Warren Buffett is an investing legend whose performance is truly worthy of nickname, the “Oracle of Omaha.” Through shrewd value investing, Mr. Buffett has grown a $183 billion empire in his holding company, Berkshire Hathaway (BRK.A). He is currently the world’s third wealthiest person with a net worth estimated at $50 billion, after having donated billions to the Bill Gates Foundation. His success has created a cult of followers who believe that Buffett is always right.
However, a few investors and commentators have questioned whether Berkshire’s CEO betrayed the core principles he professes. Mr. Buffett proclaims that he only invests in firms he understands at reasonable prices, yet he has invested in complex firms like Goldman Sachs, Inc. (GS) and General Electric Co. (GE). Which of Berkshire’s current holdings are consistent with his philosophy?
Consider two of Berkshire’s holdings: Wells Fargo & Company (WFC) and U.S. Bancorp (USB). These bank stocks seem like good value buys based on valuation. USB trades at a low P/B multiple of 1.62, a P/S multiple of 3.22, and a P/E multiple of 12.25 (ttm). Wells Fargo is just as cheap at a P/B multiple of 1.13, a P/S multiple of 1.97, and a P/E multiple of 10.58 (ttm). These multiples meet Mr. Buffett’s investment requirement of an attractive price, but does Warren Buffett really understand these companies and their values?
Not according to Warren Buffett. Since Mr. Buffett has stated that complex mortgage-backed securities (MBS) are beyond human comprehension, UBS and Wells Fargo are more complicated than a MBS, and Warren Buffett is human, we must conclude that he does not understand them. Both USB and Wells Fargo have complex loan books on their balance sheets. The values of these mortgages are not always marked-to-market, but are sometimes marked to model. This accounting distinction sounds boring, but is incredibly important. Investors in USB and Wells Fargo must trust that the firm is accurately assigning values to their loans, rather than succumb to the temptation of increasing their values by fudging a few inputs in a spreadsheet. If a complex mortgage loan book is beyond human comprehension, then a firm which contains a complex mortgage loan book and additional components must be even more hopeless.
Similarly, Mr. Buffett all but admitted to not understanding Johnson & Johnson (JNJ). When asked about big pharma pipelines, Mr. Buffett casually admitted his ignorance. It is impossible to understand the present value of a drug company without a clear picture of its patent expirations and up-coming drugs.
Is Johnson & Johnson a value buy? Big pharma has fallen from grace, after all. Traditional metrics aren’t useful in this analysis: A P/B ratio of 2.90 does not capture internally-developed intangible assets, a P/S 2.74 ratio will not capture changes in sales as new competitors capture revenues from drugs when patents expire, and a P/E 15.17 (ttm) ratio will change dramatically based on lower margins for generic drugs and dramatically changed sales profiles.
The question remains: Will Johnson & Johnson have the future cash flows or dividends to justify a given price? Analysts predict an average annual increase in earnings of 6% over the next five years, and Johnson & Johnson has had an amazing run of earnings and free cash flow increases over the past ten years. In 2010, pharmacueticals accounted for $7.1 billion of the firm’s $16.5 billion operating income. Even with severe hits to pharmaceutical sales, Johnson & Johnson will be able to continue paying regular dividends. With a beta of 0.62, we can propose a 7% required rate return on Johnson & Johnson equity. If the firm’s $16.4 billion free cash flow to equity stays flat, the present value of the equity is worth $234.3 billion, or $85.50 per share. If you subtract out the pharmaceutical operating profits (less tax) from free cash flow to equity, each share is worth $61.42. Essentially, you get the pharmaceutical business for free.
Did Mr. Buffett get lucky or had he already figured this out? Buffett worshipers will always side with him, skeptics require more (any) evidence that he had determined this on his own.
Many of Berkshire’s investments don’t require faith. For example, American Express Company (AXP) is a company whose revenues come from purchase transactions. This stable business model earns revenues from small and large purchases. American Express has attractive valuations with a P/S ratio of 2.06 and a P/E ratio of 12.69 (ttm). The firm’s earnings have been consistently positive over 10 years. This is an investment position that is worthy of his legacy.
Conversely, Buffett’s bet on USG Corporation (USG) is more of a macro play on a construction company. This firm makes sheetrock and gypsum-based products, and has not been profitable since 2007. USG trades at a P/B multiple of 2.07 and a P/S multiple of 0.37 (ttm). Should an unprofitable, cyclical construction company be trading above book value? Probably not. Moreover, Mr. Buffett is a fabled value investor, not a fabled market or economic prognosticator like George Soros. USG might be an exercise in optimism, but does not appear to be classic Buffett value investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
