Berkshire Hathaway: Lower Returns Ahead
Summary
- A detailed estimate of Berkshire's future growth and true earnings power points to lower returns ahead for BRK.B.
- With a strong balance sheet, slowing growth, and long-duration cash flows, an investment in BRK.B is a question of your investor profile.
- From these price levels, we believe BRK.B will return an underwhelming 6% per annum to long-term shareholders.
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A hush fell over the crowd at the Berkshire Hathaway 2022 Annual Meeting as Warren Buffett announced his decision to slow Berkshire Hathaway's (NYSE:BRK.B) share repurchases. Berkshire has now outperformed the S&P 500 over the past 5 years, thanks to Buffett's historic buybacks and timely purchases of Apple (AAPL) shares, beginning in 2016. However, the stock is no longer the blatant value it was. Berkshire trades around 19x our estimate of its true earnings power.
While long-term investors can be fairly certain they will get their money back from an investment in BRK.B, we argue that the returns from here could be underwhelming. In the face of slowing growth, we see just 6% annual returns for those buying BRK.B now.
Slowing Growth From Operations
The economy has left Berkshire's operating businesses in the dust. The years 2020 and 2021 were outstanding in terms of earnings growth. The federal reserve and congress increased the M2 money supply by approximately 40%, the unemployment rate fell to as low as 3.9%, and corporate earnings boomed. However, Berkshire Hathaway's operating businesses did not share in that growth. In fact, their cash flows are largely flat since 2018.
Cash Flow From Operating Activities (Berkshire Hathaway Annual Report, 2021)
Berkshire Hathaway has announced that the man in charge of its operating businesses, Greg Abel, will one day take over as CEO. Abel's performance has been rather disappointing, given the backdrop.
Going forward, we are estimating a 4% annual growth rate for BRK.B's existing operating businesses. Insurance has suffered of late for Berkshire, but higher interest rates should put an end to the decline in insurance earnings. On the other hand, BNSF, BHE, transport, manufacturing, and retailing are all capital-intensive businesses. Slow growth is likely to persist for this group for four reasons:
- Inflation increases expenditures on property, plant, and equipment for these businesses. Many of them are economically sensitive and may not be able to raise prices in line with increased costs.
- Joe Biden plans to increase corporate taxes from 21% to 28%, which would cut into margins.
- Some of Berkshire's subsidiaries will fail.
- These businesses have little organic growth and are heavily linked to U.S. GDP, which is projected to grow around 2% per annum.
An Equity Bull Market
Equity gains in a bull market have made up for the lackluster performance of Berkshire's operating businesses. Over the past year, shares have jumped on the mere announcement that Berkshire Hathaway owns an equity stake. Berkshire's Apple stake has grown tremendously as a result of relentless share buybacks, booming earnings, and multiple expansion. Equity gains have in turn driven up earnings and book value for BRK.B shareholders.
A bear market could have the opposite effect. The problem is that when the market declines, capital gains can turn into losses. This has the opposite effect of not only decreasing an inflated book value but evaporating reported earnings under generally accepted accounting principles (GAAP).
The Investment Arm
Let's take a deeper look at Berkshire's second growth machine, its acquisition and investment arm. We believe that Berkshire's Todd Combs and Ted Weschler are excellent investment officers and that the future is bright with them at the helm. It helps that they are inheriting just over $100 billion in cash and cash equivalents. However, a substantial portion of that is required to shore up Berkshire's insurance business and operations.
Below are the largest holdings in Berkshire's investment portfolio:
| Company: | % of Portfolio | % of Company Owned | Berkshire's Share of Earnings |
| Apple (AAPL) | 42% | 5.5% | $5.6 Billion |
| Bank of America (BAC) | 11% | 12.5% | $3.7 Billion |
| American Express Co. (AXP) | 8% | 20% | $1.6 Billion |
Chevron Corporation (CVX) | 7% | 8.2% | $1.4 Billion |
| Coca-Cola (KO) | 7% | 9.2% | $0.9 Billion |
| Occidental Petroleum (OXY) | 4% | 24.2% | $1.6 Billion |
| Kraft Heinz (KHC) | 3% | 26.6% | $0.3 Billion |
Source: Image created by author with data from WhaleWisdom
We prefer to calculate the underlying earnings of Berkshire's investments because the market value of the portfolio can swing from overvaluation to undervaluation, distorting both book value and net income. The above equities represent 82% of Berkshire's portfolio and $15.1 billion of earnings attributable to Berkshire. We have estimated a grand total of $18.4 billion of earnings from the portfolio as a whole.
Berkshire should be able to grow its equity earnings and the earnings of new, wholly-owned subsidiaries by 9% per year. Apple, Chevron, Occidental, Coca-Cola, and Kraft Heinz have pricing power and should grow slowly with inflation. Bank of America and American Express will grow on the back of a financially strong American consumer. Keep in mind, some of these companies could be at a cyclical peak in earnings. We expect 5% earnings growth from the investees with the additional 4% coming from the compounding effect of reinvested earnings.
The Valuation
Put simply, Berkshire's underlying earnings come from two sources: equity earnings and the free cash flow of its operating businesses. The operating businesses produced $18 billion of free cash flow in the past 12 months (after subtracting the dividends Berkshire receives from investees). Add in the $18.4 billion of equity earnings, and the total earnings power is $36.4 billion.
Now, if we combine our earlier growth estimates, we arrive at a growth rate of 6.5% per annum. This implies 2032 earnings of $68.3 billion. The company is likely to have enough free cash remaining to buy back its shares at a clip of 1.5% per year. With 1.9 billion shares outstanding in 2032, we estimate 2032 earnings of $35.94 per share.
We expect Berkshire to grow slower as it balloons in size, so we are assigning a 2032 multiple of 15x earnings. Our 2032 price target is $540 per share, implying just a 6% annual return from here.
A Question of Strategy
Whether or not BRK.B is a good investment now really depends on you. A 6% annual return looks attractive compared to the U.S. 10-year Treasury, yielding 2.7%. We are rating the stock a "hold." Despite this, BRK.B could fall as low as $200 per share in a steep market sell-off like we saw in 2020. It could also continue to charge up to 25x earnings.
Benjamin Graham, Warren Buffett's early mentor, once advised: "Invest with a margin of safety." If you are an investor seeking outsized returns or a large margin of safety, BRK.B might not be for you. We like the risk/reward better at a price below $250 per share. This would imply a return of 8% per annum, for a stable business with very long duration cash flows.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.