I enjoy Tode's insights into Berkshire's intrinsic value. I also enjoy his ability to turn a phrase. In a recent post he wrote: Become a Complete Fool
"I know Tilson and many other Berkshire fans argue that the multiple on Column Two "ought" to be higher than 10x. I think they make a reasonable case, but I also think that yardsticks ultimately must be graded on how well they measure yards."
In recent years, I have spent some time examining the yardsticks that Mr. Market might be using to measure Berkshire. In so doing, I am not focused on what Berkshire "ought" to be worth in terms of past performance and future projections. (I've done plenty of these IV estimates in my time.) Instead, I'm trying to see if I can find any yardsticks and logic behind what Berkshire has sold for in actual market transactions.
I've chosen the period of 1995 to the present for my studies. This is because I believe Berkshire began a major transition when the balance of Geico was acquired. Since then it has evolved into both a large insurance/investment business and a major operating company. This evolution took a major step - for better or worse - with the acquisition of Gen Re in 1998. With the earnings and float from these steps, the pace of acquiring non-insurance businesses has intensified, and Berkshire has become a huge multi-conglomerate.
I'm also influenced by Greenwald's approach to valuing a business, which he divides into three slices:
1. The reproduction cost of assets, tangible and intangible, under conditions of free entry.
2. The earning power value from current competitive advantages, which includes and adds to No. 1.
3. The value of growth, but only if within the franchise and benefits from the competitive advantage. This further adds, where present, to No. 2.
So I began my search by focusing on assets.
Enough preamble. Let's move on to the observations. I've covered some of these in past posts, but I'll update everything through 2006 YE, and repeat myself at times to have everything in one place. One warning, This may have too many numbers and become boring to those seeking a quick answer.
Price vs. Adjusted Assets
One popular yardstick over the years has been to add float and deferred taxes to book value. My adjusted assets (AA) is similar, but I've chosen the sum of losses and loss adjustment expenses plus unearned premiums in place of float. This simply permits doing all calculations using only the balance sheet. Also I only add back 25% of the deferred taxes. This is based on some modeling of a future world of lower growth rates for the major holdings and the low dividends we currently receive. Munger used to use 35% of deferred taxes in estimating Wesco's IV, so this is a little more conservative. It really doesn't make much difference in the conclusions reached.
From 1995 to 1997 (and especially in the mania of 1998) the ratio of price to AA jumped around a lot. Price was 120% of AA as a minimum, and generally higher. However, for the 8 years (32 quarters) since the Gen Re acquisition closed, price has averaged 98.4% of AA, with a standard deviation of 9.0%. Not a bad yardstick.
Why did the price to AA ratio drop after the Gen Re acquisition. Simply put, book assets went up a lot more than intrinsic value. The market recognized this, so the ratio dropped.
Looking at the extremes, the lowest quarterly close was on March 31, 2003 when Berkshire dropped to $63,800 and the ratio was at 81.6%. Probably the lowest interim ratio was about 72%, when WEB talked about buying back shares and Berkshire' price briefly dropped below $45,000. However, all quarterly closes besides March 03 have been at 90% or higher.
The highest ratios were the first two quarters of 1999, when the ratio remained at the "old" 120% range. Berkshire was still in the $70,000 range of euphoria during this period although the AA (and I believe IV) was around $57,000. However, since then the price has not exceeded 110% of AA. The March 31 2004 price of $93,300 was at 106%. 2005 closed at 92% and 2006 at 101%.
These trends are much easier to view graphically, but I can't do graphs on the MF boards. Suffice it to say that Berkshire's price has been pretty stable between 90% and 110% of AA since the middle of 1999, and the average closely tracks this yardstick. Two things happened in 2006. AA grew by 12.6%, and the price to AA ratio improved by 9% as Berkshire moved from the low end of the range to just above the average.
What are the implications of this yardstick? Well, the growth adjusted assets per share since the Gen Re acquisition closed has averaged 8.4% a year. And the rolling 12 month average for the past 32 quarters has been 8.6%. If price continues to track adjusted assets, then the implications for future price growth are clear unless growth rates accelerate. This will be difficult as the size anchor grows.
There are some obvious objections to this approach. It implicitly assumes that float (or my balance sheet proxy for float) is equal to equity, just as Buffett does when he sets column 1 equal to investments. AA is a little more conservative, since it does discount deferred taxes, and Buffett doesn't. Float = Equity obviously depends upon the future ability to invest this float at rates above the discount rate, including any underwriting profits, and float growth rates enter into the calculation.
But the bigger objection is that this approach implicitly values the operating businesses at book value. This obviously understates the case for the older acquisitions, while the newer ones are probably closer to book value because of the required purchase price. So, in theory, the price to adjusted assets ratio should be growing as the acquired businesses mature.
But it hasn't. It has only cycled within a fairly narrow range around the midpoint. Why?
One guess is that the market's concerns with Gen Re's troubles, 911, and the hurricanes have masked the underlying growth of the non-insurance businesses. If so, we may can expect better times ahead with respect to Berkshire's market prices. But this remains to be demonstrated. And concerns about global warming risks and Buffett's replacements continue. I note that Sequoia sold a good chunk of its Berkshire holdings last year.
Based on this yardstick, I'd keep my expectations for Berkshire's future market price growth on the conservative side until otherwise demonstrated.
Price to Book
Another popular historic yardstick has been price to book. Again a graph would be helpful, but I'll try to paint a word picture.
