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The Rational Walk was created to provide a platform to publish equity research based on value investing principles. We believe that diligent and thorough security analysis has the potential to identify opportunities in the financial markets for the small number of investors who truly have long... More
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The Rational Walk LLC
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The Rational Walk
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Berkshire Hathaway: In Search of the “Buffett Premium”
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  • Buffett’s Annual Letter Offers Insight on the ‘Three Pillars’ of Berkshire’s Intrinsic Value
    Note to Readers: In this article, we cover selected highlights from Warren Buffett’s letter to shareholders which was released this morning as part of the company’s 2010 annual report (pdf).  Later today, we will provide a brief  summary of Berkshire’s Q4 and full year 2010 results.  Next week, we will publish The Rational Walk’s comprehensive report on Berkshire Hathaway, In Search of the Buffett Premium, which is currently available for pre-order.

    Warren Buffett and Charlie Munger have made it a habit to never directly state their estimates of Berkshire Hathaway’s intrinsic value.  Due to the fact that intrinsic value estimates are heavily dependent on assumptions made regarding the future, even Mr. Buffett and Mr. Munger come up with somewhat different estimates of Berkshire’s intrinsic value.  However, Mr. Buffett has often provided shareholders with the criteria he uses to arrive at intrinsic value estimates.  At times, he has either strongly implied or directly commented on his views regarding Berkshire’s stock price versus intrinsic value.  In this article, we will take a brief look at additional details Mr. Buffett provided in his 2010 annual letter to shareholders regarding how shareholders should go about calculating intrinsic value.

    Two Column Approach

    In previous annual reports, Warren Buffett has often commented about Berkshire Hathaway’s two sources of value:  Investments per share and the capitalized value of earnings per share of the non-insurance businesses.  This approach has been described as the “two column” method for calculating Berkshire’s intrinsic value.  Essentially, Berkshire is being viewed as having one area of value in the form of investments funded by shareholders’ equity and insurance float and another source of value represented by non-insurance operating companies.

    Mr. Buffett describes Berkshire’s $158 billion of investments in stocks, bonds, and cash equivalents and notes that $66 billion is funded by insurance float.  Float represents funds held by Berkshire’s insurance subsidiaries that  is carried as a liability on the balance sheet.  However, as long as Berkshire’s float can be obtained through insurance activities that run at a break-even level or, better yet, at an underwriting profit, float has the utility of equity for Berkshire shareholders in the sense that the investment income emanating from these funds belong to the shareholders.

    Viewed in this manner, Berkshire had $94,730 per A share of investments as of December 31, 2010.  Overall per-share pre-tax earnings of the non-insurance operating companies was $5,926 for 2010.  Mr. Buffett notes that investments per share and earnings can be calculated in a precise manner, but these only form two of the three pillars of intrinsic value.  The third is more subjective and is the source of differences in intrinsic value estimates even among those who buy into the “two column” method.

    The Third Pillar:  Deployment of Future Retained Earnings

    Berkshire Hathaway has never paid a dividend or repurchased stock and, as a result, all earnings have been reinvested in various businesses.  In most cases where managements hoard cash, poor returns can result if funds are deployed in suboptimal ways either due to the tendency of managers to want to build empires or the fact that most businesses tend to reinvest in the same lines of business where the earnings were generated to begin with irrespective of the availability of acceptable incremental returns on capital.

    Mr. Buffett notes that some companies can “turn these retained dollars into fifty-cent pieces, others into two-dollar bills”:

    This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.

    A shareholder’s individual view of how earnings will be redeployed dramatically impacts the manner in which a company’s existing earnings stream should be evaluated.  In the case of Berkshire Hathaway, we know the value of investments per share and we have last year’s figure for pre-tax earnings but what capitalization is appropriate to assign to this earnings stream?

    The answer depends on the degree to which earnings are paid out to shareholders, in which case shareholders can estimate the cash flows they will personally receive from the company.  In the case of Berkshire, however, 100 percent of earnings are reinvested.  The power of Berkshire’s business model, other than the fact that Mr. Buffett is the capital allocator, is that businesses that generate significant cash (such as See’s Candies or Business Wire) but lack reinvestment opportunities can have their cash flows directed to more attractive opportunities.

