With U.S. markets continuing to rise, my activity has been fairly limited since my last post. However I have made some moves, and this will be the first in a series of posts summarizing changes to my portfolio since last September.
First up is Berkshire.
Berkshire has been a very large part of my portfolio since May 2011. While not dirt cheap today, it is certainly not expensive and I have added to it recently below $140. It currently represents a whopping 25% of my actively managed portfolio.
I won't go into any back story around Berkshire's history or current businesses here. I'll focus on valuation. Buffett provides pretty good clues as to how he thinks about Berkshire's value. There's a huge amount of discussion in the investment community around valuing Berkshire, along with a great variety of approaches. Below I discuss one such approach that is simple and logical to me. It goes without saying, but any investor should come to terms with whatever valuation approach(s) they use and be comfortable with the valuation. Shares trade in the $144 range, and Buffett's buyback threshold is currently $119 (120% of BVPS).
Buffett has two key quantitatve valuation metrics, the first relating to the insurance companies, and a second related to its operating companies. The figures for 2014 YE:
(1) investments per B share: $93.42
(2) operating income per B share: $7.23
(1) investments per B share: $93.42
(2) operating income per B share: $7.23
A simple, logical, and I believe a conservative approach to value Berkshire is to tack a multiple onto (2) (representing the approximate value of the non-insurance subsidiaries) and add (1) (the the approximate value of the insurance companies) to the resulting figure. Using a 10x multiple on the operating income results in a value estimate of $166 (see post publish edit below). The operating earnings are pre-tax, so a 10x multiple is around a 6.5% post-tax yield, which is reasonable regardless of interest rates, given Berkshire is also likely to grow, albeit at a much slower rate than in the past. I think this approach is fairly conservative because it ignores material adjustments to the upside such as superior capital allocation, long-term shareholder oriented and rational culture and, as I discuss below, this approach arguably understates the value of the insurance subsidiaries.
As it relates to the insurance companies, the obvious question is why does (1) represent the value approximation when it only considers the assets, ignoring the liabilities all together. After all, the economic value of equity is market value of assets minus the fair value of liabilities. So shouldn't the liabilities financing the investments be subtracted from (1) to derive the net equity? Of course we should, but the key thing to note is that the fair value of the liabilities isn't even close to the GAAP value shown on the balance sheet. The reason is that Berkshire has a tremendous group of insurance companies. Specifically they have generated an underwriting profit (before a dime of investment income is considered) for 12 years straight. And over the past 4 decades they have consistently delivered money ranging from extremely cheap (less than 30 year treasuries) to better than free (profitable underwriting). Importantly, this "float" is not only long enduring (i.e., it doesn't mature or amortize like a regular liability because it is constantly replenished), it has grown at rapid rates. Lastly Berkshire has a strong track record of reserving for its obligations.
Since Berkshire's liabilities have largely been better than free and long enduring, one could reasonably argue that they are not just overvalued at the GAAP amounts, but are literally on the wrong side of the balance sheet, or more conservatively are worth 0. And hence, getting back to market value of assets minus fair value of liabilities, the value of the insurance companies are worth at least the investments and cash (market value of assets minus 0). Here I ignore other net insurance assets (excluding goodwill), which are positive. This approach also ignores growth in float (i.e., the present value of additional free money to be received in the future). In his 2014 shareholder letter, Buffett stated that he does not expect significant growth in float in the future, so this seems like a reasonable assumption.
I have heard some argue against this math because the liquidation value of the liabilities is their face value shown on the balance sheet. This is totally wrong for the simple reason that if the liabilities are arguably sizeable assets on a going concern basis, why would any rational manager pursue a course of action that not only destroys the asset value, but converts them into huge liabilities? More concretely, a manager could
(a) Unintelligently put the liabilities into runoff and pay someone to manage them. This would still convert an asset into a liability, which is irrational. But the liability would still be worth way less than face because it would be cheap money and payments would stretch years. Or
(b) More logically sell the business /transfer the liabilities at something close to fair value. If the liabilities are an asset to us as a going concern, why wouldn't they be for someone else?
