Warren Buffett’s legacy as one of the all-time great investors is assured. However, in recent years his prowess has been called into question as the share price of Berkshire Hathaway (US:BRK.A) has underperformed a cheap index-tracking fund. Does Berkshire have the right portfolio of investments and businesses to make investors happy?
Berkshire and Buffett have been doubted before. Twenty years ago, Buffett was accused of not understanding the new world of the internet as he refused to buy grossly overvalued technology and telecom stocks. He was proved right back then as the bubble burst, but now some people think that he is out of touch again and has been too slow or unwilling to invest in the businesses that are seen as the drivers of progress and wealth creation in the years ahead.
This is not a groundless point of view. We have seen and are seeing the rise of the intangible economy or capitalism without capital. Growth and wealth is being created from leveraging technology investments in areas such as software as a service (SaaS), data, digital payments, internet retail and electric vehicles.
Buffett and Berkshire have not missed out completely on some of these trends, but their exposure to slower-growing and asset-intensive businesses does go some way to explaining why the ability to beat the returns of the S&P 500 has been hard to come by in the past couple of years.
However, you could be forgiven for thinking that an investment in Berkshire Hathaway’s shares has been a total disaster given some of the media commentary out there. That would be unfair in my view.
In the 11 years since the end of 2009 until the end of 2020, Berkshire has performed better than the S&P 500 in seven of them. Up until the end of 2018, it had marginally outperformed the index. It has only been in the past two years since tech stocks have surged in value that Berkshire has lagged. Given that there are grounds for thinking that tech stocks in general are very highly valued – if not overpriced – and have seen their share prices increase faster than their profits, Berkshire has actually held up quite well.
It’s also the case that many of the things that have served Buffett and Berkshire well are still in place. Both remain great examples of the power of retained earnings and of compound interest over time, but there can be no doubt that the playing field has changed and it is going to be much harder for Berkshire to grow and outperform the stock market in general in the years ahead.
Cheap money and the cash resources of private equity and special acquisition companies (SPACs) mean that Berkshire is no longer seen as a place to turn to when times are tough as they undoubtedly were in 2020.
After the financial crisis, Buffett was able to do some cosy deals with the likes of Goldman Sachs and Bank of America for high-interest-paying preference shares with cheap options (warrants) to buy shares at a later date. These deals are not available now.
Near-zero interest rates have pushed up the asking price for the big deals that a big company like Berkshire needs to do to make a meaningful difference to its performance and investment returns. This goes for buying shares on the stock market as well, as Berkshire was actually a net seller of shares in 2020 for the first time since 2014. Berkshire spent nearly $25bn buying its own shares instead.
So should investors hang up on Buffett and Berkshire given how tough its task looks? To try to answer this I’m going to look at the key building blocks and drivers of the company’s value.
The Insurance float looks better than ever
The great advantage that Berkshire has had is that it gets to invest money that doesn’t belong to it without paying for it. This very large pool of money is known as a float and it is a feature of the insurance business.
Berkshire’s insurance businesses take in money from customers in the form of premiums. The potential claims against those premiums may not have to be paid out at all or for many years. As long as the companies’ premiums are bigger than its claims (the business makes an underwriting profit) the size of the float gets bigger as the size of the business – by generating more premium income – gets bigger.
The size of Berkshire’s float was a massive £138bn at the end of 2020 and has grown substantially over the past decade as premium income has more than doubled and underwriting profits have been made in all but one year.
This float has provided the money for Warren Buffett and his helpers to invest in the stock market. While claims are made against the float every year, money is added to it from new premiums, which Buffett says will create an almost permanent source of money to be invested. At the end of 2020, $109bn of the £138bn float had been invested in shares.
The float may decline in some years, but it is unlikely to do so by much given that Berkshire’s insurance contracts are structured not to blow a massive hole in its finances. This view of permanence to the float makes it equivalent to an interest-free loan that does not get paid back as long as big unexpected losses are avoided
The money invested in shares was worth $281bn at the end of 2020. On top of this, the insurance company also had $135bn of cash and cash equivalents. Added together, these give the company an enviable position of competitive strength compared with its peers and more than cover the $120.8bn of unpaid losses and loss adjustments.
It is this insurance float and cash that underpins the foundations of Berkshire Hathaway as a business. Without it, there is no cash to invest in shares or operating companies and grow value for shareholders without issuing new shares or borrowing money.
