This article has been adapted from our sister site across the pond, Fool U.K.
On May 10, 1965, an investment manager named Warren Buffett took control of the struggling New England textile producer Berkshire Hathaway
Since then, Buffett has turned the company into a powerhouse whose shares, as I write this, trade at $120,495, a compound annual return of almost 22%, valuing the company at just over $198 billion.
Given the past performance of the shares, you may be forgiven for thinking that they are overvalued. But I'd argue that they are fairly cheap on price-to-earnings grounds, and that they also offer non-U.S.-based investors a very interesting way to invest in the American economy.
The business
Berkshire Hathaway can be seen as the sum of three parts:
- A collection of insurance companies, including GEICO and General Re.
- A substantial investment portfolio, which includes 12.7% of American Express
(NYSE: AXP) (NYSE: KO) - A collection of businesses that Berkshire has bought over the years, most of which supply goods and services to the American market.
Unlike many conglomerates, Berkshire Hathaway doesn't micromanage its subsidiaries; Buffett gives his managers free rein to manage their businesses as they see fit. However, should any subsidiary wish to retain its profits for reinvestment, they must justify this by referring to market rates of return.
Surplus profits are sent to headquarters, some of which Buffett may invest, while the other divisions can call upon these funds (but they still have to pay market rates).
So if one business can't find any good opportunities to reinvest its profits, then rather than investing in sub-par businesses (as many conglomerates are prone to do), the money can be redeployed elsewhere within the web of companies that form Berkshire Hathaway, or to buy new companies such as the Israeli toolmaking multinational Iscar.
High price doesn't mean expensive
Berkshire Hathaway's share price puts off many investors. After all, most shares don't trade at a price where selling one share produces enough to buy most of the flashier cars tested by Jeremy Clarkson's team on Top Gear.
But a high share price doesn't necessarily mean that the shares are expensive.
Shares in Britain's most successful supermarket, Tesco, currently trade at 425p. But if the directors said that every 1,000 shares in "old Tesco" would be converted into 1 share in "new Tesco," then these shares would be worth roughly 4,250 pounds.
Tesco's shareholders would still own the same percentage of the company as they did before the change, yet it's very easy to think that the new Tesco shares are expensive.
Shares are cheap or expensive relative to their assets, earnings, and prospects -- whether you divide a pizza into four slices or four hundred, it's still the same pizza!
The cheap alternative
However, with a share price of almost 78,000 pounds, many investors can't raise the cash for one share. But in 1995 Berkshire issued a cheaper alternative, its "B" shares, and after making its biggest acquisition in 2009, Burlington Northern Santa Fe railroad, in a cash-plus-shares offer the B's were further subdivided by 50 to 1.
So 1,500 B shares are equivalent to one A share (except when it comes to shareholder voting rights, where the ratio is 10,000 to 1).
As I write this, the B shares are trading at $80.11, which is now within every investor's price range. They had a pretty good 2010, outperforming the S&P 500 with a 21.8%.
Moats and crocodiles
Most of Berkshire Hathaway's businesses possess what Buffet calls a "moat," a sustainable competitive advantage such as strong brands or are in a market with large barriers to entry. Both of these protect the business from competition (try setting up a new railroad if you don't believe me!). He then encourages his managers to strengthen their moats, "filling them with crocodiles" to improve their ability to repel competitors.
Some of Berkshire's businesses have seen their moats crumble in recent years, notably The Buffalo News as the newspaper business has been eroded by the Internet, whilst Dexter Shoes was unable to compete with far cheaper production from overseas. But these are the exceptions to the rule.
The numbers
Berkshire's profits for the first nine months of 2010 were $5,265 per share. I'd estimate that this puts the shares on a forward price-to-earnings ratio in the region of 17 to 18.
The P/E ratio is a useful metric for valuing Berkshire Hathaway, but investors should be warned -- Berkshire's P/E ratio can be very volatile thanks to one-off investment gains (and losses). Also, Buffett doesn't go in for the "smoothing" tricks used by many companies to flatten out fluctuations in their earnings in order to meet Wall Street's targets.
Buffett prefers to use the ratio of share price compared to book value (the net asset value), and his annual letter to shareholders invariably opens by referring to that year's change in book value. This ratio using the last quarter's figures is just over 1.3, but historically, it has been much higher (in 1995 the multiple was 2.6).
Book value is not an arbitrary figure; if the vast majority of Berkshire's businesses were put up for sale, they'd be worth substantially more than 1.3 times their net asset value!
The future
Many investors are rightly concerned over the succession when Buffett "retires," arguing that the company is too dependent on one man. In my book, their worries have already been addressed since Berkshire Hathaway has many managers, such as David Sokol, boss of MidAmerican Energy Holdings, who are more than capable of taking over the day-to-day running of the company.
History has shown us that many firms continue to prosper when a dominant figure leaves the scene. Thomas Edison was a far more dominant presence than Buffett, but after him, General Electric went from strength to strength under a succession of great managers.
Importantly, there's a very strong presence on Berkshire's board, including Bill Gates of Microsoft fame, which should ensure that the company will be in good hands when Buffett retires. Gates has a strong interest in Berkshire's success; he's a substantial shareholder himself, and most of Buffett's shares will eventually be gifted to Gates' charitable foundation.
In the future, I expect Berkshire Hathaway's share price performance to become closer to that of an S&P 500 index tracker, but it should still outperform the index over the medium to long-term because of the quality of its businesses.
Just don't expect a dividend; the last time Berkshire paid one was in 1967 -- Buffett said that he must have been in the bathroom at the time!
More from Fool U.K.'s Tony Luckett:
Tony owns Berkshire Hathaway "B" shares. American Express, Berkshire Hathaway, Coca-Cola, and Microsoft are Motley Fool Inside Value selections. Berkshire Hathaway is a Stock Advisor pick. Coca-Cola is a Motley Fool Income Investor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Berkshire Hathaway, Coca-Cola, and Microsoft and has a disclosure policy.
