Berkshire Shares Could Rise Another 20%

On Monday, Standard & Poor's announced it would add Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) to the S&P 500, the gold standard of U.S. equity indexes. It's highly unusual for a company of Berkshire's size (market capitalization: $166 billion) to be added to the index. As of yesterday's close, shares have already risen 9% since the announcement, but I'm convinced they could rise still further -- here's why.

A big effect
The "index effect" -- the excess returns on a stock that is added to a major index -- is a well researched phenomenon. While there is some evidence that it has shrunk during this decade, the effect looks substantial in the case of some of the largest companies that have been added to the S&P 500:

Company

Start Date: S&P Announces Stock Will Be Added to S&P 500

Outperformance* (End date: Announc. Date + 5 days)

Outperformance* (End date: Addition Date + 5 days)

MetLife

Nov. 29, 2000

18.3%

27.8%

UPS

July 9, 2002

4.6%

14.1%

Prudential Financial

July 9, 2002

9.5%

10.3%

Goldman Sachs (NYSE: GS  )

July 9, 2002

7.9%

8.6%

*Outperformance is measured as the excess return over that of the S&P 500.
Source: Capital IQ, a division of Standard & Poor's.

(Index funds tend to rebalance their portfolios near and just after the component addition/deletion date. In Berkshire's case, that date is not yet known; Berkshire's acquisition of Burlington Northern Santa Fe is expected to close next month -- the former will replace the latter in the S&P 500.)

Low float, bigger pop
The stock that experienced the highest index effect (MetLife) is also the one that currently has the lowest float, the proportion of shares that are available to be traded (I'm assuming here that MetLife's float was also lower at the time of its IPO). That should come as no surprise, since a lower float equates to a reduced supply of shares. At 72%, Berkshire's float is probably lower than any company its size, barring Wal-Mart (NYSE: WMT  ) (55%), and is almost identical to MetLife's float. Even that figure probably overstates the actual number of Berkshire shares available to be traded.

Indeed, Berkshire Hathaway's shareholder base has -- partly by design and partly by self-selection -- a long-term ownership orientation (see the following table which shows the average holding period of Berkshire Hathaway compared to other megacap, blue chip stocks). This means they are less concerned with share price volatility and they are willing to hold shares that are somewhat overvalued. As such, investment funds that need to own Berkshire once it becomes part of the S&P 500 may have to pay a premium to pry the shares away from their owners.

Stock

Market Capitalization (US$billions)

Average Holding Period

Berkshire Hathaway

$166.3

6.7 years*

Procter & Gamble (NYSE: PG  )

$177.7

324 days

ExxonMobil (NYSE: XOM  )

$310.1

251 days

General Electric (NYSE: GE  )

$173.6

133 days

Bank of America (NYSE: BAC  )

$131.5

34 days

Source: Capital IQ, a division of Standard & Poor's and author's calculations, based on data from same.
*Estimated based on a 2006 Fortune interview with Warren Buffett. A more recent figure was unavailable.

A big slug to buy
Approximately $3.5 trillion in investment fund assets are currently benchmarked on the S&P 500 and Berkshire represents approximately 1.1% of the index's total market value. Thus, in order for these funds to reproduce the same weighting in their portfolios (the S&P 500 is market value-weighted), they'll need to purchase shares with an aggregate value of $38.5 billion. That's an enormous amount relative to Berkshire's low share turnover.

Shares look cheap
Furthermore, shares don't look overvalued right now -- rather the opposite, in fact -- which reduces the incentive for Berkshire shareholders to part with their shares. Berkshire closed yesterday at 1.37 times book value per share (using the latest available book value figure from the third quarter, which probably understates Berkshire's current book value).

Using daily closing price data provided by the University of Chicago Booth School of Business's CRSP US Stock Database, I calculated Berkshire's end-of-day price-to-book multiple going back to October 1976. Over that period, the multiple's average value is 1.60, and it was higher than the current value for nearly three-fourths (73%) of the days. Given Berkshire's characteristics, that average multiple doesn't look like an absurd valuation -- which would imply at least a 17% gain from the current price.

Don't do it
I don't recommend you buy into Berkshire shares to try to make a quick profit from the index effect; however, they do look somewhat undervalued, and the effect could be the catalyst that helps close the gap with fair value. While shares have certainly been cheaper over the past twelve months (at the beginning of March, they could be bought at around book value!), now looks like a reasonable time to become a long-term shareholder.

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You can follow Fool contributor Alex Dumortier on Twitter; he has no beneficial interest in any of the companies mentioned in this article. Berkshire Hathaway is a Motley Fool Inside Value and a Motley Fool Stock Advisor recommendation. Procter & Gamble is a Motley Fool Income Investor recommendation. The Fool owns shares of Berkshire Hathaway and Procter & Gamble. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (68)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 29, 2010, at 3:40 PM, mrwizard555 wrote:

    oops.

    S&P 500 index wieghting uses only the market cap of the added stock, when there are more than one class of company stock. looks like you are using BRK total market cap. only the B shares are going into the index.

  • Report this Comment On January 29, 2010, at 4:05 PM, henryking54 wrote:

    mrwizard 555,

    This author (Dumortier) typically makes at least one basic math mistake per article. You just found it.

    Regards,

    Henry

  • Report this Comment On January 29, 2010, at 4:10 PM, crazy4swayze wrote:

    oh snap!

    you just got sonned.

  • Report this Comment On January 29, 2010, at 4:26 PM, TMFEditorsDesk wrote:

    @mrwizard,

    Do you have a source for that?