    While there are no easy answers regarding how to evaluate the stream of future earnings that Berkshire will reinvest, some estimates can be made based on management’s track record and views regarding future prospects for internal reinvestment and acquisitions.  This is one of the valuation models that will be discussed in our upcoming report:  In Search of the Buffett Premium.

    Bullish on the Long Term Economic Outlook

    Mr. Buffett’s letter returned to some old themes such as Berkshire’s history with GEICO, the economics of the insurance business, and an expansion on the discussion of freight rail due to Berkshire’s acquisition of Burlington Northern Santa Fe last year.  The letter also reiterated Mr. Buffett’s bullish long term outlook for the United States economy and noted that much of Berkshire’s capital investment has flowed toward opportunities in America over the past two years. All of Berkshire’s increase in capital investment in 2011 will be directed toward opportunities in the United States.

    Berkshire’s Unusual Insurance Business

    Berkshire’s insurance companies have now operated at an underwriting profit for eight consecutive years after several years of large underwriting losses following Berkshire’s 1998 acquisition of General Re.  Mr. Buffett emphasizes how unusual Berkshire’s insurance operations are by highlighting the fact that Berkshire has posted $17 billion in underwriting profits over the past eight years while State Farm, a well run insurer, has incurred underwriting losses in seven of the past ten years and posted aggregate underwriting losses of $20 billion over that period.  This long run record bolsters Mr. Buffett’s view that Berkshire should enjoy cost free float over the long run.

    Record Earnings at Four Subsidiaries

    Four of Berkshire’s businesses in the manufacturing, service, and retail group set record earnings in 2010:  TTI, Forest River, CTB, and H. H. Brown shoes.  Additionally, Mr. Buffett believes that  NetJets is now “fixed” due to David Sokol’s management.  NetJets is a topic that we will cover in great detail in our upcoming report.

    Todd Combs

    Mr. Buffett commented briefly regarding Todd Combs who was hired in 2010 to run $1 to $3 billion of Berkshire’s vast securities portfolio.  While Mr. Buffett will continue to manage the majority of Berkshire’s investments as long as he is CEO, he anticipates hiring “one or two” more managers if he can find the right individuals.  Mr. Buffett is looking for investors who can anticipate the effects of  economic scenarios not previously observed rather than simply showing good past track records.

    The Rational Walk will publish selected thoughts on Berkshire’s Q4 and full year 2010 results later today. Next week, we will publish The Rational Walk’s comprehensive report on Berkshire Hathaway, In Search of the Buffett Premium, which is currently available for pre-order.

    Disclosure:   Long Berkshire Hathaway
    Tags: BRK.A, BRK.B
    Feb 26 11:30 AM | Link | Comment!
  • Lou Simpson’s Retirement Prompts Berkshire Portfolio Changes
    Note to Readers:  The following article is an excerpt from the introduction to The Rational Walk’s analysis of Berkshire Hathaway’s 13-F filing listing positions held as of December 31, 2010.  The full report, which includes a much “deeper dive” into Berkshire’s portfolio, is available for members of The Rational Walk’s Berkshire Hathaway Corner.

    Berkshire Hathaway’s equity portfolio underwent significant changes during the fourth quarter of 2010 due to Lou Simpson’s retirement from GEICO. Although most media reports attribute Berkshire Hathaway’s portfolio moves exclusively to Warren Buffett, a significant portfolio has long been managed by Mr. Simpson.

    According to Warren Buffett’s 2004 letter to shareholders, Lou Simpson delivered average annual gains of 20.3 percent from 1980 to 2004 compared to average annual gains of 13.5 percent for the S&P 500. During the 25 year timeframe, Mr. Simpson posted only three annual losses and underperformed the S&P 500 only six times. Mr. Buffett appropriately stated that Lou Simpson is “a cinch to be inducted into the investment hall of fame.”

    Although Mr. Buffett has been effusive in his praise for Lou Simpson’s stock picking acumen, he has not always agreed with specific stock picks in the past. In his 2004 letter to shareholders, Mr. Buffett noted that he typically learns of Mr. Simpson’s transactions ten days after the end of each month. Although noting that Mr. Simpson is “usually right”, sometimes Mr. Buffett “silently disagrees” with his decisions.

