Semper Augustus Investments Group’s annual letter for the year ended December 31, 2015.
Value Investing World says:
For all fans and followers of Berkshire Hathaway, this is a must-read. I’ve known and have been friends with Chris Bloomstran for several years and on February 1st of this year, he released his annual letter to clients, which is now available on the Semper Augustus website. It’s a colossal 70-page effort, of which the majority is the best deep-dive into Berkshire Hathaway and its valuation that I’ve seen. He views some things differently from what often gets reported (such as the Gen Re and Burlington Northern acquisitions), and I really appreciate the effort he put into this. And if any readers happen to know the journalists asking questions at the Berkshire Hathaway Annual Meeting this year, please try and get this in their hands!
Stone House Capital Partners returned 4.1% for September, bringing its year-to-date return to 72% net. The S&P 500 is up 14.3% for the first nine months of the year. Q3 2021 hedge fund letters, conferences and more Stone House follows a value-based, long-long term and concentrated investment approach focusing on companies rather than the market Read More
Semper Augustus - Party Like It's Nineteen Ninety-Nine: Bad Breadth, Intrinsic Value, And A Deep Dive Into Berkshire Hathaway
I was dreamin’ when I wrote this, forgive me if it goes astray;
But when I woke up this mornin’, could’ve sworn it was judgment day.
The sky was all purple, there were people runnin’ everywhere;
Tryin’ to run from the destruction, you know I didn’t even care.
Say two thousand zero zero party over, oops, out of time;
So tonight I’m gonna party like its nineteen ninety-nine - Prince
2015 went out with shades of 1999. The Federal Reserve raised interest rates, Luke Skywalker owned the box office, and a narrowing group of popular and increasingly overvalued stocks led the market to new highs, while the majority of stocks, including Berkshire Hathaway, lost altitude.
This year’s Semper Augustus letter begins with an overview of the unfolding deterioration of breadth in the stock market. It compares the current bifurcation to the period leading up to the 2000 bubble, then discusses our intrinsic value model, a tool we created in March 2000 that demonstrates the degree to which the S&P 500 is nearly as overvalued today as it was then. We ruminate about a group of four highflying tech names known fondly as the FANG’s (Facebook, Amazon, Netflix and Google). We sense they will be licking major wounds going forward. Finally we examine Berkshire Hathaway, our largest holding, in detail so deep that it would put both Warren Buffett and Charlie Munger to sleep, permanently. We address last year’s 12.5% decline in the stock and what it means for expected returns going forward. The report describes multiple approaches we use to value the business. It is a lengthy analysis; so long in fact, that the competition’s drumming pink bunny can’t keep going and going. The bottom line: Berkshire is increasingly durable and the stock is considerably undervalued. We expect to earn 8% to 12% per year depending on multiple expansion for at least the next decade and a half holding Berkshire, and the shares may earn double the return produced by the S&P 500. Berkshire is trading at 70% of intrinsic value, giving it 45% upside from today, just to get to fair value.
Semper Augustus - Breadth Leading Up To The 2000 Bubble Peak, And Today...
Yogi Berra’s best malapropisms and expressions lacking logic included:
- The future ain’t what it used to be.
- No one goes there nowadays, it’s too crowded.
- You can observe a lot just by watching.
- It ain’t over till it’s over.
- When you come to a fork in the road, take it.
- It’s like deja vu all over again.
Each of these “Yogiisms” fits today’s investment climate. The last is extremely apt here at the outset of 2016. The run-up to the bubble that burst in early 2000 involved such excesses and extremes that we really believed we’d never again see anything like it again. Well, history repeats, or at least rhymes, and in the words of Yogi, “It’s like déjà vu all over again.” Valuations and market behavior are frighteningly similar to what we saw in the late 1990’s, even more extreme in some cases. The number of stocks moving down has exceeded those moving ahead since May. EVERY major stock market decline since 1929 was preceded by a breakdown in breadth leading up to each market peak. While we saw such divergence in late 2007 through the fall of 2008, the episode leading up to 2000’s market peak is worth revisiting.
