Author Topic: Catalyst for BRK from Book Value to New Metric  (Read 1900 times)

longterminvestor

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Catalyst for BRK from Book Value to New Metric
« on: February 19, 2020, 10:47:14 AM »
Traditionally BRK's proxy for fair value has been Book Value.  Buffet himself said BV is not a good proxy for valuation for BRK moving forward however market is still using.  Recent example of market changing its valuation methodology is AAPL.  AAPL had no material change in YOY earnings however market just doubled the multiple because revenue for Services has large run-rate and renewed love for iPhone revenues.   Post from earlier this week talking about the goodwill value on balance sheet of businesses acquired years ago being outdated got me thinking - When does BRK get "Re-Rated"?  What are the catalysts for this re-rating?

Reasons why BRK has not been re-rated:
#1 - Market sees BRK as an insurance business with operating subsidiaries rather than operating business with insurance subsidiaries
#2 - Permanent Owners in public market:  The share float in BRK does not trade like other public companies.  I estimate there is an overwhelmingly large amount of forever holders.  Homegamers, Institutional Funds, and Berkshire Insiders have no interest in selling.  IE - there is no exit price on my shares that I own - I am looking to buy more.  On the other hand, Bill Ackman's Pershing Square probably has an exit price.  So stock just sits where it sits.
#3 – Dead money: cash earning nothing is a HUGE drag on ROE
#4 – Size hinders growth
#5 – Market loves leverage.  Only leverage on balance sheet is insurance company float and regulated leverage on balance sheet of utility/railroad not hypothecated to parent. 
#6 – Insanely low interest rate environment: low borrow costs allow acquirers to buy businesses that otherwise couldn’t afford or didn’t have cash to sit at the table

Reasons why BRK could be re-rated:
#1 - Dividend: with a dividend mutual funds with requirements for dividend payers could be owners
#2 - Significant re-purchases of shares
#3 - Large Acquisition that puts an exclamation point on BRK being an operating business with insurance subsidiaries
#4 – Market values investees “look through earnings” as a real number (Big thanks to Dynamic for spreadsheet – man do I look at that a lot)
#5 – Market understands Berkshire has become the “World Bank” of public markets.  I view BRK as a bank of sorts (this comment does bring BV back to conversation on how to value).  BRK is willing to finance any transaction to a size that would make most BOD’s of banks skin crawl – and FAST!
#6 – ORGANIC GROWTH: If Able/Jain look inward to BRK and figure a way to incentivize managers for internal organic growth would be a monster boast
#7 - Market figures out a way to value earnings on a multiple basis taking into account for the change in stock portfolio mark to market running through Income Statement

I don't believe enough work has been done on #7, hoping someone can help me better understand implications of this change (I am no accounting expert - I know enough to be dangerous).   

Could BERK ever trade using a new valuation method that would cause a significant change in value of the business?  Other public companies would hire teams of consultants and advisers to educate the public on why they should value their business using the classic "Multiple of Eyeballs" & “Adjusted EBITDA”.   Part of me thinks Buffet intentionally lulling the market to sleep and will buy back 30% of the outstanding shares after his eventual departure from firm. 

The more I write the more I think of Charlie Munger laughing at me saying “we are not gonna change” and I totally understand sloth like management has gotten BRK to where it is today.  Hoping to strike interesting conversation here with people who follow inner workings.  I am ultimate fanboy and have humility to say so.  I just hear the same people saying the same things about BRK on TV or annual letters and hoping to discover new ways to think about valuation and learn how to read the tea leaves.  Poke holes in above - enjoy the fun of valuation - really interesting exercise.  I would talk for hours about valuation with anyone just to learn and get better.  Cheers!
« Last Edit: February 19, 2020, 11:09:04 AM by longterminvestor »


Swedish_Compounder

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Re: Catalyst for BRK from Book Value to New Metric
« Reply #1 on: February 20, 2020, 05:43:24 AM »
Interesting post. I personally think that if they introduce a large regular dividend for some years which is slowly increasing year by year, this is the most likely trigger for higher valuation, since the market likes safe and increasing dividend companies and tends to put high valuations on those. I think this is more likely to happen after Buffett's departure, since he is probably more likely to make large irregular one time dividends if he needs to distribute cash via dividend. I believe he mentioned that in some interview.

I think it is un-likely that the general market will understand how to value Berkshire other than via the dividend power, since it is composed differently than any other company, does no marketing efforts and try to report as conservative profits as possible in order of minimizing tax. Most people tend to over-simplify or over-complicate the valuation method in my view.

