A quick glance at Berkshire Hathaway's BRK.ABRK.B 13-F filing for the fourth quarter of 2011 revealed more than a handful of moves by the insurer during the quarter, with some of the transactions actually bearing the mark of incoming manager Ted Weschler. The first transaction of note was Berkshire's purchase of another 22.3 million shares of Wells Fargo WFC, which brings the firm's stake in the bank up to 383.7 million shares (worth $10.6 billion at the end of the fourth quarter). After touting Wells Fargo in his annual review to shareholders last year as a major holding that could see a meaningful increase in its divided, Warren Buffett put his money where his mouth was and snatched up another 41.1 million shares of the bank last year, increasing Berkshire's holdings in the firm by 12%. About the only other transactions we can ascribe to the Oracle of Omaha were the purchase of 6.6 million additional shares of International Business Machines IBM (which we already knew about last quarter), and the sale of 8.4 million shares of Johnson & Johnson JNJ and 2.7 million shares of Kraft Foods KFT.
While the purchase of another 16.1 million shares of The DIRECTV Group DTV looks like a Buffett move, given that the stock position was worth more than $870 million at the end of the fourth quarter, it is more likely a combined purchase from Berkshire's two new hires--Todd Combs and Ted Weschler (who had DIRECTV listed as the second largest holding in his Peninsula Capital fund at the end of third quarter 2011). We assume that it was a combined purchase because Berkshire was already building a stake in the firm in the third quarter, and Weschler's hiring wasn't announced until mid-September). Looking at the rest of Weschler's holding at the end of the September quarter, it looks like he was also the driving force behind Berkshire's new money purchases of 2.7 million shares of DaVita DVA and 1.7 million shares of Liberty Media LMCA, as both firms were top five holdings in his fund. What's interesting to note, though, is the absence of W.R. Grace & Company GRA form the portfolio, given that it was Weschler's top holding at the end of the third quarter (accounting for close to one third of his total stock portfolio).
As for the remaining transactions, which we assume were handled by Todd Combs, Berkshire picked up another 573,000 shares of Visa V to go with the 2.3 million shares that had been picked up with new money during the third quarter. Combs also picked up another 1.4 million shares of CVS Caremark CVS in the fourth quarter, adding to the 5.7 million shares stake that he had initiated in the previous quarter. The same sort of activity occurred with General Dynamics GD and Intel INTC, both of which were new money purchases during the third quarter. In the case of General Dynamics, Combs added 813,000 shares to a 3.1 million share stake. With Intel, it was the addition of 2.2 million shares that brought Berkshire's stake in the semiconductor firm to 11.5 million shares at the end of the fourth quarter. We also assume that Todd Combs sold of the remaining 422,000 shares of ExxonMobil XOM, which was originally purchased in the third quarter of 2009, and was never a meaningful position in the portfolio.
With regards to the only other transaction in the filing, the addition of 1.3 million shares of Verisk Analytics VRSK, we don't believe that it was a purchase. Verisk is essentially a technology company that provides insurance companies with data and software that they need to run their business. Prior to its initial public offering in October 2009, Verisk had been funded by a number of large insurance companies--including Berkshire--that received shares in the company as it went public. With restrictions placed on the Class B shares the insurers received as part of the IPO, Berkshire has held approximately 7.1 million shares of Verisk's Class B common stock since that time. With half of these shares automatically converting to Class A common stock in early April of last year, and the remainder converting in early October, it was the conversion rather than an outright purchase of Verisk that is responsible for the change in Berkshire's 13-F filing.
Stay tuned as we intend to publish a much deeper look at Berkshire's holdings as part of our Ultimate Stock-Pickers content.
Thesis 09/12/11
Berkshire Hathaway's wide economic moat has been built on the firm's track record of acquiring and managing a portfolio of businesses with enduring competitive advantages. Whether through direct ownership of individual companies, or via significant stock holdings, famed value investor Warren Buffett has looked to acquire firms that have consistent earnings power to generate above average returns on capital, have little to no debt, and have solid management teams. Once purchased, these businesses tend to remain in Berkshire's portfolio, with sales occurring rarely. Buffett strives to raise capital as cheaply as possible to support Berkshire's ongoing investments and measures the success of the portfolio by per-share growth in intrinsic value. Book value per share, which is the main proxy used to measure the intrinsic value of the firm, has increased 20% per year on average over the last 45 years. Given the current size of its operations, the biggest hurdle facing Berkshire will be its ability to consistently find deals that not only add value but are large enough to be meaningful. The other major issue facing the firm is the longevity of Buffett and managing partner Charlie Munger, both of whom are octogenarians.