A Look Back at 1999
The stock market bubble peaked on March 10, 2000, with the NASDAQ closing at 5,048. The S&P 500 peaked two weeks later at 1,553, trading for about 40 times normalized earnings. The NASDAQ, dominated by high-flying tech and Internet shares, traded at an unbelievable 242 times earnings. We have fond memories of March 10, 2000, because from that day forward, for the first two years of the market collapse, which took the S&P down 50% and the NASDAQ by more than 80%, our stocks essentially went straight up. Under the surface, the market was breaking down long before March 10.
The late 1990’s were brutal for value-oriented investors. We launched Semper Augustus in late 1998 and managed to generate decent gains on the stocks in our portfolios, keeping pace with the S&P in 1999. But we were so far behind the 84% posted by the NASDAQ that the pressure to own and chase the tech names that were making everybody else “richer” was enormous. The first 70 days of 2000 were brutal. The markets, led by the insanely overvalued tech names, marched higher on a daily basis, while nearly every stock we owned was in decline. Investors liquidated real businesses with real value for the names creating arguably the greatest bubbles in capital markets history. Janus’ stock funds, all loaded with the same inflated tech names, were getting half of all of the money flowing into the entire mutual fund complex during the six months leading up to the March 10 peak. When the “markets” blew up, Janus blew up.
It took enormous effort to keep clients from chasing the tech bubble. We had cash on hand and as the stocks of real businesses got cheaper and cheaper, we put money to work at increasingly favorable prices. Several of our buys from that period we still own today. But it took every bit of energy we had to keep our clients on board and confident in the quality of businesses we were buying and in our favorable expectations, regardless of what the S&P or the NASDAQ did.
We penned a client letter in July 1999 titled, Large Cap Stocks Still Overvalued; Some Bargains in Small-Caps and Mid-Caps. The letter discussed a breakdown in breadth, the bifurcation in the market as a small handful of names drove the markets higher while the average stock lagged behind, many declining in price. The blue chips, the GE’s, Coca-Cola’s, Wal-Mart’s and Exxon’s - the “new nifty fifty,” peaked at over 40 times earnings during 1998. Tech heavy indices continued to defy logic, narrowing through the remainder of 1999 and into early 2000. Tech, media and Internet stocks led the way toward the end of the advance. Everything unrelated to tech or telecom was in decline while tech sprinted ahead.
Our stocks managed to keep pace with the S&P 500’s 21% gain during 1999, but the NASDAQ was up an incredible 84%. We had lots of cash on hand, which muted our portfolio gains even more. As breadth deteriorated, we were able to put money to work. Toward the end of the bubble, in early March of 2000, nearly everything we owned fell. On the morning of March 10, the day of the peak, I was sitting at my desk literally shaking as Microsoft, Sun Microsystems, Lucent, Cisco and Pets.com screamed upward as our portfolio names bled red. To maintain sanity I wrote a piece for Alan Abelson at Barron’s which pointed out the market cap of the NASDAQ was set to pass that of the NYSE, yet the businesses on the NASDAQ generated less than 10% of the profits of those on the big board. The P/E ratio of the NASDAQ was 242 while that of the S&P was over 40. We had a portfolio trading for less than 15 times earnings, and it was falling fast on that day.
