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:

*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.

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.

During the crisis, Warren Buffett made multi-billion dollar investments in companies such as General Electric and Goldman Sachs, but there's one home run stock Buffett can't buy.