I've long made the argument that Berkshire Hathaway's (BRK.A) (BRK.B) transition to a company where the bulk of profits are generated from its operating subsidiaries, has not been fully appreciated by most market participants, due to the fact that the company generally trades at a slight premium to book value, much like it did when the company's investment portfolio constituted a much larger portion of annual profits then it does today. Berkshire's operating subsidiaries are of superior quality than many of their competitors, yet the implied book value multiple lags behind, largely due to Berkshire Hathaway's conglomerate structure. I believe that this material and persistent underestimation of Berkshire's intrinsic value is obvious to Warren Buffett, who has gotten far more aggressive of late in his willingness to buy back the company's stock, even stating that he is willing to pay up to 1.2 times book value. For investors, Berkshire Hathaway represents a safe-haven for capital at current prices, and I believe that the stock should be accumulated on dips in the price.
In 2012, Berkshire Hathaway grew book value by 14.4% or $24.1 billion, which was slightly below the 16% the S&P 500 returned including dividends. Amazingly, over the last 48 years this compounding machine has grown book value from $19 to $114,214, or 19.7% compounded annually. Berkshire's increasing profitability from its owned subsidiaries tend to generate more stable earnings in spite of a weaker market, but will serve as more of an anchor when the S&P 500 has a robust year like it did in 2012. Berkshire's five most profitable non-insurance companies produced $10.1 billion in aggregate earnings, which was up $600MM from a strong 2011.
Buffett believes that the companies are well positioned to see further growth going into 2013. The company made $2.3 billion worth of bolt-on acquisitions for 26 companies that were incorporated into the existing businesses. Berkshire's focus is always on broadening the moat of its companies and the incremental returns on invested capital on these types of investments are generally quite high. Buffett has invested in alternative energies and real estate near the bottom of their respective market cycles, which should enhance Berkshire's earnings leverage to recoveries in those industries. The ability to invest based on a truly long-term time horizon with permanent capital is one of the most unique and enduring characteristics of the Berkshire Hathaway business model.
Like many of Warren Buffett's large investments, the Burlington Northern Santa Fe acquisition was questioned as being too richly priced by many commentators, including value investing brethren such as Bruce Greenwald who teaches the value investing course at Columbia, which was actually inspired by Benjamin Graham's course at the same school that Buffett attended. This acquisition has been an unabashed homerun, despite a very weak U.S. economy, and an utterly abysmal coal market. Conspiracy theorists might have fun with the fact that BNSF has seen shipments increased markedly for oil transports, partially assisted by delays in the Keystone Pipeline project. Warren Buffett realized that there are few high return on invested capital businesses, that are also large enough to move the needle for Berkshire as the company has increased in size.
Railroads have become increasingly more attractive from a cost perspective, for shipping goods in comparison to trucking due to changes in technology and high fuel prices. Railroads can carry a ton of freight about 500 miles on a single gallon, which is about 4 times more efficient than trucks. Burlington Northern carries about 15% of all inter-city freight as measured by ton-miles. This makes the company irreplaceable to the infrastructure of the United States, and as the United States economy grows over time, so too will BNSF's profits. Both BNSF and Mid-American Energy require large and regular capital expenditures, but the profitability on this incrementally invested capital is protected by regulation. Due to Berkshire's size, these types of consistent and low-risk utilizations of Berkshire's ample cash flows are highly attractive, accentuating the company's ability to compound capital.
Berkshire Hathaway continues to amaze me with its underwriting acumen in its vast insurance operations. The company has now posted 10 consecutive years of profitable underwriting, culminating in a total of $18.6 billion in underwriting profits during that timeframe. This was accomplished by only writing new business when it offers a high likelihood of profitability, as opposed to chasing premium to maintain market share in soft markets. Berkshire's underwriting profit in 2012 was $1.6 billion and the $73 billion of float listed as a liability on the balance sheet, serves as the diesel fueling Berkshire's investment engine. Investing the float will not be an easy task for non-Berkshire insurance companies as record low interest rates are contracting investment yields; therefore insurers must have underwriting margins near breakeven to produce profits for the year.
