Berkshire Hathaway
Truth or Dare

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By gdefelice
March 6, 2006

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I've reviewed the report twice now.

I should note that I have a very large percentage of my portfolio in Berkshire as well as for clients. I occasionally hear the question: "Why should I pay you to own Berkshire?" Though, after the last few years, I get the sense the questions are tilting towards: "Why should I pay you -- at all?" Berkshire certainly doesn't appear to be the sure thing it used to be...especially based on the recent performance of the stock price.

At first blush, I felt mild disappointment that Buffett did not validate my thoughts on under-valuation and/or overcapitalization by either suggesting the stock was cheap and/or he would consider paying a dividend. Recall that at last year's annual meeting in May, he suggested that they would have some explaining to do if they still had huge amounts of cash two years hence. Despite putting many billions to work this year, the cash position has not been reduced. The questions loom. Nevertheless, this is a good problem to have.

After reading the report a second time, I feel that WEB is almost daring people like me to sell. "Look," he seems to be saying, "you're not going to get any 'help' from me to boost this company's stock price in the market. If you think it is undervalued based on the explicit information I've given you, then you've got your truth right there."

Here are some somewhat random thoughts.

Buffett states that his singular goal in writing the letter is to give readers the information necessary to estimate Berkshire's intrinsic value.

Buffett, bucking the commentary I often hear from other analysts, says that valuing Berkshire is easier than valuing most other companies and not more difficult. Still it isn't as easy as it used to be and thus Buffett has broken out the business in a manner that should greatly aid an analyst:

My goal in writing this report is to give you the information you need to estimate Berkshire's intrinsic value. I say "estimate" because calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base. (For an explanation of intrinsic value, see pages 77 � 78.) Here Berkshire has some advantages: a wide variety of relatively-stable earnings streams, combined with great liquidity and minimum debt. These factors mean that Berkshire's intrinsic value can be more precisely calculated than can the intrinsic value of most companies.

Yet if precision is aided by Berkshire's financial characteristics, the job of calculating intrinsic value has been made more complex by the mere presence of so many earnings streams. Back in 1965, when we owned only a small textile operation, the task of calculating intrinsic value was a snap. Now we own 68 distinct businesses with widely disparate operating and financial characteristics. This array of unrelated enterprises, coupled with our massive investment holdings, makes it impossible for you to simply examine our consolidated financial statements and arrive at an informed estimate of intrinsic value.

We have attempted to ease this problem by clustering our businesses into four logical groups, each of which we discuss later in this report. In these discussions, we will provide the key figures for both the group and its important components. Of course, the value of Berkshire may be either greater or less than the sum of these four parts. The outcome depends on whether our many units function better or worse by being part of a larger enterprise and whether capital allocation improves or deteriorates when it is under the direction of a holding company. In other words, does Berkshire ownership bring anything to the party, or would our shareholders be better off if they directly owned shares in each of our 68 businesses? These are important questions but ones that you will have to answer for yourself.

Since Buffett is not proposing to break up Berkshire, presumably there are benefits to Berkshire's structure.

Buffett lays out his two columns approach once again. Now, though, it seems to be "two columns plus MidAmerican and the equity in Financial Products". As you know, Berkshire had, basically, no underwriting profits this year so those don't influence the operating earnings column. In the past, he included UW gains/losses in his calculation of the operating earnings column (and its growth over the years). I'm not positive, but it also appears to me that his number does not include MidAmerican's earnings. It does appear to include the earnings from Clayton, XTRA and CORT.

Pre-tax earnings from these businesses were $2441 per share or $3.75 billion. Slap a multiple of 12 on those and you have $45 billion. Add in the $113 billion of investments and you already have $158 billion. Now, add in MidAmerican and Financial Products (excluding Clayton and XTRA and CORT). MidAmerican seems pretty easily to be worth $6 billion (without PacifiCorp) and there is $4 billion in equity in Financial Products (it is my view that none of that equity is 'necessary' to support Clayton's business or the business of XTRA or CORT -- please feel free to correct/comment on these assumptions). So, that's another $10 billion for a total of $168.