Then, it ended. Everything changed. The NASDAQ went red; my screen went green. We went on to post positive gains during the bear market that ensued, which took the S&P down by 50% and the NASDAQ by 80%. Late in the 2000-2002 rout, the Federal Reserve intervened, talking about “helicopter drops” of money and lowering Fed Funds to 3%. This sounds absurdly high by today’s standards. Thanks, Ben. Short-term rates stayed at 3% for several years until the real estate bubble fully developed and the S&P, at least, by 2007 had recovered all of its losses. Then, in 2007, a breakdown in breadth began again, setting the stage for the 2008-2009 crisis. The movie began anew…
Fast Forward to 2015
We could well have written our July 1999 letter today. Star Wars is back, dominating the box office, and the Federal Reserve just raised interest rates by ¼ percent. As it was then, stock gains in 2015 were uneven with much of the market in decline, a decline in breadth that began in May 2015. The average S&P 500 stock was down almost 4% last year, but the median stock finished 2015 down more than 22%. Half of the stocks in the S&P 500 finished 2015 down more than 20% from their 52-week highs. The Russell 2000 was off 5%, the Value Line Geometric was down 11% and the Dow Transports shed almost 18%. Uglier still, more than 70% of Russell 2000 and 68% of NASDAQ stocks finished the year more than 20% below their yearly highs. Profit margins, which peaked at an all-time record in the third quarter of 2014 at 10.1% (8.7% estimated for the fourth quarter 2015) for the companies making up the S&P 500, weren’t evenly distributed. As an extreme example, Apple contributed 22% of overall S&P 500’s margin expansion since 2009.
Financial academics define risk as volatility. That may be fine for theory, but for those of us who live in the real world, we define risk as a permanent loss of capital. The likelihood of risk using our definition is always highest at the point where the general perception of risk is lowest. The years 1929, 1937, 1966, 1972, 2000 and 2007 all marked moments when the perception of risk troughed, and the stock market peaked. The ensuing bear markets saw stock indices plummet anywhere from 50% to 89%. As markets plunge, the perception of risk rises, with fear peaking as markets hit lows in 1932, 1942, 1970, 1974, 1982, 2002 and 2009. Fear, and the perception of risk, peak at a market low, not at market highs. Only after suffering devastating losses do people believe stocks are “risky”. The reality is: we think 2015 will be added to the list above. But, which list?
The stock market is expensive. We said that last year, and the year before that and the year before that. Just because the stock market is expensive doesn’t mean prices can’t go up. Markets peak, however, following a period of time where the breadth of the market erodes, that is, where more stocks are declining than advancing. Yet, a narrowing group of popular leading stocks continues to make new highs. Breadth was positive and virtually straight up from the 2009 market low through May 2015.
These “bad breadth” episodes preceded every single market peak listed above. They also have lasted for anywhere from several months to two years. The three most extreme cases of divergence occurred in the years leading up to the 1929, 1972 and 2000 tops. For the holder of broadly diversified funds and indices, the deterioration in breadth is sending a warning shot over the bow. Coupled with extremely expensive valuations, risk is high.
Semper Augustus - Intrinsic Value In 2000 And 2016
By the end of March 2000, despite a massive reversal that began on the 10th of that month, we still had no objective evidence that the bubble had popped. We needed a tool to help clients understand that we owned a portfolio of undervalued quality businesses. We also wanted to demonstrate how overvalued the market was. Thus, we developed our intrinsic value report (March 31, 2000) and have regularly updated since then. The report highlights each holding, what we paid for it, its current price, and how we valued its intrinsic worth.
The report contains our estimate of normalized earnings, and the P/E, earnings yield and dividend yield for each holding and for the portfolio as a whole. The earnings yield is essentially our base-case expectation for prospective annual returns over a long period of time. Each yardstick is measured on cost basis, current market value and on intrinsic value.
On top of expecting to reap the earnings yield, we further expect to earn any accretion of a discount to fair value that exists over some period of time (the market is very efficient over the very long haul). As stocks move up to fair value and are sold, we expect to earn an additional premium to the extent we are able to find additional undervalued businesses and repeat the process. Of course, you have to subtract for those mistakes we will invariably make, where any combination of lower business quality than envisioned, or developing poor economics, or simply erring on our appraisal of value or of lower actual growth than expected unfolds.