    The source for the S&P 500 weighting in this article was a WSJ piece:

    "S&P will include most of Berkshire's B shares as well as the A shares not held by insiders such as Mr. Buffett in its calculation of the company's market capitalization. Roughly 30% of the A shares are held by insiders, according to regulatory filings. Mr. Buffett would not comment."

    http://online.wsj.com/article/SB1000142405274870490560457502...

    -Anand Chokkavelu (TMFBomb)

  • Report this Comment On January 29, 2010, at 4:28 PM, eurotrash01 wrote:

    No, the whole market cap of the company goes in, even though the B shares are the security traded. Otherwise the A share holders would hold a free option to increase the supply of B's at 1500:1, and S&P can't have their weighting (factor) for BRK hostage to those folk.

  • Report this Comment On January 29, 2010, at 4:30 PM, eurotrash01 wrote:

    No, the whole market cap of the company goes in, even though the B shares are the security traded. Otherwise the A share holders would hold a free option to increase the supply of B's at 1500:1, and S&P can't have their weighting (factor) for BRK hostage to those folk.

  • Report this Comment On January 29, 2010, at 4:38 PM, henryking54 wrote:

    According to S&P Float Adjustment Methodology:

    In cases where holdings in a group exceed 10% of the outstanding shares of a company, the holdings of that group will be excluded from the float-adjusted count of shares to be used in index calculations.

    The "groups" they are talking about include current and former officers and directors as well as Foundations. As I understand it, this means shares given by Buffett to the Gates Foundation wouldn't change float in S&P's eyes until Gates Foundation sells shares.

    You can read the whole document here:

    http://www2.standardandpoors.com/spf/pdf/index/Float_Adjustm...

  • Report this Comment On January 29, 2010, at 4:40 PM, mrwizard555 wrote:

    Multiple Classes of Stock

    Some companies have more than one class of common stock outstanding. In Standard & Poor’s U.S. indices, each company is represented only once. The stock price is based on one class, usually the most liquid class, and the share count is based on the total shares outstanding. To determine the available float for companies with multiple classes of stock, Standard & Poor’s calculates the weighted average investable weight factor (IWF) for the stock using the proportion of total company market capitalization of each share class as the weights. The result is reviewed to assure that when the weighted average IWF is applied to the class included in the index, the shares to be purchased are not significantly larger than the available float for the included class.

    from: http://www.standardandpoors.com/servlet/BlobServer?blobheade...

    i interpret this as only the B market cap is counted.

  • Report this Comment On January 29, 2010, at 4:42 PM, mrwizard555 wrote:

    Multiple Classes of Stock

    Some companies have more than one class of common stock outstanding. In Standard & Poor’s U.S. indices, each company is represented only once. The stock price is based on one class, usually the most liquid class, and the share count is based on the total shares outstanding. To determine the available float for companies with multiple classes of stock, Standard & Poor’s calculates the weighted average investable weight factor (IWF) for the stock using the proportion of total company market capitalization of each share class as the weights. The result is reviewed to assure that when the weighted average IWF is applied to the class included in the index, the shares to be purchased are not significantly larger than the available float for the included class.

  • Report this Comment On January 29, 2010, at 4:58 PM, TMFAleph1 wrote:

    Thanks for your comments.

    In the article, I wrote:

    "Berkshire represents approximately 1.1% of the index's total market value"

    This figure was sourced from a Wall Street Journal article (http://online.wsj.com/article/SB1000142405274870490560457502....

    The Wall Street Journal, in turn, obtained that estimate from Howard Silverblatt, S&P senior index analyst.

    I obtained Berkshire's Hathaway's float percentage (72%) directly from Capital IQ, a division of Standard & Poor's.

    Enjoy!

    Alex D

  • Report this Comment On January 29, 2010, at 5:43 PM, henryking54 wrote:

    <<Approximately $3.5 trillion in investment fund assets are currently benchmarked on the S&P 500>>>

    The amount of benchmarked assets is irrelevant. Many actively-managed mutual funds are benchmarked to the S&P 500 but that doesn't mean they own all of the S&P 500 components. In fact, they are trying to beat the S&P 500 so they most definitely do not try to mimic the index.

    The important figure is indexed assets. According to the S&P's website, only $915 billion worth of assets were actually indexed to the S&P 500 at the end of 2008:

    http://www2.standardandpoors.com/spf/pdf/index/2008_Survey_R...

    1.1% of $915 billion is only $10.1 billion, which is only about a quarter of the $38.5 billion amount that Dumortier claims indexers will need to purchase.

    Furthermore, Dumortier completely disregards the fact that indexers will receive 40% of their payment of Burlington Northern shares in Berkshire stock, so that amount will not need to be purchased.

    I'm sure there are other mathematical or conceptual errors, but I'll be charitable and stop here.

    Henry

  • Report this Comment On January 30, 2010, at 12:40 AM, StarWitchDoctor wrote:

    criminy, that didnt look so good after all.

    nimby.

  • Report this Comment On February 02, 2010, at 7:05 AM, langco1 wrote:

    after the rise in brkb by being put in the s+p fades it will slowly drop to the 50 level where it belongs...

  • Report this Comment On February 03, 2010, at 1:34 PM, ReadEmAnWeep wrote:

    I think that the rise will be temporary. It will eventually be valued at a more fair price. If you bought before it was split and only wanted the qucik raise - sell now. Otherwise just hang on want wait for real growth and not a small jump from being added to an index.

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