Regarding your #7, Buffett says that these variations flowing through the P&L should be disregarded. One simple way to look at the expected value increase / earning power of BRK is to take:
a) the earnings excluding unrealized and realized profits from sales of stocks but including underwriting income and investment income such as received interest and dividends (say approx 25 BUSD)
b) add your own epectation of the expected annual increase in the current stock portfolio value net of tax. If you expect 8% on a 250 BUSD portfolio you here have 20 BUSD
c) this is heavily debated, but if you want to include some of or the full expected annual cash flow received from float increase you can do this. Add between 0 and 8 BUSD

Thus, from the above assumptions the earnings power can be estimated to approximately 45-53 BUSD (very rough approimation). But will the market use this methodology to value Berkshires earnings? Most likely not because it is not precise, contains assumptions and even unusual components such as the float increase. Their large excess cash makes it possible to probably add 7-10 BUSD to that number if they find the right acquisition target and borrows some money to fund the acquisition.

The Danish insurance company TopDanmark is an interesting example to study in my view. They had not paid any dividend for many years, but used all cash flows for share repurchases. Once it was in the spring of 2017 declared that they would change policy to instead pay dividends, the share price increased something like 50% within a year or so and seems to have stabilized on higher multiples than before, at a level yielding 4,5% dividend or so. It is though not certain that the increased share price was due to the change of cash distribution policy. If others have more examples of how the aluation changed for stable companies that went from buy-backs to dividends, it would be interesting.

I personally have lost any expectations for changes in the valuation multiples of Berkshire, at least short term. I mainly use Berkshire as a low risk component to balance the high potential cases in my portfolio, since it gaves me a feeling of safety to keep some Berkshire. In the next major market downturn it is possible that I sell all my Berkshire shares if they do not decline so much and I find bargains in the market. So, it is for me also a "potential dry powder" component. However, if I run out of good ideas in a strong market it is possible that I put all my money in Berkshire until I get new good ideas. This is the way Dynamic works and that makes a lot of sense to me.




IceCreamMan

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Re: Catalyst for BRK from Book Value to New Metric
« Reply #2 on: February 20, 2020, 10:48:08 AM »
Would paying a dividend be consistent with the Berkshire's culture and management's philosophy? It seems like management views capital allocation as central to the company's purpose. Presumably the reason it is holding so much cash right now is that it intends to deploy it at more favorable prices in the future, and it believes the result will be better than if shareholders were holding it. When Buffett and Munger are gone, a new generation of allocators will control the capital. If Berkshire was ever going to pay a dividend, wouldn't it have paid it already?

(Now watch Buffett announce a dividend in his annual letter this weekend...)

longinvestor

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Re: Catalyst for BRK from Book Value to New Metric
« Reply #3 on: February 20, 2020, 11:53:47 AM »
Buffett outlined the approach shareholders should take in buying the stock in the past present future essay in 2015. Hold for 5 or more years, buy below IV etc. I believe he’s looking out for the next guy in charge hoping that a majority of owners will like that person 20 years from now. Lower entry prices relative to IV is a good way to get such a group of likers. The ones who like management today are folks who have owned this stock for 20, no make that 30 +years. Well, many of them won’t be around, so they need a new group of likers. What’s most likely to cause rerating is the weighing machine thing. Give 10 more years of above average per share earnings the market will unlull itself.

Viking

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Re: Catalyst for BRK from Book Value to New Metric
« Reply #4 on: February 20, 2020, 06:06:09 PM »
The simplest and most effective catalyst would be to institute a dividend with a meaningful yield (slightly better than S&P 500 current yield). Makes so much sense. Would make future CEO’s job so much easier.

The world is changing; it is digitizing quickly. BRK’s largest stock holdings (Apple and BAC) are leading the way in their respective industries. I hope Buffett is learnings from these two companies and lighting a fire under all the large subsidiaries he owns (hello Geico). Let’s hope WFC and Kraft Heinz are one offs. Buffett was slow to recognize the rot at both companies.

