When I look for a blue-chip recommendation, I want to find long-term growth in shareholder value, a rock-solid balance sheet, and superb management that does not gorge itself on the company's profits at the expense of outside shareholders. If I can get such a company at a significant discount to my estimate of intrinsic value, then my investment thesis is an absolute no-brainer.
Here's what you get when you invest in Berkshire:
- A company that aligns corporate and shareholder interests like no other. The philosophy and culture is ingrained in all senior managers, and it's set to continue long after Buffett steps down.
- Enormous financial strength, a competitive advantage even when Berkshire owns businesses in narrow-moat industries.
- A wide array of businesses that produce cash, which is then expertly reallocated to purchase additional cash-producing entities.
- Improved returns on $64 billion in cash and fixed-income securities as interest rates rise.
- An insurance float of $49.7 billion and growing. As long as underwriting stays profitable, this is effectively free capital that the company deploys to the benefit of shareholders.
- A company uniquely positioned to benefit from a market downturn -- it has more than $30 billion, plus new cash flow to acquire new assets, and the deeper the downturn, the cheaper those assets.
- A philosophy of long-term commitment to acquired companies and incumbent management, which gives it an edge in acquiring private companies at a fair price without an auction.
Berkshire is often likened to a mutual fund because it owns so many operating subsidiaries, as well as $57 billion in equity investments in some very well-known companies. However, the heart and soul of Berkshire is its insurance operations, which provide float (cash) for Buffett and others to allocate. Float, which essentially consists of unearned premiums and unpaid insurance losses, totaled $49.7 billion at the end of September. Provided that insurance underwriting is profitable, the cost of float is zero. That's right -- $50 billion of essentially free cash is in the hands of one of the world's greatest investors! Most of the wholly (or majority) owned businesses are in fairly boring industries that predictably produce lots of excess free cash flow, which goes back to Berkshire for future investments.
A good place to start when valuing Berkshire is to take Buffett's advice, which he outlines in the Berkshire Owners' Manual (link opens a PDF). A simple way to view the company is in terms of book value per share (BV/S). In May 1996, when Berkshire first issued its B class shares, Buffett indicated that the stock price was somewhere close to fair value or possibly slightly overvalued then. At that time, the first-quarter reported BV/S was around $15,200, and the share price was around $34,000. Applying the same ratio to today's BV/S of $66,300 results in a share price of more than $148,000 per A share, or $4,930 per B share. My more elaborate valuation produces a range of $123,000 and $144,000 per A share. Translated for B shares, this amounts to $4,100 to $4,800. At today's price, that puts Berkshire between 13% and 25% undervalued.
Foolish bottom line
I don't expect Berkshire shares to rocket up next week (although they are up 21% this year), but I can see them at $5,000 per B share (and $150,000 per A share) in two to three years. When I remember Buffett's first rule of investing -- don't lose money -- I can't think of a better lower-risk investment or a better blue chip than Berkshire Hathaway.
If you agree with my position (and how couldn't you?), please let us know in our brand-new Motley Fool CAPS community-intelligence database and simply rate Berkshire Hathaway "outperform." To make your voice heard, please click here. Based on your thoughts, we'll declare the best blue chip of 2007 early next week.
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Philip Durell is the advisor/lead analyst for the Motley Fool's service. He owns shares of Berkshire Hathaway but of no other companies mentioned in this article. Berkshire Hathaway and Coca-Cola are both Inside Value recommendations. Johnson & Johnson is an Income Investorrecommendation. The Motley Fool has a disclosure policy.