Our expectation of prospective returns is:
Per the first March 2000 report, we owned a portfolio of stocks trading at 15.7 times normalized earnings, which gave us an earnings yield of 6.4%. Next, our holdings were trading at 83 cents on the dollar of fair value, which mathematically implied we should earn about 20% over some period of time as the valuation gap closed. An immediate closing would be big but the gap seems to take on average about five years to close. At ten years the accretion would yield us a little less than an additional 2% annually, on top of our 6.4% earnings yield. Further add a little premium for repeatability, subtract a little for mistakes, and we thus expected to earn about 8.5% to 9.5% per year over a long number of years, beginning at March 31, 2000. How accurate was the report? Our stocks indeed produced our expected return over more than 15 years, which lends integrity to the report, its assumptions and expectations.
So what did the intrinsic value report say about expectations for the market? On March 31, 2000, the S&P closed at 1499. Our estimation of intrinsic value was 590. We calculated $37.05 in normalized earnings, scrubbed for accounting aggressiveness, where trailing operating earnings were $48.26. Trailing reported dividends of $16.79 equated to a scant 1.1% dividend yield, a fraction of the return produced historically by dividends over the years. In fact, that was the lowest dividend yield on record. Using our normalized earnings number, the index thus was trading at a nosebleed 40.4 times earnings, which equated to a puny 2.5% earnings yield. Even using trailing operating earnings without our accounting adjustments the P/E was 31, giving the market an earnings yield of only 3.2%.
Our adjusted 2.5% earnings yield was thus the base-case expectation for annual market gains for a long period of time. Know that the investment world expected far, far more. Stocks produced a total return of more than 17% per year since the bear market low of 1982, when P/E’s were in single digits (7 times) and profit margins were extremely depressed (3% after-tax). Virtually nobody in the year 2000, save the small universe of investors grounded in price, believed stocks would only produce returns in the low single digits, or even losses, for far more than the next decade.
Our appraisal of fair value for the S&P 500 at March 31, 2000 assigned a 15.9 multiple to our normalized $37.05 in earnings, suggesting fair value at 590, demanding a not small 61% decline from 1499, or, as mentioned, requiring a whole bunch of years for underlying fair value to catch up with the inflated price.
We all know how the S&P fared subsequently. The index declined by 50% for the balance of 2000 through the low in late 2002. It then recovered by 2007, back to its former 2000 high, ballooned upward alongside the housing market with the Federal Reserve’s hot air. By late 2007, valuations were again very high, though not quite fundamentally as extreme as in 2000 (same index price but with 40% growth in GDP). The market then rolled over again during the “Great Recession”, seeing almost 70% of its price shaved away, bottoming at the demonic 666 level in early 2009. Enter Sandman; rather exit Greenspan and Enter Bernanke. With helicopter drops of monetary intervention, rounds of QE’s accompanied by matching monetary policy abroad, we saw the S&P blow through its former highs in 2013 and touch 2134 this past April.
Putting it all together, the S&P produced a total return of only 4.0% per year from March 31, 2000 through the end of 2015, barely more than our normalized 2.5% earnings yield. The market spent much of that time underwater. Only with a push from central banking’s quantitative easing did the market eclipse its 2000 and 2007 highs. Even with an ephemeral annual gain of only 4.0% per year, the market remains far from cheap. In fact, we still peg fair value below the 2000 and 2007 highs. The bear market that began more than 16 years ago has more work to do.
Using our intrinsic value report today, the index closed out 2015 at 2044. Trailing operating GAAP earnings (excluding write-offs and write-downs) will likely come in around $103 – down $10 or almost 10% year over year. Using this number, the market ended 2015 at 20 times earnings, which gives you an earnings yield of 5%. Not bad in a world of low interest rates. But we didn’t use GAAP earnings in 2000 and we don’t today.
The quality of earnings is again incredibly poor today. We normalize free cash profits at $70 for the S&P, 85% higher than our calculation in 2000. Nominal GDP grew by about 80% in 16 years. In addition to a poor quality of earnings, we also allow for some profit margin contraction over time from levels we think are too high. If our normalized number is more free cash correct, then the market is really trading for 29.2 times (2044/70), which equates to an earnings yield of 3.4%. That gets our long-range expectations for the market down to about what its done for the past 16 years.
