- Berkshire Hathaway is a "cult" stock - the "cult of rationality".
- Core holders of Berkshire tend to have a coolly rational long-term view of investments, grounded in Berkshire's price relative to book value.
- The price of Berkshire stock has an interesting and complex market history, sometimes quite different from market averages but at the same time providing insights into market behavior.
- Berkshire currently seems reasonably valued compared to book value with positive asymmetry to the upside for long term investors.
- Berkshire has been dragging behind the market breakout since May, a pattern which, if it continued, might raise questions about overall market strength.
Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) is a "cult" stock. It is not a cult stock in the sense that the "four horsemen" of each generation are - the likes of Amazon (NASDAQ:AMZN), Facebook (NASDAQ:FB), Priceline (NASDAQ:PCLN), etc. Rather it is a cult stock for a "cult of rationality." I considered concepts centered in such definitions as "value," Graham and Dodd principles, stockholding as business ownership, owner-friendly management, loss avoidance, corporate integrity - you can add to this list from many such favorite angles of approach. What ties them all together and bonds the hard core of Berkshire investors is a cool, patient, persistent rationality.
If you follow Berkshire articles on Seeking Alpha, you will soon learn to distinguish between those who are true communicants of this Berkshire cult, those who are looking in from the outside and trying to understand it, and those who from various postures are seeking to debunk it. By way of disclosure, I am a true communicant, skeptical of most orthodoxies but committed to this one. To me, Berkshire Hathaway represents not just a particular investment but a model of investing which stands as an example of many core virtues. As such, it occupies a unique anchoring position for all who buy securities traded in the financial aftermarket.
Berkshire and the Cult of Rationality
As rational investors, let's consider how to think about what Berkshire Hathaway shares are worth at any particular moment. Buffett himself has provided us with his preferred measure - book value - and his actions, his statements of policy, and his occasional ad-libbed hints have provided valuable guidance in the use of this measure. With this tool we can come to an accurate evaluation of Berkshire stock - not a specific number, but a nuanced estimate suggesting bands within which Berkshire is inexpensive, fairly valued, or expensive.
During much of the middle 1990s, as Berkshire enjoyed popularity and rose steeply, its price to book value was quite expensive, in an area ranging between 1.7 and 2.0 to 1. During these times Buffett made no mention of stock buybacks and had nothing favorable to say about Berkshire as a purchase. Only reluctantly, in 1996, did he introduce the cheaper B shares in response to exploitative funds which were manufacturing them artificially, and he struck a cautionary tone for individual investors who rushed to buy them. Then beginning in 1998 Berkshire suffered its own private bear market as non-rational investors ruled the markets amidst the explosion of the dot com craze. Novice investors lost interest in stodgy old Berkshire and became busy losing their heads over Cisco (NASDAQ:CSCO) and Microsoft (NASDAQ:MSFT) and any dot com IPO. The price of Berkshire was cut roughly in half, as was its price to book. It is worth noting that this was a purely valuation-driven decline. Berkshire itself continued to prosper. Book value itself continued to rise. At the bottom of this decline Buffett did consider buying back shares, but Berkshire rose too quickly for him to execute.
Oddly enough Berkshire stock bottomed at exactly the moment the rest of the market peaked, in March of 2000, and then rose steadily for almost eight years. At its absolute peak in December of 2007 it again sold at almost two times book value. A very close secondary peak, again at two times book, occurred in October 2008 even as the market was being crushed. The price of Berkshire was cut in half over two months, bringing it down to book value. By then Buffett was too busy buying other things to do share buybacks.
The movements in Berkshire shares relative to the market as a whole make for an interesting narrative, although interpretations of the story may vary. My own interpretation begins with the idea that core Berkshire holders are not prone to sell even as Berkshire becomes significantly overvalued. There are cap gains taxes, of course, along with the problem of getting back in. Such market forces as indexes and novice investors with a short time horizon may, however, tug the shares one way or another.
In any case Berkshire's price and book value history, along with Buffett's policy statements, provide excellent insight into Berkshire's valuation at a given moment. At two times book or anything close to it Berkshire is clearly overvalued, although it sustained that sort of valuation for several years in the 1990s as a market darling. Priced at book value the shares are clearly cheap; they have not fallen below book for more than a very brief period even as the market as a whole collapsed. Buffett has long felt the shares were cheap enough to buy back at 110% of book and now feels they are cheap enough to buy at 120% of book. This liberalization in his view stems partly, I think, from a single transaction in which he bought out a long term holder, in the process coming to a clear understanding that 110% was too low. He may also have been influenced by observing that the increasing importance of Berkshire's wholly owned businesses, which sit on the books at purchase price and do not reprice upward, causes book value to be increasingly understated.
