In a recent article, I laid out a valuation technique for Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) utilizing "look-through" earnings, where Berkshire's proportional share of equity earnings is consolidated onto the income statement. You can read the entire article here, but the basic thesis is that Berkshire will earn an estimated ~$26 billion in 2016 and fair value is in the neighborhood of $180 per class B share, or 40% upside from its current price of $128/share.
This article focuses less on Berkshire's economic prospects and instead emphasizes expected shareholder returns based on historical price-to-book levels. Central to this article, and seen in the graph below, is that Berkshire's valuation over the past 30 years has been mean reverting at approximately 1.6x book value. As such, investors have garnered significant excess returns with purchases below the average price-to-book multiple while purchases above this level have actually produced a return slightly below the S&P 500 (despite massive overall outperformance). In fact, over the last 30 years, the subsequent year return from purchasing Berkshire below 1.58x book value has been 20.3% while the return from purchasing Berkshire when it traded above this level fell to 10.3%. This compares to an average annual S&P return of 11.8% (including dividends). Another interesting observation from this data, and pertinent given Berkshire's negative performance last year, is that Berkshire has not had two down years in a row over the past 30 years (and only once since Berkshire was acquired by Warren Buffett). Therefore, given that Berkshire is: (1) trading at 1.24x estimated year-end 2015 book value (2) coming off a year of negative returns and (3) has fundamental earnings power supportive of $180 per share, it would be reasonable to conclude that 2016 has a high probability of strong shareholder returns.
The basic price and book value per share I am using in this analysis come from a recent article by Professor David Kass and Berkshire's 2014 annual report - the rest of the calculations are my own. The table below shows book value per Class A share and the resultant price-to-book level from 1985 to present. The next column shows whether Berkshire was trading above or below its 30-year average. The next column shows the return during the subsequent year. Note that 1988 was a statistical tie as Berkshire was trading exactly at its mean price-to-book level of 1.58x and is not included in the returns of the "Above Avg." or "Below Avg." columns. I estimate that Berkshire's year-end 2015 book value of $256 billion, or $155,781 per Class A share. The final column shows the S&P return during the subsequent year.
|Period||Book Value||Price||Price-to-book||Trading Below Avg.||T+1 Return||Below Avg.||Above Avg.||T+1 S&P Return|
A couple of interesting observations from the data:
- Berkshire has actually had more down years than the S&P 500 over the last 30 years - 6 years for Berkshire versus 5 for the S&P. However, Berkshire's average annual return has been 18.4% versus 11.3% for the S&P (meaning Berkshire "good" years are fantastic relative to the S&P);
- Average return after negative year of 19.5%;
- In the 17 years where Berkshire has ended the year trading below its historical price-to-book level, in only 2 observations has the subsequent year return been negative. Furthermore, if the return has been negative, it has been a relatively modest -8.9%;
- Conversely, in the 12 years where Berkshire traded above its average price-to-book multiple, it has had a negative return in 4 observations. The average loss from above-average multiples has been significantly more dramatic at 19.6%;
- Berkshire has not had consecutive years of negative performance in the last 30 years.
These observations are so intuitive that they should be self-evident. To paraphrase: Berkshire is more attractive when it is cheap than when it is expensive... send me a Nobel Prize. However, in discrete periods where the shares have underperformed, you are inevitably confronted with widespread skepticism that would attempt to convince you not to invest just when you should be. Sound familiar…
The difference between today and 1999 is that Berkshire is now trading at 1.24x book value versus 1.48x in 1999. Fortunately, history repeats itself.
Disclosure: I am/we are long BRK.B.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.