I’m again pouring over Berkshire Hathaway’s 2014 annual letter to shareholders released last Saturday. The expanded, 43-page letter marked the 50th anniversary of Warren Buffett’s reign at Berkshire. As always, there was wisdom and valuable lessons found on almost every page. No surprises, really, but valuable investment truths along with the honest goings on of a $350 billion empire. The letter also included separate chapters from Buffett and his partner, Charlie Munger, discussing their take on the past, present, and future of Berkshire.
The man known as the greatest investor in history is also arguably one the world’s greatest financial writers. Buffett’s letters are always a good read and a good source of business education.
One thing that rattles around in my head every time I read the Berkshire letter is just how different Berkshire is. Here are three examples:
– Berkshire is a conglomerate, with hundreds of businesses comprising 340,000 employees—roughly the population of Honolulu. Yet, world headquarters for Berkshire is 25 people. Highly decentralized.
– Despite all its operations, Buffett spends most of his days free of appointments or obligations. Just a lot of free time to think, read, and do whatever is most productive at the moment.
– Many, if not most, companies almost mindlessly choose a course of action for its earnings once made. Many companies (1) automatically reinvest earnings in the operations from where it came (even if it’s obvious the return-on-investment will be poor); (2) pay as much in dividends as it can; (3) try to raise their profile by buying other companies; (4) buy back their stock regardless of price; or (5) do a little bit of everything. Berkshire has no pre-conceived notions on what to do with its earnings. It seeks to allocate funds as rationally as it can, seeking high return and low risk.
This last characteristic is truly what defines Berkshire. It chooses to reserve all options regarding how it invests. See’s Candies is perfect example. Berkshire bought See’s in 1972 for $25 million dollars. Since then See’s has generated $1.9 billion in pre-tax earnings, but Berkshire has only re-invested about $40 million into See’s since 1972 (meaning $65 million in total invested capital). Could it have invested more and expanded See’s? Sure, it could have launched thousands of See’s stores. But it didn’t. There are only over 200 See’s stores.
Why is that? The reason is opportunity cost. Simply put, Buffett and Berkshire had more productive uses for the capital, like buying GEICO (which was then small but had the ingredients of a superior business with lots of growth) and other assets—whole companies and securities—that proved to have a much higher return-on-investment.
By allowing itself options, Berkshire has reserved a huge advantage. Another example: by willing to buy partial ownership of a business, Berkshire allows itself more options, and thus more opportunities. Buffett explains:
“Another major advantage we possess is the ability to buy pieces of wonderful businesses—a.k.a. common stocks. That’s not a course of action open to most managements. Over our history, this strategic alternative has proved to be very helpful; a broad range of options always sharpens decision-making. The businesses we are offered by the stock market every day—in small pieces, to be sure—are often far more attractive that the businesses we are concurrently being offered in their entirety. Additionally the gains we’ve realized from marketable securities have helped us make certain large acquisitions that would other wise have been beyond our financial capabilities.
“In effect, the world is Berkshire’s oyster—a world offering us a range of opportunities far beyond those realistically open to most companies. We are limited, of course, to businesses whose economic prospects we can evaluate. And that’s a serious limitation: Charlie and I have no idea what a great many companies will look like ten years from now. But that limitation is much smaller than that borne by an executive whose experience has been confined to a single industry.”
What’s surprising is how few companies share Berkshire’s structure. Berkshire can be copied; any company with operations generating consistent free cash flow has the opportunity to elevate their business into a compounding machine.
Buffett and Munger are decidedly bullish on their company’s prospects after they are long gone. Buffet writes:
“I believe the chance of permanent capital loss for patient shareholders is as low as can be found among single-company investments. That’s because our per-share intrinsic business value is almost certain to advance over time.”
His opinion is not based merely on hope but rather the exceptional qualities of Berkshire’s businesses. Additionally, the Berkshire culture and financial strength are two elements that should ensure that smart opportunities will be seized.
Now that Buffett has two superb investors in Todd Combs and Ted Weschler on the job, Berkshire’s modus operandi looks unshakable. Their jobs will be no different than how Buffett describes his and Munger’s:
“Charlie and I hope to build Berkshire’s per-share intrinsic value by (1) constantly improving the basic earning power of our many subsidiaries; (2) further increasing their earnings through bolt-on acquisitions; (3) benefiting from the growth of our investees; (4) repurchasing Berkshire shares when they are available at a meaningful discount from intrinsic value; and (5) making an occasional large acquisition. We will also try to maximize results for you by rarely, if ever, issuing Berkshire shares.”
One could also argue it’s much easier to replace a Buffett—who invests and oversees a company that is in the business of owning things—than a CEO whose company depends on for innovation or managerial mastery, like a Steve Jobs, Jeff Bezos or Jack Welch. (It should be noted Apple has performed spectacularly since Jobs died in 2011; on the other hand, it has had no new product launches since Job’s death. The iWatch will be the first new hardware of the Tim Cook era).
Munger shared his views of Berkshire’s future in classic Munger fashion during last year’s shareholders meeting when he ordered his family: “Don’t be so stupid as to sell after I’m dead.”
Valuing Berkshire Stock
Buffett’s letters in recent years have carried an increasingly optimistic tone regarding Berkshire’s business prospects and stock prospects. The trend continued in Saturday’s letter. For a shareholder, this was reassuring though not surprising. Berkshire took huge advantage of the financial crisis, buying large profitable companies like Burlington Northern Santa Fe on the cheap and being the pricey lender of last resort for giants like General Electric, Goldman Sachs, and Bank of America.
Berkshire’s profit machine is stronger than ever, and thankfully, ownership doesn’t come at a steep price.
In 2010 Buffett provided a framework to evaluate Berkshire stock: one qualitative element and two larger—and easily measurable—quantitative elements. Those quantitative elements are (1) Berkshire’s investments per share, currently $140,123 (using A-shares here); and (2) its per share earnings, currently $10,847, pre-tax. (B-shares represent 1/1,500 an A-share.)
Any investment is about what you give versus what you get. Today you would give $218,000 for a Berkshire A-share based on yesterday’s price. What you get is $140,123 in investments (including the interest, dividends and gains in the future) and $10,847 in pre-tax earnings per year going forward from the operating subsidiaries (likely to increase over time).
A good deal? We think so, but it depends on how you discount that earnings stream, your expectations on its growth, and, invoking Buffett’s third element to his valuation framework, your expectations of how successfully Berkshire will reinvest retained earnings in the future.
Investors should do reasonably well, but only if the stock isn’t purchased at an expensive price. As bullish as Buffett is on his company going forward, he cautions:
“If an investor’s entry point into Berkshire stock is unusually high—at a price, say, approaching double book value, which Berkshire shares have occasionally reached—it may well be many years before the investor can realize a profit. In other words, a sound investment can morph into a rash speculation if it is bought at an elevated price. Berkshire is not exempt from this truth.”
Considering this and Buffett’s previous guidance that Berkshire stock is undervalued enough at 1.2 times stated book value for Berkshire to buy back its stock, today’s price of 1.5 times book value is probably reasonable-to-cheap.
To ensure a satisfactory return, Buffett advises, “Since I know of no way to reliably predict market movements, I recommend that you purchase Berkshire shares only if you expect to hold them for at least five years.”
The author and clients of Cadinha & Co. LLC own stock in Berkshire Hathaway. This commentary is for informational purposes only and is not a recommendation to buy or sell the securities discussed. The reader should not assume that an investment in the securities identified was or will be profitable.