Berkshire Hathaway's BRK.ABRK.B
third-quarter 13-F filing, which details the firm's equity holdings,
continued to show evidence of the primary theme that we expect to drive
portfolio movements over the near- to medium-term. With Berkshire's
appointment of Ted Weschler and Todd Combs as lieutenants to Warren
Buffett, the company has been active over the last several quarters
selling legacy positions and in the process raising capital for the two
managers to invest. While a fair amount of the buying activity of late
has been initiated by Buffett--with his favorite target continuing to be
Wells Fargo WFC--we
have seen plenty of trading activity on the part of Weschler and Combs.
And while Buffett did make a point during the third quarter of noting
that each of these two managers would be working with a "bank" of around
$4 billion each (exclusive of any gains/losses on capital that has
already been put to work)--up from $1.75 billion each at the end of last
year and $2.75 billion each at the end of the first quarter--we think
that this amount could rise even higher in the near term, given the
amount of selling that has taken place in the portfolio.
Some of
the most notable moves in the most recent quarter were sales of legacy
positions that can be tied directly to Buffett. Among these were
significant sales of shares of Johnson & Johnson JNJ, General Electric GE, United Parcel Service UPS,
and Kraft Foods. With regards to Johnson & Johnson, which Berkshire
has been selling fairly regularly over the last year, the firm
eliminated another 9.8 million shares (equivalent to 95% of the shares
that the firm held at the end of the second quarter and worth more than
$680 million based on today's closing price for the stock). At this
point, Berkshire holds less than 500,000 shares of the health-care firm,
and we would not be surprised if the firm eliminated this holding
completely before the end of the year (given that it is now one of the
smallest positions in Berkshire's equity portfolio). As for General
Electric, which we've always ascribed to Lou Simpson, the firm reduced
its stake in the company by close to 90% during the third quarter, with
less than $15 million left invested in the conglomerate at the end of
the period. UPS received similar treatment, with Berkshire eliminating
77% of its stake in the firm, which at less than $5 million was the
second-smallest holding in the insurer's portfolio. Meanwhile, the sale
of half of its Kraft position was intriguing in that Buffett initiated
the trade before the packaged foods giant was set to spin off its
grocery operations, Kraft Foods Group KRFT, and rename itself as Mondelez International MDLZ,
which retained global snack food operations. Having sold off close to
80% of its shares in Kraft over the last several years, we expect
Berkshire to continue to whittle down this stake (which is still a top
10 holding at more than $1.2 billion at the end of the third quarter),
much like they have with Johnson & Johnson.
Other sales of legacy positions during the quarter included ConocoPhillips COP, which was reduced by 16% (or 4.7 million shares), Procter & Gamble PG, which was trimmed by more than 10% (with 6.8 million shares sold), and US Bancorp USB,
which saw a less than 10% reduction (equivalent to 4.7 million shares).
While not quite what we would consider to be a legacy position, it was
interesting to see Berkshire sell about two thirds of its stake in Lee
Enterprises LEE,
given that the insurer had really only started to build a position in
the firm this year. That said, the stock has doubled since the start of
the year, partly because Berkshire was taking a stake in the firm, so
this could be a move to book some gains, which would mean that this was
likely a Combs holdings as opposed to a Buffett purchase (which is what
we had originally believed it to be). Combs was also likely behind the
sales of CVS Caremark CVS, Dollar General DG, and Visa V,
all of which were been built up over the last year or so. With the
first two holdings, he eliminated the positions from the portfolio, with
CVS up 25% in the year leading up to the start of the third quarter,
and Dollar General up more than 60%. Combs also took advantage of the
45% runup in Visa's stock price to eliminate about one quarter of his
stake in the firm. As for the other sales in the portfolio, Berkshire
reduced its stake in Verisk Analytics VRSK, and finally eliminated its position of Ingersoll-Rand IR.
Looking
more closely at the purchases, Buffett was likely behind the additional
purchases of shares of Wells Fargo and International Business Machines IBM.
Buffett has thrown money at Wells Fargo in eight of the last nine
calendar quarters, with Berkshire now holding a $14.5 billion stake in
the bank. As for IBM, the purchase was much smaller, with Berkshire
adding another 870,000 shares during the third quarter, leaving the
insurer with just over $14 billion invested in the technology giant at
the end of the third quarter. The rest of the purchases during the
period were initiated, in our view, by Weschler and Combs, with the
former likely behind the purchases of shares of DIRECTV Group DTV, DaVita DVA, Viacom VIAB, and Media General MEG, given his penchant for media stocks, while the latter was likely behind increased stakes in Bank of New York Mellon BK, National Oilwell Varco NOV, and General Motors GM, as well as new money purchases of Deere DE, Precision Castparts PCP, and Wabco Holdings WBC.
