Rising Star Buy: Berkshire Hathaway

This article is part of our Rising Star Portfolios series.

Cash might be king, but that doesn't make Warren Buffett some court jester. Today, the Young Gun Portfolio is showing its reverence for his majesty and plunking 12% of the portfolio in Berkshire Hathaway (NYSE: BRK-B  ) .

In the quick couple of months since we launched the Young Gun Portfolio, we've made two trades, in hotel-buying jockey play Pebblebrook Hotel Trust and in banana champ Chiquita Brands. We took what was intended to be an initial bite in each -- 3% in Pebblebrook and 2% in Chiquita. The market, beneficent all around lately, has been especially generous to these two, and they are up about 12% and 14%, respectively, outperforming the market. Lovely as that may be, the rising tide has floated each of these stocks away from where I'd happily add to our positions. Incremental investment in either or both may yet become warranted, but right now I'm keeping these two at their current allocations.

That means that a nice chunk of cash I had mentally earmarked for further investment in Pebblebrook and Chiquita is no longer set aside for those opportunities. Taking into account the additional $1,000 added to the portfolio every month, our look-through cash balance is now more than 90% of the portfolio.  Especially in such frothy markets, I am a patient investor, but that level of cash is excessive. I have more ideas today than at any time over the previous two months, but while I flesh them out, I am going to invest a nice chunk of our change in Berkshire Hathaway.

Berkshire needs no introduction, and I am not going to reinvent the wheel with a novel take on Warren Buffett's investment vehicle. This is mostly a placeholder trade, so don't be surprised if I trim our position to invest in more opportunistic places as I uncover them.

I said this was "mostly" a placeholder trade because, cash balance considerations aside, Berkshire is looking cheap these days. By reverse engineering a discounted cash flow model for Berkshire, we learn that the market is expecting a mere 4.5% average sales growth for the next 20 years before declining to a 3% terminal rate. Sure, it gets harder and harder to grow as a company gets bigger, but for Berkshire, which has grown revenue at an average clip of more than 25% annually since 1991, 4.5% is a pretty darn low hurdle.

Berkshire is also cheap relative to its book value. Over the past 10 years, Berkshire has traded at an average of about 1.6 times book value, and peers (or, as close to "peers" as it gets for Berkshire) Markel (NYSE: MKL  ) and Leucadia National (NYSE: LUK  ) have likewise average price-to-book value multiples of 1.7 and 1.6 over the same time frame. Today, Berkshire is selling at just 1.3 time book value, or about 25% below its -- and its peers -- historical average.

My own discounted cash flow model, which assumes overall sales growth of about 8% gradually declining to about 5.5% over the next 20 years before going to a terminal rate, gives us a base case valuation of about $101 per B-share, or about 24% above today's $81 price.

Patience is key in investing, and the Young Gun Portfolio will not chase valuations. I remain wary of these frothy markets, but having more than 90% of the portfolio in cash is not something with which I am currently comfortable. Believe me, I'm all for having dry powder ready, and this trade will leave us with a still-hefty cash balance -- and besides, there are other ways to make sure you have dry powder in case of a market correction (keep your eyes peeled for more on that). In the meantime, Berkshire Hathaway offers us a great place to store some cash while we continue to hunt for other opportunities. I'm always happy to put my extra dollars to work under the supervision of the world's greatest investor, and at today's valuation, this move is a no-brainer.

Follow the Young Gun Portfolio on Twitter to stay up to date on all portfolio trades, updates, and news.

Alex Pape owns shares of Pebblebrook Hotel Trust. The Fool owns shares of Berkshire Hathaway, Chiquita Brands, Markel, and Pebblebrook Hotel Trust. Markel is a Motley Fool Inside Value selection. Leucadia National is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (48)

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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 18, 2011, at 5:38 PM, daveandrae wrote:

    Oh My God-

    90% of your portfolio is in an asset class that currently yields ZERO percent in interest, all the while being sucked down by a 2-3% annualized rate of inflation as i type. Good grief man. Why are you even in the business of managing other people's money?

    Are you even aware that your "Why I am not buying anything" post was printed on November 1st, 2010, when the s&p 500 was trading at 1184 and stocks like GE were trading at a price to book ratio that was less than 1.5?

    Thus, not only was GE cheaper than Berkshire Hathaway is today, you, Sir, did not want a-n-y-t-h-i-n-g to do with it.

