Long Berkshire Hathaway: Share Buybacks Likely Solution To Excess Cash

Summary

• A historic bet ends.
• Berkshire posts a strong balance sheet in 2017, but Wells Fargo gets frozen.
• Share buybacks are the most likely solution to Berkshire's excess cash, but won't happen soon.
• Despite narrowing gap, Berkshire will continue outperforming SPY based on fundamentals.
• I give notes on the letter to the shareholders.

News

2017 brought a $65B gain: $36B came from Berkshire's (NYSE: NYSE:BRK.B) (NYSE:BRK.A) operations while $29B came from changes in the Tax Code.

The 10-K footnote sums up changes to the biggest holdings between 2017^[1] and 2016^[2]:

[1]	Approximately 65% of the aggregate fair value was concentrated in five companies (American Express Company (AXP) - $15.1 billion; Apple Inc. (AAPL) - $28.2 billion; Bank of America Corporation (BAC) - $20.7 billion; The Coca-Cola Company (KO) - $18.4 billion and Wells Fargo & Company (WFC) - $29.3 billion).
[2]	Approximately 60% of the aggregate fair value was concentrated in five companies (American Express Company - $11.2 billion; Bank of America Corporation - $14.5 billion; The Coca-Cola Company - $16.6 billion; International Business Machines Corporation (IBM) - $13.5 billion and Wells Fargo & Company - $27.6 billion).

Click to enlarge

Notice they sold off IBM, boosted Apple. I would not read this as a sign that IBM is failing. IBM still looks promising with their industry lead in Quantum Computing. But for now, they’re mainly a consulting company by revenue.

The Bet

Buffett's S&P destroyed Protégé with 8.5% annually vs. 4.7%.

It’s important to keep in mind he isn’t saying that the hedge fund managers’ research is all for hocus. The parameters of the bet look at returns minus fees. The point that he was trying to make was that low-cost index funds are superior from the vantage point of the average investor. I see a lot of Seeking Alpha readers saying Buffett isn’t taking his own advice because he is actively trying to beat the market himself. No, he’s just aware that if he told the average investor that they should try to beat the market through hedge funds, they would lose all their money. Bets like this are good because they get recorded in history and told as memorable stories. Also, it was a charity event.

Teva (TEVA)

There was no mention of TEVA, which comprises of 0.19%. Some talk about Buffett picking up TEVA shares to advance his healthcare agenda with Bezos and Dimon. The size of the investment itself was less than $400M, so it’s possible that Buffett didn’t have much input on this decision. It’s still entertaining to see the magic Buffett touch elevate TEVA 8%.

Reinsurance

Buffett relishes in float for reinsurance. 2017 had $61B in Premium volume and $114B in float. He expects slow declines in float (at most 3%). Buffett has reaffirmed his confidence that the reinsurance business will remain profitable.

Wells Fargo

I was hoping Buffett would give more comment about Wells Fargo's asset freeze. Before Janet Yellen left her chair position, she ordered that four board members leave, without specifying which ones. Buffett has stated he still has confidence in Berkshire’s second-largest stake.

As a consumer, I’m glad that the Fed is making unprecedented strides in policing runaway banks. I have never heard of a bank that made twenty fake accounts under a single customer’s name.

As a BRK shareholder, I’m upset that it cut net value. Shares of Wells Fargo fell about 11% after the asset freeze announcement. By market value, Wells Fargo makes up 14.5% of Berkshire’s portfolio, which should translate to a 1.5% fall of BRK shares in a rational market. The following day’s drop in BRK was 9.3%.

Buffett famously said “If you lose money for the firm I will be understanding. If you lose reputation I will be ruthless.” This was after investment firm Salomon Brothers, where Buffett was the largest shareholder and director, made fraudulent bids for treasury bills. In his book, he called it the worst day of his life and he immediately stepped in to take responsibility. It seems odd to me that he has distanced himself from the matter but still holds faith in the management.

Pilot Flying J

Berkshire owns 38.6% of PFJ and will own 80% of it in 2023.

Analysis

My favorite thing about the stock is the quality of the shareholders (more so BRK.A than BRK.B). Yes, there are algorithmic traders but the whales will keep the shares forever. Buffett has always said he takes pride in the fact that BRK shareholders buy with the long-term horizon in mind.

