2018 Valuation

[khturbo]

Hi all. I just posted a writeup on the valuation at EOY 2018:

https://concentratedcompounding.com/brk/

My model is attached in the post. I'd love to get all your thoughts on it!

[Lemsip]

Looks interesting and good work.

I have not yet digested the whole thing but at first glance I think it looks over conservative.
You are valuing at $202 per B share whereas Buffett, chronically reluctant to repurchase unless there is a huge discount to IV-  has been buying shares upto $207.9 in the recent past.
Also Ajit Jain recently put down $20m of his own money at $198 per B. Neither of these would happen if their general valuation was not somewhere  in the $240-260 per B range which is also the general range from Semper Augustus using 3 different methods.

[khturbo]

It's a good point. I've been thinking about that a bit. My clearest answer is that if you were to discount it at 8% or 9%, the value would be much, much higher. Arguably, using a 10% discount rate for Berkshire is too high, especially in a world of 2.5% 10-year yields and a stock market that might make 7-8% through the next cycle. So I think where I say "fair value," I'm actually kind of saying that my opportunity cost is probably around 10%, so for me to be interested I'd need to see a 10% IRR, and low $200s is the price where I see that, using fairly conservative assumptions.

I went back and discounted everything back to 9% instead of 10% (admittedly an imperfect exercise) and got a value of ~$235. I think that kind of makes sense. Like you probably shouldn't make 10% on BRK over time given the risk profile. So if you think a fair return is somewhere below 9% then it's probably worth ~$250-260 or so.

[SHDL]

Thanks for sharing.  I personally took a somewhat less sophisticated approach but my bottom line was more or less in line with yours.

My rough estimate is that the company effectively earned around $32 bn during 2018:

- 17.2 bn from the railroad, utilities/energy, and MSR segments
- 12.0 bn in look-through earnings from the stock portfolio
- 1.5 bn in interest income earned by the insurance group
- 1.6 bn in insurance underwriting profits
- (0.2 bn) in other losses

So on a $490 bn market cap we have about a 6.5% earnings yield.  Combine that with modest assumptions about growth and inflation going forward (say 3% real growth, 13% ROE, and 2% inflation), and we can probably expect a long term nominal IRR of around 10%.  Not too bad, all things considered. 

PS:  On your question about the 13% tax rate on dividends in the blog post, my guess is that state/local taxes are the culprit. 

[khturbo]

Thanks for those inputs SHDL. I generally agree with those thoughts.

On the 13% tax rate issue, someone posted a link in the comments that talks about special tax rates for insurers. Looks like they didn't get much relief on the dividends from tax reform, unfortunately.

[AdjustedEarnings]

I'm as much of a fanboy as anyone else on this board so it took me longer than it should have to realize/accept that BRK is simply too big for anyone to run, including Buffett. I don't care about short term stock performance but on a longer term basis, it has under performed for the last 10 years and also the last 17 years (if that's not long term then I don't know what is). I picked these dates to coincide roughly with the last two stock market bottoms. No one can handle this much cash (which is why I picked the bottoms because that's when you're ideally positioned to put it to work). The problem gets worse on a daily basis and, despite their advice to others, they've been quite stubborn on returning any kind of cash at all... which means the problem only gets worse.

Buffett is rational but also human. He's had tremendous success investing in and acquiring businesses. So I think there's some inertia to move the thought process along (the switch from net-nets to good businesses also took a LONG time for the same reason; difficult to change what's working). Every fact would tell you that the ability to put money to work is behind them... Ted/Todd under performing with smaller books, WEB under performing, major mistakes in IBM and KHC with large commitments (counting opportunity cost here as I know they didn't lose $$), Coca Cola (this used to be a good investment but total return since investing is now pedestrian given that the stock has been flat since 1998 so the only return is the dividend; their own advice to not do anything for tax reasons appears to have been ignored here since WEB has complained that if they sell KO they'll have a large tax bill and would need a much better investment to make up the tax hit), General Re IRR most likely not good though difficult to quantify, BAC worked out great, but GE didn't. GS was just okay. So taken together, the fall of 2008 investments were just okay. Probably under performed the SP500. BNSF was terrific. But PCP was only slightly above average. Add to that, the mistakes of omission as told by WEB: Google, AMZN, MA/V, etc.  How will they do better with MORE money?

