Berkshire Hathaway: Shooting Dead Fish In A Drained Barrel
At its present price, Berkshire Hathaway ([[BRK.B]]/[[BRK.A]]) appears to have very favorable risk/reward characteristics. Berkshire's share price is essentially flat since mid-year 2013 despite what I estimate is an addition of an incremental $17-$18 billion in shareholders' equity during this period. This means that Berkshire has cheapened to the point where its share price sits just above the level of Berkshire's perpetual, and nearly unlimited, share repurchase authorization at 1.2x book-value. Investors should note that a Berkshire Director felt that repurchasing Berkshire shares was "like shooting fish in a barrel, after the barrel had been drained and the fish had quit flopping." While I tend to discount most management teams who think their stock is cheap (especially when they use hyperbole), I feel that Berkshire has a better track record here than most and they have been candid about when they think their stock is fairly valued or overvalued. For this reason, one could reasonably expect Berkshire to repurchase as many shares as possible if given the opportunity, thus limiting the downside potential in the stock. This is my favorite type of investment, because in my experience, I have learned that what can't go down (permanently) in price has to (eventually) go up. In regards to upside, it appears that Berkshire trades at a 25%-30% discount to its sum-of-the-parts when calculated on a conservative basis.
I estimate that Berkshire's year-end book value will approximate $219 billion, an increase of over $10 billion from Q3. If my estimate is correct, this would correspond to a market capitalization of $263 billion (1.2 * $219 billion = $263 billion), or the level at which Berkshire could commence share repurchases. At $115 per Class B share, Berkshire has a market capitalization of $283 billion, implying approximately 7% downside until Berkshire likely starts repurchasing shares. It is interesting to note the Berkshire's stock has never traded, for any prolonged period, below the level at which they are permitted to repurchase shares. For this reason, investors are essentially getting a free out-of-the-money put option 7% below the current price. Below represents my rough estimates on the change in book-value during the 4th quarter.
|Q3 2013 BV||208,382|
|Q4 Operating Earnings||2,490|
|ATAX Underwriting Profit||452|
|HoldCo. Int. Expense||(166)|
|Non-cash Taxes on Inv. Appreciation||(3,600)|
|ATAX Dividends and Int.||1,000|
|Estimated YE 2013 Book Value||218,843|
|Stock Repurchase Multiple||1.2|
|Market Cap at 1.2 BV||262,612|
|Current Market Cap.||283,552|
|Downside Repurchase Authorization||-7.38%|
Fundamentally, it appears that the intrinsic value of Berkshire is 25-30% greater than the current price. First, I estimate Berkshire's wholly-owned operating businesses will generate $11.6 billion in after-tax net income in 2014. I assume Berkshire's insurance operations, except GEICO, underwrite on a break-even basis and I also subtract all estimated interest payments on holding company debt. To these earnings I apply a multiple of 13x, implying a valuation of $151 billion.
|Business||2014 Estimated ATAX Net Income|
|Manufacturing, Service & Retail||4,398|
|Finance & Financial Products||592|
|Intangible Amortization (( ATAX ))||650|
|Holding Company ATAX Int. Exp.||(432)|
Note that this valuation reflects a full 3-turn discount to the current S&P multiple of 16x (1850 S&P, $115 Earnings) despite the fact that half of these earnings will be derived from railroads and utilities. These industry groups tend to trade at a premium multiple relative to the overall S&P (i.e., Union Pacific). Additionally, Berkshire's non-GEICO insurance operations typically generate significant underwriting profits, although results are unpredictable on a quarter-to-quarter or even yearly basis. Given these considerations, I am fairly confident that I am taking a conservative approach to valuing Berkshire's operating businesses, thus embedding a margin of safety.
