EML.PR.A Valuation

Upon further research, I was able to find the prospectus on Empire Life Insurance Co‘s preferred share class on SEDAR‘s website. I was surprised, on the negative side, to discover that EML.PR.A is redeemable by the company, when there is no mention of this on the annual report or anywhere at www.empire.ca.

EML.PR.A Prospectus

As per the prospectus, the Series 1 Preferred Shares (EML.PR.A) are not redeemable by the company before April 17, 2021 (which is also the date of the first rate reset to the Government of Canada 5 year bond yield + 4.99%). On that day, and on April 17 every fifth year after that, subject to certain provisions and restrictions, Empire Life may redeem all or any number of the outstanding Series 1 Preferred Shares by payment of CAD $25.00 in cash per share, together with accrued unpaid dividends, with at least 30 to 60 days prior notice.

To sum up, the company can buy back these preferred shares for $25 every time the rate resets. If the company doesn’t like the new dividend rate, and can borrow at a lower rate than that, it is in their interest to redeem them (and they will probably do it (I would)).

That said, these shares are now trading at CAD $26.85 (??!!), 7.4% over the face value and redemption price. The only reason I can think of for this to be happening is that investors are not aware that the shares can be bought back for $25 (like me, even after reading the annual report), and they are paying a higher price because Canadian bond rates have been going up and they think the dividend rate will be much higher on April 17, 2021.

Therefore, I am changing Empire Life Insurance Co from the ‘Yes’ tray to the ‘No’ tray, since I am very suspicious because they didn’t mention all the above in the annual report. This fact has a huge bearing on the value of these shares and they should have disclosed all this.

I would not invest in this company, and if I did, the maximum I would ever pay would be $12.50 per share for a 50% discount over face value.

Berkshire Hathaway Valuation

“It’s better to be approximately right, than precisely wrong.” – Warren Buffett

Following from my last post, where I placed Berkshire Hathaway on the ‘Yes’ tray, I read the latest quarterly report to value the company according to its latest figures. Coming in at 51 pages, it was definitely a faster read than the annual report, but lacking Warren’s personal touch.

Latest quarterly report

The first thing I noticed was that cash on hand increased from $86 billion to $96.5 billion, a 12.21% increase in just three months! This was mainly due to a retroactive reinsurance agreement with AIG in which National Indemnity Company received cash consideration of $10.2 billion. Book value increased from $286,359 million to $296,280 million. Since there are 1,644,559 equivalent A shares, book value per share is now $180,158 ($120.11 per B share), up 4.69% from $172,108 at yearend 2016. Since the company’s stock repurchase program is actioned at 120% of book value, the new floor for the A share is $180,158 x 120% = $216,190 and $216,190 / 1,500 = $144.13 for the B shares, up from $137.69 at yearend 2016.

Revenue increased from $52,163 million to $65,187 million quarter on quarter, a 25% increase. On the negative side, net earnings decreased almost 30% quarter on quarter, from $5,589 million at first quarter 2016 to $4,060 million at first quarter 2017, mainly due to higher insurance losses and loss adjustment expenses. Comprehensive income, however, increased from $3,061 million to $9,832 million quarter on quarter, mainly due to unrealised appreciation of investments.

Investments in equity securities increased from $122,032 million at yearend 2016 to $135,020 million, other investments (preferred stocks and common stock warrants) totalled $18,412 million, and investments in The Kraft Heinz Company had a market value of $29,553 million, a total of $182,985 million.

Insurance float increased from $91 billion at yearend 2016 to $105 billion at March 31. Total cash and investments held in the insurance businesses came to $226,268 million.

Back-of-the-envelope valuation

In Berkshire Hathaway’s 2012 Annual Report, Buffett said that the company’s intrinsic value could not be precisely calculated, but that we could measure two of three pillars to estimate this value. The three pillars are:

  1. Value of investments (stocks, bonds and cash equivalents);
  2. Operating earnings (excluding investments and insurance);
  3. Effective future deployment of retained earnings.