The impressive financial strength also lowers the risks for Berkshire shareholders while allowing it to invest in shares and generate more investment income than many of its peers who are largely stuck with low-yielding bonds.
This, in turn, gives Berkshire an ability to price insurance – relative to risk – very competitively with its peers and still make money. It’s a source of competitive advantage that looks set to continue for many years to come.
All this cash and float is fine, but it is what’s done with itb that counts. The value of Berkshire essentially boils down to what Buffett calls its “groves” which hopefully produce a growing harvest in the years ahead. There are five of them:
- The value of cash and cash equivalents.
- The portfolio of shares funded by the float.
- Direct equity stakes in operating companies.
- The value of Berkshire’s wholly owned non-insurance companies.
- The value of Berkshire’s insurance underwriting business.
I will look at each of these in turn to weigh up Berkshire as a business and to try to determine how much it is worth. I will base all of the analysis and valuation on the numbers in Berkshire’s recently published 2020 annual report.
Cash and cash equivalents
This is the simplest part of Berkshire to value. At the end of 2020 it had $138.3bn of cash and cash equivalents. Warren Buffett has always said that he wants to keep at least $20bn set aside to cover an unexpected insurance event. This leaves $118.3bn of surplus cash.
The portfolio of shares
Berkshire’s equity portfolio was valued at $281bn at the end of 2020.
|Berkshire Hathaway Equity Portfolio at the end of 2020|
Market Value $m
Bank of America
Occidental Petroleum Preferred
|Source: Annual Reports/Investors Chronicle|
This portfolio has generated some impressive gains but is also very unbalanced. Buffett is a big fan of concentrated investing and making big conviction bets, but nearly 43 per cent of the portfolio was invested in Apple (US:AAPL), with 68 per cent invested in just four stocks.
Apple has also contributed over half the portfolio’s gain in value and was almost certainly not Buffett’s investment decision but was probably Todd Combs’ or Ted Weschler’s, who have managed part of Berkshire’s portfolio for the past decade.
Big gains have been made in Coca-Cola (US:KO) and American Express (US:AXP) over many years of ownership and also in shares such as Moody’s (US:MCO ) and BYD (CH:002594) – a Chinese electric vehicle and battery company.
Yet, you look at this portfolio and you can’t help asking where are the growth companies that are going to compound in value to make a real difference in the years ahead. Apple is a very good business, but if you take away its ongoing share buybacks and its continued, though diminished, reliance on the iPhone, there’s not a lot of real growth expected.
This is a portfolio full of mature, slow-growth businesses. Ask yourself, if this was a managed fund, would you invest your money in it as it is now? I wouldn’t. The portfolio has also changed dramatically in make-up from a decade ago.
|Berkshire Hathaway portfolio 2010|
% of portfolio
Procter & Gamble
Johnson & Johnson
|Source: Annual Report/Investors Chronicle|
Note that this portfolio was also very concentrated, but not to the same extent, but many of the names have changed. Berkshire has bought a direct stake in Kraft Heinz (US:KHC) and has swapped its investment in Procter & Gamble (US:PG) (it still owns a small stake) by buying Duracell batteries from it. Some investments such as Tesco (TSCO) and Munich Re were mistakes and have gone.
If the 2020 portfolio was sold off at its year-end valuation and the gains of $172bn were taxed, the value for shareholders would be $224.9bn.
Direct equity stakes in companies
Berkshire has direct investments in four key companies which it does not control. It has a 26.7 per stake in Kraft Heinz, which has not worked out well and was valued at $11.3bn at the end of 2020.
It has a 50 per cent stake in commercial loan business Berkadia, 38.6 per cent of Pilot Flying J (road-based service stations) and 50 per cent of ETT, an electricity grid business. These businesses produced $631m of net earnings in 2020. Valuing these at 15 times earnings gives a valuation of $9.5bn.
Non-Insurance operating companies
Despite Buffett rightly saying that the best businesses are ones with high operating margins that require not much capital to grow, Berkshire has two businesses in BNSF and Berkshire Hathaway Energy that only grow by investing lots more money in them.
Burlington Northern Santa Fe (BNSF), is one of the biggest railroads in the US with operations mainly in the west and south of the country. It moves around huge amounts of consumer, industrial and agricultural goods and has historically moved a lot of coal.