Buffett predicted last year that the float would likely stop growing but his prediction was wrong in 2012, and he believes that the float should grow slightly in 2013, which I would believe is due to better market conditions after Hurricane Sandy drew a lot of capital out of the industry. The primary reason float might decrease in a few years is because of some run-off contracts in National Indemnity's reinsurance division, but any decline should be gradual. With Berkshire's underwriting acumen, scale and distribution, I believe the division is worth 1.5-2 times its book value. This is far higher than most insurers but much of this value resides in Geico, which has seen consistent underwriting profits and market share growth. Top-tier auto insurers' tend to trade at premiums to book value and Geico is best in class in this writer's opinion.
In February, Berkshire Hathaway teamed up with 3G led by Jorge Paulo Lemann, for the acquisition of Heinz. In the deal, Berkshire and 3G are both putting in $4 billion of equity, while Berkshire is also investing $8 billion in preferred stock that will pay a 9% dividend. Warren Buffett also released details that the preferred stock will eventually be redeemed at a significant premium price, and the preferred came with warrants permitting Berkshire to buy 5% of the holding company's common stock for a nominal sum.
There are so many reasons to like this deal, as I've identified previously and I believe that it does move the needle in terms of increasing the intrinsic value of Berkshire. The preferred investment will generate $720MM pretax with very little risk; while 3G's operational skill and Heinz's top-tier global distribution system position the leveraged purchase to have tremendous long-term upside.
The relationship with 3G is just another partnership with top-notch talent that can potentially help create shareholder value for many years into the future. Warren Buffett has parlayed his investment and managerial acumen to leverage his relationships with top talent for the benefit of Berkshire shareholders. Berkshire's relationship with Leucadia (LUK) in its lucrative Berkadia joint-venture, and the hiring of skilled money managers Todd Combs and Ted Weschler, are all just some of the more recent examples of Buffett's skill in identifying talent. Combs and Weschler both outperformed the S&P 500 in 2012, and more importantly their sound investment philosophies should lead to above-average returns over the long-term. Buffett actually increased both their allocations to close to $5 billion apiece.
During the Financial Crisis, Buffett's well-deserved reputation made him the most attractive source of capital when all other funding sources seemed to freeze-up, as evidenced by his lucrative investments in General Electric (GE) and Goldman Sachs (GS), among others. Some Berkshire bears have pointed to Buffett's future exit leaving a vacuum in obtaining these sorts of sweetheart deals, but I believe that the culture that Berkshire has created will allow the company to have the wherewithal and acumen to be an extremely attractive partner for companies seeking long-term partnerships, with a well-funded operation such as Berkshire, that isn't interested in juicing up short-term profits only to sell to the highest bidder at a later date. I believe that Buffett has assembled a stable of managers to choose a successor from, so I believe concerns about life after Buffett are somewhat overblown from an investment standpoint.
Ajit Jain from Berkshire's insurance operations, Tony Nicely from Geico, and Matt Rose from BNSF, all have the credentials to make them compelling options for the position of CEO. I believe business history will be written quite favorably about the job that Warren Buffett & Co. did in creating an enduring culture, which will allow Berkshire to compound shareholder wealth at an above-market rate many years after Warren Buffett steps aside. Of course the rates of return in excess of the S&P 500 will not be what it was when the company was smaller, but even 2-4% outperformance can lead to a lot of money over the long-term.
Even after the Heinz acquisition, Berkshire Hathaway still likely has in excess of $15 billion for another large acquisition, and of course this number grows as Berkshire accrues cash monthly. Berkshire is so well-diversified that it is difficult to predict where Buffett will strike next. I believe that Buffett could be interested in a number of companies such as Illinois Tool Works (ITW), General Mills (GIS), or even a Hershey, which might see Berkshire as a logical long-term home that could assure the company is able to maintain its own culture and hometown of Hershey, Pennsylvania. None of these stocks are overwhelmingly cheap, but I believe that the attractiveness of low long-term interest rates would allow Buffet more comfort in financing a larger portion of the deals with debt, than he normally might do.