At March 31, Berkshire held cash, cash equivalents and US Treasury Bills of $96,464 million; investments (equity, preferred stock, warrants and bonds) of $175,117 million; plus an investment in Kraft Heinz with a market value of $29,553 million. Therefore, the total value of this first pillar is $301,134 million. Some of these investments are funded by float, but if the insurance companies manage to at least break even on their underwriting (they’ve been significantly profitable for decades), Warren says that these investments ‘can be viewed as an element of value for Berkshire shareholders’.

Net earnings from operations excluding insurance and investments totalled $12,571 million in 2016. For the past 10 years, a period that includes the financial crisis, Berkshire’s net earnings from operations grew 13% per year. Peter Lynch, one of the greatest fund managers of all time, and author of ‘One Up On Wall Street’ and ‘Beating the Street’, had a rule of thumb to determine a company’s fair value: the PE ratio should match the growth rate. For a company growing earnings at 13% per year, the fair value PE is 13. This way, the PE to Growth (PEG) ratio is equal to 1. If a share is selling for a PEG greater than 1, the share is considered expensive. And if the PEG is less than 1, the share is considered cheap.

Net earnings

However, if we look at the last 5 years, growth was closer to 12%, implying a fair PE of 12, in which case the total value for this second pillar is $12,571 million x 12 = $150,852 million.

The third pillar is subjective and hard to quantify. If a CEO is expected to reinvest retained earnings well, this will ‘add to the company’s current value; if the CEO’s talents and motives are suspect, today’s value must be discounted’. I think it’s safe to say that Warren adds a great deal of value here and that the value of Berkshire is greater than the sum of the first two pillars, but we don’t know how long he will remain with us, and the future performance of his replacements is uncertain (although I believe that they should perform well, otherwise Warren wouldn’t have hired them).

Taking into account only the first two pillars, the fair value of Berkshire is $451,986 million. This translates to a value of $274,837 per A share, or $183.22 per B share, which gives me a price to book value ratio of 1.53. And these values are very conservative since they don’t even take into account potential growth in cash and investments, and assign no value to the manager’s ability to reinvest earnings. Then again, the value of the investments is volatile, since they can easily decrease 20% or 30% if another recession or market crash comes along. Let’s call it even.

To invest or not to invest?

Benjamin Graham recommended buying a company at two-thirds (66,67%) of estimated intrinsic value, since the potential profit would be 50% on your cash once the company’s market price reached fair value. Warren Buffett is known to favor a 50% margin of safety (or more), which implies a return of 100% once the company reaches fair value.

Berkshire’s A shares are currently selling for $254,965 for a market capitalisation of $419,305 million, a discount of just 7.23% to my fair value estimate of $451,986 million. The B shares are selling for $170, compared to my fair value estimate of $183.22. The company is only slightly undervalued, and 7.23% is not a big enough margin of safety to make me want to buy it at this price.

Warren Buffett is willing to buy Berkshire shares at a price to book value (PBV) ratio of 1.2, implying a purchase price of $144.13 for a B share. This is a 21.34% discount to my estimate of $183.22, implying a possible return of about 27%.

Because it is Berkshire Hathaway, a huge company with a strong balance sheet and reasonable growth prospects, that has a zero chance of going bankrupt, I would be willing to accept a 20% margin of safety ($183.22 x 80% = $146.58). If I happen to have money available and no better ideas (for companies growing faster and/or with a huge margin of safety), this would be a very decent place to park it.

Final verdict: I am a buyer of B shares at $146.50.

Berkshire Hathaway 2016 Annual Report

I’ve been following Warren Buffett and his company, Berkshire Hathaway, for more than 10 years now, ever since I was at university, so it’s only suitable that this is the first company I write about. Warren Buffett says that he never looks at a share’s price before reading its annual report because he’s afraid that it might influence his decision (one way or the other), and this is what I intend to do for every company I analyse in the future. The trouble with this one is that I know exactly what price Berkshire Hathaway is trading at, but I’ll try not to let it influence me if we get to the valuation stage (which will only happen after and only if this annual report goes into the ‘Yes’ tray).

