Boring Portfolio

Bore to Buy
Berkshire Hathaway the next five days

by Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (Dec. 28, 1998) -- For the last month, the Boring portfolio has been considering Berkshire Hathaway (NYSE: BRK.A, BRK.B). We're substantially done with the research for publication and we have completed the research necessary to come to the conclusion that we do want to be associated with this excellent company. Thus, the Boring Portfolio will acquire five shares of Berkshire Hathaway "B" class within the next five days.

Portfolio Weighting

We will be using all our spare cash to acquire these shares. This will leave us with a weighting of 17.3% of the portfolio in Berkshire, which is actually a little bit lower than we'd like. Don't be surprised if we add to our holdings. We've made our view on diversification known through our posts on the message boards and through the publication of our Boring tenets shortly after we took over the portfolio in October. In short, we view a portfolio much like a business. Just as Coca-Cola Co. (NYSE: KO), McDonald's (NYSE: MCD), GEICO, Dell Computer (Nasdaq: DELL), or Costco Companies (Nasdaq: COST) are most affected by the economics of a few good ideas, we want our performance to reflect our best ideas. With a portfolio of this size, we don't need to come up with tons of great ideas. We just need to make one good-sized acquisition (or less) each year, once we've gotten the portfolio where we want it. We don't believe in re-balancing or modern portfolio theory.

We do believe in being owners of businesses. As such, our yearly performance isn't always going to fit within a standard deviation or two of the S&P 500 -- we're not looking for alpha. We're looking for the returns that come from owning superior businesses acquired at attractive prices. Volatility is a side issue for us. For more on simplicity in running an investment portfolio and avoiding wasteful diversification, we have reprinted (with permission) an address Berkshire Hathaway Vice-Chairman Charles Munger gave earlier this year on these topics. We think you'll find this address excellent reading, especially in light of this year's Long-Term Capital Management blowup. And just a note here, for those who believe the ideas we endorse here are dangerous. A concentrated investment portfolio is certainly not for everyone and can be a dangerous alternative to index fund investing. There's nothing more we'll add to that. We just pretty much wanted to take care of our legal obligations and address any potential criticism with that one.

A final note on diversification. Berkshire Hathaway is a diversified company. We don't have problems with the succession plan at the company, either. This is commonly brought up when people ask about Berkshire. Our answer to that is this: If you can accept that Warren Buffett is one of the most talented businessmen of this century, you can accept that he has had the foresight to deal with the issue of his eventual succession. This is one of the least ego-driven and most rational CEOs we can think of. These are the sorts of people that plan for this kind of eventuality. For further discussion on this point, we would recommend Mr. Buffett's letters to shareholders as well as Berkshire Hathaway's Owner's Manual.

The Company

Berkshire is a diversified holding company with interests in the insurance and reinsurance, flight training and ships' captains training, aircraft leasing services, media, furniture and home furnishings retailing, jewelry retailing, shoes manufacturing, quick-serve restaurant franchising, and confections. Among the insurance segment, we can further break down the company into: supercatastrophe, property & casualty, credit, life, commercial trucks and truckers, public auto, special types, garage and dealer, prize indemnification, general liability, and inland marine cargo.

The largest member of the Berkshire Group of insurance companies, by premium volume, is GEICO Direct Auto Insurance.

For more on the company's diverse business interests, here are our looks at the major Berkshire Hathaway companies:

At its current price, the company's market cap is a couple billion dollars lower than the amount of capital invested in the business. On an enterprise value-to-invested capital basis, Berkshire trades at 104% of invested capital. This is just not a hard decision to make, because the market is currently saying that Berkshire will add very little value to that capital over the rest of its lifetime. This just doesn't make sense to us, as the people at Berkshire have an extremely strong track record of adding value to capital invested in the company. This is an understatement, by the way.

We can also look at the company on the basis of price to equity equivalents, where equity equivalents are retained earnings, paid-in-capital, minority shareholders' interests, net preferred stock, the net present value of deferred tax liabilities, and the insurance float. It's basically anything that is perpetual capital. This is not a new or novel way of looking at the business. In fact, Jack Byrne, the guy that turned around GEICO in the 1970s after a near-death incident for the company, looks at a company's adjusted book value and its ability to grow adjusted book value as determinants of a company's intrinsic value. Adjusted book value for long-tailed insurers is "defined as tangible book value plus (the present value of all future earned premiums) minus (the present value of all expenses and reserves), all adjusted for taxes."

In Berkshire's case, the company is more than just a long-tailed insurer, but this is an instructive way of looking at the company. It's pretty much the same way we think of things. Depending upon a company's ability to add or detract from the value of the capital invested in the business, it should trade at a premium or discount to that invested capital. Tangible equity equivalents as we calculated them for Berkshire are $73.199 billion, putting the company's premium to tangible equity equivalents at 38%. However, we're not so much in the "tangible" camp, because "tangible" anything looks at the balance sheet from the liquidation side of things or the regulatory side of things. We look at the balance sheet on the basis of the company's being an ongoing entity that demands a return on invested capital. Goodwill, representing the difference between market value traded for book value received, is nonetheless invested capital. On the basis of market price to equity equivalents, without an adjustment for goodwill, Berkshire is priced at a 16.8% premium to equity equivalents.