Honest hypothetical question: If any name other than WEB was associated with this collection of assets and performance, how fast would investors be screaming A C T I V I S T? In fact, if you ignore size, isn't this the type of thing that WEB attacked in his partnership days (Sanborn map, separating business from securities)

I know I'm going to invite a lot of criticism here. I like WEB/CM and their whole philosophy more than most but I'm just trying to state the facts, to be clear eyed, and view these things outside of WEB and CM's quips and quotes. At this point, it seems Berkshire will plod along with subpar returns on assets due to, size and cash drag. Best that we can hope for is a nice deal for $80 billion+ but that just seems kind of foolish (or two deals for $40 billion but tough to imagine 10 deals for $8 billion in any reasonable time frame). How many $80 billion+ deals are there? and how many of them go for prices that WEB will pay? Deals at that size (when they come around once every 5 years) are heavily negotiated. So, in my mind, I simply adjust long-term ROE down (unfortunately) by 200 bps on a forward basis, which means 1.3x BV may well be the right price. That's my view anyway.

[SwedishValue]

I think the thread starter’s analysis is good and thought through. I disagree with putting such big discounts on BNSF etc., so in the end I come up with a higher value.

However, I also mostly agree with adjustedvalue. At some point Buffett needs to adress what to do with the cash if interest rates stay low and no elephant appears. His reasoning and unwillingness to repurchase a meaningful amount of Berkshire shares suggests to me that the excess cash problem is likely to increase.

Buffett and Munger have previously stated that material buybacks would be in the cards if no other options were found and Berkshire was trading at a significant discount. My impression was that ”material buybacks” would mean that the cash pile would be kept roughly the same as a result of the buybacks. I’ve come to revise this position considering the very limited use of the repurchase program so far.

I think that over time, Berkshire will spend somewhere between 2% and 5% of their owner earnings on share buybacks (probably above 10% whenever Berkshire is significantly undervalued, but most of the time Berkshire stock will not trade at a discount big enough). Until we see another significant economic meltdown, cash is likely to increase in excess of 20 BN USD per year. If a meltdown comes five years from now, we can only hope that there are deals out there for the excess 200 BN USD in cash that Berkshire will have by then.

If interest rates stay low and valuation levels stay where they are now (or higher), I think it is unlikely Berkshire will do anything with its cash rather than hoarding it. Although it is very strange to me. Up until recently I’ve been under the impression that it would be better to spend the money repurchasing your own undervalued stock rather than hoarding cash. At some point I just have to admit I’ve been wrong.

[Jurgis]

I'm as much of a fanboy as anyone else on this board so it took me longer than it should have to realize/accept that BRK is simply too big for anyone to run, including Buffett. I don't care about short term stock performance but on a longer term basis, it has under performed for the last 10 years and also the last 17 years (if that's not long term then I don't know what is). I picked these dates to coincide roughly with the last two stock market bottoms. No one can handle this much cash (which is why I picked the bottoms because that's when you're ideally positioned to put it to work). The problem gets worse on a daily basis and, despite their advice to others, they've been quite stubborn on returning any kind of cash at all... which means the problem only gets worse.

Buffett is rational but also human. He's had tremendous success investing in and acquiring businesses. So I think there's some inertia to move the thought process along (the switch from net-nets to good businesses also took a LONG time for the same reason; difficult to change what's working). Every fact would tell you that the ability to put money to work is behind them... Ted/Todd under performing with smaller books, WEB under performing, major mistakes in IBM and KHC with large commitments (counting opportunity cost here as I know they didn't lose $$), Coca Cola (this used to be a good investment but total return since investing is now pedestrian given that the stock has been flat since 1998 so the only return is the dividend; their own advice to not do anything for tax reasons appears to have been ignored here since WEB has complained that if they sell KO they'll have a large tax bill and would need a much better investment to make up the tax hit), General Re IRR most likely not good though difficult to quantify, BAC worked out great, but GE didn't. GS was just okay. So taken together, the fall of 2008 investments were just okay. Probably under performed the SP500. BNSF was terrific. But PCP was only slightly above average. Add to that, the mistakes of omission as told by WEB: Google, AMZN, MA/V, etc.  How will they do better with MORE money?