    Since that time, the s&p 500 has been smoking you like crack, up over 9%, and GE is up 17.125%

    ( In full disclosure, I've grown my own portfolio by 14.4% since 11-1-2010)

    I sincerely hope you go back and re-read the nonsense you were printing back on November 1st. Because it is obvious to me that you do not know what you're doing with this money.

    Thomas Edmonds

  • Report this Comment On January 18, 2011, at 6:46 PM, TheDumbMoney wrote:

    Thomas, we all make mistakes. I notice you redthumbed KO in April, which in retrospect was just about the worst time to do so in the last twelve months. Or me, long before Housel and other fools started talking about current values in MSFT, etc., I was invested in stocks like that, as reflected in my RL CAPS portfolio, and my reward?... has been a sea of red in CAPS. He acknowledges 90% cash is too much, is remedying it, and he has held the cash, what, two or three months? Not a lot lost, as far as I can tell. People who bought certain Indian ETFs and other vehicles when he decided to stay in cash would, I'm sure, love to have that zero percent interest rate return, minus the less than a percent loss from inflation during that time period. Nobody knows what the future will bring but there's got to be some significant chance we'll see at least a 10% correction in the next three months or so, things are just so complacent now, so maybe he gets a better buying opportunity, maybe not.

  • Report this Comment On January 18, 2011, at 6:49 PM, XMFPapester wrote:

    Hey Thomas,

    I look at cash balances as percentages of the portfolio about a year out. Most people are adding money to their portfolios regularly (say, monthly), and so it is with this portfolio. We add $1000 each month. I consider those future $1000 contributions, up to about a year out, part of the portfolio today when calculating allocations. Otherwise, each month all the allocations would be diluted by the influx of new cash, and you'd rack up trading costs if you wanted to keep rebalancing to your intended allocations. So, over 90% of the portfolio is in cash taking into account that cash - which of course we cannot invest yet. But it is still worth taking into account.

    We've been down the GE road before. Congrats on your success with that investment.

    I am not managing other people's money. The portfolio is free and public-facing, and people can take ideas from it as they wish.

    I agree that the current cash balance is excessive, but I would not want to be fully invested, especially in small-caps, in which the portfolio generally focuses, right now. I'm not going to chase valuations in a market on a tear. I'm also not putting any stock in returns - good or bad - less than a quarter in.

    All the best,

    Alex

  • Report this Comment On January 18, 2011, at 8:01 PM, Merton123 wrote:

    Wow - talking about egos :). Warren Buffet back in the 1970s closed his investment partnership because the stock market was over valued and took a vacation for a couple of years. The Nifty 50 crashed and Warren purchased Berkshire Hathaway and the rest is history. So having a large amount in cash actually shows discipline in my opinion. Berkshire Hathaway is basically a closed end mutual fund run an an excellent investor who is about to retire. Why not put your money in Johnson and Johnson (JNJ) versus Berkshire Hathaway as a placeholder bet where you getting a nice dividend while you are waiting for market to take a breather?

  • Report this Comment On January 18, 2011, at 8:15 PM, dqstolemoney wrote:

    Comments

    Dairy Queen Continues to Hammer the Small Guy - How's that Fair?

    Submitted by Anonymous (not verified) on January 13, 2011 - 15:55.

    Further complicating these matters is the notion that a very large number of Dairy Queen franchises are governed by old, antiquated, and insufficient contracts. Thus, INDQ will see a lot more litigation over their alleged control of the brand, QSR location improvements, and general store operations. Many of these Franchisees operate under agreements originating (and then assigned) as early as the 1940's. These agreements call for "cents per gallon of milk mix" as when the primary business was making and selling an awesome ice cream cone. Modern day agreements are wrapped around transfer fees, signage specifications, brand usage, modernization plans, and even the color of the paint on the restroom walls. Get over yourselves!

    It should also be duly noted that the ownership structure of Dairy Queen, including a majority stake by Berkshire Hathaway, is a single point of failure as it relates to reputation risk. What might it be worth in terms of lost good will for a disenfranchised owner to show up at the Berkshire Hathaway Annual Meeting of Shareholders in a clown suit, huge signs displaying discontent, and flyers with cartoons of Warren Buffet counting his huge piles of DQ profits? National networks and the Money Show Pundents will eat that stuff up. Can you see W.B. trying to explain himself away on "In the Money?" Me thinks not!

    Lastly, what about another law suit from one of the "little Guys" who was trying hard to do the right thing, feed his family, and leave a legacy for his growing family? Who looks like the schmuck then? Moreover, who wants to eat in a restaurant whose reputation is one of being owned by "da Man" who rules with an iron fist and a massive legal checkbook?