In regards to Berkshire's investment portfolio, I simply add up the expected year-end value of Berkshire equities, fixed-maturity securities, hybrid securities, and cash. Berkshire's "Big Four" investment positions (WFC, KO, IBM & AXP) increased by over $5.7 billion during the quarter, with the overall equity portfolio likely appreciating by more than $10 billion. One should also note that Berkshire's $4.4 billion in Wrigley subordinated notes were redeemed at 115% of par ($5.1) during the 3rd quarter. This amount was booked as a receivable in the 3rd quarter 10-Q but will be booked as cash at year-end. Hence, it is likely that Berkshire's year-end cash balance will exceed $50 billion. The aggregate amount of Berkshire's securities and cash should approximate $226 billion by year-end 2013. This is likely a somewhat conservative valuation as no adjustments were made on my part to the value of 700 million Bank of America warrants or the fact that investments such as $8 billion in Heinz preferred stocked is booked "at cost" despite having a yield-to-call of 10%, meaning it would trade at a significant premium to par if it was a publicly-traded security.
From this amount we deduct the net present value of Berkshire's deferred tax liability associated with the investment portfolio. At the end of 2013, I estimate Berkshire will have approximately $66 billion in unrealized investment gains in its investment portfolio. At a 35% corporate tax rate, this corresponds to an undiscounted tax liability of $23.4 billion. However, this amount is overstated because (i) the obligation does not come due until Berkshire realizes the gain (ii) Berkshire will likely receive the majority of the value of the security vis-à-vis dividends, which are taxed at a rate of approximately 10%. For my purposes, I cut the deferred tax liability in half to better reflect the time value characteristics of the liability as well as the dividend consideration. While this is admittedly imprecise, it likely captures the economic impact I am trying to control for.
Additionally, we need to deduct the value of Berkshire's derivative liabilities. At the end of the 3rd quarter, this amount was $5.8 billion. Given the appreciation of global equity indices during the 4th quarter, this liability likely decreased (Berkshire is short puts). However, the impact would be relatively small, so I take the full reduction for the sake of conservatism.
|Securities||2013 Est. Year-end Values|
|PV of Sec. Portfolio DTL||(12,000)|
|Class B Equivalent||2,466|
|Value per Class B||$ 145.72|
Adding the value of Berkshire's operating businesses ($151 billion) and their investment portfolio, net of tax and derivative liabilities ($209 billion), yields an aggregate value of $360 billion, or $146 per Class B share. This value is 27% above the current trading price of the shares. In totality, I believe this represents a massively favorable risk-reward dynamic as Berkshire's fair value, conservatively calculated, presents roughly 4x the upside (27%) relative to the downside (-7%) at which they repurchase shares.
If one accepts the methodology under which I calculated the intrinsic value of Berkshire, some interesting deductions can be made by inverting the typical investment question "how much money will I make?" to "how do I permanently impair my capital by purchasing Berkshire at the current price?" My contention is that Berkshire currently trades at approximately an $80 billion discount to its fair value. If we apply this discount to the $151 billion valuation of Berkshire operating businesses, we get a value of $71 billion. The implication arising from this discount is that we are purchasing a group of world-class and predictable businesses like Burlington Northern and Mid-American at 6x earnings ($71 billion / $11.6 earnings = 6x earnings). Is it reasonable to assume that we will lose money buying these businesses at 6x earnings? Probably not.
Alternatively, we can take the $80 billion deduction from Berkshire's investment portfolio $209 billion, implying a valuation of $128 billion, or a 38% discount to fair value. In essence, this would allow us to purchase shares of Coke at and effective cost of $24 or shares of Wells Fargo at a cost of $28. Again, it is difficult to envision a scenario where making a purchase at these levels would lead to an impairment of capital.
In summary, other securities may appreciate by a greater amount than Berkshire, but relatively few offer better downside protection. This is okay with me as my main goal in investing is to define my downside scenario and then let the upside take care of itself.
Disclosure: I am long BRK.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I may change my views about this investment position at any time for any reason or no reason. I disclaim the obligation to notify readers of any such changes. I make no warranty as to the completeness or accuracy of this presentation.
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