Berkshire's most important business continues to be its insurance operations. Not only do they contribute a significant portion of the firm's profits but they also generate low-cost float (the temporary cash holdings arising from premiums being collected well in advance of future claims), which is a major source of funding for investments. Berkshire underwrites insurance through three main units: GEICO, General Re, and Berkshire Hathaway Reinsurance. GEICO, which is the third-largest auto insurer in the United States, relies on direct selling to consumers, a model that provides it with cost advantages over some of its competitors. While this practice has become more common, GEICO was a pioneer in the channel and continues to generate solid underwriting profits and negative cost of float for Berkshire.
The firm's two other main insurance businesses are both reinsurers. For a premium, they will assume all or part of an insurance or reinsurance policy written by another insurance company. General Re is one of the largest reinsurers in the world based on premium volume and shareholder capital, while Berkshire Hathaway Reinsurance's claim to fame is its ability to take on large amounts of super-catastrophe underwriting, which covers events like terrorism and natural catastrophes. These unique policies often contain large tail risks which few companies (other than Berkshire, with its strong balance sheet) have the capacity to endure. When priced appropriately, though, these types of transactions can generate favorable long-term returns on capital for the firm.
Berkshire's non-insurance operations include a wide array of businesses from Burlington Northern Santa Fe (railroad) to MidAmerican Energy (energy generation and distribution), McLane (food distribution), Marmon (manufacturing), Shaw Industries (carpeting), Benjamin Moore (paint), Fruit of the Loom (apparel), Dairy Queen (restaurant), and See's Candies (food retail). Of the more than 70 non-insurance businesses in its portfolio, the two largest contributors to Berkshire's operating earnings are Burlington Northern, which the firm acquired in full in February 2010, and MidAmerican, in which Berkshire maintains a 90% stake (having initially added the company to its holdings more than a decade ago).
Buffett's shift into such debt-heavy, capital intensive businesses as railroads and utilities is a marked departure from other investments, which have tended to require less capital investment and have had little to no debt on their books. While running railroads and utilities requires massive reinvestment, Berkshire has entered these businesses because they can earn decent returns on incremental investments, ensuring that the large amounts of cash generated by other operating businesses are reinvested in value-creating projects. And while Berkshire does consolidate the debt of these two subsidiaries on its own balance sheet, the firm guarantees none of it.
All of Berkshire's operating businesses are managed on a decentralized basis, eliminating the need for layers of management control and pushing responsibility down to the subsidiary level, where managers are empowered to make their own decisions. This leaves Buffett free to focus on capital allocation decisions and managing the investments in Berkshire's portfolio--two things that he has been extremely adept at doing during the last four-plus decades. While we could certainly argue that Buffett is not the sole reason for Berkshire's success, he has been (and continues to be) a critical element in the firm's competitive positioning. In our view, Buffett's ultimate departure would cause the firm to lose some of the significant advantages that have resulted from his being at the helm.
Valuation
We've lowered our fair value estimate for Berkshire Hathaway's Class A shares to $133,500 from $140,000 to account for the impact we believe underwriting losses from the firm's insurance segment will have on operating earnings this year. We also expect Berkshire to be adversely impacted by the downturn in the equity markets, which not only impact the value of the firm's investments (which would diminish book value per share) but the value of its equity derivative contracts as well. Our new fair value estimate is equivalent to 1.4 times the company's reported book value of $98,716 at the end of the second quarter of 2011. Over the last decade, Berkshire's Class A shares have traded in a range of 1.1 to 1.9 times book value, with a median value of 1.5 times. Our fair value estimate for the Berkshire is derived from a sum-of-the-parts methodology, which values the different pieces of the company's portfolio separately, then combines them to arrive at a total value for the firm.