    Haven't we seen enough of this bulling in our society, let alone hammering the small business person?

    Knock it off, Dairy Queen and get back to the business of making kids happy from the notion of a soft serve ice cream cone with their parents, siblings, and grand parents!

    reply

    .INDQ Puts Operator on COD - Say What?

    Submitted by Anonymous (not verified) on January 17, 2011 - 15:08.

    So here's an interesting question to ponder.

    At what point is it legal for a large corporation like Dairy Queen to interfere with the vendor relationships of its franchisees? If, for the sake of a simple misunderstanding or even a greater contract dispute, is a Dairy Queen within its legal rights to demand a vendor put a store operator on payment terms? Is there some mysterious clause in one of their antiquated contracts from the 1940's that allows them to demand a supplier to revise credit terms to a store operator?

    Where is this all leading to? Does anyone think Warren Buffet would approve of such actions and business practices? Doesn't he visit a Dairy Queen nearly every day to enjoy his Blizzard treat? What if IDQ interfered with that Omaha store owner's credit and he wasn't open one day when W.B. walked down the street for his treat? Do you think someone at corporate would give a thought to that? How about when the old man gives them a ring and grabs a piece of their butts through the phone?

    What's it all coming to when the power brokers start to interfere with the store operator? Isn't that a conflict of interest? Isn't that the likes of Dairy Queen wielding the power of becoming or acting like an operator? If so, then they might as well just buy all the stores and operate them as a chain. Maybe that's what they plan to do anyway.

    I guess only time will tell....

  • Report this Comment On January 18, 2011, at 9:35 PM, XMFPapester wrote:

    Hey Merton,

    Thanks for your comments. I agree with you that JNJ is looking cheap itself these days - actually, a number of large-caps are looking pretty cheap, and JNJ is likely one of the prime choices among them. You also make a good point about the dividend - being paid to wait for other opportunities.

    The day Buffett is no longer at the helm of Berkshire, not much will change in terms of the value of the company. I'm sure the stock will take a temporary hit as emotional investors flock. But the value of the Berkshire's operating businesses won't have changed - remember, Buffett doesn't get involved in the day-to-day operations of the companies in which he invests. Those companies will keep plugging along. We'll lose some value in Buffett's ability to allocate the cash the businesses throw off, but I think that should be minor relative to the value of the businesses themselves, and besides, Buffett has a succession plan in place - we might not know all its details, but Buffett's been a pretty darn good judge of management so far.

    Cheers,

    Alex

  • Report this Comment On January 18, 2011, at 11:47 PM, goalie37 wrote:

    I sympathize with your cash dilemma. I am very happy to see all my real life holdings going through the roof, but they are no longer at levels where I would consider buying more. Mr. Market may continue higher, but this is crossing the line from investment to speculation.

    I just sold my JNJ this morning. They have always been my favorite holding, but the recall nonsense has gone too far. This many in so short a time is a giant red flag for how these guys are running their company. Buffett says that a company should be so simple an idiot can run it - because someday an idiot will. JNJ has just those kinds of idiots now.

  • Report this Comment On January 19, 2011, at 3:03 AM, daveandrae wrote:

    Alex-

    Cash, except for the case of emergencies, is an irrational holding, in the portfolio of the long term investor.

    For once you subtract inflation, and its evil twin, taxation, from the interest rate that cash offers, which we all know is ZERO, the forward return is quite negative.

    ( keep in mind gas prices, one year ago, on average, were 2.65 a gallon. Thus the PURCHASING POWER of cash has been deflating whether you realize it or not)

    The only logical reason why someone would hold a large percentage of cash in their portfolio is because they believe the forward return of all of the other asset classes, stocks, bonds, gold, real estate...etc.etc... will be even MORE negative.

    Thus, cash is not an asset class as much as it is a place to "hide".

    The problem is, of course, timing.

    Net, the general public has pulling money out of the stock market for the last four years. Thus, whether you realize it or not, you, Sir, are a part of of the herd.

    As I said before, I hope you re-read these posts a year from now when the "frothy" s&p 500 is trading well above, say, 1500.

    Maybe then, what I have said will make more sense to you.

    Thomas Edmonds

  • Report this Comment On January 19, 2011, at 7:40 PM, gilsh wrote:

    considering current state of the market, and considering that 2011 will probably be as volatile as 2010. staying at a high cash ratio is a very rational decision. at these heights of the market, one is sure to lose some money going in, while patience, a cold clear thinking and identifying the right opportunities, may bring very good returns.

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