Berkshire Hathaway – A buy for Value and Franchise seekers alike
Mar 2020 ($320K)
For many years now we have annually modelled the value of Berkshire Hathaway (BRK). Doing so to see whether the entity represented good value not just versus a prudent valuation of its constituent parts today but also against the likely future growth it might deliver to investors in the future. Whilst we are fans of Munger and Buffett’s approach to business and investing we have always tried to remain dispassionate when assessing the company’s value. As such we have endeavoured to be disciplined in our valuation work only recommending the company as a buy when we saw a valuation anomaly. Today looks to be one such moment.
In the attached slide presentation, we show a variety of charts which explain our current and past thinking on BRK’s value. (These are the outputs of a model which we are happy to share). We conclude that for the first time in a number of years Berkshire looks cheap vs. the consistent value yardsticks we have been measuring the company on for almost ten years now. Adjusting for today’s lower share prices of its owned securities but also putting a 17x multiple on controlled businesses (ex insurance) gives us a best guess valuation range of $329,000-$408,000. Buy Berkshire.
What our slides show
This note is intended to accompany our slides and model on Berkshire Hathaway. To understand our approach best, it is best looked at accompanying either, or preferably both.
Simply put the slides show:
- That Berkshire has traded very closely to our modelled range of values for the company over a very long period. Our intrinsic valuation has compounded at 11% on average over the last nine years. This we think is a reasonable proxy for its long-term growth.
- That today using this exact same approach of a ‘Prudent’ and ‘Optimistic’ values gives a suggested fair value for BRK of between $309K and $388k per each A share. However:
- This is a backward-looking estimate using December 2019 financials, so it does not take into account any owned business growth happening in 2020 nor does it factor today’s lower share prices of owned securities
- Crudely adjusting for today’s values for its owned market securities only, this range might reduce to $280k to $359k
- Additionally, using Buffett’s own view on valuation (expressed a few years ago) would give a value of:
- $393k per share
- And this in turn would be reduced to $380k, again crudely adjusting for today’s lower share prices
But… are we too prudent?
We are delighted that the BRK price has closely mirrored our consistent valuation approach suggesting it is a very useful method for investors to decide when to/not to buy BRK stock. However, we also think as time has evolved, our approach perhaps ought to have evolved a little too.
Ergo:
- The owned businesses we have valued using a 10x PBT multiple every year for the last decade. Doing so at the time we started our work this equated into a not unreasonable multiple of c.15x PE when corporate tax rates were 33%. However:
- At a 20% tax rate a 10x PBT multiple equates to a PE of 12.5x!!
- At the same time the price of high-quality businesses has been rated ever higher in Equity markets making this ‘look-through PE’ seem more and more unrepresentative of the generally high ROIC businesses that Berkshire controls
- Indeed, nowhere is this truer than in the railroads and utility space where such predictable businesses now sit on c.20x PE multiples.
- Adjusting our valuation for:
This range of $329k to $408k we think is a better guide to the real value of the assets sitting inside Berkshire today. We remind readers that the range of values we have is created by either assuming the whole cost of the float liability is deducted from investments or none of it is. The debate on which of these is the correct approach is a long one for nerdy BRK watchers, thus we think the range of values is a useful to bypass of it.
Reflecting on Optionality and Mortality
In previous valuation exercises for BRK we have sometimes noted the risk of Buffett’s inevitable mortality and how news of his death might bring uncertainty and some risk to the share valuation. Whilst we still feel that is a relevant argument as he will not create easy shoes to fill, the value in BRK today provides some good comfort to that overhang. Today in contrast we see possible upside optionality in the company. This is in part due to the fact that his and Charlie’s golden touch has arguably created little value for the group in recent years (Ref. Heinz deal), but more due to the collection of other assets the group is now sitting on.
- Of our fair value estimate a remarkable 23% of which is currently in cash. Whilst that will limit compounding potential of Berkshire’s intrinsic value in its current form recent market volatility points to the optionality it brings particularly inside such a parent. For an example see our recent reflections on Aercap. It is the perfect example of a business that could fail as a separate entity, but would never do so as part of a huge parent. Were someone like Aercap to fail there will be few buyers for its fleet, but we would expect Berkshire to interested.
- Additionally, in the quoted security portfolio Berkshire is a huge owner of arguably the two most depressed sectors in the world judged on earnings power/ROIC vs. Equity value. These being Banks and Airlines:
- Banks and Airlines represent c.$52k/share or c15% of our estimate of BRK’s value.
- If they recover strongly over the longer term as we expect then BRK will be a strong beneficiary
The Arbitrageur
A final strength we think stands out for Berkshire in a world of 0-1% interest rates – that of the interest rate arbitrageur:
- Arguably there are two types of companies in the investing world today. Those being hurt by interest rates and those profiting from them
- Mr Market’s focus is on those clear winners and losers:
- Today the losers (banks as an example) are fighting the headwind of ever lower interest rates and the difficulty it poses for their earnings power
- Conversely the winners are those whose equity value has risen almost exponentially as their predictable profit streams have been re-priced ever higher against 0% interest rates
- We suggest investors look out for a third type of company – what we might call the arbitrageurs
- Such an arbitrageur, we think, is a company that can make maybe a decent (c.8-15%) rather than super high (50%+) ROIC, but importantly the business is structured as such and stable enough that it can use leverage as a part funder of this earnings stream
- A small local example of this is JD Wetherspoons who’s ROIC is arguably low when looked at across its entire capital structure (c.9% depending on your definition). However, with a very predictable cash generative business and with a freehold estate it has a permanent access to very cheap bank capital (which last year it fixed at low rates for the next 5y). The effect of this ongoing very low cost of debt results in an attractive return on tangible equity for JDW of c.25%.
- Jumping to Canada, Brookfield is a larger and more Berkshire-like comparable with super long-term quality property assets and a scale which gives it access to very low funding.
- Another topical example of low ROIC and more acceptable (over time) ROTE is Carnival!
- Almost no one can borrow cheaper than Berkshire can. The fact that they have not done so in significant size instead choosing to sit on cash belies an optionality that we think is not at all lost on those sitting at the helm in Omaha.
- When the next Burlington Northern type deal comes along its equity, we think, will most likely be purchased for cash.
- But, crucially, any financing of such a businesses can then be done at a level of cost that few others can match.
- Berkshire’s deployment of huge sums in its utility division are an example of this capital allocation.
- Today credit is seemingly plentiful for all, but this will not always be the case.
- We think the Arbitrage of cheaper credit use in stable business models today is well discounted in some companies (American Tower being a stand out example). But we think in others there is an opportunity. Berkshire today is a huge example of such a business, but one that so far is keeping its hands in it pockets.
Our best guess valuation range for Berkshire using today’s share prices and a 17x PE for owned business gives a range of values of $329k to $408k (+3% to +28%). For super-safe global entity that might compound at 8-10% long term and its sitting on much optionality we think this is a good margin of safety.
Buy Berkshire Hathaway
Andrew Hollingworth & Mark Power
The Directors and employees of Holland Advisors may have a beneficial interest in some of the companies mentioned in this report via holdings in a fund that they also act as advisors to.
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