I would bet a significant amount of money that he wouldn't pass up a deal for one of these companies if he was able to structure it in a similar fashion to the Heinz deal. Although unlikely, I'd like to see Berkshire take a large stake in AIG (AIG) at less than 60% of book value. While AIG doesn't meet Berkshire's criteria for a high return on equity, the company will likely have a large surplus of liquidity that can eventually be used to buy back stock, reducing the equity component of the equation, and improved efficiency should further bolster profitability far into the future. Berkshire would be a wonderful partner for AIG but I don't believe it is likely Berkshire would ever buy the whole company, which would require Berkshire using its own stock, unless AIG were to solicit Buffett's investment.
The reason I'm spending a little time covering this unlikely possibility is that Berkshire has one of the best track records of underwriting profitability and successful investing, while AIG has one of the great global insurance brands and distribution systems, and AIG trades for an absurdly cheap price. I believe Buffett is too smart not to have the idea cross his mind at the very least. Utilities are also a space where I could see Buffett making a large deal. An out-of-favor company like Exelon (EXC) could fit the bill as a company that could benefit from Berkshire's ownership, which wouldn't require the company to pay out such a large portion of earnings as a dividend if there are more attractive uses for that capital, such as investing in the business or paying down debt.
While Berkshire's operating companies continue to have an increasingly important role in driving value creation for the company, Buffett's investment portfolio continues to compound. Berkshire owns 8.7% of Wells Fargo (WFC), and 6% of IBM (IBM), which have been his two largest conviction investments over the last year. Wells Fargo is a compounding machine with a better market position than it has had in its history, with incredible earnings leverage to an improving housing market. The stock is cheap and there is no doubt that Buffett is confident the company will continue to compound at an accelerated rate.
IBM is a model that other large-cap technology companies should follow in terms of how capital should be allocated. IBM buys its stock aggressively when the shares are undervalued and returns the rest of its excess cash that is not needed to grow its business as dividends. This dramatically increases per share value despite lackluster revenue growth. The company is hell-bent on maximizing profit margins and returns on invested capital. The Bank of America (BAC) investment has been and will continue to be, a complete homerun for Berkshire as the company continues to clean up its act, while profitability should begin to really ramp up over the next couple of years.
As Berkshire Hathaway has grown, Warren Buffett and his investment managers' have shown a preference for large companies that are willing to buy back their own stock when it makes sense to do so. Both Weschler and Combs have invested in Direct TV (DTV), which meets that criterion, while also possessing cost advantages that give the company a moat versus some of its competition. Davita (DVA) is another Berkshire position that is an extremely large position for Weschler, that focuses on lowering health care costs by improving patient outcomes through dialysis, and where management is extremely shareholder friendly. Berkshire now owns about 8.9% of Coca-Cola (KO) and 13.7% of American Express (AXP), which are both performing very well and trade at reasonable valuations.
Nobody understands better than Buffett that companies with durable competitive advantages and strong management, bought at attractive valuations are likely to perform very well over the long-term, so these investments are far from dead money.
There is no perfect way to value Berkshire Hathaway due to the complexity of its operations, and the variability of future investment performance. Berkshire Hathaway ended 2012 with per-share investments of $113,786, up 15.7% in the year, while pre-tax earnings from businesses other than insurance and investments increased 15.7% also, to $8,085 per-share. At a recent price of $152,955.00, I believe Berkshire Hathaway to be slightly undervalued. The stock trades at just over 1.3 times book value and I believe there is upside to 1.5 times book value.
The only aspect of the company that should be valued at book value in my opinion are the investments and even that is discounting the likely appreciation of Warren Buffett and his team's investment selections. Berkshire's insurance operations are best in class, while the other operating businesses are worth well over book value. I wouldn't allocate new money to Berkshire at current prices, but if the stock were to trade down 10-15% the margin of safety would likely be adequate enough to increase our position. I wouldn't be surprised to see another big deal before this year is over, and as always I'll be observing closely, as I never cease learning from the best investor of the 20th century.