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…

 

My Investment Criteria

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Before I start writing about the annual reports I read I want to let you guys know about my personal biases (because you might not share them) and about what kind of companies I look for…

To put it simply, my personal biases are:

  1. I hate debt;
  2. I like dividends;
  3. I love discounts.

I hate debt because it’s the main reason companies go bankrupt. I am well aware that, if used conservatively and efficiently, debt can be used to increase returns on equity, but if the company runs into trouble (even if it is temporary) and is unable to meet its loan payments it will go bankrupt, the creditors will claim the assets, and the shareholders will be lucky if they retain a small sliver of their investment. If a company has no loans, I’m much more confident that it will be able to survive any bad periods it may have, and that I will not suffer a permanent capital loss.

I like dividends because, even if you find a company you think is undervalued, it may take years for the market to fully recognise its value. If I am to wait patiently for this to happen, I want to at least have the satisfaction of seeing some money coming into my account. Having said that, I would not insist upon this if I’m fairly confident that management is using the retained earnings rationally and getting a good rate of return on capital.

I love discounts (aka margin of safety) because you make your money when you buy, not when you sell. Most people buy shares in the expectation that their price will rise, without having any clue as to how much they are really worth. Safe to say this sometimes doesn’t work out so well. I feel it’s much better to do the opposite. Know the value, and buy it for much less (money in the bank, basically). Don’t you like going to the supermarket and seeing a promotion to buy 2 for 1 (a 50% discount!) of one of your favorite items?

So, what kind of companies do I want to invest in? In Berkshire Hathaway’s Shareholder Letters and annual reports, Warren Buffett has mentioned several acquisition criteria throughout the years. I think the most important ones are:

  1. Demonstrated consistent earning power with favorable long-term prospects;
  2. Good returns on equity with little or no debt;
  3. Honest management that makes rational capital allocation decisions;
  4. Simple business selling for a significant discount to its value.

Easier said than done! The great majority of public companies do not fulfill these criteria. Many of them are cyclical (meaning they do well in good economic times but struggle when the tide turns), or complex (you couldn’t figure them out even if you had years to do it), or are selling for an expensive price, or have poor returns because their managers just keep plowing money into bad investments or buying companies for more than they are worth just to make their company bigger (when they should just return that money to shareholders).

Hence, I do not expect to make new investments every week, or every month for that matter. If I can find a good investment or two per year, I will be happy. One of my favorite Buffett quotes is:

“An investor should act as though he had a lifetime decision card with just twenty punches on it.”

Instead of buying shares like you’re buying candy or a six-pack (like most retail traders), buy shares with the same care as you would when buying a house.

How to start building wealth

“A PART OF ALL YOU EARN IS YOURS TO KEEP.” – George S. Clason

Coming from a working class family, as a young kid I was used to seeing my parents spend all their money until their next payments came along. Even though the money was spent on necessities like rent, utilities, gas, food, school, even when we had a little to spare, we would find a way to spend it. We lived paycheck to paycheck, and we were lucky if we still had some money left at the end of the month. Saving was an unfamiliar word in our family. We were unaware of other ways to manage money.

That’s why my mind was blown away the first time I read The Richest Man in Babylon, by George Clason. And the second time. And the third time… It opened my eyes to the possibility that I could become wealthy, or at least financially safe, if I followed a few simple money management principles. And I still learn something new every time I read it, usually at least once a year. It is, without a doubt, my all time favourite book about personal finance.

The most important thing I learned? Pay yourself first!

The great majority of people just go through the motions: work, get paid, spend, work, get paid, spend… And so on and so on. They pay all their expenses and bills without much planning, and if by luck some money is left over at the end of the month, then they might put it into a savings account or leave it in their current account for next month’s expenses.

Instead of following this same old routine, the most important rule in the book says that we should save first, and then use the remaining amount for your cost of living. Pay yourself first! As soon as you get paid, take at least 10% of your income (you can take a bigger percentage, if you wish), put it into a savings account and out of your sight. Very simple, right? Simple, but not easy…

The first several times I read The Richest Man in Babylon  I missed the most important point. I started saving a little, and then when I had an emergency, or an unexpected charge, or when I just wanted to buy something and didn’t have enough money in my current account, I would dip into my savings (huge no no). It took quite a few more reads to understand it fully: your savings are not to pay bills, not for taxes, not for food or travel, not to go out, not to buy toys or shiny objects. It is for you and you alone, to invest. Period!

