Why Berkshire? Why now?
We started looking for bargains in March 2020 – once the crash began. Berkshire Hathaway made the list, not because we’re students of Warren Buffett, but because the company has roughly $120 billion in cash. We look at this as dry powder at Buffett’s (and Munger’s) disposal. We asked ourselves, what are they going to do with all that cash?
Implicit in this was our real question: “Is Berkshire Hathaway a good investment now?” For a long time, we’ve shied away from investing in our greatest mentor’s company, not because we wanted to be original and “different”, but because – funnily – a lot of Berkshire’s investments didn’t fit into our worldview. For example, we have deliberately stayed away from Oil & Gas and from direct plays in Retail. And Airlines companies just don’t fit into our Investment Themes.
But as you’ll see below, Berkshire is more than that. If we give some benefit of the doubt to the Jedi Masters – Buffett and Munger – on the issue of companies that don’t fit into our worldview, there are two other parts of the business that add significant value to the franchise. And, of course, there’s all that cash on the balance sheet.
Below, we lay out our framework for evaluating this behemoth. You’ll notice that we had to improvise and adjust our normal valuation process, which, ironically, is heavily derived from the methods Buffett himself has espoused.
But don’t worry, we still stick to his principles – we will never deviate much from them.
Benefit of the doubt.
We give Buffett and Munger (and their chosen lieutenants) the benefit of the doubt for two simple reasons:
- Their performance has been fantastic.
- We know exactly why they’ve been so good at what they do because they’ve been generous to share their experience with us.
The second point is important because often we hear of superstars who’ve crushed the market over the last one, two or even three years without much idea of their investment philosophy and process. Many of them are one-hit wonders. Others do well until they blow up because of leverage or bad risk management. In Berkshire’s case, there is no mystery in their success. Here is the result:
The annualized gain in Berkshire stock from 1965 to 2019 is 20.3%. For the S&P 500 during that same period, it’s 10.0%. Berkshire trounced the overall market.
But I should point out that Berkshire’s performance has been lagging in the last few years. It’s been an era where technology companies have far outpaced the market, and Berkshire has been (for the lack of a better word) underweight tech. This has hurt their relative performance.
I should also point out that judging Buffett’s investment acumen by Berkshire stock performance is an imperfect measure, especially over the short-term. He makes very long-term bets, and many of those investments take years to pay off handsomely. Traditionally, Buffett encouraged us to look at Change in Book Value of Berkshire over time as a better measure of performance. But since some new accounting rules have been imposed upon companies like Berkshire – most notably the inclusion of unrealized gains/losses from investments in the revenue line-item – the change-in-book-value measure has lost its relevance. In the last shareholder letter, Buffett lamented this rule change and encouraged us to focus on operating earnings instead. Yes, we will, because at The Buylyst we always do our homework to estimate Free Cash Flow. We do that to steer clear of any accounting rule changes and shenanigans. Cash is cash is cash – there is no argument on that.
Back to BRK stock performance: It has lagged the S&P 500 over the last few years, and I think Buffett has realized that ignoring “Big Tech” was not a wise strategy. In the past, he has steered clear of Tech because he claimed he didn’t understand any of it. In the last few years, he as slowly warmed up to Big Tech. He’s a big investor in Apple (albeit more from a Retail perspective) and he recently started buying Amazon stock (here the thesis may have more to do with AWS and its moonshot project, rather than their low-margin retail business). It’s been hard to beat a FAANG-dominated Index without investing in any of the FAANGs.
Bearing all this in mind, we will give Buffett, Munger and their lieutenants the benefit of the doubt. But we won’t expect them or the stock to generate 20%+ returns per year going forward. We will temper our expectations.
The question is: given our tempered expectations, is Berkshire still undervalued?
How does Berkshire make money?
Berkshire’s business model is unique. It’s surprising that more businesses haven’t copied the model. Of course, other businesses don’t have Buffett or Munger, but my point is that the business model itself has merits.
Berkshire has many sources of revenue, but I’ll make things simple. There are 3 main sources we need to remember:
- Premiums from its Insurance and Reinsurance businesses.
- Operating Earnings from its Private Investments – companies in which Berkshire has majority or complete ownership stakes.
- Dividends from its Public Investments – companies in which Berkshire has minority stakes, acquired via publicly-traded stocks.
In the full investment thesis, I’ll lay out all the underlying businesses in more detail. For now, we’ll keep things manageable. Berkshire earns regular cash flow from premiums collected by its Insurance business. Of course, insurance businesses have operating costs and cash liabilities to pay their policyholders. But Berkshire usually has a lot of surplus left-over. Buffett & Team invest this surplus in Private companies or Public securities. The idea is that the surplus invested over time compounds much faster than their liabilities. Buffett calls this constant source of cash “Float”.
