April 19, 2015

Warren Buffett Hints That Berkshire Hathaway Shares Are Cheap In Stockholder Letter

I’m taking it as a given that practically everyone who reads this site has already gone through Warren Buffett’s stockholder letter, which Berkshire Hathaway released today.

Personally, I love how, for only the third or fourth time in his career, Buffett essentially provides enough mathematical evidence to say to people, “You’re a moron for not buying Berkshire Hathaway at these prices, but I’ll never come right out and say it.”  He did it in sort of a clever way, too, to encourage people to run the figures.  He gives the per share book value of the stock (if you want the Class B equivalent, you have to make the 1,500-for-1 adjustment, which comes to $89.98 per share) in the beginning of the shareholder letter.  He then, later, talks about how intrinsic value has grown so much in recent years that anytime the stock is trading at 1.2x book value or less, the company will aggressively repurchase its own shares as they represent the best possible use of money.

A quick calculation puts this repurchase threshold at $107.98 per Class B share.  As of the close of the stock market yesterday, the shares were trading at $115.78.  That’s only a $7.80, or 7.2%, premium to the point at which he advocates acquisitions stop and the focus turns entirely to buy backs, something he’s been loathe to do throughout his almost 50-year career at the helm of the conglomerate.

In the past six months, I’ve had my parents, in-laws, and other family members buying up shares.  The last purchase was at $112.61 back on February 11th.

Then again, this shouldn’t come as a surprise since I periodically use Berkshire Hathaway as an illustration of how my intrinsic value calculations differ from analysts.  A year ago, I gave you my number – $125 to $130 per share – when it was at $96.51 in the open market.  Three years ago, I told you the intrinsic value was between $100 and $115 at a time when the stock was at $72.23 in the open market.  Going back even further six months before that, I wrote that the stock was trading at the lowest valuation in a decade and that we had been buying it for our own accounts (so much so that when it later surged to almost $120 per share, it created a portfolio composition problem that required some strategic adjustments).

My opinion?  Since Berkshire Hathaway is one of those exceptions I discuss, I’ll just come out and say it.  The stock is at $115.78 today.  I think there is a very strong argument the intrinsic value, conservatively estimated, falls somewhere between $140 and $155 per Class B share, meaning the current market value represents a discount of between 17.3% and 25.3%.  If I didn’t already own so much of it, I’d be buying for myself.  As it stands, Berkshire Hathaway is my second largest personal position (the surge in Wells Fargo shares to nearly double their price since I wrote about them being stupidly cheap back in October of 2011 and mentioned we were buying whatever we could afford, meant that they became my family’s largest holding).

Why Is Berkshire Hathaway So Undervalued?

I think the undervaluation in Berkshire Hathaway is happening for three reasons:

Berkshire Hathaway 2013 Annual ReportFirst: The record-low interest rates have left yield-starved investors looking to stocks in the 2.5% to 3.5% range, sometimes even causing them to overpay for shares with low growth and high payouts.  Buffett refuses to pay a dividend so the stock is off the buy list of a lot of people who would otherwise love to own it.

Second: Despite the fact he says succession isn’t an issue, knowing that Warren Buffett probably won’t be around in 10 years judging by the actuarial tables causes some uncertainty and anxiety.  Other businesses, like General Electric or Johnson & Johnson, have long, established processes for choosing the next leader.  Berkshire stockholders essentially are trusting Buffett’s “it will be fine” sentiment.  Related to the first point, even if the lack of dividend is more tax efficient, dividend payments keep the non-Buffett managers of the world disciplined as they can’t squander what they don’t have.  If, say, 50% of profits were being mailed out to owners, the damage a new CEO could do if things go south is less than he could do if he were retaining all of the annual surplus.

Third: Following the banking crisis, a lot of investors are terrified of banks and financial firms in general.  Berkshire Hathaway has enormous insurance subsidiaries, as well as large stakes in major banks.  Therefore, $1 in earnings isn’t being valued as highly as it would be if it were a pure software or chemical enterprise.  Seeing how AIG went from a AAA blue chip to near total wipeout in a matter of days because of small staff in a London office made all such firms suspect; a problem you don’t have with a business like J.M. Smucker that sells jams, jelly, coffee, and shortening.

Personally, I’m not too concerned about the three, which is why I’m fine holding so much of the stock.  Despite his demonstrably true mathematical arguments, I still think it’s a mistake for Buffett not to distribute a dividend as a control mechanism on his successors.  Charlie Munger once mentioned this during a shareholder meeting, saying something along the lines of, “Look, they can’t mismanage what they can’t touch so if it’s really a concern, the board can approve a huge dividend policy and solve the problem overnight, shrinking the responsibility of the executives by giving them access to a smaller pile of money.”

I’ll sleep better at night with Berkshire Hathaway paying a dividend, even if the returns are lowered a bit.  As long as Warren Buffett is at the helm, the retention is fine.  Anyone else in the world?  They need to pay out some of the earnings or the company will deserve to have a lower valuation for the increased risk it poses.

  • Gilvus

    I remember there being a lively discussion about succession back in 2011 when the share price was hovering around $70 and the price/book was under 1. What I took away from it was that even if WarBy and Charlie got hit by a bus, it’d take a steady stream of monumentally stupid decisions to dismantle the cash fountains that Berkshire has acquired over the years.

  • DP

    My favorite line: “Next time I’ll call Charlie”, in reference to wishing he had never heard of Energy Future Holdings, as most of us have never heard of them. Regretting his decisions made for investing without consulting Charlie.

  • innerscorecard

    It’d be nice if Buffett paid a dividend before he died. I wonder how the market would react to a dividend only being paid out after the fact. Would that too obviously say that Ajit Jain (or whoever) isn’t 100% up to the task of replacing Buffett (even if that’s painfully true)?

    • Jay Bugg

      Same logic applies to AAPL?

      • innerscorecard

        Yeah, AAPL was definitely on my mind. I think there are a lot of similarities (at least superficially) between AAPL and BRK.A/BRK.B – scale (and its flip side, running into the law of large numbers), generate tons of cash, unusual degree of identification with founder, sticking to core principles even when competitors do not and the market tells them otherwise, etc.

  • Frederick

    PE as of this years earnings is still 22+. That’s an earnings yield of just 4.5% So a dividend, paying out 1/3 of earnings, would only be 1.5% While BRK’s track record has been phenomenal, and expectations for the future are high, I wouldn’t say the stock is cheap right now. With that said, I’d never want to bet against Berkshire either.

  • Joshua

    For whoever’s interested, loyal3 is a great way to dollar cost average into BRK.B with zero fees.

  • Steve Root

    Just bumped into your blog. Very good stuff. I agree that BRK-A / B trades at a substantial discount to intrinsic value. It resembles closed end mutual funds in that respect; they historically have traded at a discount to net asset value. I don’t necessarily expect the stock price to converge with intrinsic value, if it has not consistently done so in the past, but it is comforting to buy assets with earning power at a discount. Getting the skills of one of the historically best allocators of capital, for extremely modest management costs, is a further reason to own BRK-A or BRK-B. I noticed that Warren pointed out that his two top investment guys smoked him in their 2013 performance.

    • Tent

      Not sure what Todd Combs has done, but in my opinion Ted Weschler has really stood out. Weschler has made some impressive investments in DirecTV, DaVita, and Liberty Global.

  • jwheeler79

    youre great. i really like this blog

  • Steven

    I’ve often wondered if one were to dollar cost average into Berkshire shares in the years ahead if the shares would compound at a rate higher than the S&P 500 (assuming dividend reinvestment) as they did in the past. Josh, do you have any thoughts on this?