Pay yourself first, and use the rest of your paycheck for your normal expenses. This way you automatically control your spending, because you only see and use the money in your current account. If you find yourself needing money for an unforeseen event, find a way to make more money, or cut back on your expenses, but do not touch your savings!

Your savings are solely to invest in assets that provide you more income. Make your money work for you. That is how you start to build wealth.

Besides this principle, you will learn about the ‘seven cures for a lean purse’ and ‘the five laws of gold’ (among others). It is a short book (about 72 pages) full of parables written in old english (old fashioned but I like it) that you can read in about two hours, and whatever price you pay for it, you’ll get back more than a thousand fold in money management wisdom. Invaluable!

Welcome to Investing: Move by Move

When asked how he became so successful in investing, Buffett answered: “We read hundreds and hundreds of annual reports every year.”

When I was a teenager I liked to play chess, but no matter how many books I read, my level of play didn’t seem to improve. They were either for beginners, or too advanced for me to understand the concepts that would take me from beginner to intermediate, and then to advanced level. And then I found a book called “Logical Chess: Move by Move” by Irving Chernev. I had never seen or read anything like it. Instead of just writing down moves and annotating a few variants whenever a mistake was made, this book explained every single move in 33 master games of chess. It made me much more aware of the reasons why a certain move was good or bad, either tactically or positionally, and greatly improved my understanding of the game, helping me break through that plateau.

Hence, the name for this blog.

My name is Rui Rodrigues. I moved from Portugal to London almost two years ago looking for employment opportunities in the financial sector, since I love finance, financial markets, and am a huge fan of value investing and Warren Buffett, considered to be the most successful investor of all time. I have a degree in Business Management from a portuguese university, passed the CFA Level 1 Exam but failed the Level 2 Exam (more times than I care to admit), and I recently achieved the Investment Management Certificate (IMC). My career has been built mostly in sales and customer service, however.

Like most millennials, I’m still not in the property ladder and my retirement planning leaves much to be desired. Aside from some personal savings and my company’s pension savings plan, I have nothing else in place. Safe to say this will never be enough to provide me with a comfortable life when I’m old, so I knew that decisive action was necessary. Better late than never, so…

A couple of months ago I won an equity trading challenge with a performance of 45% in one month, and the prize was a £2000 travel voucher, which I sold with a little discount. I decided to put some of that money into an Investment ISA (Individual Savings Account, for those of you who don’t live in the UK) and start investing in shares without paying capital gains tax or dividend tax (huge advantage over people who live in countries that don’t have something like this!). I have tried trading forex and CFD’s in the past (not with much success) but like to think that I have become wiser since then, hopefully.

I want to invest using Warren Buffett’s and Benjamin Graham’s principles and buy good companies when they are trading at a discount to their intrinsic value. The question is: how do we determine that value? As the quote at the beginning of this article suggests, we start by reading annual reports.

The purpose of this blog is for me to record my journey and share with you every move I make when investing (or when deciding not to invest, which will probably happen most of the time) by analyzing every annual report I read, as well as the best books I like about this subject, so that you learn from my experience (and probable mistakes). I hope I can help you prepare for your retirement, or improve your financial situation, or simply improve your knowledge about personal finance and investing, and add value to your life. Also, it would not hurt if I could make some extra income from this blog (although, at this time, I have no idea how that might happen) so I can put a bit more money towards my retirement (and buy a house and start a family, eventually…).

Warren Buffett says that he has three trays where he puts reports after reading them: Yes (companies that he would invest in); No (companies that he doesn’t like); Too Hard (companies that are outside his circle of competence and that he feels he can’t analyse competently). I propose to do the same with every annual report I read. And if one ends up on the Yes tray, I will start researching the company and try to value it. When the value of the company is greater than the price for what it is selling in the stock market, we have a margin of safety (aka discount), and it might be the right time to invest.

Now the question is: where to start?