There are crazy investment ideas, and then there are crazy investment ideas. A recent article called Buffett-owned Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) a "broken business model" and concluded "time to short?" This is, unequivocally, one of the most confounding investment ideas I've ever heard. It doesn't make any sense.
In fairness, I do agree with the author on one point - I will grant that Buffett's investment in IBM looks to be a mistake. In fact, I wrote about that yesterday here. But one mediocre investment does not equate to a broken business model.
Misunderstanding The Businesses
The author did not go into any sort of depth, but what he did say seemed to fundamentally misunderstand how Berkshire's businesses work (not to mention which ones are actually important).
Let's give two examples. First, the author discussed how many of Berkshire's companies are subject to disintermediation. One point here was an argument about how Duluth Trading will disintermediate Fruit of the Loom's distribution by selling online rather than in stores.
This was kind of bizarre. I must be missing something here. As someone who likes digging into the weeds, I scrolled around Duluth's website to try to understand what the author's point was here. It looks like the products have great reviews, so good for them.
It also looks like it costs around $20 for one pair of Duluth's underwear. In contrast, I seem to recall my wallet being about, oh, $10 lighter last time I purchased an FTL 6-pack. I have never once in my life thought my underwear was so uncomfortable that I needed to spend 12x the price to upgrade it.
In fact, at that price point, Duluth appears to be competing with whatever brands are sold at Saks Fifth or Dillard's - not the ones sold at Wal-Mart and Target. If you're going to name a comp, you might as well at least make it one that is actually, you know, comparable.
This isn't even a pure affordability thing, either - it's just value for money. The Hanesbrands (NYSE:HBI) investor day provided this color in 2014:
I would imagine that FTL has fairly similar demographic diversity and a broad appeal to a large swath of the population. I'm a happy FTL/Hanes customer and I'm likely to stay that way. Under Armour at the gym, keep it simple everywhere else. Maybe I'm just crazy, but I have a really hard time seeing Duluth stealing a ton of share from Hanes or FTL at 10x the price. The two can coexist just fine; the apparel market is plenty big for everyone.
More quantifiably: Hanesbrands reported innerwear sales up 3% last quarter, and more broadly they've absolutely blown it out of the water since 2012. The apparel businesses at Berkshire in total have gone from $4.15B/$251MM revenue and pre-tax earnings in 2012 to $4.3B/$455 in 2014. Summarily, not seeing any disintermediation here in the numbers. What's changed?
Oh, and by the way, as far as online vs. in-store shopping? There's an all-you-can-wear buffet of Fruit of the Loom on Amazon. Pages and pages, every color, size, and style. Click here to see for yourself. So...what was the argument about disintermediation, again?
Then the author talked about Clayton Homes - right next to a comment about "companies without distribution can get around any of them, with a quality pitch and a warehouse." This too fundamentally misunderstands the business model. When was the last time you bought a home on the internet that got shipped to you from a warehouse? For that matter, when was the last time you 3D-printed a manufactured house in your garage?
I've spent time working on peer Cavco (CVCO), and while I'm not at all optimistic about the industry's future growth, it would be very hard to replicate the scale advantages that Cavco and Clayton have. Even if you managed to manufacture for the same price, the financing process is very different for manufactured homes and having a financing arm is beneficial. Again, not seeing a clear disintermediation angle here.
Going into depth about every single one of Berkshire's businesses is way beyond the scope of this article - but don't be scared into selling by someone who clearly misunderstands many of them. In fact, the author failed to discuss a single one of the "powerhouse five" businesses - BNSF, Lubrizol, Iscar, Marmon, and Berkshire Hathaway Energy, to which we would likely now add Precision Castparts. These (not including PCP, obviously) contributed $12.4 billion in pre-tax earnings in 2014, vs. $5.1 billion for the "many dozens of smaller non-insurance businesses" like FTL, H.H. Brown shoes, etc.
It seems odd to make a short call that ignores these enormous sources of profits entirely. Perhaps I'm just missing something here - please explain to me how a warehouse and the internet will disintermediate any of the powerhouse five businesses. Why are we even talking about FTL and Clayton anyway? They're not even the big picture here...
Misunderstanding The Business Model
The author made a comment about the potential "Ubering" of property-casualty insurance, with investors hungry for yield apparently coming in. Okay. That's fine. Say that happens. This fundamentally misunderstands the beauty of the Berkshire business model. Buffett/Berkshire can allocate capital somewhere else. They've already stepped away from reinsurance due to an influx of capital in that area, and they're redeploying it elsewhere. Oh, and on disintermediation? From the WSJ article I linked to:
Last month, Berkshire agreed to buy a stake in a major Australian insurer to gain access to business clients in Asia. By next year, Berkshire plans to sell insurance to small and medium-size businesses directly over the Internet, bypassing the industry's middlemen.
