In December 2007, Barron's published an article titled "Sorry, Warren, Your Stock's Too Pricey." The writers argued that Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) was overvalued for several reasons: It was trading above its historical price-to-book multiple. It was questionable whether Buffett would ever land his "elephant" investment, making a meaningful dent in Berkshire's growing cash hoard. And insurance pricing, a pillar of Berkshire's business, was crumbling. Nothing looked good.
Most of the article was prescient. Berkshire stock peaked a week before publication, and it still remains about a third below those levels. (Other parts of the article weren't as lucky, with painful predictions such as "our bet is that financial companies like AIG ... will do even better [than Berkshire].")
But today, Berkshire investors couldn't be staring at a more different world. Historical valuations are about as low as they've ever been. The elephant acquisition, Burlington Northern, has already been bagged. And there's reason to believe insurance pricing could stage a rebound. All of this leads me to believe Berkshire Hathaway is a buy.
Let's start with valuation. I've rambled on this topic more than a few times, so my apologies if this is repetitive.
The most reasonable way to value Berkshire is the price-to-book ratio. Why? For most companies, using discounted cash flow or price-to-earnings multiples is what you'd focus on. That's the agreed-upon yardstick. But Berkshire is a different animal. Rather than cranking out profits and cash flow, Berkshire has a portfolio consisting largely of investments where price appreciation is the goal.
Take BYD, a Chinese electric-car company that Berkshire purchased a 10% stake in two years ago. At the end of 2009, Berkshire's original $232 million investment was worth $2 billion. How much income and cash flow has this investment produced? Exactly zero dollars. Yet the return to shareholders is obvious in terms of Berkshire's book value.
Looking at Berkshire's historical price-to-book value going back to 1994 shows an average multiple of 1.85 and a five-year average of 1.5. When Barron's ran its article in 2007, the five-year average was 1.6, while Berkshire's then-current multiple was 1.8 -- hence the overvaluation worries.
Today, shares trade at about 1.3 times book value. That's below the five-year average, and it's considerably below the long-term average. I'm comfortable calling that considerably cheap.
To be fair, plenty have argued that Berkshire's valuation premiums deserve to shrink as the company grows. The idea is that size will shackle returns as Buffett is forced to buy massive investments to move the needle on Berkshire's ever-growing balance sheet.
Ominously, the loudest bell-ringer of this threat has been Buffett himself. In 1995 he warned, "The giant disadvantage we face is size: In the early years, we needed only good ideas, but now we need good big ideas."
No doubt, Berkshire has settled for lower-returning ideas. But the good news is that Buffett has had no problem finding big ideas. It started with the $22 billion purchase of General Re in 1998, and it built momentum as the years progressed. There's the $5 billion Iscar investment in 2006, the $4.5 billion purchase of Marmon in 2007, the $8 billion combined savior investments in Goldman Sachs (NYSE: GS ) and General Electric (NYSE: GE ) in 2008, and the Big Kahuna $44 billion purchase of Burlington Northern last year.
If anything, finding big ideas has become easier as Berkshire's reputation as a nurturing parent to privately owned businesses gains credibility. Berkshire's ability to not just grow, but to do so at attractive rates, hasn't missed a beat. That's a major plus for long-term investors who thought the company had hit a plateau.
Berkshire is a mess of businesses from almost every industry imaginable -- from underpants to credit default swaps. Insurance, however, is the largest focus by far, accounting for roughly one-third of revenue.
That's been a thorn of worry for many years as underwriting pricing has marched steadily downward. Insurance underwriting is typically either extremely profitable, or a hard-to-watch money sink. The last few years have been more of the latter.
But these things move in cycles. Insurance pricing can't, and won't, drop forever. And if you want a good place to start looking for a rebound, today's seeds of a budding economic recovery offer a good place to start. There's so much pessimism in the insurance-pricing market, and valuations are so thoroughly pricing that pessimism in, that even a small positive surprise could be a serious boon to insurance-company shareholders.
Shoot me down, Fools
Add it all up, and I think Berkshire is a buy. Disagree? No sweat. Just show me where I'm wrong in the comments section below.
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