This has been a very good business since Berkshire bought it in 2010. While 2020 has been difficult, operating margins improved and are at a very high level. Despite spending more than its depreciation expense, BNSF generates decent amounts of free cash flow to give back to Berkshire to reinvest.
|BNSF financial performance|
|Source: Annual Reports/Investors Chronicle|
Railroads are highly valued on the US stock market right now. Union Pacific (US:UNP), which is very similar in revenues and profits to BNSF, currently trades on 26 times historic earnings. BNSF at the same multiple would be worth $134.2bn.
Berkshire Hathaway is an electric and gas utility with most of its assets in pipelines and grids. It is investing heavily in wind farms to shift its energy mix away from fossil fuel. This combined with huge investments needed to upgrade electricity grids is likely to provide Berkshire with a growing source of stable, regulated earnings, but at the expense of near-term cash flow. The investment in renewables is very tax-efficient with the company getting tax credits to boost its net income. Putting this business on 20 times 2020 net income gives a valuation of $61.8bn.
|Berkshire Hathaway Energy financial performance|
BH Energy $m
|Source: Annual reports/Investors Chronicle|
Berkshire’s remaining businesses represent a sprawling conglomerate. They range from building products such as John Manville, Clayton Homes, the Marmon industrial manufacturing service business, NetJets, Precision Castparts, Lubrizol, car dealerships and things such as furniture, jewellery and chocolate businesses. They are collectively known as Manufacturing, Service and Retailing (MSR) in Berkshire’s annual report.
Precision CastParts was bought in 2016 for a hefty $37bn and has not performed well. Its complex metal components, castings and fastenings have been hit hard by a downturn in the aerospace business. Buffett has admitted he paid too much for it and it has been written down in value.
|Source: Annual Reports/Investors Chronicle|
Many of these businesses are cyclical and not particularly high-margin and this is shown by the decline in profits in 2020. Valuing all of them is not easy, but they do produce a meaningful source of earnings. 15 times 2020 net income gives a value of $124.5bn.
The value of insurance underwriting profits
The basics of insurance companies are quite straightforward, but in practice they are very complicated. Valuing them is not easy. The bulk of the value comes from the float, which we have already counted in the equity portfolio and cash balances earlier.
Underwriting profits are volatile. GEICO, Berkshire’s auto insurance business, usually makes a decent profit, but the reinsurance business frequently posts losses.
Trying to work out what a sustainable value of annual underwriting profits could be is not easy. I’ve made a guess at $2bn, but this could be too generous. Taxing this and putting it on 12 times earnings gives a value of $19bn. It is not a big driver of Berkshire’s value on its own, but is vital to preserving the cost-free status of the float.
Berkshire sum-of-the-parts valuation suggests the shares are undervalued
Berkshire is best valued on a sum-of-the-parts basis using the building blocks that i have just described. This is not easy and requires a detailed understanding and thorough research of the business to come up with a good and realistic valuation. Admittedly, mine is more a scrap-of-paper approach, but I’m hopeful it gives a reasonable guide as to what the fair value of the business could be.
|Berkshire Hathaway: sum-of-the-parts valuation|
Cash & Cash Equivalents
Cash less $20bn for catastrophe Contingency
Value less tax on gains
Direct Equity Investments
Value of Kraft Heinz Shares at 31/12.20, ETT, Berkadia and Pilot valued at 15x 2020 net income
Insurance Underwriting Profits
$2bn of l-term U/w profits taxed and valued at 12x PE
Union Pacific PE of 26x
Berkshire Hathaway Energy
20x 2020 Net Income
Manufacturing,Service & Retail
Current Market Cap
|Source: Investors Chronicle|
The main criticism of my valuation is that it is based on applying high valuations based on comparable market valuations in energy and railroads. The value of the equity portfolio is also vulnerable should Apple shares fall in price. That said, as it stands, there are grounds for thinking that the current market capitalisation of $585bn undervalues the company,
Should the recent shift back into value and cyclical shares continue, the shares could perform well and beat the S&P 500 in the short term. However, it is growth that drives the value of shares over the long haul and I’m not convinced that Berkshire’s equity and business portfolio has what it takes to do this.
This puts the onus on Buffett doing a big company-transforming deal, which looks difficult in the current environment. Investors also need more than share buybacks.
While the current concentrated tech exposure of the S&P 500 brings risks, the companies behind it do look to have better growth prospects and this is why I’d probably rather put my money in an S&P 500 index fund rather than Berkshire Hathaway shares right now.