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Thanks to mindshar for the above chart. It provides a simple but compelling picture of something important that is going on at Berkshire.
After years of taking pitches, WEB is swinging again.
He actually started about three years ago. Somebody asked him at the last meeting if he had lowered his standards. He joked about how the interval since your last date can impact your objectivity on such matters, but said he didn't think he had lowered the bar.
By virtue of its huge size, Berkshire's equity investing universe now is limited to the large caps. As that sector has become more reasonably priced, WEB has been ramping up his purchases, and this trend now seems to be accelerating. I think it is that simple.
Take WFC, for example. WEB has been paying about 12x forward after-tax earnings as he has added to this position over the last few years. Munger, the self-described "cheerful pessimist," has remarked that WFC is now considered Berkshire's opportunity cost hurdle when they evaluate other alternatives for deploying capital. Paying 12x after-tax is roughly 8x pre-tax. (By the way, it now is selling for about 7x and USB is going for below 7x so it would not be shocking if WEB is buying both at these levels.)
At the Wesco meeting in May 2004 Munger said:
"Berkshire and Wesco are full of cash that we don't know what to do with. Berkshire has $70 billion if you count the bonds, and Wesco is drowning in cash. It's the most extreme it's ever been. In the past, we've just been patient and we were able to put it to work."
At that time, Berkshire's entire net worth was about $80 billion. So they had almost their entire net worth in stuff they really didn't want to own, a condition that was "the most extreme it's ever been" and one that they certainly did not want to continue.
But later that same year, a few of the large caps moved into WEB's strike zone. The above chart speaks for itself on how he has reacted since then.
It will be interesting to see in a couple weeks what WEB has been buying. There are a number of large caps that are trading at single digit or low double digit multiples of their forward pre-tax earnings. For example, JNJ is 9x. WMT is between 8 and 9x. PG is at between 10 and 11x. AXP is between 9 and 10x.
WEB commented at the last meeting how he thought owning a stock index for the next 10 years was a no-brainer compared to owning treasuries. Why would you buy a 10-year treasury bond with a coupon fixed at under 5% when you can buy a basket of equities with a much higher earnings coupon that is growing? Now that some of his favorite large cap equities are in his buy zone, I think it is reasonable to expect him to continue to increase the proportion of the investment portfolio that is in equities, and to lower the percentage that is in cash and bonds. This is simply a move away from the "most extreme it's ever been" allocation in 2004 to a more normal, and more desirable, allocation for Berkshire.
This is good news for Berkshire shareholders, even if the market seems to be slow to catch on. Berkshire itself is a large cap, so it is not surprising that its own market valuation would be discounted by the same market that devalues other large caps. Many of us have lamented the poor functioning of the voting machine in recent years, but perhaps a more intelligent reaction would be to welcome that malfunction as the NECESSARY PRECONDITION for the Berkshire weighing machine to bang on all cylinders once again. The sharp upward slope on the above chart shows that those cylinders are kicking in again. The voting machine will catch on in due course.
Many of us argue, with reference to WEB's "two column" yardstick, that the non-insurance businesses in Column Two ought to be valued at 10x pre-tax earnings, on a conservative basis (some argue for even higher).
The market today values those earnings at half or less that amount. And WEB is transforming Column One before our very eyes, finding equities that sell for 10x pre-tax earnings or less. That's nothing but good news for Berkshare shareholders.
What could make this story even better? Well, if we wanted to get a little greedy, we might wish for our competitors for acquisitions of entire companies to lose their ability to borrow money cheaply. We also might wish not only for devalued large cap stocks, but a press conference where the CEO of Bear Stearns announces that the bond market conditions are the worst he has ever seen. Of course, this surely would be wishful thinking, but we can always dream.
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