Honest hypothetical question: If any name other than WEB was associated with this collection of assets and performance, how fast would investors be screaming A C T I V I S T? In fact, if you ignore size, isn't think the type of thing that WEB attacked in his partnership days (Sanborn map, separating business from securities)

I know I'm going to invite a lot of criticism here. I like WEB/CM and their whole philosophy more than most but I'm just trying to state the facts, to be clear eyed, and view these things outside of WEB and CM's quips and quotes. At this point, it seems Berkshire will plod along with subpar returns on assets due to, size and cash drag. Best that we can hope for is a nice deal for $80 billion+ but that just seems kind of foolish (or two deals for $40 billion but tough to imagine 10 deals for $8 billion in any reasonable time frame). How many $80 billion+ deals are there? and how many of them go for prices that WEB will pay? Deals at that size (when they come around once every 5 years) are heavily negotiated. So, in my mind, I simply adjust long-term ROE down (unfortunately) by 200 bps on a forward basis, which means 1.3x BV may well be the right price. That's my view anyway.

Good post.

It might be argued that BRK is attractive compared to elevated market/SP500 valuations and future expected returns. I.e. even if you get ~10%ish (or even high single digits) return on BRK, it may outperform the market. Of course, this argument has been made in the past and so far it has not worked. 

[khturbo]

Lots of good thoughts there adjusted earnings. I actually agree with most of them. It's impossible to prove, but I think that if Buffett would have just steadily repurchased stock starting in 2012 instead of making all the investments that they did then per share IV would be higher than it is today. I also think that might be true of a much longer period maybe back to 1998 or so, but it's impossible to prove. Agreed as well that they could have done better in 2009.

I would say that in tracking performance I prefer to look through the cycle, not trough to peak (or close to peak at least). It makes perfect sense that Berkshire would outperform through the cycle but might underperform trough to peak, which is roughly what it has done. Since it's perceived as non-cyclical the relative valuation should be higher at the bottom and lower at the top. Another way to say it is that a good chunk of the return of the S&P since the bottom in 2009 is due to valuation expansion. That isn't quite true for BRK.

Back to cash deployment that adjusted and swedish point out, I wrote that saying that this assumes all earnings are paid out. I honestly think the biggest risk is that Buffett likes to empire build and keeps a bunch of cash waiting for a deal that never happens, in line with what you guys are saying. I hope I'm wrong and that they'll buy back a ton of stock this year. If they use all fcf to buy back stock they really should hit something like a 10% IRR with lots of certainty. If they just keep a bunch of excess then obviously that would take the IRR down a bit, but hopefully not by more than 1-2% annualized.

And to Jurgis, I think that's right. I've had a couple people mention that the valuation is too low. Like I mention earlier, if you discount it at 9% you get ~$235 in value and something higher obviously if you discount at 8%, which is what I'd guess a market return is. I personally think that BRK will continue to trade in the range of where it is to maybe up 10%, which is roughly the ratio of where it has traded relative to perceived intrinsic value over the last maybe 5 years. I don't think the discount will close, but I think it would be hard for the valuation to go lower by 20% and stay there, so I think you lock in through the cycle returns around the rate that IV increases.

I appreciate all of the thoughts and feedback by you guys!

[Lemsip]

A number of comments here about Berkshire underperformance. This of course is very sensitive to the end points used.
As measured at the end of the last calendar year, Berkshire had beaten the S&P by 7 points the previous year and then starting Jan1 of all years since 2010. So far in 2019  we have had a 2.5 month period where Berkshire has flatlined while the S&P has shot up so using the current date as the endpoint gives a different result.
Through a strategy of building up my position when Berkshire has been attractive ( 2011, late 2015 and lately), I have had a modest edge on market returns since 2004 in my personal portfolio.

I think 10%-11% from Berkshire from current prices is a reasonable expectation and more importantly the range of outcomes is narrower than for the average firm. There is no chance of it shooting the lights out but also the safety factor makes it a reasonable candidate for a chunk of the portfolio that will survive adverse periods from a position of strength.

Cash build up  and usage is an issue but there are companies with bigger market cap than Berkshire which are also operating and growing reasonably well with a similar amount of cash ( Alphabet has $110bn , Apple double that). It will take time for Berkshire to return cash but any effects of that will need time to work through. I am encouraged by specific moves to relax the weird book value criteria last summer and the start of buybacks.