Looking for Berkshire’s Fair Value

Berkshire Hathaway is currently sitting on $128B in cash/short-term securities. That’s more than the entire market capitalization of Nike, IBM, Starbucks, and 356 other companies in the S&P 500. But as Berkshire’s cash accumulates (at a pace of ~$2B per month), it’s stock price remains within just 2-3% of it’s December 2017 levels, despite an otherwise strong run by the U.S. equity markets and new investors like Pershing Square.

Is it’s current price, at around $222/share for its class B stock, an attractive investment?

I’ll argue that it represents a good value, especially in contrast to other high prices in the S&P 500.

What do you get for a share of Berkshire?

For ~$222 in December of 2019, your slice of the Berkshire pie represents $52 of cash/cash equivalents across the business and ~$112 in Berkshire’s investments, like those in Apple and Wells Fargo (calculated by dividing these figures from Berkshire’s most recent 10Q by the number of outstanding shares, noting that Class B shares are 1/1500th the value of Class A shares).

In addition to these combined $164 cash and investments per Class B share, you’ll also own a slice of their businesses, including BNSF railroad, BH Energy, Marmon, Lubrizol, Iscar and Precision Castparts. In Q3 2019, Berkshire’s insurance, railroad, utilities and energy businesses earned ~$6.4B in pretax profits (not including investment income from interest/dividends), or roughly $2.6 per class B share, ~$10.45 annualized.

How does Berkshire’s valuation compare to historical levels and the broader market?

Using a 21% corporate tax rate approximation for Berkshire, we can subtract the ~$164 cash and investments figure from the ~$222 share price to see we’re paying $58 for Berkshire’s earnings, or ~5.5x pretax profits and a ~7.0x P/E for these businesses, which have historically earned above average returns on equity and increasing earnings power. Now, recent falters in Kraft Heinz has demonstrated that not all of Berkshire’s portfolio is likely to compound at 15-20% perpetually in the future. Nevertheless, a seven times earnings valuation for these businesses compared to the current S&P average of 23.6 times is very attractive. As another proxy, the current price to book is hovering at roughly 1.36x, a bit higher than the 1.2x that Berkshire has historically sought to buy back its own shares, but still lower than its 5 year average of 1.4 and comparable companies in the S&P. Lastly, while it’s not feasible to predict the timing of the next correction in equity prices, it’s safe to say that Berkshire has developed itself into a machine ready to capitalize on such a downturn, and is well poised to do so with its cash-rich balance sheet and ability to execute deals on attractive terms quickly.

What kind of downside are we looking at?

Berkshire is among the safest investments of any such large, well documented and historic businesses in America. The best margin of safety is a discount to intrinsic value, the argument for which is outlined above. In addition, Berkshire’s massive cash pile, intention to buy back stock at 1.2x book value or higher (which effectively places a price floor at ~$195-$200, or ~10% below its current price, given its current book value), and strong diversified businesses in defensive sectors, suggests significant downside protection on the investment.

This week's links: 12/01/19

The problem with Cisco’s “spin-ins”

Cisco Systems tried to pioneer a new form of corporate innovation roughly 20 years ago with the “spin-in” methodology. The process: make venture capital-style investments in a variety of semi-independent startups, spreading risk, and buying out the successful ventures that hit pre-agreed upon revenue goals within 24 months. Benefits: Cisco could presumably have greater risk tolerance, the “spin-ins”-to-be had access to Cisco’s sales channel, manufacturing base and support functions, and Cisco had the ability to retain entrepreneurial talent that would have otherwise left to start/join ventures. Some drawbacks: two-year revenue targets are not long-term thinking, and was described by some Cisco executives as a “time bomb.” In addition, you still have the cultural challenges of entrepreneurs who return into the Cisco organization with a multi-million dollar payout, causing tension with their peers who decided against the risky propositions. There’s promise in the model, but has yet to be scaled up and adopted by other large corporations.

When writers review writers – on Robert Caro’s Lyndon B Johnson biographies

For Caro, ambition carries the stench of power, and no word in the lexicon disturbs him more. He is both fascinated by power and repelled by those who exercise it. He is like a religious fundamentalist in the grip of a sexual passion he cannot control and cannot extirpate.

The writer doesn’t stop there: “Such a view of power in a sophisticated author and former reporter, who has presumably descended into the kitchen of politics, is odd. It is like being repelled by the realization that surgeons actually enjoy their bloody work. Few in the political arena are morally pure or devoid of ambition, and those few do not last long. To denigrate ambition and the quest for power does not put one on the side of the angels but, rather, establishes one as living in the clouds.