P/B was at 2.3 at 1995 YE when WEB thought Berkshire overpriced. It dropped to 1.8 at 1996 YE when WEB thought the price more appropriate. It jumped back above 2.0 during 1997, but closed the year again at almost 1.8. Things got crazy during 1998 with the Gen Re activities, but P/B closed 1998 at 1.85, probably a little overpriced. It dropped as low as 1.4 in 2000, climbed back to 2.0 by 2001 YE, and then began an irregular slide downwards. 2005 closed at 1.5 and 2006 improved slightly to 1.57. The average quarterly close since the end of 1998 has been 1.64 with a standard deviation of 0.15. This decline in P/B has obviously caused the market price to grow less rapidly than the book value.
I began to wonder what the picture would be if $1 of cash was being treated by Mr. Market as being worth $1. So I recalculated the numbers with the cash (net of debt) from the insurance businesses (only) being excluded from both the book and the market price.
The graphs track each other pretty closely until 2Q 2003 when Berkshire's cash hoard began to really build. This "non-cash" P/B moved from 1.6 in 1Q 2003 to 1.8 by 2Q 2003, and reached 2.0 by the end of 2003. It peaked at 2.3 on March 31, 2004, almost where it was in 1995, and near a time when Berkshire's price touched $95k. Then it gradually declined to a low of 1.66 in 3Q 2006, when. Berkshire's price (ex. net cash) was $74k. The "ex-cash" P/B improved to 1.8 by 2006 YE as the price (ex. net cash) grew to $88k. The "ex-cash" P/B has averaged 1.83 since Gen Re closed, with a standard deviation of 0.20. The 1.83 matches the 1996 and 1997 year end numbers. In this view, cash buildup is the primary reason for the overall P/B decline.
I'm not sure this "adjusted P/B" yardstick is telling us much except that Mr. Market doesn't highly value a lot of cash sitting around on the balance sheet. (duh!) I do find it interesting to speculate what would happen if Berkshire could (a) rapidly invest the extra $28 billion of cash above his $10 billion reserve for super-cats, and (b) the market assigned the 1.83 ratio it has averaged excluding cash to this new investment. Berkshire's price would climb by $15k a share, reaching $122k a share. This would be in the range that many people might accept as a "fair" price for Berkshire today.
Enterprise value is another common yardstick. For my purposes, I only used the cash and debt associated with the insurance businesses. At the end of 1995, the EV was $30.7k, growing to $34.6k at the end of 1997, and $47.0k at the end of 1997. It jumped to $62.6k at the end of 1998 with the Gen Re acquisition and the resulting price jump. For the 28 quarters beginning 1-99, the EV averaged $64.3k with a standard deviation of $5.7k. 2005 ended with an EV of $64.7k, little changed from 1998. In other words, the price movement during this period reflected the buildup in net cash, with some market gyrations around this trend line. The way Mr. Market valued the underlying businesses hardly changed over seven years. This is difficult to rationalize, other than to say that either Mr. Market significantly overvalued the businesses at the beginning of this period or significantly undervalues them today (and combinations thereof).
But do note that the 2005 price (and EV) was at the low end of the price to AA correlation discussed earlier. In 2006, the EV improved to $87.8k, reflecting both asset growth, the ability to reinvest that year's cash generation, and the return of price to asset trend line. There's hope if we can (a)grow assets rapidly, as happened in 2006, and (b) reinvest that growth rapidly, which also happened in 2006.
The Underlying Question
While I haven't found any magic yardsticks, I come away from the above studies with the clear impression that Mr. Market continues to value Berkshire pretty conservatively, and primarily on assets rather than on future expectations. This is in spite of the performance numbers that Buffett continues to demonstrate in Column 1 and Column 2. Why?
There is a fundamental belief expressed by most Berkshire shareholders that the price of Berkshire will ultimately converge on its value. This is a basic tenet of a well functioning market. So (a) are we significantly overvaluing Berkshire by the expectations of many shareholders? or (b) is something going on to continually suppress the price of Berkshire?
There are some fundamental reasons, I believe, why the market price of an equity usually converges upon the value of the underlying business:
1. The stocks are liquid, with many individual decisions impacting the price. (However, Berkshire is relatively illiquid, and the situation could get worse with foundation and aging shareholder sales. It probably won't improve without some major changes, e.g., splitting Berkshire.)
2. The company management promotes the value of the stock through its communications and actions - such as dividends and buybacks. (Berkshire basically doesn't. WEB sometimes hints, but that's about all.)
3. Takeover/vulture investors buy up undervalued companies and rework them to realize their underlying value. (Berkshire is immune to such actions. And succession plans are structured to maintain this position.)
I personally don't doubt that Berkshire could command prices in the $120-140k range, maybe higher, if the company were broken up to realize the underlying value of the assets. However, the evidence of the past eight years suggests that the market doesn't price Berkshire in this manner. Nor does it price Berkshire based on projections of future growth. What you see today in assets is what you see in price.
My studies indicate that Mr. Market values Berkshire on a very conservative basis, and there is yet no evidence that this is changing.
I think investors should temper their enthusiasm for Berkshire's value with the actual performance of Berkshire's price in the marketplace
It is very important that Berkshire be able to reinvest its ongoing cash flow as well as the excess cash that has been accumulated. I thought that WEB's announcement that he intends to bring in additional talent to develop as Chief Investment Officer was some of the best news in the 2006 report. Besides the succession issue, this provides the opportunity to expand Berkshire's circle of competence. Given the competition for investment today, and the abundance of capital, the ability to reinvest cash is probably the major strategic issue for Berkshire.
Still, Berkshire remains a very solid investment at current prices. The cash generation machine is working well. With moderate reinvestment success, Berkshire should somewhat outperform the S&P 500 over time, and be competitive with the broader indexes. And it has better downside protection than most, due both to the cash/bond hoard and to the improved investment opportunities that a down market would bring.
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I enjoy Tode's insights into Berkshire's intrinsic value. I also enjoy his ability to turn a phrase. In a recent post he wrote: