Does that mean I'm selling? Heck no! While it's no fun getting in too early, I love beaten-down stocks if (and this is a big if) I have confidence that the company will rebound. In the case of Berkshire Hathaway, my confidence in Warren Buffett and the company is unshaken. As the stock drops farther and farther below what I believe to be its intrinsic value, I become more and more bullish about its future potential, and thus I am continuing to buy.
Am I being stupidly stubborn, or am I going to make a lot of money on Berkshire Hathaway? Only time will tell. But let me explain why I'm betting on the latter.
Berkshire Hathaway's Wealth Creation Drivers
Berkshire Hathaway has been one of the best performing stocks of all time: It is worth 1,100 times more than its 1969 price of $42/share (that's 26.4% annual growth for 30 years). Of course, the only thing that matters is the stock's future, not its past, but it helps to understand what accounted for Berkshire Hathaway's success in order to evaluate what its future is likely to be.
Obviously, Buffett's investing acumen has been a major factor, but that's only part of the story. Most companies that are successful in the long run are able to invest capital at high returns -- substantially higher than their cost of capital -- and increase the amount of capital they are able to invest at these high rates over time. The beauty of Berkshire Hathaway is not only that Buffett has invested increasing amounts of capital very wisely, generating compounded returns consistently greater than 20% over many decades, but also that the company's cost of capital has been very low -- even negative in many years -- due to its primary source of capital, insurance float.
What's Gone Wrong?
In the past year or two, the fundamental drivers of Berkshire Hathaway's wealth creation engine were impaired, at least temporarily, and some other factors have also hurt the stock. Here are some of the things that have happened:
- Berkshire Hathaway's major stockholdings did poorly in 1999. On a weighted basis, the seven largest positions (in descending order of size: Coca-Cola, American Express, Gillette, Freddie Mac, Wells Fargo, Disney, and the Washington Post) were flat versus a 21% increase in the S&P 500 (they're down another 5% so far this year, approximately matching the S&P). Despite the decline, these positions alone are worth $30.2 billion today (not including the unrealized capital gains tax obligation).
- Due mainly to high valuations in the market, during 1999 Buffett did not make any major stock purchases (that have been disclosed anyway), and only made one acquisition of consequence: MidAmerican Energy Holdings (click here to read about it). You can imagine the market's lack of enthusiasm for the acquisition of a utility. Hence, low-return cash and bonds have accumulated to $36.0 billion on Berkshire Hathaway's balance sheet. For perspective, that's approximately twice as much as the cash and short-term investments Microsoft has, and represents half of Berkshire Hathaway's $71.7 billion market capitalization.
- The cost of Berkshire Hathaway's insurance float rose sharply. Overcapacity in the worldwide insurance industry and subsequent price competition have hurt results at a number of Berkshire Hathaway's insurance subsidiaries, especially General Re. There have also been higher-than-expected claims. Finally, GEICO is growing explosively -- approximately 20% annually -- but is forgoing current profits to do so (a strategy I endorse).
Poor results on occasion should not be a surprise, as Buffett does not try to manage earnings so that they increase smoothly and steadily. In fact, he highlights the fact that one of the company's competitive advantages as an insurer (especially when writing super-catastrophe policies) is that Berkshire Hathaway, unlike its publicly traded competitors, is willing to accept the risk of periodic large claims in exchange for a higher level of overall profitability over a long period of time. - Interest rates have been rising, which tends to hurt the value of stocks in general and stocks of financial companies like Berkshire Hathaway in particular.
- Given Berkshire Hathaway's size, there are questions about how quickly it can grow going forward.
- Berkshire Hathaway has very long-term-oriented investors. The average holding period of its freely traded shares is 15 years, more than double the average holding period of the next-longest-held company among the 100 largest American companies. Because it is so thinly traded, relatively few buyers and sellers set the price, which can lead to large price swings.
- Wall Street barely covers the stock because Buffett does not try to promote it, refuses to play the quarterly earnings game, and has little need for investment banking services. Also, the stock's high price and low turnover discourages brokers from promoting the stock since their commissions are based on the number of shares traded.
- The high price of Berkshire Hathaway's shares (even the B shares trade at more than $1,400 each) has a psychological effect that intimidates many buyers. In addition, the increasing number of small investors may not be able to purchase even a single B share and still maintain as much diversification as they would like.
- There may still be residual selling from General Re shareholders who are frustrated with the stock's underperformance since they have owned it.
- In a market increasingly enamored with technology stocks, Buffett's avoidance of this area -- where he correctly believes he has no competitive advantage as an investor -- has caused many investors to abandon Berkshire Hathaway.
Implicit in Berkshire Hathaway's depressed stock price today is the assumption that the company's ability to grow profitably has been materially and permanently damaged. I don't believe it. Over the long term, do I expect Berkshire's current stock holdings -- businesses of exceptional quality -- to continue to trail the market? No, though I'm not expecting dramatic outperformance either. Do I expect the poor pricing environment and high claims in the insurance industries in which Berkshire competes to improve? Yes, as they always have, though I don't know when this might happen. Do I expect that Buffett will be able to wisely invest the company's growing insurance float and cash flow? Absolutely, though this might take a while as well.
I believe what happened to Berkshire Hathaway in the past year or so was the equivalent of a 100-year storm -- pretty much everything that could go wrong did go wrong. Yet even under these circumstances, the company remained enormously profitable. I am steadfast in my opinion that Berkshire Hathaway is still a gem of a business.
Valuation
Berkshire Hathaway is a complex company. As such, it is very difficult to understand and value. That's one of the reasons why I think a generally efficient market is significantly mispricing this stock. At some point I plan to write about the company's valuation, but right now I don't spend a lot of time thinking about it. Why? For the same reason that I no longer get carded when I buy a bottle of wine. The person behind the counter doesn't know how old I am, but you only have to look at me to know that I'm older than 21. Similarly, it doesn't take more than a few minutes of back-of-the-envelope calculations to figure out that Berkshire Hathaway is worth a lot more than it's trading for today. How much more? I don't know for sure, but of the dozens of valuations I've read and those I've done myself, I've never seen a figure lower than $60,000/share -- and I think it's worth quite a bit more.
Dale Wettlaufer, the former manager of the Bore Port, did some nice valuation work a year ago, which you can read by clicking here.
Conclusion
I think it is highly unlikely that Berkshire Hathaway has turned into a dog of a business or that Buffett, after more than 40 years of investment genius, has become a fool -- yet that's how the stock is being priced today. I don't know when, but Buffett will be vindicated, and I intend to profit from it.
--Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous guest columns in the Boring Port and other writings, click here.
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