    During the fourth quarter, eight positions held in GEICO’s portfolio were liquidated. These positions had a combined market value of nearly $1.2 billion as of September 30, 2010. While many of the media reports stating that “Buffett has sold” the stocks in this list are technically true, it does not necessarily follow that he is bearish on these companies since he never initiated the positions to begin with. Warren Buffett and Charlie Munger have often spoken about “not backing into decisions” and perhaps these liquidations represent an example of this philosophy.

    In addition to liquidating the eight GEICO holdings, Berkshire also reduced positions in Moody’s and Bank of New York. Mr. Buffett has been reducing Berkshire’s position in Moody’s for several quarters with the most recent reduction reported in late October in a Form 4 filing. The position in Bank of New York was reduced by 10 percent and is a relatively small position for Berkshire with a market value of $54 million as of December 31, 2010.

    Berkshire added 6,215,080 shares of Wells Fargo which is ranked as the portfolio’s #2 holding. Mr. Buffett has long been bullish on Wells Fargo and numerous Berkshire subsidiaries hold shares in the bank. In the eight page report we provide comprehensive information and analysis regarding Berkshire’s portfolio as of December 31, 2010.

    For More Information

    The Rational Walk’s eight page analysis of Berkshire Hathaway’s 13-F report includes details regarding each of Berkshire Hathaway’s subsidiaries holding equity securities, a consolidated summary of positions held as of December 31, a comparison of the consolidated portfolio at September 31, 2010 and December 31, 2010, and a drill-down listing positions held by Berkshire reporting subsidiaries.  We also address the question of whether Warren Buffett’s personal portfolio is reflected in Berkshire Hathaway’s 13-F filing and whether any conclusions can be made regarding Mr. Buffett’s views on the current valuation of securities within the portfolio.

    Click on this link for a screen shot of the first page of the report

    Click on this link to become a Berkshire Hathaway Corner Member

    Disclosure:  Long Berkshire Hathaway

    Tags: BRK.A, BRK.B
    Feb 15 7:56 PM | Link | Comment!
  • Letter From the Editor: Announcing The Rational Walk’s Berkshire Hathaway Corner
    Dear Readers,

    I am pleased to announce the rollout of The Rational Walk’s Berkshire Hathaway Corner!

    The Berkshire Hathaway Corner is an effort to offer readers a consolidated source of quality information and analysis on topics relevant to the company.  Over the past two years, Berkshire Hathaway has been a significant focus on The Rational Walk and we marked a major milestone last year with the publication of the 2010 Berkshire Hathaway Briefing Book.  We are following up this year with a new report on Berkshire scheduled for release after the 2010 annual report comes out at the end of February.  This report, entitled In Search of the Buffett Premium, will be included for members of the Berkshire Hathaway Corner and is also available for purchase by non-members.

    It is no secret that publishers of all sizes have faced a major dilemma in recent years as a greater volume of information appears on free websites.  There is no doubt that the avalanche of free information has done great things for society in general and investors have been among the primary beneficiaries of free content that in years past would have been available only at a steep cost.  Of course, the problem is that high quality information is very expensive to create and can rarely be supported by advertising revenues alone except for the highest volume websites.

    There is perhaps no major company that is as misunderstood as Berkshire Hathaway.  We hope to provide quality content that is worth paying for, but understand that not all readers will choose to become members.  This is not the end of free content on The Rational Walk. The Rational Walk will continue publishing content on Berkshire and other companies on the free portion of the website in the future.  However, selected content specific to Berkshire Hathaway that is differentiated from other free sources will be moving to The Berkshire Corner section of the site.

    We are offering an introductory price of $199 for a one year membership to The Berkshire Hathaway Corner which will include In Search of the Buffett Premium.  The membership price will rise after February 25, 2011.  Members have a 100% money back guarantee for the first 30 days and a pro-rated money back guarantee thereafter.

    I would like to thank readers of The Rational Walk for visiting the site over the past two years and am looking forward to this new initiative.

    Best Regards,

    Ravi Nagarajan
    Managing Editor
    The Rational Walk

    Tags: BRK.A, BRK.B
    Jan 29 9:19 PM | Link | Comment!
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