To determine which tray I will put each company, I will use a very simple and effective tool popularized by a Founding Father of the United States of America and one of my personal heroes: the pro and con list (derived from the Latin ‘pro et contra’, meaning ‘for and against’). Benjamin Franklin used this tool when he needed to make difficult decisions. He would simply divide a sheet of paper in two columns, write pro on top of the first and con on top of the second and then, during the course of several days, he would write hints in each of the columns as they came to his mind. When he could think of no other arguments pro or con, he would weigh their respective value and start to strike them out. If he found that a pro was equal to a con, he would strike both out. If he found a pro that matched two cons, those would also go, and so on until he could find no more matches. At the end he would more clearly see where the balance was, and make the decision accordingly.

Background

The Berkshire Cotton Manufacturing Company was established in 1889 in Adams, Massachusetts. The Valley Falls Company was a textile manufacturing company established by Oliver Chace in 1839 in Valley Falls, Rhode Island. In 1929 both companies merged to create Berkshire Fine Spinning Associates. In 1955 it merged with the Hathaway Manufacturing Company, which was founded in 1888 in New Bedford, Massachusetts, and was being run by Seabury Stanton who increased its profitability after the Depression. After the merger, Berkshire Hathaway had 15 plants, employed 12,000 people, had over $120 million in revenue, and was based in New Bedford, Massachusetts.

The November 1, 1965 Buffett Partnership letter was the first time Warren mentioned Berkshire Hathaway, disclosing that the partnership owned a controlling interest in the company. At this time, the company was down to two mills and 2,300 employees. Because of the illiquid nature of its shares, he was valuing the company at 100 cents per dollar for current assets and 50 cents per dollar for fixed assets (demonstrating the reliance he had on Benjamin Graham’s valuation methods at that time).

More information is supplied in the 1965 performance letter, dated January 20, 1966. Warren began buying Berkshire in 1962 at a price of $7.60 per share and continued buying until acquiring control in spring 1965. The average cost was $14.86 per share and the company had net working capital of $19 per share (without putting any value on plant, property and equipment) at the end of 1965. Realising that the textile business would not improve, he started to invest the proceeds in insurance companies, buying the National Indemnity Company in 1968 for $8.6 million, and eventually closed down the textile operations in 1985. It has been a legendary journey. Today that same share that he started buying for $7.60 is selling for $248,000.

Pros and cons

Having read all 122 pages of the 2016 annual report, I summed up the most important points (at least, to me) into two pages split in half between pros and cons. You can find the file here:

Berkshire Hathaway 2016 Annual Report Pros and Cons

With 28 Pro arguments and 13 Con arguments, it’s safe to say that Berkshire Hathaway is in very positive territory. Actually, Pro 1 and 2 are more than enough to strike out all Con arguments. Over 50 years of such out-performance is an extraordinary achievement. You can read Warren Buffett’s Shareholder Letters since 1965 and get an amazing education as an investor.

The two Con arguments that I’m still a bit concerned about are Con 4 and Con 13. Because of its huge size, it is highly unlikely that Berkshire Hathaway will grow at the same rate as previous decades, and I would prefer that my investments compound faster than a market index (otherwise I would simply put my money in an index fund, but I’m already doing that with my company pension plan). Also, if I were to invest now, I would be a bit nervous about the effect that Warren’s passing would have on the share price at the time (even knowing it would probably be just a temporary decline; maybe one can use this to buy more shares cheaper, if I have money available) and on the company’s policies and investments.

Conclusion

This annual report easily goes into the ‘Yes’ tray.

I would invest in Berkshire Hathaway in the absence of better ideas (smaller companies that would grow and compound capital faster) and depending on the price I pay for the shares. Even though I know the chances of permanent capital loss are nonexistent, and the chances of quotational capital loss are tiny due to the $137.69 floor price for the B shares (Pro 8), I would still require a significant margin of safety to intrinsic value.

Would I feel comfortable owning it for 10 years or more? Yes. I like and admire this company, trust that my money will be in good, honest hands, and am reasonably confident that I will at least get a decent result over time.

The questions that still remain are: How much is it worth? Can I buy it at a substantial discount?

Stay tuned for my valuation of Berkshire Hathaway…