Berkshire Hathaway's BRK.ABRK.B
fourth-quarter 13-F filing, which details the firm's equity holdings,
continued to show evidence of the primary theme we've believed would
drive portfolio movements over the near term. Ever since Berkshire
appointed Ted Weschler and Todd Combs as investment managers, the firm
has been fairly active about selling legacy positions as part of an
ongoing process to raise capital for the two managers to invest.
The biggest sale during the period involved 28.8 million shares of Kraft Foods Group KRFT,
which, by our estimates raised around $1.1 billion for the firm. At a
little more than $75 million at the end of last year, Kraft is now one
of the smallest holdings in Berkshire's equity portfolio, and we'd be
surprised if the shares remained there much longer. As for the other sales during the period, Berkshire sold off another 165,000 shares of Johnson & Johnson JNJ,
whittling its stake in the health-care firm down to less than $23
million at the end of the year. Much like with Kraft, we expect Johnson
& Johnson to continue to be a source of cash for the managers at
Berkshire. The only other sale during the fourth quarter involved Lee
Enterprise LEE, which is now the smallest holding in Berkshire's equity portfolio.
Looking at the purchases during the quarter, Warren Buffett committed another $585 million to Wells Fargo WFC, which is now Berkshire's largest holding (at 20% of the total equity portfolio). DaVita DVA, General Motors GM, and DIRECTV DTV
all saw more than $200 million in additional capital allocated to them
as well during the period, with DaVita and DIRECTV both firmly placed
as top 10 holdings at Berkshire at the end of the year. As for the other purchases during the quarter, the firm increased its stakes in IBM IBM, Wal-Mart WMT, Liberty Media LMCAV, Precision Castparts PCP, and National Oilwell Varco NOV,
but the buys were relatively small compared with Berkshire's holdings
in these stocks. While there was a more meaningful purchase of Wabco
Holdings WBC, and new money purchases of Archer Daniels Midland ADM and VeriSign VRSN, these transactions paled in comparison with the company's $12.2 billion investment in Heinz HNZ announced yesterday.
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 typically looked to acquire firms that have consistent
earnings power, 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. Given the current size
of the firm's 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
company 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 meaningful amount of the
firm's pre-tax earnings, but they also generate low-cost float (the
temporary cash holdings arising from premiums being collected well in
advance of future claims), which has been 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
super-catastrophe 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 non-insurance 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
non-insurance businesses in its portfolio, the two largest contributors
to Berkshire's pre-tax 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 the
firm's 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.
We've
increased our fair value estimate for Berkshire Hathaway's Class B
shares to $117 per share from $110 after updating our valuation model to
account for changes in our assumptions about the firm's revenue,
profitability, and cash flows since our last update. Our new fair value
estimate is equivalent to 1.6 times Berkshire's reported book value per
Class B share of $74 at the end of the third quarter of 2012 (and 1.5
times our estimate of the firm's book value at the end of 2012). During
the last decade, Berkshire's Class A shares have traded in a range of
1.1-1.6 times book value, with a median value of 1.4 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 $63 per Class B share, slightly higher than our previous
valuation owing to our belief that premium growth and underwriting
profits for the full year will come in better than we were originally
forecasting. We have not, however, altered our view on the firm's
investment income, which remains depressed because of the historically
low-yield environment (as well as the fact that several 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 non-insurance subsidiaries, we believe the
manufacturing, service, and retailing operations are worth $22 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 slow recovery in
the U.S. economy. We estimate that Berkshire's railroad, utilities, and
energy operations are worth $29 per Class B share, also higher than our
previous forecast, due to the strength we continue to see at BNSF, as
well as the ongoing operating improvements and long-term investments
being made at MidAmerican. Finally, we estimate that Berkshire's finance
and financial products division is worth $3 per Class B share, which is
not much different from our previous forecast.
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 much 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 non-insurance operations,
meanwhile, are exposed to the cyclicality of the economy, with results
typically suffering during economic slowdowns and recessions.
The
company is also heavily dependent 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, with the expectation being that investment returns and
capital-allocation quality will deteriorate under new management. The
2011 departure 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. While
Berkshire does not pay a dividend, the firm did initiate a
share-repurchase program during the third quarter of 2011 that allowed
management to buy back both Class A and Class B shares at prices no
higher than a 10% premium to the firm's most recently reported book
value per share. Berkshire altered the terms of the share-repurchase
program during the fourth quarter of 2012, with the board now
authorizing the firm to repurchase Class A and Class B shares at prices
no higher than a 20% premium to the firm's most recently reported book
value per share (which stood at $111,718 per Class A share, and $74 per
Class B share, at the end of the third quarter of 2012).
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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