two and value the insurance business separately from the rest.

Let's start with the non-insurance businesses. Their earnings are reported in Berkshire's annual report as $3921 (pre-tax) per Berkshire share. I'm not going to go through them individually, but I'm happy to accept that they are all good quality companies deserving a decent P/E ratio – let's say 16. US Corporation tax is 35%, so the value of $3921 of pre-tax profits is about $41,000.

Next, let's take the insurance business. Berkshire holds about $93,000 of investments per share (as of end September 2009), partly funded by $40,000 of float. How should we value that? I see three approaches:

• One argument is to go by the liquidation value, which is $53,000. But Berkshire has no plans to wind down any time soon, so surely that underestimates the total value?

• Another approach is to look at the float as an interest-free loan that never needs to be paid back, and which comes with few, if any, conditions on how you can spend it. Such a loan is identical to a gift, and that would suggest that the value is $93,000.

• Finally, there is the argument that Berkshire has historically increased its float by about 8% per year, and therefore it is better than a free gift – it's the gift that keeps on giving. Depending how you discount the value of increased float in the future, you can assign an almost arbitrarily high value to it.

I've opted for the middle approach as a reasonable compromise.

Adding the two together, that gives Berkshire shares a value of $134,000.

Valuation #2: Book value

If we look at Berkshire's share price over the last 10 years, and compare it to its book value, there's a remarkably consistent pattern. The multiplier has varied from 1.5 to 1.75, but never deviates far from its average of 1.63. For simplicity's sake let's use 1.6 as the multiplier. On Berkshire's current book value per share of $84,300, that would value them at $135,000.

Valuation #3: Market-adjusted value

This is really a variation of my Divide and Conquer valuation, but first it adjusts the value of Berkshire's investments according the S&P P/E ratio, assuming a long-term average of 18. If the S&P is at 18 then the result is the same as Divide and Conquer. If the S&P is amazingly cheap at a P/E ratio of 9, then this method will double the value of Berkshire's investments before calculating the value.

This tends to smooth out the valuation across market highs and lows. At the end of September 2009 the S&P had a P/E ratio of 19, so this method gave a slightly lower valuation than Divide and Conquer: $127,000.

Value vs price

My 3 valuation methods rate Berkshire at about $130,000 per A share. It's currently trading at $103,600. So in my opinion, it's cheap – unlike every other US share I looked at. It ticks all my boxes except for adding diversification to my portfolio – but Berkshire itself is already so diversified I don't think that's much of a handicap.

Arguments against Berkshire

Of course, if life was this simple then investing would be no fun. Clearly there are plenty of people who'd disagree with my method of valuation, and rate Berkshire much lower (or higher).

One of the key arguments against investing in Berkshire is the age of Buffett and Munger, the chairman and vice chairman. Buffett is almost 80, and Munger has just turned 86. Clearly they're not going to be around forever – and I could well imagine the shares taking a big hit when Buffett retires or dies. Berkshire has prospered over the last 45 years due to Buffett's capital-allocation genius, and whoever replaces him will inevitably be inferior.

Another reason that Berkshire's future returns will be lower than in the past is the sheer size of the company. It has a market cap of over $150bn. If it sustained its historical 20% per year growth rate for another 25 years it would be worth $15 trillion – or roughly the current US GDP.

When Buffett finally does die, his Berkshire shares will go to charity. If that charity wants to spend money, rather than just hoard it, then they will have to sell those shares. Since he owns such a vast amount of the company, that means there will be a huge selling pressure for years (possibly decades) after Buffett dies, which could leave the shares undervalued for the foreseeable future.

Selling a share isn't the only way to extract value. If a share is undervalued for the next 100 years, but pays a decent and growing dividend, then you will reap the rewards without having to sell. But Berkshire don't pay a dividend, and show no sign of wanting to do so.

Some people say that Buffett has lost his touch, and Berkshire is losing its way. They point to the large portfolio of derivatives that Buffett has built up (which were significantly underwater at the start of 2009, but have since recovered in value), and the forthcoming purchase of BNSF as signs of a declining investment sense.

I'm sure there are innumerable other reasons to steer clear of Berkshire, as there are for most shares. Every investor has to make up their own mind – and I'm happy that provided I'm investing for the long term, that I will get a good return from Berkshire Hathaway.

Conclusion

I've convinced myself that Berkshire is still a good place to invest, and that it remains undervalued. I've therefore put my money where my mouth is, and doubled my holding of Berkshire shares. It was already my largest shareholding, and it now forms almost 17% of my portfolio. I may find room for one or two further US shares, but I think for now I'll keep an eye on things and wait for cheaper opportunities in the future.