A reasonable long-term multiple on profits is 15 times (6.7% earnings yield). Even if you don’t use our more conservative adjusted number, using GAAP earnings of $103, fair value for the index would be 1545, demanding a nearly 24% drop to fair value, or, as before, simply not making money for a whole bunch of years until fair value catches price.
Incidentally, an index price of 1545 gets you precisely back to the 2000 and 2007 highs. Using our more conservative $70 in normalized free cash earnings, fair value drops all the way to 1050, nearly half of today’s 2044 level.
The market forecast using our intrinsic value methodology is thus ugly. It’s not quite as grim as 2000 but still pretty bad. So how do we size up against the market now?
From our current intrinsic value report, our prospective advantage versus the index is nearly as great as it was in March 2000. Our stocks are trading for 12.1 times our calculation of normalized earnings, which gives us an earnings yield of 8.2%. Compared to the S&P 500’s GAAP earnings yield of 5.1%, or our more conservatively estimated 3.4%, our annual advantage is between 3.1% and 4.8%. We believe we have a huge long-term prospective advantage versus the market. Our report in March 2000 suggested that then, and it suggests it today. The report now has nearly 16 years of history behind it so it’s not merely a hypothetical. Again, the market is pretty darn efficient over the long haul, and those that appreciate that can benefit.
Of course, our stock portfolio didn’t get to 12.1 times earnings all of a sudden. Sixty percent of our long equity holdings were down last year. We owned 31 long equity positions during the year. Of those, 18 were down. Of the 13 that were up, one was sold entirely for a nice gain and would have been down had we kept it; and one was half sold and would have also been down otherwise. Our biggest position, Berkshire Hathaway, was down more than 12% last year, though it grew its profits and underlying value considerably. Our second largest holding, Exxon Mobil, was also down more than 12%, falling far less than the price of oil, but down nonetheless. Our third largest holding, Mercury General, was off almost 14% last year. The list goes on. This is most definitely the definition of declining breadth. Despite the price declines, on average our businesses grew their profits (even allowing for the notable exception of those who extract things from Mother Earth), which means the P/E multiple necessarily declined and our prospective earnings yield necessarily grew. The same thing happened in 1999 and early 2000, and also toward the end of 2007 and into 2008.
Combining asset prices in decline with underlying fundamental growth equals the expansion of value. How investors react to the unfolding of value dictates either long-term success or permanent failure. If you don’t expect to need all of your money for consumption for many years, then such short-term changes in price, particularly extant correspondent changes in value, shouldn’t matter. To the extent price deviates markedly from value, opportunity presents itself, whether as a buyer or as a seller. Understanding the difference between price and value is perhaps the most critical aspect of investing. Was the decline in Berkshire last year a loss? Was it giving back some of the gain from much lower cost bases? Does the decline indicate deteriorating permanent fundamentals inside the company and a reduction in long-term expected profits and gains? Is the decline in the shares really an opportunity to acquire shares, either by us or by management on our behalf at attractive prices? Does the decline increase our expected long-term return or lower it? Depending on how you answer those questions dictates long-term success or failure. It also necessarily dictates how well you sleep at night worrying about things beyond your control.
We spent the latter part of last year with our stocks in decline. It felt like late 1999 and early 2000. We watched a narrowing band of names; many of the tech variety, as well as a handful of branded consumer names, march ahead. Share prices in companies like Colgate, Clorox, Proctor & Gamble and Costco marched higher to very expensive levels, but none more so than a new era of tech favorites.
