Warren Buffett has managed to ensure that Berkshire (BRK.B) (BRK.A) will be around for another generation. This was not really clear a few years ago. Yet he hired two investment managers that are making a difference. He hired Todd Combs in 2010 and Ted Weschler in 2011. The two are having a spectacular start and managing each about $5bn. They are outperforming the S&P widely and Buffett seems very happy about having hired them. He said hiring Combs and Weschler happened because of "a lot of good luck. Like Woody Allen said, 95 percent of it is just showing up," he said. "That's what's happened with Berkshire. That's happened with the people. And once you get 'em, you've got 'em for decades to come."
This is often underappreciated in my mind. Without Todd and Ted, the right valuation for Berkshire might have been a liquidation value. And liquidation value is probably closer to book value given the significant tax consequences. However now that succession is in place, one should value Berkshire on a continuing basis. This is closer to what Buffett calls the intrinsic value. As such I recommend buying Berkshire shares currently based on two reasons:
A. There is a margin of safety compared to intrinsic value that should close soon. Calculating the intrinsic value is outside the scope of the article. But Eric and others have done enough quality calculations to show that it was around 1.5-1.6x.
B. Todd and Ted will ensure that Berkshire's advantages will continue for a long time. In particular Berkshire benefits from the longer-term investment horizon, the lower taxation for private investors by reinvesting cash flows and being first-call in a crisis.
I would hence buy the shares currently at a discount to intrinsic value. This promises 10-20% upside to intrinsic value by year-end. From year-end Berkshire will continue to deliver outperformance over the S&P over the long-run.
In the annual report, Buffett writes about Ted & Todd:
"Todd Combs and Ted Weschler, our new investment managers, have proved to be smart, models of integrity, helpful to Berkshire in many ways beyond portfolio management, and a perfect cultural fit. We hit the jackpot with these two. In 2012 each outperformed the S&P 500 by double-digit margins [and the S&P was up 16%]. They left me in the dust as well.
Consequently, we have increased the funds managed by each to almost $5 billion (some of this emanating from the pension funds of our subsidiaries). Todd and Ted are young and will be around to manage Berkshire's massive portfolio long after Charlie and I have left the scene. You can rest easy when theytake over." [emphasis mine]
Let me translate: "they're good and they're here to stay".
Without them, Berkshire might have had to shut its doors when Buffett passed away. But now, you can buy Berkshire for the next generation. You need to value Berkshire on a continuing basis rather than on a liquidation basis. What does that change concretely?
1. Berkshire has significant deferred tax liabilities on unrealised capital gains on Coke (KO), Wells (WFC) and Amex (AXP) (mostly). They amounted to $44bn at year end. If you save 35% on that, that's $15bn in the bank (or $15bn less to the IRS). On $188bn of book value, that's already 8%.
2. If Berkshire continues in its existing structure, that means no dividend for the foreseeable future. Buffett said that as long as he could invest at a better return than the S&P; Why would that change with T&T? And they clearly have some margin ("double-digit margin"). That means that *you* won't be paying income tax on your dividends. That matters a great deal.
Dividend taxation is 0% - 39.6% in the US depending on your income. Assuming you keep your shares for the long-run, these are "qualified dividends" and the federal tax rate is capped at 20%. But you need to add 3.8% for the Medicare tax. And depending where you live, add in the state tax. For simplicity's sake let's say you save 20% on the dividends. That's like having a 25% higher dividend.
3. Then you need to consider the float. You will keep the $73bn of float for a while and likely grow it. That free financing is worth something. You need to compare with the alternative cost of debt. Let's say Berkshire can issue long-term debt at the same rate as Burlington. That's about 4% currently (120bps above the 10-year yield). Over the next year, the float will have been worth $3bn. Over a generation the float itself could be responsible for creating almost as much as the current book value. Apply the discount rate you want to it but we're talking real money.
T&T are giving you the right to value Berkshire on a continuing basis. That alone is worth easily over 30% to the shares.
As such I would recommend buying the shares now. The discount to intrinsic value should close as soon as investors realize how capable Todd and Ted are.
But even at intrinsic value, Berkshire will remain a good investment. Intrinsic value only covers the business value. But there are intangibles that are worth something: the brains of Ted and Todd; the Berkshire structure enables a longer-term investment horizon than most corporate investment vehicles; high quality investors usually charge much higher fees (2/20 in hedge funds if not more in some cases); the willingness of Berkshire to lower taxation for private investors by reinvesting cash flows; and the strong reputation enabling Berkshire to be the first-call in a crisis for advantageous preferred investments.