Berkshire: Little Downside Left at Current Levels

After a a year of saying Berkshire Hathaway (BRK.A) was of no value, I'm thinking it just may be getting there.

In July 2008 I said:

Wholly-owned subs such as Shaw Industries, Clayton Homes, Jordan's Furniture (there are 4 furniture companies), Benjamin Moore, Home Services and Acme Brick and directly tied to housing and will suffer in the downturn.

For all its holdings, Berkshire is essentially an insurance company. It has operated under "perfect" conditions for the last two years according to Buffett and eventually to run must end. Premiums are already falling and as houses are re-poed and fewer new cars are purchase, insurance premiums derived from those products will fall accordingly. I know people who are looking at homeowners and auto policies for way to decrease coverage and save money. Whether or not this is a good idea is irrelevant (I do not think it is), it is happening. Throw in a hurricane or two (we are due) and insurance could suffer quite a poor year.

For more on Berkshire's insurance read this former post:

Back in March when shares sat at $133,000 I argued they were not a "value". Today they sit at $111,000. Are they a value now? Perhaps but one also has to expect that the near term, if Tilson is correct is fraught with potholes for Berkshire and earnings ought to take a hit.

Based on that, share price ought to suffer also meaning you will probably be able to pick them up cheaper down the road. If I owned shares would I sell? If I needed the money in the next year, yes. If I had a multi-year time frame would I sell? No. If that was the case I would be watching down the road for a cheaper entry price, I think you'll get it.

What has happened since then?

From Barrons: Berkshire agreed to purchase $150 million of 10 1/8% notes due in 2015 and $250 million of 10 3/8% notes due in 2018 from Birmingham, Ala.-based Vulcan. The note sale was reported in late January, but Vulcan didn't identify the buyer of the notes until Tuesday's earnings conference call.

Other recent Berkshire bond purchases include $300 million of Harley Davidson Inc. (HOG) 15% notes due in 2014 and $150 million of Sealed Air 12% notes due in 2014.

These purchases follow big transactions in the fourth quarter, when Berkshire purchased $5 billion of 10% preferred stock from Goldman Sachs (GS) and $3 billion of 10% preferred from General Electric (GE). Both those deals came with a sizable amount of equity warrants. During October, Berkshire also bought $4.4 billion of 11.45% subordinated notes and $2.1 billion of 5% preferred stock issued by Wrigley, which was purchased by Mars in a leveraged buyout.

One deal that Buffett probably regrets is his agreement to purchase $3 billion of convertible preferred stock in Dow Chemical Co. (DOW) if it goes forward with its deal to buy chemical maker Rohm & Haas Co. (ROH) for $15 billion. Berkshire's purchase is contingent on the consummation of the deal.

Buffett may be hoping that the deal dies, or that Dow comes back to Berkshire with more generous terms to get a larger investment from Berkshire if Dow goes forward with the deal. Dow is resisting completion of the transaction, arguing that the debt that it would have to take on would be ruinous financially. As it stands, the Dow convertible preferred that Berkshire agreed to purchase will carry an 8.5% interest rate and a conversion price around $40, way above Dow's current share price of $10.

If we do some simple math, Bekshire has put roughly $17.9 billion to work at 10%. That will provide Berkshire $1.7 billion a year for the next three years (some of it may convert to equity at that point). When one considers Berkshire has earned $7.8 billion in the last 12 months (Q4 2008 numbers not released yet), Buffett's recent move will add 21% to those earnings.

Now, insurance. Yes as stated above, the party is over but, rates are scheduled for increases. As insurance companies look to cover losses in investment portfolios, the aggressive pricing that has taken place in the past few years will abate, causing industry rates to rise. Also, one should expect those insurance companies feeling the pinch to take fewer large risks. Since this is an area Berkshire loves to play in, fewer players will mean stronger pricing power on the part of Berkshire.