Nothing gets his Oedipal adrenaline going like a successful, powerful man of great accomplishment and impure heart…

Also: (data here)

This week’s links: 17/11/19

Book notes on Alfred P. Sloan’s My Years with General Motors

As a company increases its productivity (either by more efficient processes, better technology, or other experience curve effects), how should the gains be distributed? I.e., if General Motors can produce a car for $35,000 one year and $30,000 five years later, but keeps the retail price constant over time, where should that $5,000 of profit flow? Perhaps to the consumer (lowering retail price), to the labor (increase wages), to other capital projects (re-invest in the business), to shareholders (buy back shares or issue a dividend)?

The Prescription Escalator

As the title reads, rising spend on prescriptions is driven by the number of prescriptions used as people grow older; not by the changes in prices.

Martin Scorsese on the Marvel Universe

“I don’t think they’re cinema… And if you’re going to tell me that [film-making is] simply a matter of supply and demand and giving the people what they want, I’m going to disagree. It’s a chicken-and-egg issue. If people are given only one kind of thing and endlessly sold only one kind of thing, of course they’re going to want more of that one kind of thing… But the most ominous change has happened stealthily and under cover of night: the gradual but steady elimination of risk. Many films today are perfect products manufactured for immediate consumption. Many of them are well made by teams of talented individuals. All the same, they lack something essential to cinema: the unifying vision of an individual artist. Because, of course, the individual artist is the riskiest factor of all… There’s worldwide audiovisual entertainment, and there’s cinema. They still overlap from time to time, but that’s becoming increasingly rare. And I fear that the financial dominance of one is being used to marginalize and even belittle the existence of the other.”

The Global Fertility Crash – Bloomberg

“Population growth is vital for the world economy. It means more workers to build homes and produce goods, more consumers to buy things and spark innovation, and more citizens to pay taxes and attract trade.” So why are birth rates falling across so many countries?

The Complacent Class by Tyler Cowen:

  • There’s a shift in advanced economies, societies from creation to optimization. “Rebellion into a vacuum:
  • Lost faith in the system, but without a strong ideology and a strong belief in the future, the vacuum can be filled by other, worse ideas.”

Interviews with HBS alumni entrepreneurs:

Includes Tom Murphy of ABC/Cap Cities, Dan Lufkin of DLJ, and other entrepreneurs behind Intuit, Bain & Company, and other VC/Finance firms

Peter Thiel’s Wistron Lecture

An interesting take on the ultimate power dynamics shaking out between US/China, as predicted by Lee Kuan Yew decades ago as the Prime Minister of Singapore.

The four vectors of globalization: movement of free goods (free trade), movement of people (migration/immigration), movement of capital (banking/finance), movement of ideas (the internet). Thiel posits that the US has maintained a stronghold on the movement of capital and ideas, but has retreated from its global leadership on free trade and immigration. Even then, sentiment towards finance and tech has waned. On the other hand, the largest container shipping ports are in China; the largest US port is in LA and is 11th largest in the world. Shenzhen and comparable cities have demonstrated immense migration of people, unseen on any similar scale in the US. Thiel concludes that the migration of goods and people, therefore, is not where the US should be competing.

This week’s links: 24/10/19

Secrets of Greatness: How I Work

The Rise of the New Global Elite – The Atlantic

“For the super-elite, a sense of meritocratic achievement can inspire high self-regard, and that self-regard—especially when compounded by their isolation among like-minded peers—can lead to obliviousness and indifference to the suffering of others.”

How Great Entrepreneurs Think

Upon surveying 45 willing participants that passed the screening criteria of having at least 15 years of entrepreneurial companies, having started multiple businesses (both successful and unsuccessful ones), and having taken at least one of them public, she concluded that master entrepreneurs rely upon effectual reasoning vs. causal reasoning. Effectual: choosing goals based upon the assets at your disposal; causal: choosing goals, and then seeking/building the assets required to complete said goals.

CostCo’s foray into meat production

Costco was willing to sacrifice “$30 million, $40 million a year on gross margin by keeping [their chicken] at $4.99,” Galanti said the following year. “That is what we do for a living.