But where is the upper band of fair value? A hyper-conservative view might say 140% of book, but a more liberal definition of the point at which to hold (neither buy nor sell) might be 150%. It is probable - Buffett hints as much about the future - that in certain markets Berkshire might sell for 160% of book or more, but the rational core holder would certainly see that as a price with greatly reduced margin of safety.
How Is Berkshire Valued Now?
As of the end of the first quarter of 2014, the book value of Berkshire B shares was 92.28. At 120% of this amount Buffett would be expected to buy back shares aggressively at 110.74. This amounts to a reasonably firm bottom for the stock roughly 12% below the current price around 126.
But wait: we are close to the end of the second quarter, and at that point Berkshire's book value based on recent and historic trends is likely to increase to around 94.50. This means that Buffett would buy shares aggressively around 113.38, or a bit over 10% below the current price.
And to project to probable year-end book value, a practice that most analysts observe with valuation metrics for all stocks, Berkshire's year-end book might be around 99, meaning Buffett's aggressive buyback price would be a little under 119, or around 6% below the present price.
As rational "cultists" know to do, this analyst has looked at risk first. Just for the fun of it, though, let's think what the upside might be. At the end of the second quarter - a few days from now - the values might be: at 140% of book about 132, at 150% of book about 142, at 160% of book about 151. At year end (a wildly distant prospect to us conservatives from the cult of rationality) we get the following figures: at 140% of book about 139, at 150% of book about 149, at 160% of book 158. Now forget that 160% of book number. To us communicants in the cult of rationality, it is not the pot of gold at the rainbow's end. It is rather a threshold for worries, problems, and hard decisions ("Should I get cute and sell a bit?").
What all this suggests is a reasonably balanced expectation for Berkshire at the present moment, with asymmetry to the upside for longer term investors. My brief take on this is that Berkshire is the one of my present holdings I might be inclined to buy at the current price or a slight dip.
Berkshire and the Market
But what do Berkshire's value and price performance have to contribute in assessing the present condition of the market?
Let's consider as simple an approach as Dow Theory. Stated simply, Dow Theory says that bull markets involve higher lows and higher highs with industrials and transports confirming each other's moves. Often neglected, however, is the explication in depth by the original Dow theorists a century ago who argued that major bottoms and tops are produced by value or the lack thereof. Markets bottom when rational people buy enough to absorb panic selling and top out when the last idiot has bought in.
Berkshire, as a loosely managed conglomerate, has a unique position in being composed of businesses which are, in practical terms, both small niche companies and businesses which would be mid and large caps if standing alone. It also includes a broad spectrum of the economy with financials, industrials, utilities, and transportation. It is somewhat sensitive to the economy, but also reflects some low-beta moderate-growth holdings. It is composed, in my view, of companies which are mainly best of breed in their respective niches. Doesn't the price performance of such a company tell a meaningful story about the market?
No individual stock tells the whole story, of course, and Berkshire has certainly had its idiosyncrasies. It had severely negative beta for two years starting in the middle of 1998, rallied in the face of the dot com collapse, then held up a little too well before falling very hard and fast in the housing meltdown. Yet its price movements are not sheer perversity (a role which Apple (NASDAQ:AAPL), with negative beta expressed on an almost daily basis, seems to embody in this market). When Berkshire and the market are out of whack, there is a story behind it, and that story can often be decoded.
What is today's story? I've sort of come to look at Berkshire's price action as something like an additional Dow Theory instrument. If market highs are accompanied by new highs in Berkshire and good price action in Berkshire generally, it suggests to me that the market is well grounded. If Berkshire fails to accompany, the market's move, to my mind, is somewhat more suspect. It may suggest that the cult of coolly rational people with longer term perspectives do not share the enthusiasm of the market as a whole.
So what is happening right now? Berkshire has done well for the year so far, up about 6 1/2%, a little better than the S&P 500. It did not suffer greatly as the froth stocks crumbled, hinting that their fall might be a self-contained correction rather than a sign of fundamental problems. So far so good. Its high for the year, however, was on May 1. Its price has churned below that high for the past six weeks, trading heavily, as technical analysts would say, while the market broke out to new highs. I wouldn't be too quick to make a great deal of this sort of movement - Buffett himself would probably consider it pure voodoo and Berkshire might break out at any time - but I do think the price action of this well-diversified best-of-breed market leader with its strongly rational core of holders may contain some information about the health of the market as a whole. In any case, the part of me that pays attention to technical market indicators will have a more positive view of market health if Berkshire breaks out to meaningful new highs.