When you look at price to book value, it's not just a comparative exercise. This is supposed to tell you what expectations have been priced into the company's stock market value. We don't believe a company "should" trade at such-and-such a multiple to equity value or that such and such a multiple to book value is attractive. We believe that the economics of a business should dictate the multiple to book value or multiple to invested capital a company deserves. In the case of our valuation of Berkshire, we've taken a pretty conservative view of the company's ability to add value to capital. And we're definitely still learning how to quantify things at Berkshire, given the new mix of business introduced into the picture by the General Re acquisition.

We've priced the future value-added in two ways that both look at return on capital versus cost of capital. We've used what Mr. Buffett calls "look-through earnings," which counts as value-added Berkshire's share of undistributed earnings of investees, after tax. This is put together with the earnings and cash flow of Berkshire's wholly owned businesses to arrive at return on capital. In the other way of looking at it, we look at the return on equity holdings as part of the value-added, rather than the look-through earnings. Both points have their merits, and we suspect the people at Berkshire itself focus on look-through earnings. But we also know that GenRe has used a metric expressing comprehensive ROE, which counts unrealized equity gains as part of return on equity. So, we've got two ways of looking at it.

In our analysis of the company's future performance, we've put in some pretty hard stress tests to account for the possibility of major catastrophe losses in the future. This shows up as negative cash flow performance as well as diminutions of invested capital. Some people just choose to do a straight-line cash flow, in which these performance drop-outs aren't accounted for. While we haven't seen huge catastrophe losses causing billions of dollars in losses of economic value at Berkshire, we would rather build them into the model. We're told by Berkshire's management that we should expect big losses in the future, so we'd rather be on the realistic side of things in our assumptions and be pleasantly surprised down the road than vice-versa.

On the basis of these two methods of accounting for all value the company can add in the future, we see intrinsic value at $80,500 to $83,660 per "A" share. Without the two major super catastrophe years, in which over $12 billion in value is destroyed and nearly $5 billion in opportunity cost is borne, the value would reach about $90,000 per share. We're satisfied that we are buying at a safe discount to intrinsic value calculating intrinsic value in a realistic way. We only regret that we weren't able to move last week while the margin of safety was even larger with Berkshire trading near $60,000 per "A" share. The bigger the discount today, the better the performance in the years to come. We consider ourselves to be lucky, however, in having the chance to acquire the shares at well below their fair value and look forward to a lengthy association with this company as part of its ownership.

Here are links to our spreadsheets in Excel 97 and Excel 95 formats. Note, we are still working on parts of these spreadsheets, so there are pro-forma balance sheets, for instance, that miss their balance by a couple tenths of a percent.

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12/28/98 Close

Stock  Change    Bid
ANDW  -  15/16 16.06
BGP   +  3/16  23.38
CSL   +1 9/16  47.38
CSCO    ---    94.19
FCH   -  5/8   21.94
PNR   +  5/16  37.88
TBY   -  1/16  6.56
                   Day   Month    Year  History
        BORING   +0.12%   5.99%   3.80%  30.61%
        S&P:     -0.06%   5.32%  26.28%  97.14%
        NASDAQ:  +0.80%  11.84%  38.84% 109.45%

    Rec'd   #  Security     In At       Now    Change
  6/26/96  225 Cisco Syst    23.96     94.19   293.18%
  2/28/96  400 Borders Gr    11.26     23.38   107.66%
  8/13/96  200 Carlisle C    26.32     47.38    79.96%
  4/14/98  100 Pentair       43.74     37.88   -13.41%
  5/20/98  400 TCBY Enter    10.05      6.56   -34.67%
  1/21/98  200 Andrew Cor    26.09     16.06   -38.43%
  11/6/97  200 FelCor Sui    37.59     21.94   -41.64%

    Rec'd   #  Security     In At     Value    Change
  6/26/96  225 Cisco Syst  5389.99  21192.19 $15802.20
  2/28/96  400 Borders Gr  4502.49   9350.00  $4847.51
  8/13/96  200 Carlisle C  5264.99   9475.00  $4210.01
  4/14/98  100 Pentair     4374.25   3787.50  -$586.75
  5/20/98  400 TCBY Enter  4018.00   2625.00 -$1393.00
  1/21/98  200 Andrew Cor  5218.00   3212.50 -$2005.50
  11/6/97  200 FelCor Sui  7518.00   4387.50 -$3130.50

                             CASH  $11273.22
                            TOTAL  $65302.90