Today’s teaser is a pretty short one, from the Motley Fool for their flagship Stock Advisor newsletter, but most ads from the Fool make the Gumshoe faithful perk their ears up so we’re going to cover it quickly for you today.
And I think I’ve covered more teaser picks for Motley Fool Stock Advisor than for any other single newsletter over the past ten years… so who knows, maybe it will be something we already know. The spiel is similar to the past “double down” alerts we’ve seen from the Fool — they’ve long pointed out that when founding Fool brothers Dave and Tom Gardner re-recommend a stock, those stocks do exceptionally well… only this time, it’s a “triple down” because apparently Tom Gardner is now recommending a particular “millionaire maker” stock for a third time.
So what is it?
Here’s the intro from David Hanson, one of the Fool’s analysts:
“Not to alarm you but you’re about to miss an important and rare event.
“You see, renowned investor Tom Gardner (whose investing newsletter has been reported in The Wall Street Journal as one of the best in the world*) just pounded the table and issued a THIRD BUY ALERT for this ‘millionaire maker’ stock.”
And then we get our clues about the stock in question:
“The balance sheet of Tom’s latest pick is an absolute fortress (so you can sleep easily when you invest in this company)…it generated an astounding $17.7 billion in free cash flow over the last 12 months..
“Amazingly, according to a recent report from CNBC, more than 4 in 5 American investors are ignoring this ‘millionaire maker’ stock.
“And perhaps most incredible of all…Are you getting our free Daily Update
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“This stock has minted millionaire after millionaire, yet it’s still shockingly inexpensive…
“It’s only trading at 1.36 times book value!”
OK — cheap valuation and strong free cash flow? That’s enough to get me interested. What is the stock?
Thinkolator sez this is our old friend, Berkshire Hathaway (BRK.B, or BRK.A if you’re a high roller).
Heard of that one? Yep, me too. I, too, have suggested Berkshire Hathaway many times, and have owned the stock since 2005 (and bought a bunch of times since then, most recently in March).
Berkshire is currently my largest individual equity position, now that Facebook (FB) shares have fallen a few percent, and it is, obviously, a well-known conglomerate and a headline generator every Spring as Warren Buffett summons his followers to Omaha for the Annual Meeting (I’ve gone the past two years, it’s an event worth experiencing). Buffett is everyone’s favorite avuncular billionaire, and a great example of the power of disciplined thinking and patience as he’s built up his business from a failing textile mill to become one of the largest companies in the world, with a market cap of about $350 billion.
What is there to know about Berkshire that you don’t already know? Well, it’s not really ignored by most investors — it’s a substantial part of the S&P 500 index these days, so most of us own at least a small taste (that wasn’t always true, it wasn’t added to the index until they split the stock back in 2010 to make the Burlington Northern acquisition possible).
Berkshire Hathaway is certainly not a high flier, and it’s not likely to dramatically outperform the market when the market is doing well. It has become a pretty widely diversified company, with major railroad and utility operations in addition to hundreds of relatively small businesses (See’s Candy, Fruit of the Loom, Justin Boots, etc.) and a huge stock portfolio (with Berkshire’s massive holdings in companies like Wells Fargo and Coca Cola that it has held for decades), though the foundation of it all is still the large insurance operation, headlined by GEICO but also including lots of other insurance companies. Insurance helps supply “free” cash that Buffett and his lieutenants can allocate among their investments, and the conglomerate structure enables them to move the cash generated by insurance and other operations to where it’s needed as their businesses require capital investment, or to feed it to the parent company to be invested in something new by Buffett or his relatively new investment managers.
So how does one evaluate Berkshire Hathaway? Well, there are many ways to assign a value to the stock… but there are two that I prefer.
