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I won’t win any points for creativity on this one, but after the recent buyback announcement I think Berkshire Hathaway is a very attractive risk/reward.  Right now you can buy the greatest compounding machine of all time with an effective floor set on the share price right near current levels.  The best part is that shareholders will actually be better off in the long run if the price goes down below the floor and the company can use its huge cash pile to buy back shares. The reasonable downside case from here is that Berkshire compounds in the high single digits, and the most likely outcome is something in the teens. Combined with a risk profile that is significantly lower than that of the market as a whole, that seems like a very good deal in a low return environment.   

“At our limit price of 110% of book value, repurchases clearly increase Berkshire’s per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase                                             stock aggressively at our price limit or lower.” – Warren Buffett, 2011 annual report

“Heads I win, tails I win more”

I’ll keep this pretty simple and won’t rehash the basic Berkshire story since we all know it already.  While there are a few ways you can estimate Berkshire’s intrinsic value, I’m going to focus on price/book for a few reasons – it’s a simple proxy for the company’s overall value (especially in a directional sense), the company is now using P/B as the metric by which buybacks are determined, and the conclusion is basically the same regardless of the method you use.  For example Whitney Tilson has a detailed presentation that places a multiple of 8x on pre-tax earnings (excluding those from investments), adds in the value of investments, and comes up with intrinsic value of $180,000/share: http://www.tilsonfunds.com/BRK.pdf.  It’s also worth pointing out that Berkshire’s book value is likely an understated measure of intrinsic value, in part because it holds the accounting value of certain assets like GEICO at their original purchase price despite decades of growth since the purchases were made.

“…we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values.” – Warren Buffett, 2011 Annual Letter

VIC History:

Berkshire has been written up as a long three times in VIC’s history.  While each has resulted in a positive gain, the returns of the stock have lagged the growth in Berkshire’s book value in each instance:

So book and intrinsic value have continued to compound at nice rates but the stock has only gotten cheaper.  Looking forward I think intrinsic value will continue to compound but at current levels it’s also very unlikely that the multiple will compress further given the recently announced buyback that allows purchases up to 1.2x book value. While it’s an admittedly simple framework, one can think of your future returns from holding Berkshire as a function of 1) the rate at which book value compounds, and 2) the multiple of that book value that Mr. Market gives to the stock.  So let’s look at each of those in a bit more detail.

Book value growth from here:

Book value as of 09/30/2012 was $111,718 per class A share. The company’s ~$80 billion in listed investments is up slightly on the quarter, and overall book value has likely grown a couple percent quarter to date.  If you assume year-end book value of $114,000, than the 1.2x level at which Berkshire can buy back shares would be $136,800, above the current stock price.  If you don’t adjust for likely quarter-to-date gains, than the current cap for buybacks would be at $134,061.  The stock was actually below that level yesterday, and is only slightly above it today, so it’s possible the company has already bought back additional shares.

Book value has grown at consistently high rates of return since Berkshire began in 1965. In fact there has never been a single 5 year period in which book value did not grow at a faster pace than the S&P 500.  Through inflation, deflation, numerous wars, multiple asset bubbles and subsequent crashes, Berkshire’s book value has consistently outperformed the market:

So what will book value compound at going forward?  Obviously it depends on the economy and what markets do, but the past decade’s experience gives me confidence that high single digits is achievable even in a very tough economic environment and at Berkshire’s large size.  Given that size 20% growth is very unlikely, but 5 years from now GEICO will be insuring more people, Coca Cola will be selling more beverages, Burlington Northern should be producing higher cash flows, future cash flows will be reinvested into something else, etc.  The best relative performance will come if the S&P falls and if there is any chance the streak of outperformance ends it would be in a strong up market (Berkshire almost fell behind by 2007) – but Berkshire’s absolute returns should be just fine in that situation.  So depending on your view of the world I think you can reasonably plug in anywhere from 6%-12% in terms of where book value compounds from here, and if I had to pick a single number I’d use 8%.   

Price/book over time:

Today’s price/book is approximately 1.18x my estimate of year-end book value. This is low by historical standards and below the 1.2x cap at which Berkshire just announced it would buy back shares. What is particularly interesting to me is not only that the average price/book over time has been well above current levels, but that the multiple has been much, much higher even in recent years, when all the issues about the company's size, Buffett's age, etc. have been around. During the fall of 2008 it was almost 1.8x, during 2009 it was over 1.4x at times and in 2010 it almost hit 1.5x.  So while you don’t need big multiple expansion to get decent returns here, it’s certainly possible that at some point over the next few years the multiple grows.  If book value compounds at 8% for the next 3 years and the multiple goes back to 1.4x, Berkshire stock would compound at 14% from here.   

Risks:

I think it’s unlikely that we’ll see an outcome from here that is worse than a “muddle along” situation, where book value compounds at 6% or 8% and the multiple stays where it is.  The company’s recently disclosed, and increasing, willingness to return capital to shareholders is a huge mitigant to most of the major risks here. Warren is 82 and won’t live forever, but the board and remaining management team are very high quality and strongly aligned with shareholders. If he was hit by a truck tomorrow and the stock went down 10% or 15%, it’s a safe bet they would be buying back shares.  Book value should still grow over time, and the stock at current levels is not pricing in any heroic gains from re-investing future cash flows, despite the hiring of two very talented investors in Todd Combs and Ted Weschler.  Before the first buyback was announced last year I would have said there was a real risk that the company after Buffett could become a messy conglomerate trading at a huge discount to the sum of its parts, but that seems very unlikely after the two buyback announcements have been made. The quality and alignment of the board further decreases this risk – Bill Gates has over $8 billion and counting of his foundation’s assets invested in Berkshire for example.  I don’t think he’ll let the next management team at Berkshire decrease all of the good deeds he’s able to perform in the world by not returning capital if it clearly makes the most sense for shareholders.  It’s possible that book value could decrease but I think that’s a very small probability over a long period of time, and if it happens it’s likely that markets generally are down significantly and that Berkshire will have outperformed them by a wide margin. The private businesses should continue to grow and the listed equities seem reasonably priced at 13-14x earnings for high quality, global businesses (top 5 being Coca Cola, Wells Fargo, IBM, American Express, and Procter & Gamble). 

Overall:

There are various things investors can reasonably debate with Berkshire.  How should one value float?  What multiple of operating earnings is fair?  What IRR should be used for the reinvestment of cash flows?  How much cash is likely to be re-invested?  What will happen the day Warren passes away?  Should deferred tax liabilities be adjusted for?  Has Warren lost it with all this talk of raising taxes?  I’m happy to discuss any of those in the Q&A, but what does not seem debatable to me is that Berkshire’s current multiple is cheap, the company will continue to compound its intrinsic value over time, and the multiple is unlikely to get any cheaper from here because of the buyback announced last week.  The worst case return from here should equal the company’s book value growth, and if the multiple either goes up or down shareholders will end up with even better returns.  For a collection of growing, resilient, world class businesses this seems like a very attractive entry point.  

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