U.S. chicken production is large and has seen strong and steady growth for half a century; ~60% of the American production is dominated by 5 companies with ever-increasing bargaining power over retailers. In addition, while customers want entire rotisserie chickens at CostCo, only 15% of chicken is produced in full-bird form (down from 50% in the ’80s), since companies like Tyson Foods can earn higher margins on selling individual parts of chicken instead of as a whole. That has led Tyson and others to produce heavier, larger chickens, to the point that the now seven-to-eight pound chickens are too large for CostCo’s rotisserie lines, and place higher pressures on even the slimmest of margins when selling for $5/chicken.

Following their insourcing of hot dog production in 2009, CostCo is bringing their chicken production in-house, building a facility in Nebraska where the primary cost drivers of chicken production (grain, water and labor) are in the cheapest supply. Nebraska is the third largest state by corn production; however, corn prices have fallen in recent years and, compounded by the Chinese trade war, farmers are looking to diversify and answered CostCo’s call.

This could be interesting for many retailers, following other vertical integrations such as Walmart’s Angus beef production, and insourced milk supplies for both Walmart and Kroger.

This week’s links: 29/9/19

Joe Rosenfield – Grinnell College Endowment

The Valeant Meltdown

The Empire Reboots – Vanity Fair

A long piece on Satya Nadella’s assumption of the CEO position at Microsoft. Interesting to see how he’s diversified away from Office and Windows and turned around the business after some very questionable strategic investments in the 2000s. Since Nadella took over in 2014, the company’s share price has risen from ~$40/share to ~$140/share today, or about 23% a year.

Becoming a publicly traded person – HackerNoon

“I am James Gallagher, and I am your latest investment.” He’s offering “shares” of himself as a publicly traded entity, and shareholders get to weigh in on his decisions. I’m not sure what I’m missing, but I’ve got a few questions. Do shareholders get a stake in his future earnings potential? Is he going to issue dividends? How many outstanding shares are being traded? How much voting power is carried per share? To what purpose will the funds raised be applied?

Evernote’s business model struggles

As an avid Evernote user, it’s a real shame that the company was unable to really take off and monetize it’s user base. This article explores the challenges of the freemium model and how a semi-engaged user base stagnates a SaaS business. It’s worth questioning whether the fundamental product – a notes app that competes with native apps developed by Apple, Google and Microsoft as well as Bear and other consumer apps – is one that a large and stable set of customers are willing to shell out more than a few dollars a month for.

“The chief products of the tech industry are (in B2C) developing new habits among consumers and (in B2B) taking a business process which exists in many places and markedly decreasing the total cost of people required to implement it.” – Patrick McKenzie

This week’s links: 22/9/19

32 Thoughts from a 32 Year-Old – Ryan Holiday

Big Mistakes: The Best Investors and Their Worst Investments – Michael Batnick

Super interesting: the mistakes that shaped the investing careers of Warren Buffet, Bill Ackman, Chris Sacca, Jack Bogle, Mark Twain, John Maynard Keynes, and more.

Black Edge: The Story of Steven A. Cohen & SAC Capital – Sheelah Kolhatkar

Really great book on Steven Cohen and his fund SAC Capital, one of the greatest traders of all time, that mirrors the show Billions (or vice versa) in so many ways.

Saudi, Inc. – Ellen Wald

Talking to Strangers – Malcolm Gladwell

David Skok on the right SaaS metrics

Insights on VC Pricing – Aswath Damodaran. Looking at the IPO plans of Peloton, Uber and WeWork, you may notice unrealistically large addressable markets, dangerous governance structures, insufficient detail on their intended paths to profitability, and a variety of adjusted earnings metrics.

This week's links: 9/1/19

Why don’t people talk about breaking up Microsoft?

Stock Picker Bill Miller’s Defeat (WSJ, 2008)

How the prison economy works

A Dozen Lessons for Entrepreneurs

  • Advice from iconic Silicon Valley figures: Steve Blank, Bill Campbell, Eric Ries, Sam Altman, Steven Andersen, Marc Andreessen, Rich Barton, Roelof Botha, Jim Breyer, Chris Dixon, John Doerr, Peter Fenton, Jim Goetz, Paul Graham, Kirsten Green, Bill Gurley, Reid Hoffman, Ben Horowitz, Vinod Khosla, John Koppelman, Jenny Lee, Doug Leone, Michael Moritz, Chamath Palihapatiya, Keith Rabois, Andy Rachleff, Naval Ravikant, Mark Suster, Peter Thiel, and more.