Doesn't sound like an "old and tired" business to me. Sounds like they're on top of things. Berkshire will prune areas that aren't generating sufficient returns and invest in areas that are. That's the model. It doesn't matter if some of their assets are on the decline - unlike a public company that's only in that line of business, they don't have to throw good money after bad. They can simply milk it for cash and turn their attention elsewhere.
Misunderstanding The Investments
I agree with the author on IBM - I'm not necessarily bearish, but I'm certainly not bullish. I would add that American Express may not have the cachet it once did. That said, one (or two) mediocre investments is hardly cause to short. Find me a public-company CEO of a company anywhere near the size of Berkshire that hasn't made at least a few "mediocre" investments (if not a few downright awful ones). Any takers? If you don't like Buffett's capital allocation, exactly whose do you like? You're probably limited to companies you can count on one hand (at least if we're talking about mega-caps).
Indeed, on the other hand, Buffett inks many deals that are quite astounding. While the specific Kraft-Heinz gain was one time, as an astute commenter pointed out, Berkshire has many "one time" deals. Year after year. Berkshire gets deals that nobody else does. Think back to Bank of America. If you don't understand why this is, you probably need to do a bit of reading...
...I would also note that, while Berkshire's book value includes deferred tax liabilities, this is a form of free "float" since it's likely not going to be realized anytime soon. Buffett may advocate for higher taxes for the 1%, but he sure doesn't like paying them himself. See: the Duracell deal.
Berkshire is analytically complex to value, but several people have made interesting stabs at it using various methodologies. My favorites that I've seen so far: Whitney Tilson here, Left Shark Investing here, and Default Investing here (several years ago). You can (and should) review each of these on your own. They go into some depth.
Summarily, a reasonable way to look at Berkshire is to calculate the value of its operating businesses, and then add that to the value of its held investments. Your assumptions here will obviously vary. All of them, however, usually come up with a value higher than book, or even 1.2x book, and often higher than the market price - which makes sense, because how else would Berkshire be able to continue to outperform over time? Using a straight P/E ratio makes no sense given the unique nature of the business.
From a tactical standpoint, shorting Berkshire at 1.25x book, it's not clear what sort of downside you're reasonably likely to see:
A caveat to this is that given the dramatic decline in security prices between the last reporting date and today, Berkshire's investment portfolio is likely down some. Moreover, operating earnings may be down at many of Berkshire's industrial businesses. Still, it would be one thing to make a short call if we were at 2x book - but it's quite another thing when we're close to the level at which Buffett typically repurchase shares (1.2x book). Berkshire has plenty of cash and generates plenty of dry powder. Even in the financial crisis, we didn't get below book - why would you expect to get there now?
Wrapping It Up
It is completely unclear to me what a short on Berkshire would accomplish. If you don't like some of the investments in the portfolio, you could short them directly. If you don't like some of the operating businesses, you could short their publicly-traded peers. If you don't like the market, short...the market. Why short Berkshire specifically? There's no justification.
Especially in a market that is going down, shorting Berkshire is dangerous. Why? They have lots of dry powder to put to work at a time when financing is unavailable - Buffett's actions during the financial crisis resulted in significant accretion to Berkshire shareholders. If the current sell-off deepens, I would expect no less.
There is likely to be a bit of a "shock" when Buffett eventually passes away, but he has been grooming his eventual successor for a while, and frankly the current valuation does not appear to bake in much of a Buffett premium anyway.
Personally, I don't own Berkshire because I believe I can compound capital at a faster rate than Berkshire. This is not arrogance - please note that I am in no way saying I can compound capital at a faster rate than Buffett could. He would kick my butt if he was working with my amount of capital. But Berkshire is facing the law of large numbers and even Buffett agrees that he cannot outperform by the margins he used to - simply because he's locked out of many attractive but un-scalable investment opportunities.
That said, I think owning Berkshire at the right valuation as a compounder makes a lot of sense. If you own it, keep owning it; I don't see a reason to book those capital gains. And I would be happy to own it myself - I have in the past.
So go ahead and short Berkshire...if you dare. If you hold that short position for any length of time, you'll probably end up feeling like you've been run over by a BNSF train, with your remains made into a precision cast part, dipped in some various Lubrizol chemicals and subsequently smashed to smithereens (again) by a windmill blade.
There are plenty of valid arguments on why someone doesn't have to own Berkshire - but literally none I can think of on why someone should short it at this valuation. Short-seller beware.
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