That said, this is pure speculation on our part. Unless we are told
directly the purchases and sales made by respective managers at
Berkshire, we can only guess which transaction belongs to Buffett,
Weschler, and Combs based on their past trading activity.
Thesis 10/17/12
Berkshire
Hathaway's economic moat has been built on the firm's 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, increased
20% per year on average from 1965 to 2011. 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 also 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, 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, these subsidiaries 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
supercatastrophe underwriting, which covers events like terrorism and
natural catastrophes. These unique policies often contain large tail
risks that 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 noninsurance operations encompass a wide array of
businesses, including Burlington Northern Santa Fe (railroad),
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
noninsurance businesses in its portfolio, the two largest contributors
to Berkshire's pretax earnings are BNSF, 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 many of Berkshire's
past investments, which have tended to require less capital investment
and have had little to no debt on the books. While running railroads and
utilities requires massive reinvestment, Berkshire acquired 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 over the past 40-plus years. While we could
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 come
from having a capital allocator of his caliber at the helm.
Our
fair value estimate for Berkshire Hathaway's Class B shares is $110 per
share, which is equivalent to 1.5 times Berkshire's reported book value
per Class B share of $72 at the end of the second quarter. Over the
past decade, the Class B shares have traded in a range of 1.1-1.7 times
book value, with a median value of 1.5 times.
Our fair value estimate for Berkshire is derived using 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. We estimate that Berkshire's insurance operations
are worth $60 per Class B share, somewhat higher than our previous
valuation, with much of the difference tied to an even stronger recovery
in underwriting income than we were expecting this year. It should,
however, be noted that the firm's investment income remains depressed
due to the historically low-yield environment. We expect this trend to
continue for some time, with Berkshire unable to avoid reinvesting
maturing securities in its fixed-income book into lower-yielding
securities. Furthermore, many of the high-coupon investments the firm
made during the financial crisis have been (or are in the process of
being) paid off.
With regard to Berkshire's noninsurance subsidiaries, we believe the
firm's manufacturing, service, and retailing operations are worth $20
per Class B share, somewhat higher than our previous estimate, owing to
the ongoing improvements that continue to be seen in revenue and
operating profits throughout the division, even in the face of a
lackluster U.S. economy. We estimate that Berkshire's railroad,
utilities, and energy operations are worth $26 per Class B share, also
higher than our previous forecast, due to the strength we continue to
see at BNSF as well as slight changes we've made to the returns we
expect MidAmerican to generate from its ongoing investments. Finally, we
estimate that Berkshire's finance and financial products division is
worth $4 per Class B share, slightly higher than our previous estimate,
as revenue and operating earnings have increased this year, even with
the weak U.S. housing market.
Berkshire
is exposed to large potential losses through its insurance operations.
While the company believes its supercatastrophe 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
almost all other insurers, which we believe helps to 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
have an impact on 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 affect
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 noninsurance operations, meanwhile, are
exposed to the cyclicality of the economy, with results typically
suffering during economic slowdowns and recessions.
Berkshire also depends heavily upon two key employees, Buffett and
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
last year of David Sokol, who many had assumed would be Berkshire's next
CEO, has raised serious questions as well about the firm's internal
controls and, to some extent, tarnished its 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. Buffett is Berkshire's largest shareholder, with a 34% voting
stake and 22% economic interest in the firm. He has been a strong
steward of investor capital, consistently aligning his own interests
with those of shareholders, and Berkshire's economic moat is derived
primarily from the success that he has had in melding the firm's
financial strength and underwriting ability with his own investment
acumen. Buffett's stewardship allowed Berkshire to increase its book
value per share at a compound annual rate of 19.8% from 1965 to 2011,
compared with a 9.2% total return for the S&P 500 Index.
This makes it even more important that Buffett's legacy remains
intact once he no longer runs the firm. Succession was not formally
addressed by Berkshire until 2005, when the firm noted that Buffett's
three main jobs--chairman, chief executive, and chief investment
officer--would probably be handled by one chairman (expected to be his
son, Howard Buffett), one CEO (with one candidate already identified but
not revealed), and three or more external hires (reporting to directly
to the CEO) to manage the investment portfolio. 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. As such, the real long-term question for investors is
whether or not the individual that succeeds him 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
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 a collection
of finance, manufacturing, and retailing operations, along with
railroads, utilities, and energy distributors.
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