Here’s what I wrote to the Irregulars back in March when I last added to my Berkshire stake — the numbers are from 2015, so they don’t include the update for the first quarter, but the difference from that quarter would be small (the Precision Castparts acquisition is complete now, cash and investments are down a bit, and earnings are up a bit — the price/book valuation is essentially identical):
I like to look at Berkshire Hathaway’s valuation in two ways — shorthand, by using book value and calling it a “buy” whenever it gets to 1.25X book value or lower, because there’s a very strong chance that Berkshire will do substantial share buybacks if the price gets down to 1.2X book value or below. Downside at valuations like this is limited, unless you believe that many of Berkshire’s businesses (railroad, utilities, industrial companies, major positions in publicly traded stocks) will fall substantially in value at the same time. Right now, the price/book valuation is about 1.35 as the stock has been moving up with the market, so I didn’t make a major move into more shares but did bump up my position a little bit.
And the other way to think about Berkshire’s valuation is a little bit more complicated, but not terribly so — you basically take the market value of all their publicly traded stock (leaving aside the inconvenience that Berkshire would have major tax obligations if they sold them all), and add the value of all of Berkshire’s fully owned companies by taking the earnings that Berkshire reports on those companies and applying some conservative PE ratio to those earnings.
Berkshire’s cash and investments stood at $158 billion as of the end of 2015, of which $66 billion was funded by “float” that doesn’t actually belong to Berkshire. GAAP Accounting requires that this float be considered a liability, but free access to a rolling source of funds (from new policies and renewing policies that replace existing policies, at theoretically similar underwriting cost) is also, conceptually if not accounting-wise, an asset, particularly because Berkshire’s insurance operations are so consistently profitable (meaning, the float never shrinks because premiums always exceed claims, though that is not, of course, guaranteed to continue forever). That’s largely why Buffett believes that book value drastically underestimates the actual “intrinsic value” of the company.
We’ll ignore Precision Castparts, the most recent addition, because that deal closed in 2016 so the cash hasn’t yet been removed from the books, and we can’t count their earnings for 2015 (for what it’s worth, Berkshire paid about 17.5X projected earnings for Precision Castparts — and as with Berkshire’s takeover of Burlington Northern in 2010, pundits and analysts complained that Berkshire overpaid).
Here’s the excerpt from Buffett’s letter (which you should read, if you haven’t) about this way of calculating intrinsic value:
“As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). It is possible, however, to make a sensible estimate. In our 2010 annual report we laid out the three elements – one of them qualitative – that we believe are the keys to an estimation of Berkshire’s intrinsic value. That discussion is reproduced in full on pages 113-114.
“Here is an update of the two quantitative factors: In 2015 our per-share cash and investments increased 8.3% to $159,794 (with our Kraft Heinz shares stated at market value), and earnings from our many businesses – including insurance underwriting income – increased 2.1% to $12,304 per share. We exclude in the second factor the dividends and interest from the investments we hold because including them would produce a double-counting of value. In arriving at our earnings figure, we deduct all corporate overhead, interest, depreciation, amortization and minority interests. Income taxes, though, are not deducted. That is, the earnings are pre-tax.
“I used the italics in the paragraph above because we are for the first time including insurance underwriting income in business earnings. We did not do that when we initially introduced Berkshire’s two quantitative pillars of valuation because our insurance results were then heavily influenced by catastrophe coverages. If the wind didn’t blow and the earth didn’t shake, we made large profits. But a mega-catastrophe would produce red ink. In order to be conservative then in stating our business earnings, we consistently assumed that underwriting would break even over time and ignored any of its gains or losses in our annual calculation of the second factor of value.
“Today, our insurance results are likely to be more stable than was the case a decade or two ago because we have deemphasized catastrophe coverages and greatly expanded our bread-and-butter lines of business. Last year, our underwriting income contributed $1,118 per share to the $12,304 per share of earnings referenced in the second paragraph of this section. Over the past decade, annual underwriting income has averaged $1,434 per share, and we anticipate being profitable in most years. You should recognize, however, that underwriting in any given year could well be unprofitable, perhaps substantially so.”
That’s using the per-share values based on the A shares, which are in the $200,000 range right now — but most regular human beings deal with B shares, which are each worth 1/1,500th of an A share, so we can just do a little math to say that per-share investments total $106.53 for B shares, and per-share earnings total $8.20. I would suggest giving the investments a 25% haircut to account for taxable gains that might be taken and the fact that some of the insurance float that fuels a third of those investments may be unprofitable sometimes… call it a conservative “fudge” factor to derisk things a bit, and you can make up your own number.
