For the first time in the history of Berkshire Hathaway (BRK.A), the company is initiating a share repurchase program. The stock is up over 6% on the news, versus just 2% for the SPDR Financial Select Index Fund (XLF) and 1% for the SPDR S&P 500 (SPY). Clearly many investors have been persuaded by Warren Buffett's conviction in the undervaluation of his own company, and they're showing it by throwing in their lots with the Oracle of Omaha. It's important for investors to realize that Buffett isn't buying back any Berkshire stock just yet, and may never actually do so. The board has just given him the authorization for a share repurchase. He's under no actual obligation to follow through on it.
But the fact that such a greenlight has been issued shows that this a landmark moment in Berkshire's history. Buffett has always been critical of other companies repurchasing their stock at inopportune times and destroying shareholder value. This move indicates that not only does he believe Berkshire to be trading far below its intrinsic value right now, but that the company's shares represent a materially superior investment than other opportunities on the market.
Just how cheap is Berkshire? Motley Fool's Morgan Housel published an article in June showing the downward trend of Berkshire's price to book ratio over the past two decades. The stock has dropped quite a bit since then, and now trades at just around book value. The convergence between Berkshire's per share price and its per share book value is something that hasn't happened in a very long time. Warren Buffett last considered a share buyback in 2000, and the stock was trading at a 50% premium to book then.
Does this mean that Berkshire today is 50% cheaper than Berkshire 10 years ago? Actually, it may be an even better bargain than that. Berkshire has undergone a huge transformation in the past 10 years. Back then, it derived almost all of its value from its investment portfolio, which contained ownership stakes in publicly traded corporations like Coca Cola (KO), American Express (AXP) and Wells Fargo (WFC). Now, the greater part of Berkshire's value comes from its operating businesses, smaller private companies that Buffett has gobbled up whole.
The extremely relevant difference between these two asset classes is this: the book values of Berkshire's operating businesses understate their intrinsic values far more than the book values of its stocks. That's because stocks are carried on Berkshire's balance sheet at their market values, which are generally pretty close to their intrinsic values as a group. Any individual stock in Berkshire's portfolio may be undervalued or overvalued at any point in time, but the portfolio as a whole is probably pretty close to fair price.
However, Berkshire carries its operating businesses at acquisition price, plus any funds reinvested into the businesses, matched dollar for dollar. That means that any additional earning power generated by those capital expenditures above cost aren't accounted for. If Berkshire were to sell any of its subsidiaries to another company, the premium would be recorded as goodwill, but Berkshire keeps the goodwill of its businesses unchanged on its own balance sheet despite their actual growth over time.
The conclusion that can be drawn from all this is that Berkshire, as the result of its growing shift to investing in operating businesses instead of stocks, represents an even better deal than historical data would imply based on the metric of price to book. Buffett said that he won't buy back stock if it rises above a 10% premium to book, so one hard rally may strip Berkshire of the chance to follow through on its buyback program. However, this doesn't change the fact that the stock is a fantastic bargain right now. This buyback represents a significant milestone in Berkshire's lifecycle, and is as much a testament to the company's age (and corresponding slowdown of growth) as it is to its undervaluation. Next up: dividends!