(a) Unintelligently put the liabilities into runoff and pay someone to manage them. This would still convert an asset into a liability, which is irrational. But the liability would still be worth way less than face because it would be cheap money and payments would stretch years. Or
(b) More logically sell the business /transfer the liabilities at something close to fair value. If the liabilities are an asset to us as a going concern, why wouldn't they be for someone else?
I've heard other arguments such as the fact that the assets the liabilities fund must earn low returns to defease the liabilities, so therefore one cannot simply zero out the value of the liabilities. While I understand Berkshire must hold some capital to protect policy holders, which is a yield drag, I don't think the assets are at all relevant to the valuation of the liabilities. If someone wants to haircut the value of the assets separately based on one's own asset return hurdles, by all means. I would note though that my understanding is that Berkshire does not sell policies with unlimited liability, so Berkshire has chopped the tail of the loss distribution to where it knows it's worst case scenario. I think it may be for this reason that Buffett has stated minimum cash balances he will hold. Haircutting the value of this minimum cash could possibly be reasonable, but I currently don't make any adjustments myself because I think there's enough conservatism baked into zeroing out the liabilities (rather than adding additional value given the expectation of underwriting profit) that it probably more than washes.
Buffett and Munger
Investors in Berkshire must also be comfortable with Buffett and Munger's respective ages. Obviously their passing will be a huge blow. The stock will also most likely fall significantly, as it reasonably should given simple math, and the value they add. Overall from an investment standpoint, this is not a huge concern for me. For one thing, the valuation above does not consider any premium for superior capital allocation or other "Buffett premium", even though I think there should still be a a capital allocation premium absent Buffett and Munger. I think this because, Berkshire is uncommonly disciplined, rational and shareholder oriented. And they mean it, rather than pay lip service to it. Capital allocation aside, culture runs deep in organizations and all along Buffett has put good incentives in place for managers (and board members), so I expect that Berkshire will still manage to thrive after Buffett and Munger.
Conclusion
In conclusion, I think Berkshire, with a value of at least $153 (see post publish edit below) and price of $144, is an attractive investment right now. Particularly when compared to general market valuations today. Further, I think succession risk, while not to be dismissed, is minimal given Berkshire's culture and current valuation.
Post publish edit: Regarding valuation, I actually think it also makes sense to subtract around half of Berkshire's deferred tax liabilities. This comes to $13 per B share, bringing the estimate to around $153 ($166-$13). How did I come up with half? Very subjectively. Berkshire's DTL relates primarily to capital gains and accelerated depreciation in BNSF and the utility businesses. These are both liabilities where payments will stretch many many years. The capital gains are arguably worth close to zero because Buffett does not tend to sell core holdings. In any event, treating them like a 30 year zero coupon bond, discounted at the 30 year treasury rate of 3.05% gives a present value of around 45% and I rounded to 50%.
Disclosure: Long BRK.B
Conclusion
In conclusion, I think Berkshire, with a value of at least $153 (see post publish edit below) and price of $144, is an attractive investment right now. Particularly when compared to general market valuations today. Further, I think succession risk, while not to be dismissed, is minimal given Berkshire's culture and current valuation.
Post publish edit: Regarding valuation, I actually think it also makes sense to subtract around half of Berkshire's deferred tax liabilities. This comes to $13 per B share, bringing the estimate to around $153 ($166-$13). How did I come up with half? Very subjectively. Berkshire's DTL relates primarily to capital gains and accelerated depreciation in BNSF and the utility businesses. These are both liabilities where payments will stretch many many years. The capital gains are arguably worth close to zero because Buffett does not tend to sell core holdings. In any event, treating them like a 30 year zero coupon bond, discounted at the 30 year treasury rate of 3.05% gives a present value of around 45% and I rounded to 50%.
Disclosure: Long BRK.B