We will not see a resurgence to the "glory years" in insurance, but conditions for the first time in a few years will improve. Remember, Berkshire is essentially an insurance company, since that business seems to have stabilized, being the best of that lot, we must assume Berkshire has.

Berkshire's investment portfolio has been hurt this year by the weak showing of some of its major equity investments, Wells Fargo (WFC), U.S. Bancorp (USB), Kraft (KFT), Coca-Cola (K) and Procter & Gamble (PG). While prices here are depressed, there is no permanent impairment to earnings and that is a point being missed by folks. To believe these companies will be at depressed prices 3 years from now means the global economy will not recover. If you believe that, buying any equity is a waste of time.

Berkshire is a big holder of those three companies' shares and it also is short $37 billion of long-dated put options on the S&P 500 and other equity indexes. As the market has dropped, Berkshire has taken a charge to earnings (no cash) in the write-down of the value of these options. When the market rises, the opposite will happen (write-up). Again, to assume no improvement here implies U.S. business is stagnant for the next decade.

Now, Berkshire is down roughly 33% since my first post on it. The difference now is that several of its businesses are showing signs of life and Buffett has put billions to work at 10% vs the pittance it was getting previously in Treasuries.

The next piece of the puzzle is the Berkshire manufacturing businesses listed above. They will turn when the economy does. If you believe that is the second half of this year, the time to buy is now. If you believe that is 2010, you have time to wait.

Will Berkshire go lower? I do not know but I do know that there isn't a good reason for it to go much lower barring further dramatic worldwide economic collapse. Time will tell but I think Berkshire at its current levels does not have much more downside.

Disclosure: Long WFC

Comments

[devowevo:]

Todd, this is the most sensible, thoughtful article ever written on Seeking Alpha. I think BRK will do great over the next few years. It's not going to be a 3-4x bagger, but it is pretty much a solid return (again, as you said, assuming there is not a further worldwide economic collapse. If so, we're all in big trouble.)

Feb 13 08:37 AM

[Gravity404:]

Agreed. This are very good thoughts. Great article.

I had BRKA and sold a few years ago, and I was looking to get back in. I was thinking that we would see $80K again. Especially based on the fact I think the economy will turn later; maybe 2010 if then.

I am interested to hear if you think we will see low $80ks again.

Feb 13 09:49 AM

[mkreisel:]

In this environment, I would not buy BRKA above a P/B of 1.

Feb 13 01:23 PM

[Gravity404:]

So with current numbers you think it could drop to $75K?

I great appreciate your thoughts.


On Feb 13 01:23 PM mkreisel wrote:

> In this environment, I would not buy BRKA above a P/B of 1.

Feb 13 01:31 PM

[k45:]

Todd,

You are writing from a logical standpoint. Unfortunately the market is driven by emotion. I've been in and out of BRK.B a couple of times, I usually make the wrong decisions with it. Obviously an excellent company, but it's harder to judge what it's stock is going to do.

Feb 13 02:19 PM

[123:]

how's sears doing

Feb 14 10:13 PM

[mkreisel:]

BRK's insurance underwriting should do fine this year: no major disasters, tight capital markets.

Insurance income should be a toss-up between his convertible deals and declining interest rate.

Manufacturing, retail, and service will suffer major declines, but should stay profitable.

Utilities will do ok, and may even increase earnings because of declining commodity prices.

Homebuilding and finance related will be ugly, and most likely loose some money.

Equities and derivatives: this is where the major blow to book value and earnings will come from. Buffett indicated in last 10Q that book value was down by $10 billion at the end of October. Since then, his top 10 positions (AXP, BNI, COP, JNJ, KFT, KO, PG, USB, WFC, WSC) have dropped by at least another $10 billion. However, market volatility has great decreased so that losses on his index puts will also be reduced greatly.

Earnings from operating businesses should offset investment losses by quite a bit. Overall, I think it's reasonable to expect a reduction of BRK's book value to $110 billion, about 20% lower than the latest market value.

Feb 15 11:30 PM