Berkshire Hathaway Is Safe And Cheap by John Huber
I own Berkshire Hathaway stock. In fact, it’s a stock I bought recently for the first time ever, despite following it for years. I think earlier this year it became (and to a large extent still is) far too cheap. It’s not a stock that I think has huge upside, but it is a stock that I think has no downside. (That said, I do think there is enough upside to get plenty excited). In proper investment parlance, the risk/reward of BRK is tremendous.
Berkshire Hathaway is one of the most talked about stocks in the value investing community, and so I was hesitant to even put a post together, but as I read through the annual report and 10-K a couple weeks ago, I jotted down four main reasons why I think Berkshire is an attractive investment at these prices.
I’ll outline some comments in this post stating why I like the company and the current stock price, and then in a future post or two I might discuss in more detail a few things I noted while reading the annual report and 10-K.
Berkshire is attractive for four general reasons:
- Cash-rich balance sheet
- Strong earning power
- Capital allocation (Buffett’s potential to capitalize on downturns)
- Current stock price—Almost $100 of cash and investments per share and less than 7 times earnings for good businesses with above average ROE’s and a history of strong earnings growth
Note: everything related to per share numbers will be in B shares (which are 1/1500th of A shares).
Berkshire Hathaway's Cash-rich Balance Sheet
Adjusting for the recent Precision Castparts acquisition which was finalized after 12/31/15, Berkshire Hathaway has $98 per share in cash and investments. The balance sheet has an excess cash hoard of around $40 billion, and this cash pile grows at a rate of around $1.25 billion per month (this adds around $15 billion, or $6 per share of cash to the balance sheet each year that Buffett can reallocate or just let build).
Consider this: at the current rate that free cash is building up inside Berkshire, it will take just over 5 quarters to make back the entire amount of cash they used to fund the PCP acquisition (the largest in BRK history).
The balance sheet is one huge competitive advantage for Berkshire. Should trouble develop in the economy or if markets fall apart, Berkshire has the opportunity to create enormous value for shareholders by lending money to firms in need (and extracting a heavy toll for such funding), making acquisitions, buying stocks on the cheap, or even using a few months’ worth of free cash flow to buy back BRK stock if it trades much lower than the current quote.
Strong and Diversified Earning Power
Unlike many conglomerates, Berkshire Hathaway has built a collection of quality compounding machines that produce copious amounts of cash flow that grows over time at a steady clip.
Berkshire’s insurance business (with over $110 billion of stated net worth) is not only the largest insurance company in the world, but also one of the most profitable. It has produced 13 consecutive years of underwriting profits, and while this yearly streak will come to an end at some point as insurance markets continue to soften, over time these collection of assets will remain very profitable. Over this 13-year run the insurance businesses have produced a total of $26 billion of pretax profits for Berkshire and currently hold $88 billion in float—money that has been paid by policyholders and reserved by Berkshire for future claims.
This float is listed on the balance sheet as a liability, but in reality—as long as the insurance business continues to collect premiums and underwrite profitably—it is a valuable asset.
Buffett illustrates this value by calling float a revolving fund—each day Berkshire pays out millions of dollars of claims, which reduces float. But each day millions of dollars of new business is written, which adds to float. As long as policies are written profitably (premiums collectively offset claims and operating expenses), and as long as new premiums coming in replace claims going out, then float will be both interest-free and won’t have to be paid back.
As Buffett said in the recent letter: “Owing $1 that in effect will never leave the premises—because new business is almost certain to deliver a substitute—is worlds different from owing $1 that will go out the door tomorrow and not be replaced.”
So $1 of float is listed on the liabilities side of the balance sheet alongside $1 of debt—but the former is not only free but actually produces profits and will never have to be paid back. This is one reason why Buffett feels the book value (which counts this $88 billion as a full liability) understates the economic value of Berkshire.
Berkshire Hathaway's “Big Five” (BNSF, BH Energy, Marmon, Lubrizol, and Iscar) earned $13.1 billion pretax in 2015. This will soon be the “Big Six” as PCP will be included this year, and if we assume PCP’s earnings this group made over $15 billion. Buffett puts this in perspective in his letter by pointing out that a decade ago only BH Energy existed at Berkshire, and made less than $400 million. So close to $15 billion of earning power has been created in the last decade with virtually no dilution (5 of the Big 6 were purchased all-cash, and BNSF required a minor issuance of new shares).
Earning Power per Share
Including the underwriting profits (but excluding dividend and interest income) from the insurance businesses, Berkshire Hathaway had about $8.20 per share in pretax profits in 2015. If we assume no earnings growth and include the pretax income that Berkshire will receive from PCP, we get to roughly $9 per share of pretax earnings.
Buffett has often talked about the intrinsic value of Berkshire Hathaway and how he and Charlie Munger think about it. They basically think of BRK’s value in two buckets: cash/investments per share and earnings per share. Since 1970, investments per share have compounded at 18.9% annually and earnings per share have grown at 23.4% per year. So it’s no surprise that BRK’s intrinsic value and stock price have also compounded at 20% or so for the past half century.
Of course, these rates of compounding are history, but we can still look at the two buckets and clearly see a huge margin of safety from not only a fortress balance sheet but also an earnings machine that is getting very low valuations at the current stock price.
Attractive Current Valuation
For $140 per share, we are getting $98 of cash and investments, and roughly $9 per share of pretax earning power. So backing out the investments per share, we are paying roughly 4.5 times pretax earnings for Berkshire’s businesses.
At Berkshire’s tax rate of around 30%, this is a P/E of around 6.5 for a diversified group of quality businesses that produce above average returns on equity and—as a group—are growing their earning power. Seems like a good bet.
Buffett once said he likes to pay 10 times pretax earnings for good businesses. I think this is because he thinks the businesses he buys can a) grow their earning power over time, and b) are probably worth somewhat more than 10 times pretax earnings.