With Berkshire not expected to post an underwriting profit from its insurance operations this year, and the value of its equity investments diminishing in a down market, and the firm losing lucrative investments in Goldman Sachs GS, General Electric GE, and Swiss Re (which are all likely to be paid off by the end of 2011), we estimate that Berkshire's insurance segment is worth $73,400 per Class A share (versus $82,800 in our previous valuation). As for the firm's noninsurance subsidiaries, we believe Berkshire's manufacturing, service & retailing operations--which include Lubrizol for our valuation purposes--are worth $24,500 per Class A share ($1,600 higher than our previous estimate, a direct result of the segment seeing much stronger operating profits through the first six months of 2011 than we had been forecasting for the year). We estimate that Berkshire's railroad, utilities and energy division is worth $30,000 per Class A share (relatively unchanged from our previous valuation), as stronger than expected growth from Burlington Northern this past year has been stymied by higher-than-expected capital expenditure projections for MidAmerican Energy over the next five years. Finally, we estimate that Berkshire's finance and financial products division is worth $5,500 per Class A share ($1,000 less than our previous estimate, as revenues and operating earnings from the segment continue to come in significantly lower than we had been forecasting).
Risk
Berkshire is exposed to large potential losses through its insurance operations. While the company believes its super-catastrophe underwriting will generate solid long-term results, the volatility of this particular line of business, which can subject the firm to especially large losses, could be high. That said, Berkshire maintains higher capital levels than other insurers, which we believe helps mitigate some of the risk. Several of the firm's key businesses--insurance, energy generation and distribution, and rail transport--operate in industries that are subject to higher degrees of regulatory oversight, which could impact future business combinations and the setting of rates charged to customers.
Berkshire also is exposed to foreign currency, equity price, and credit default risk through its various investments and operating companies. The firm's derivative contracts, in particular, can impact Berkshire's earnings and capital position, especially during volatile markets, given that they are recorded at fair value and, therefore, are periodically updated to record the changes in the value of these contracts. Many of the firm's non-insurance operations, meanwhile, are exposed to the cyclicality of the economy, with results typically suffering during economic slowdowns and recessions.
Finally, Berkshire is highly dependent on two key employees, Warren Buffett and Charlie Munger, for almost all of its investment and capital allocation decisions. With both men now in their 80s, it has become increasingly likely that our valuation horizon will end up exceeding their expected life spans. We also believe investment returns and capital-allocation quality are likely to deteriorate under new management. The departure earlier this year of David Sokol, who many assumed was the heir apparent to the CEO role, has also raised serious questions about Berkshire's internal controls and, to some extent, has tarnished the firm's legacy of strong ethical behavior.
Management & Stewardship
Warren Buffett has been chairman and CEO of Berkshire Hathaway since 1970. Charlie Munger has served as vice chairman since 1978. Berkshire has two classes of common stock, with Class B shares holding 1/1,500th of the economic rights of Class A shares, and only 1/10,000th of the voting rights. Warren Buffett is Berkshire's largest shareholder, with a 34% voting stake and 23% economic interest in the firm. While there are many aspects of Berkshire's corporate governance that fall short of our standards, such as having the chairman and CEO roles combined, Buffett has tended to be a strong steward of investor capital, consistently aligning his own interests with those of shareholders. This makes it even more important that his legacy remains intact once he no longer runs the firm. Succession was not formally addressed by Buffett until 2005, when he noted that his three main jobs--chairman, chief executive, and chief investment officer--likely would be handled by one chairman (expected to be his son, Howard Buffett), one CEO (with just three potential internal candidates identified), and three or more external hires (reporting to directly to the CEO) to manage the investment portfolio. The resignation of David Sokol, who had been assumed to be the heir apparent to the CEO role, has thrown succession planning back into the spotlight this year. In our view, whoever steps into Buffett's role as chief executive is going to feel more pressure from shareholders and analysts than Buffett has ever been subjected to, which means that the board will have to work all that much harder to ensure that the remaining candidates are thoroughly prepared for the role. That said, the real long-term question for investors is whether any of them can replace the significant advantages that have come from having an investor of Buffett's caliber, with the knowledge and connections he has acquired over the years, running the show.
Overview
Financial Health:
Berkshire's financial strength was tested by the collapse of the credit and equity markets in 2008, which ultimately led to the company losing its AAA credit rating in 2009. That said, Berkshire remains one of the most financially sound companies we cover, with the firm managing its risk through diversification and a conservative capital position.
Profile:
Berkshire Hathaway is a holding company with a wide collection of subsidiaries engaged in a number of diverse business activities. The firm's core business is insurance, run primarily through GEICO (auto insurance), General Re (reinsurance), Berkshire Hathaway Reinsurance, and Berkshire Hathaway Primary Group. The company's other businesses are made up of a collection of finance, manufacturing, and retailing operations, along with railroads, utilities, and energy distributors.
No comments:
Post a Comment