If you assign a PE of 10 to the other businesses, many of which are slow growth or capital intensive, that means that if you add it all up that “intrinsic value” is $82 for the operating businesses (including insurance earnings) plus $79.89 for the cash and investments after you discount those assets by 25%. Add it up and you get $161.89, and today Berkshire trades at $140, so it’s at about a 13% discount to this fairly conservative “intrinsic value” estimate. If you don’t discount the value of their cash and investments to account for float or taxes or whatever else, the “intrinsic value” could be as high as $182.53… and remember, that’s still using an abundantly conservative PE of 10 for their operating earnings.
Berkshire’s not going to beat the market every year, but I expect that it will continue to beat the market in down years… and that down years will give Warren Buffett and his lieutenants the opportunity to deploy yet more of their continually growing cash hoard into profitable and low-priced opportunities. That’s a risk-reward calculation I’m very comfortable with… so I’d wait until the stock takes a hit in a down market to really load up, but I also like to nibble on shares from time to time when I’m ready to increase my market exposure but am a little bit leery, as I am today, of downside risks. I don’t expect Berkshire’s book value to ever drop dramatically and permanently, though it will, of course, sometimes fall, so I think the downside risk is less than 20% for the shares today… and I think the performance of the investments and subsidiaries in good years will be similar to the market, and in mediocre and bad years will be better than the market. If you’d like some more perspective on why Berkshire is (I think) a low-risk, undervalued stock today there’s a recent presentation from Whitney Tilson that you can see a cached version of here.
Back to June now.
So… Berkshire’s actually up slightly from March, so it’s at $144, with a price/book valuation of 1.37. Book value per B share is about $105 today, so my guess is that the downside (absent a significant drop in book value) is probably limited to about $130 (that’s 1.25 book — Berkshire would likely start big buybacks at 1.2X book, which would be $126… and everyone knows this, so they probably wouldn’t let the shares fall that far).
I’m still comfortable with a very conservative intrinsic value of at least $160. That doesn’t mean it will get there quickly, or ever, but I’m happy to have Berkshire as a major core holding — there are plenty of risks, of course, Berkshire is a highly decentralized company (only about 20 employees at the corporate headquarters) and depends on a strong culture to keep all the subsidiaries pointing in the right direction (and sometimes scandals hit to mar the reputation, like the news this week about Berkshire affiliates being accused of some wrongdoing by the California insurance commissioner, or the earlier front-running scandal involving top lieutenant David Sokol).
And it is also, of course, a business that is tied very closely to an individual — Berkshire Hathaway is more than just Warren Buffett, but I’d say he is personally more important to his company than just about any other CEO in the United States… and Buffett will be 86 years old before the Summer is over (his partner and sounding board, Charlie Munger, is 92).
He still seems awfully sharp to me, and certainly Berkshire has wiped the floor with most of the companies that have been pitched as “the next Berkshire Hathaway” over the past decade… but Buffett won’t be running Berkshire in 20 years, and it would be pretty surprising if he was still running the company in five years (Buffett’s actuarial life expectancy is somewhere in the 92-97 age range at this point, depending on how you calculate it, he has promised to work until he’s 100). I think Berkshire’s board is ready for the transition to new leadership when it becomes necessary, and the valuation doesn’t really put any “Buffett premium” on the shares at this price… but there is certainly a risk that the company could be revalued or could lose much of its competitive advantage when Buffett retires.
Berkshire has handily beaten the S&P 500 over long periods of time, though the outperformance has been narrowing a bit as the company has grown — which I guess we should expect, given the increased size of the company and the increased weight that large, capital-intensive industries like electric utilities, heavy manufacturing, and railroads now have on the stock.
Sound like the kind of investment you’d like to buy, with or without Tom Gardner’s “threepeat” recommendation? Let us know with a comment below.