Other insurance companies have a similar model, in which their float is invested by an investment management arm. But they don’t make “conviction” investments like Buffett. And they tend to be focused on short-term asset-liability mismatches rather than maximizing returns over the long-term.
Buffett’s high-conviction style is a no-brainer for him and his confidante Charlie Munger, who says:
“[Most Investment Managers are] in a game where the clients expect them to know a lot of things. We didn't have any clients who could fire us at Berkshire Hathaway. So we didn't have to be governed by any such construct. And we came to this notion of finding a mispriced bet and loading up when we were very confident that we were right. So we're way less diversified. And I think our system is miles better.”
The results do prove that their system is miles better. Obviously, those results required brains like Buffett and Munger. And, here at The Buylyst, we’re big fans. But in analyzing Berkshire as an investment opportunity, we should discount that brilliance and invest only if the stock is undervalued based on unspectacular assumptions.
So, we’ll assume that going forward Buffett and Munger won’t deliver the sort of returns they have in the past. On the other hand, we’ll assume that they, and their carefully picked lieutenants, will be smart enough to not blow up. Berkshire’s business structure – Insurance Float reinvested into comfortable businesses at comfortable prices – is quite robust. There are no short-term bets. There is no leverage in those bets. Yes, they’re concentrated but Buffett & Team have good visibility into their Private Investments. The Public Investment piece can be volatile, but they make no impact on cash flow until they’re sold – hopefully at a profit.
Our job is to estimate how much each of the 3 businesses will earn, with reasonable assumptions, stripped of our usual hero-worship of Buffett and Munger. But don’t forget the 4th “value generator” that we find massively attractive – the pile of about $120 billion in cash that Berkshire can (and hopefully will) deploy over the next couple of years.
For context, Berkshire last reported Book Value of Equity (Assets minus Liabilities) was about $430 billion. So, about 28% of Berkshire net worth is hard cash, waiting for the right investment opportunities. There is value in that. How much? That requires some (not so heroic) assumptions.
Let’s go through our thought process on each of the revenue streams.
How much will the Insurance business return?
This business is their main source of Float, as we discussed before. By collecting premiums and investment them wisely over the years, Berkshire has amassed huge wealth. The caveat is that all Insurance businesses have liabilities – to pay cash to policyholders when things go wrong (the very situation policyholders insure against).
Just a quick look at Berkshire’s Balance Sheet reveals that the “Insurance & Other” assets amount to roughly $631 billion. The “Insurance & Other” liabilities amount to roughly $235 billion. That’s almost $400 billion on “margin of safety” or “surplus” right there. Now, I should mention, that these numbers include some Private Investments and all Public Investments. That’s because the premiums collected – the “float” – is invested in Private and Public companies. On the other hand, insurance liabilities on the balance sheet are actuarial estimates. They’re not actual cash handouts. So, there is ambiguity in the “surplus”, but there is enough margin of safety to assume that the business is safe.
What can we assume about the insurance business going forward? We can assume that despite this Pandemic in 2020, the “surplus” or “margin of safety” will remain intact. There are three reasons for this assumption:
- Berkshire’s insurance exposure is dominated by Property & Casualty policies, not Health & Life Insurance. The impact from the Pandemic should be manageable.
- Warren Buffett has assured shareholders multiple time through his annual letters that Berkshire’s insurance liabilities will not manifest in the form of sudden explosions of cash handouts. They will be a slow-bleed at worst. Here, we give the benefit of the doubt to Buffett on integrity and honesty – nobody in the investment world has a better track record on those virtues than he.
- Buffett has complete trust in his two Insurance lieutenants – Ajit Jain (Reinsurance) and Greg Abel (Geico). Buffett considers them to be the best “pricers of risk” in the business. Again, here we give the benefit of the doubt to all three gentlemen.
Net-net, we assume no growth in this business. As we estimate an intrinsic value for Berkshire, we will assume that the Insurance business stays roughly where it is now.
How much will Private Investments return?
In Berkshire’s financial statements, revenues and expenses from these businesses is included – using the Purchase Accounting method. So, when we calculate Berkshire’s Free Cash Flow, it includes numbers from Private Investments. I make this point clear because this part of the business is easier to evaluate compared to the rest – there are operating revenues, operating expenses, capital expenses and ultimately, they all trickle down to Free Cash Flow. Simple.
Generally, Private Equity funds in the US promise their investors (or Limited Partners) a 20% annualized return over the life of a fund, which usually lasts 7-10 years. Berkshire, as you’ve seen before, has been returning 20% a year on average for decades. Much of that success is attributable to Private Investments. Buffett has a knack for picking up solid businesses at cheap prices. But we won’t give him a free pass. We’ll assume that there is no growth in Free Cash Flow from this business.