Dynamic

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Re: Catalyst for BRK from Book Value to New Metric
« Reply #5 on: Today at 12:44:19 AM »
Personally, I'd be happy enough if Berkshire continues to trade for less than IV, and I think adjustment will be slow to change away from something like Price/Book Value. I'm thinking that P/BV of 1.2 still seems to be holding up as a pretty good soft floor to valuation and is pretty much the amount one can count on being available to sell at and spend on something that has become cheap. That's why I like BRK.B as a default investment rather than cash - a limited downside that is compounding very much in line with the market that meets my needs while I'm waiting for the fat pitches to come along. Then I can sell some of my Berkshire to buy the high conviction fat pitch. If it's a very high compounder, I should probably hold onto it even when it gets a bit pricey, and otherwise upon revaluation I could trade back into Berkshire when the downside risk there is lower and the upside is broadly similar. Actually, measuring my portfolio against the number of BRK.B shares it represents is a fairly good way of assessing progress compared to the good alternative avilable to me. So is comparison to the SP500TR.

I'm quite a fan of the Look-Through Earnings approach too, as well as Sum-of-the-Parts, possibly making adjustments* for heavily mis-priced portfolio holdings. Two column or two-and-a-half, also seems to be a good variation on this theme.
* at a trailing twelve month P/E ratio close to 17-18, I don't think major adjustment is necessary, though it's a blend. Banks tend to trade at lower P/E ratios, and Apple probably ought to trade at about 18-22 typically.

So far we've had only around 1% of the company bought back, so the excess over BV paid to retire shares hasn't greatly shifted the P/BV ratio that roughly equates to IV.

Now P/BV is crude and IV is certainly not at a fixed multiple of BV. For example, the huge run-up in the portfolio in 2019 Q4 greatly increased BV while IV increased moderately, whereas in 2018 Q4, the opposite was the case. Every 10% gain in portfolio valuation probably adds about 4.5% to BV before considering after tax operating earnings in the period, so the effect of market swings is dampened to a degree.

At slight variance from SwedishCompounder, I'd usually estimate that a typical year sees about a 6%-7% increase in the capital value of Berkshire's portfolio (rather than 8%) while the dividends received make up the rest to match the S&P500 typical total return, but also that few years are actually typical, but we're pretty much on the same page.

I also think that cash is not a drag as it's matched by float - a liability - and gives the opportunity to lever-up significantly when risk-reward balance becomes asymmetrically favourable - i.e. when quality asset prices are unusually low and forward returns are unusually high.

I think a change in the tax treatment of dividends to individual investors might be needed before Berkshire will change its dividend policy any time soon. Buybacks could increase somewhat, but I think they're very keen to keep volume modest to ensure they cannot be seen to be manipulating the stock price, especially as they don't seem to take advantage of 10b-18 Safe Harbor plans.

And Berkshire does not consider its job to be to encourage a stock price that's as high as possible in relation to IV, but one that's reasonably rational and perhaps slightly conservative and that encourages long-term holders who will benefit from the underlying growth in the business (a positive sum game) far more than from intermittent pricing swings (a zero sum game) where either buyer or seller is 'losing out' on the deal. Going into 2019, the price was relatively high, holding up against a declining market. Coming out it was relatively low to moderate. But over 2 years or 3 years, it pretty much performed in line with the market producing results pretty well in line with the business itself.

To me Berkshire is also well positioned to cope with inflation or rising interest rates. These are times when other insurers can lose their pricing discipline and underwrite at a loss, being rescued by bond yields on invested float, and times when other assets, and debt-encumbered companies can start trading fairly cheaply. Initially, a major rise in rates would depress most stock prices to raise earnings yields, though it may help banks. It would also curtail leveraged private equity's ability to obtain high prices for their debt-laden investments. Such a time could be a huge advantage to Berkshire, and one it's well prepared for, but not reliant upon. Whatever the environment I think Berkshire will do well, but perhaps in a low rate environment without a major shock to the system, it shouldn't be expected to do anything spectacular.

And knowing that Berkshire is usually available at a fair to attractive price relative to IV, is also comforting to me, allowing me reasonably frequent opportunities to invest new funds at reasonably attractive prices.

SwedishValue

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Re: Catalyst for BRK from Book Value to New Metric
« Reply #6 on: Today at 06:14:13 AM »
I think a change in the tax treatment of dividends to individual investors might be needed before Berkshire will change its dividend policy any time soon. Buybacks could increase somewhat, but I think they're very keen to keep volume modest to ensure they cannot be seen to be manipulating the stock price, especially as they don't seem to take advantage of 10b-18 Safe Harbor plans.

Are you sure about this? I can't explain Berkshire buying back stock up until the 9th of october without the use of such 10b-18 Safe Harbor plan. Am I missing something?