Semper Augustus - Berkshire Hathaway In 2016 And Beyond
Investors are hard pressed to find a better, more durable, more honestly and intelligently run business than Berkshire Hathaway. Their understanding of value and value creation is not only remarkable, but also unrivaled. The business owns myriad diverse and profitable earnings streams - its capital structure a fortress. It owns an enormous portfolio of free-cash producing operating businesses that are each far better off as part of Berkshire than they would be alone. The accounting is conservative and shareholders are regarded as owners. You don’t see material write-offs or spin-offs of underperforming subsidiaries. Shareholders aren’t diluted by the issuance of vast sums of option and restricted shares to management or the Board. The business has a five-decade history of using its shares in acquisitions when they are dear and will repurchase them when they become cheap.
Berkshire’s shares can be purchased at a very cheap 13 times normalized trailing profits today. You can hope to sell them at a higher multiple in the future. That might happen quickly, or it might not. We are more concerned with the long-term durability of the franchise. Berkshire is earning $25 billion on $255 billion of GAAP book value, which makes return on equity 10%. Our examination focuses on what kind of returns the business will earn going forward. We can see return on equity dropping to no less than 8% over many years. But at 8% to 10% you get a solidly profitable enterprise with a high degree of predictability.
Our goal is to understand the true economics of any business we own. In this letter we will walk through adjustments to reported GAAP income to arrive at a more normalized level of economic profitability. We will slice return on equity many ways. Returns are examined pre-tax, after-tax, including goodwill, excluding goodwill, adjusted for equity-like liability components, and adjusted for other balance sheet modifications. The different iterations of examining ROE are each one-off, where we isolate individual factors that impact returns. The intent is not to confuse. Ultimately we get to what the business really earns on its invested capital, and that is of paramount importance. For now at least, Berkshire retains all of its net earnings. An investor requires a confidence in assessing the prospects for capital deployment and redeployment.
Berkshire’s shares trade at 70% of intrinsic value, giving us 45% upside just to fair value. In addition, we own a business that can earn 8% to 10% on equity for many years, and should grow at least at that rate. Our investment in Berkshire is our largest by far, having first purchased shares in February 2000. Over the years we opportunistically added to and reduced our holdings at favorable prices.
We will devote a few pages discussing the 12.5% decline in the shares last year and what that means for investors. The majority is spent walking through the various ways we value the business. We conclude with some thoughts on many of the risks and challenges facing Berkshire, and the things that can go wrong either suddenly or over time. Monitoring the risk factors becomes increasingly important as the business evolves.
The Stock Decline In 2015 Equals An Increase In The Expected Return
We fielded questions about the decline in our Berkshire Hathaway shares during 2015. Our investment in Berkshire is far and away our largest so questions are warranted. We put together what was going to be a brief overview demonstrating that while Berkshire’s shares fell 12.5% last year, both the underlying profitability and the intrinsic worth of the company instead rose by a considerable amount. The “brief” overview turned into the following tome.
The investment case for holding Berkshire Hathaway is driven by how much the business earns on equity and the sustainability of those returns. We calculate Berkshire is earning about 10% profit as a percentage of its reported equity. Because Berkshire doesn’t pay a dividend, the earnings it produces, not only on current net assets but also on reinvested earnings, is critical. Given Berkshire’s mammoth size, the opportunity set for reinvestment is limited. We use a floor 8% return on equity for at least the next fifteen years, though today’s 10% remains viable. We need to be vigilant in our analysis, however, to ensure they are meeting our expectation. It won’t be immediately obvious if they aren’t. Gone are the days of 20% annual returns. The margin for error is much finer today. Fortunately, today’s share price gives us a huge margin of safety.
Berkshire was by far our largest holding at the outset of 2015. Few investors allocate so much capital to a single investment. Berkshire is so undervalued and is such a strong and uniquely diversified business that a single concentrated investment in Berkshire at the right price arguably satisfies any reasonable diversification standard.
Our A shares entered 2015 at $226,000 and fell to $197,800 at year-end. Our B shares declined from $150.15 to $132.04 (each B share is worth 1/1,500 per A share, and the B’s generally trade at a very negligible discount to the A’s due to immaterially lower voting rights). The market cap of Berkshire fell from $371 billion to $325 billion. In the meantime normalized profit grew from $23 billion to $25 billion. Our cost basis remains far below the current price.