So, we’ll use an average over the last 3 years as our estimate of Sustainable Free Cash Flow going forward. And we’ll assume NO GROWTH from that level.
How much will Public Investments return?
I apologize for the constant Accounting lessons, but they are important: In the case of Public Investments, the new rules force Berkshire to report “unrealized gains/losses” in the income statement. “Unrealized” means the profits/losses haven’t been crystalized – if your stock portfolio appreciates by 10% and you still hold on to it, your 10% gain is unrealized. It’s a paper profit, not a real one. But Berkshire is forced to include these volatile numbers in their income statement. Obviously, we won’t include it in Free Cash Flow (there is no cash flow if you don’t sell your stocks). But this creates a snag for us. Clearly, Berkshire’s massive Public Investment portfolio of nearly $250 billion has growth potential.
Now, in our Free Cash Flow estimate, dividends from these investment are included (because that’s a real cash inflow). But stock price changes are not. However, going forward, surely we should factor in a growth rate for that $250 billion portfolio?
Yes, we know that Buffett has been one of the greatest stock-pickers of all time. But we won’t give him hero-status when we evaluate his company. We’ll assume that this portfolio just earns “market-like” returns over the next few decades. Let’s call it 8%.
What to do will that cash?
One of our favorite Mungerisms is: “It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.”
Berkshire is currently sitting on a massive pile of cash – about $120 billion – on the balance sheet earning nothing. Berkshire has 2 choices:
- Find better-than-mediocre investment opportunities.
- Buy back shares as a way to return cash to shareholders.
We know the Berkshire will never pay dividends. Buffett looks at them with disdain. He feels there is always somewhere to invest. Right now, in the middle of the pandemic, he seems to be waiting patiently like a sniper. We don’t know what he’s thinking. How will he deploy that cash?
At The Buylyst, we never add cash balance our free-cash-flow-based valuation estimate. For most companies, cash balance is transitory and used as liquidity for short-term working capital needs. Some of Berkshire’s $120 billion pile is surely meant for that. But most of it – call it $100 billion – is looking for a home. What should we assume this $100 billion pile of cash will earn in the future? 5%? 10%? 20%?
If we were uber-conservative, we would go with 0%. But that’s not realistic given Buffett’s track record. His long-term record suggests he can generate 20%. That’s probably unrealistic too. The truth will be somewhere in the middle. To keep things simple, let’s assume 8% - a market-like return.
Keeping the math simple.
We can do our typical valuation – as a multiple of Free Cash Flow – on the Insurance and Private Investments parts of Berkshire. For the Public Investment portfolio and the $120 (or $100) billion cash arsenal, we need another method.
The final valuation of Berkshire will contain 2 parts:
- Valuation of Insurance & Private Investments
- Valuation of their Public Investments and Cash Pile
I can tell you that going by 2019 numbers, Berkshire’s Free Cash Flow (net of cash paid for interest and taxes) was about $13 billion. Using our customary 20X multiple, the Insurance & Private Investments parts of the business would be worth roughly $260 billion. Sure, dividends from Public investments are included in that Free Cash Flow number, but they’re not huge.
The other part – Public + Cash Pile – is the question. Let’s invert:
As I write this, Berkshire’s current Market Capitalization is about $450 billion. Let’s assume that our valuation estimate of $260 billion on the Insurance + Private segment is approximately right. What do we need to believe about the Public + Cash Pile segment to get to $450 billion?
We’ve laid out the framework. If we assume an 8% return on the Public + Cash Pile segment, what do we get? That – and our decision to buy Berkshire stock or not – will be revealed to subscribers in the next few days.
The math is simple. The assumptions are hard.
What are the main risks?
We see 3 obvious risks:
- What happens after Buffett and Munger pass on to the heavens? These words may sound harsh, but they are humans, and such is the circle of life. Who are the likely successors, and can they keep Berkshire’s legacy alive?
- What about Berkshire’s Energy and Railroad businesses? What are its prospects? As I mentioned earlier, their energy investments are not in sync with our investment worldview.
- What about Pandemic-induced liabilities in the Re-insurance business? It’s almost impossible to pin-point a number for this unless you’re Ajit Jain.
As we evaluate Berkshire, we will factor these risks. Any of these could be a thesis-buster. But the question is about the probability and magnitude of each of those risks. In investing, we deal with probabilities, not certainties. As bullet-proof Buffett and his fortress are, nothing is certain.
We hope this gives you definitive insight into Berkshire and what it’s (possibly) worth.
Many Happy Returns.