Acquisitions

Buffett also called out acquisitions. In a beautiful piece of Buffett wisdom “If Wall Street analysts or board members urge that brand of CEO to consider possible acquisitions, it’s a bit like telling your ripening teenager to be sure to have a normal sex life.” This reminds me of another popular Buffett witticism, “Saving sex for when you’re old is a bad idea.” It’s common that a company in 2017 would M&A at high prices, to paraphrase from Peter Thiel, “presumably because it doesn’t know what else to do.”

Dealing with Extra Cash

From looking into the cash flow, net earnings grew from $24B last year to $45B. EPS nearly doubled from $9.76 to $18.22. 2017 was good overall with S&P EPS increasing 12.05% this past year (probably more, Q4 data isn’t available yet so I pulled Q316-Q317). Buffett also spent about $158B on U.S. Treasury bills compared to $96B last year. On the record, he stated he’s holding onto his pile of cash because the market is currently overbought.

Treasury bills are much higher than they were a year ago, but you should still feel uncomfortable with the amount of cash just sitting there.

Treasury Bills | Constant Maturity Index Rate Yield Bonds Notes U.S. 10 5 1 Year Rates

Wait, no, you shouldn’t. Stocks as a percentage of GDP is sky high at around 130%. Yes, corporate profits may go up but you’d be paying a premium. You have gotten 16% returns on the SPDR S&P 500 Trust ETF (SPY) but for how long is it sustainable? Sit on the cash for a few more years, says Buffett.

Share buybacks make sense and are the most likely option

The board in their 10-K approved a common stock repurchasing program “permitting Berkshire to repurchase its Class A and Class B shares at prices no higher than a 20% premium over the book value of the shares.” Currently, it’s trading at around 47%.

Liquidatable assets ($702B) minus total liabilities ($350B) equals book value ($352B). The current market cap is around $511B. That means that at the current book value, Buffett thinks a market cap of $422B is a buy. There are 1,644,615 shares outstanding of BRK.A and 2,466,923,163 shares outstanding of BRK.B, where class B shares are 1500:1 (the real ratio is 1497:1, interestingly. The voting shares are cheaper by percentage). This works out to a buy price of $171 for BRK.B.

For a company like Berkshire, buybacks at this level would have the most benefit for shareholders. This is good news for you, but keep in mind the shares have not been that cheap for a long time.

BRK.A Price to Book Value data by YCharts

Berkshire or SPY?

Berkshire has had an amazing run, but no company can sustain high levels of growth forever, and Buffett knows this. How do these one hundred hand-picked holdings stack up against the top five hundred U.S. companies? Historically, BRK was more capable of weathering economic downfalls and has had high CAGR, despite the lead narrowing. Despite the fact that both perform extremely well, the similarities end there. They are not comparable. SPY provides exposure for established, +$5B U.S. corporations while BRK is a proxy for Buffett and Munger to value invest.

On a personal note, I actually prefer the lack of dividends, which should go back into the share price. The money for your share is yours, and voting for dividends just means that some of that cash is optionally returned to you. Since most of us are going to reinvest the dividends anyway, it doesn’t make a difference. To me, dividends are really just slow, consistent share buybacks that they don’t decrease the number of shares outstanding. I’ve noticed some people point out they have to pay taxes on dividends but they would rather pay deferred taxes at capital gains rates. It makes no difference for long-term holders; the IRS makes a distinction between qualified and non-qualified dividends.

Another reason to prefer BRK over SPY is something that was hinted at in his letters. SPY has close to a quarter of tech exposure. It’s harder to put a value on tech companies given their limited moat and unknown future potential. Reinsurance and finance will be stable as long as we don’t repeat our mistakes. At least on the days when the tech/biotech sector plummets it’s nice to see a Christmas tree instead of a bloodbath.

Other Letter to the Shareholders Notes

1. GAAP now says companies must report net change in unrealized investments. This muddies up the true value.
2. Contrarian view: Acquisition prices are too high, but most CEOs want to do it anyway.
3. Believes annual probability of U.S. mega-catastrophe causing $400B or more of insured losses ~2%. Berkshire lost $3B from the 3 hurricanes, reducing Berkshire's net worth by less than 1%.
4. There was a loss of $3.2B Pre-tax from underwriting.
5. Berkshire is not immune to dips. It’s best to always keep a long-term attitude in times of deep panic.

Analyst’s 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.