On $23 billion in core normalized profits at year-end 2014, the stock entered 2015 trading for 15.9 times earnings, which gave us an earnings yield of 6.2%. Because the stock dropped 12.5% in price while underlying profitability likely rose by about $2 billion, the stock is now far cheaper and thus prospectively even more attractive, barring any permanent future diminution in earning power. With a year-end market cap of $325 billion on $25 billion in earnings, the stock closed 2015 trading for exactly 13 times trailing earnings, which equates to an earnings yield of 7.7%. You can see the changes between 2014 and 2015 in the table below.
The 7.7% earnings yield becomes our base case low-end expected return for holding Berkshire, assuming no change in the multiple to earnings. To the extent the stock price moves up more quickly than profits grow, the P/E multiple thus obviously moves up and the earnings yield declines (that was the case for each of the three years 2012-2014). Conversely, if the price falls faster than profits grow (or shrink), then the P/E drops and the earnings yield increases. That was the case last year. Let’s now look at both a one-year scenario and a longer set of 10-year scenarios.
Moving rightward in the table, we show two scenarios for the upcoming year. In one case we assume no change in the share price and in the other we show an additional 10% drop in the share price. The no change in stock price effectively measures the current price against a forecast of next year’s earnings. As an aside, this is generally how Wall Street often values markets and businesses, by using an expectation for next year’s profits, but the Street is generally too optimistic about profit development. Index multiples historically are calculated on trailing earnings. There is a big difference between using a P/E on trailing earnings or on earnings one year hence. Far too many investors fail to grasp the difference or the significance.
Neither illustration of no change in the stock or a 10% decline is a forecast. Rather, both are used to demonstrate what happens when stock prices decline in the absence of a decline in core profitability and/or a diminution in intrinsic value. In both cases we have net income at Berkshire advancing to $27.5 billion, a gain of 10%. More on this later. In the case of no change in the stock price, you can see that with 10% growth in earnings the P/E drops to 11.8x, giving us an earnings yield of 8.5% (again another way of saying Berkshire is trading now at 11.8 times next year’s earnings). On a hypothetical 10% share price drop coupled with an earnings gain of 10% the P/E becomes 10.6x with an earnings yield of 9.4%. It should be clear that as the stock gets cheaper the prospective returns grow larger, as long as profits and underlying value advance. That was the case during 2015. A short or intermediate-term drop in the share price should not be cause for alarm. An impairment of earning power and intrinsic worth should.
An Expectation of 8% to 10% Earnings Growth
Continuing to the right in the table, you can see a longer-term projection, showing what returns from holding Berkshire look like ten years out under scenarios of two compound growth rates in earnings and at a range of P/E multiples. In the more conservative case, you can see profits compounding at 8% for the next decade, taking earnings from today’s $25 billion to $54 billion. In the second case, we assume profits compound at 10% annually, growing from $25 billion to $65 billion. Again, the range of 8-10% profit growth is our reasoned expectation for the coming ten years. We are starting today at 10%.
Our profit growth assumption is largely driven by Berkshire’s sustainable return on equity. We delve deeply into understanding Berkshire’s profitability in this report. As a base assumption, today’s ROE is 10%. We expect the business to earn somewhere between 8-10% on its equity for many years. Because the company doesn’t pay a dividend (for now), the retention of profits essentially becomes the growth rate of the business. Growth can trend higher if it comes organically, but much of the Berkshire empire is fairly mature.
Combining Earnings Growth with Margin Expansion
The table shows Berkshire’s 2025 market cap at a range of four different P/E’s from 13 times to 20 times, applied to both its $54 billion or $65 billion in 2025 earnings. In the table, below the market cap and correspondent P/E with earnings yield you can see what your cumulative return and annualized return will be at the four different P/E multiples.
See full PDF below.