The stock seems easily to be worth $110,000. This assumes that GEICO's underwriting success is worth nothing (that is, nothing more than the float it provides to purchase investments) and that Buffett isn't serious or capable of pushing the reinsurance businesses to break-even. Yet, neither of those seems likely. GEICO is a monster and he's pretty much sent out the clarion call on hurricane reinsurance. "We'll let other people write this short tail hurricane business at crappy rates -- good luck." One could argue that serious changes in the underwriting of the hurricane business means that float is likely to drop precipitously. Given all the cash we're sitting on, this de-leveraging seems perfectly reasonable. I suspect it won't amount to as much as it might seem at first blush. I didn't hear anything about no underwriting of earthquakes. I will acknowledge that I don't know how much of Berkshire's float is due to underwriting hurricane supercats. I guess we'll find out.

GEICO, Buffett confirms again, is his best investment ever. He's said that they could save 40% of car insurance buyers money and yet they still have only 6% of the market -- enormous room for growth. $500 million on advertising -- WOW, huge gains in productivity in the business as employment fell 4% even as policies grew 26% -- it's a machine and is probably worth at least twice its current float of $6+ billion. However, the valuation above assumes it isn't. The valuation above also assumes that the insurance business are only worth book value plus float as reflected by the amount of investments that said book+float can purchase. This gives no "value" to any of the reinsurance operations ability to produce future float. This is conservative but not unreasonable, in my opinion. But, we've been over all of this before.

Clayton provided $500 million pre-tax to Berkshire, if you include the $83 million paid to Berkshire to provide borrowing capacity. It could easily be argued that it is at the bottom of the cycle as well. The other two leasing operations provided $170+ million in pre-tax earnings. This group of three generated almost $700 million of what should be recurring profits inside Financial Products but I do think WEB includes these profits in his operating earnings column.

MidAmerican seems poised for enormous growth going forward. Buffett won't tip his hand on his master plan for MidAmerican but I suspect it will be nicely profitable for reasons laid out by Buffett in the past.

Berkshire's policy for acquisitions continues to work well, as evidenced by his stories about Forest River and Business Wire.

WEB's continued warnings on derivatives should give pause to anyone who doesn't know the answers to his queries -- count me firmly in that category.

NetJets continues to disappoint. This is an "on faith" part of Berkshire. Since it provides so little to current earnings, my numbers above give it almost a zero value or possibly less than zero if Flight Safety earns in excess of the total earnings for the Flight Services (which is NetJets and Flight Safety combined). If NetJets ever comes alive, there is a large boost in future years to operating earnings.

No mention of elephants. Maybe they're no longer necessary, from today's "stock price", to push Berkshire forward. I doubt he's given up on finding them since he's still got the cash and there's no mention of returning the money.

With $40 billion in cash earning 4.5% this year, that's $1.8 billion pre-tax. Given his assumption for the equities to grow at between 6-8%, cash rates don't seem too bad. I wonder if his assumption for equities excludes dividends. In either case, 6% of a $46.5 billion equity portfolio is almost $3 billion pre-tax (or before the "deferred tax") in year 1. This seems pretty conservative.

I was quite interested to see his comments that he reduced the dollar hedge: We reduced our direct position in currencies somewhat during 2005. We partially offset this change, however, by purchasing equities whose prices are denominated in a variety of foreign currencies and that earn a large part of their profits internationally. Charlie and I prefer this method of acquiring nondollar exposure.

Which foreign equities? Are they new? This suggests he's talking in the $3 - $5 billion range. Any thoughts?

I thought Buffett's commentary on the money management profession and private equity and frictional costs were more than just instructive -- I suspect he thinks they're timely. He's been pretty good on timing this kind of thing over the years.


Overall, it isn't the report I "wanted" -- I wanted to hear something that would feed my desire to see the stock price rise to my estimate of IV "soon" because of professional pressure. But, that is my own problem/failing.

It's the report I knew to expect. And, I wouldn't expect anything less.

There is a value to the near certainty and virtually unparalleled safety of Berkshire. I'd rather lose clients than lose my a$$.



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