By Ravi Nagarajan
Published on March 17, 2010 at 9:39 am
In a guest post yesterday on the excellent Greenbackd blog, S. Raj Rajagopal made a case for shorting Berkshire Hathaway and followed up later with more details regarding valuation. Mr. Rajagopal is an MBA student at Cornell and has work experience in the investment field. It takes a great deal of courage to make a public case for shorting Berkshire given the company’s long history and loyal shareholder base. We often discuss psychological tendencies that harm investors and one such tendency is to dismiss opposing points of view without critical examination. Mr. Rajagopal’s case deserves such examination before rendering a judgment.
“Adoration is not an investment strategy”
Mr. Rajagopal bases much of his initial post not on quantitative evidence but on the premise that adoration for Warren Buffett is not an investment strategy. On this point he is clearly correct. It makes no sense to simply purchase Berkshire Hathaway because of Warren Buffett’s track record. Obviously some buyers of Berkshire stock make their decision purely based on Mr. Buffett’s track record. However, any sophisticated investor understands that you do not purchase a security simply based on folksiness or admiration for a grandfatherly character. If Mr. Rajagopal intended his short case to be read by professionals, he begins with an obvious straw man argument.
Having presented this initial warning against backward looking thinking, it is ironic that much of the rest of Mr. Rajagopal’s thesis simply looks at the past in an attempt to forecast the future without providing any substantial quantitative evidence. For example, several slides in the initial presentation are devoted to Mr. Buffett’s investments in companies that were in financial distress in 2008. Much is made of Mr. Buffett’s letter to Treasury Secretary Hank Paulson offering to help construct an investment fund partly using $100 million of Mr. Buffett’s own personal fortune outside Berkshire Hathaway. Of course, Mr. Buffett’s offer was never acted upon by Treasury.
Mr. Rajagopal goes on to lambast Berkshire as a “bailout baby” simply because Berkshire took large positions in companies that were in financial distress and then allegedly manipulated the political process to stack the deck in favor of Berkshire. Mr. Buffett received numerous phone calls throughout the financial crisis with offers to invest in distressed firms at very attractive prices. Should he have ignored such opportunities? How is Mr. Buffett a “welfare queen” (why not a “bailout king”?) based on investments in which Berkshire’s capital was clearly at risk of loss and actually helped provide the votes of confidence that stabilized the system? None of this is clear from the presentation.
Incorrect Reading of Buffett’s Statement on Berkshire Valuation
Mr. Rajagopal completely fails to interpret Mr. Buffett’s recent statements on Berkshire’s valuation and claims that the “Oracle of Omaha says Berkshire is overvalued now”. This is obviously not the case. As we pointed out in January, Mr. Buffett actually stated that Berkshire was undervalued at the time based on its historical relationship to book value and in his latest letter to shareholders, Mr. Buffett explains his rationale regarding using stock for the Burlington acquisition in great detail. Berkshire’s stock price has advanced since the conclusion of the Burlington acquisition but Mr. Buffett has made no further comments to support Mr. Rajagopal’s claim that he believes the stock to be “overvalued now”.
Derivatives: Ticking Time Bombs?
Mr. Rajagopal directly calls Mr. Buffett a “hypocrite” for warning about derivatives in 2002 and then investing in derivatives for Berkshire’s account. It does not appear that Mr. Rajagopal has any grasp of the nature of Berkshire’s derivatives exposure and he offers no substantiation whatsoever for referring to the derivatives as ticking time bombs. We discussed the misunderstandings related to Berkshire’s derivatives over a year ago and suggest that Mr. Rajagopal review the article or numerous others which explain the nature of these instruments in detail.
Filling Buffett and Munger’s Shoes
Mr. Rajagopal notes that male life expectancy in the United States is 74 years but does not point out that this is life expectancy at birth. Mr. Buffett is 79 years old and has an actuarial life expectancy of over eight years. Mr. Munger is 86 years old and has an actuarial life expectancy of over five years.
At the top of his slide he has a subtitle reading: “David ‘who’ Sokol” in an apparent reference to Mr. Sokol being one of the more frequently cited candidates for CEO at Berkshire. It is unfortunate that Mr. Rajagopal has decided that Mr. Sokol is unworthy and we would suggest a review of Pleased But Not Satisfied as a good starting point for Mr. Rajagopal to educate himself on one of Mr. Buffett’s potential successors.
Mr. Rajagopal seems to also have issues with the Burlington acquisition which we have discussed here frequently over the past three months. However, he provides no valuation information and simply comes up with an “inevitable conclusion” that Mr. Buffett is seeking to “protect his franchise with a mammoth acquisition” prior to handing over the reins. We are also told that “volatility” will increase due to S&P 500 inclusion and the stock split which will cause Berkshire to become a “volatile middle aged and mature stock”.
Seriously Flawed Valuation Model
After facing a barrage of criticism regarding his initial case for shorting Berkshire, Mr. Rajagopal produced a follow up post with his valuation model. Unfortunately, the valuation only reinforces the impression that Mr. Rajagopal does not understand Berkshire Hathaway. The following problems were noted in the model:
- Earnings per share are used in the valuation model even though reported earnings per share for Berkshire are inadequate for judging progress in intrinsic value on a year to year basis because of the volatility to earnings caused by the timing of capital gains and losses as well as the mark to market requirements for the derivatives book. In addition, many of Berkshire’s publicly traded holdings have earnings far in excess of paid dividends and Berkshire’s share of such earnings are not reported in Berkshire’s earnings figures.
- Projections for earnings per share going forward are based on an average of the past five years in reported earnings growth which is purely backward looking and fails to take into account any of the drivers of reported earnings that have changed in recent years (purchase of high yielding securities such as the Goldman Sachs and GE Preferreds, acquisition of BNSF, etc).
- Book Value progress each year is apparently calculated by adding starting year book value to earnings for the year which fails to account for any changes in book value associated with unrealized gains in Berkshire’s portfolio of publicly traded securities.
- The model uses a 9% discount rate even though the “notes” section states that an 8% rate will be used. This has a material long term impact on the valuation. Neither the 8% or 9% rate is ever justified.
- Target ROE is set at 10% “since BRK is so big” which is an inadequate explanation of a key variable used in the valuation.
- The model produces prices at a discount to book value but no explanation is provided regarding what element of goodwill is impaired or why Berkshire would trade at a discount to book value which would be unprecedented.
- The model mysteriously produces declining valuations for Berkshire after 2016 even though book value continues to grow. At 2021, we have an absurd calculation of an $84 valuation along with an estimate of $209 of book value leading us to believe that Mr. Rajagopal believes that Berkshire’s price to book value will shrink to 0.40 over the next ten years.
It is difficult to know what to make of Mr. Rajagopal’s short thesis in light of the obvious flaws in both the original presentation and the follow up valuation model. It took some courage for Mr. Rajagopal to offer a short case for Berkshire but unfortunately he completely failed to justify his thesis.
Disclosure: The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.
Disclosure: Long BRK