Over this weekend, many investors will focus their attention on Warren Buffett's letter to shareholders. As always, this letter offers information specific to Berkshire Hathaway (BRK.B) as well as general investing advice. While this information is useful for all, Berkshire Hathaway shareholders should focus more on the financial data the company just released for the fourth quarter and all of 2013, which together suggest that Berkshire continues to be modestly undervalued, though risks persist. In this article, per share data relates to Class B shares (as these are far more widely owned), but this analysis also fully applies to Class A shares (BRK.A). Investors can multiply Class B data by 1,500 to get equivalent Class A figures (all financial data and the shareholder letter can be found in the 10-K).
Berkshire Hathaway is a large company that does many things. To value the company, it is best to look at individual parts. We can then value the operating units and add the net value of investments on to generate the fair value of the whole firm. Importantly, the operating companies continue to perform well. Operating income (excludes mark to market accounting of long term derivatives and other volatile items) in the quarter totaled $3.78 billion, which was up 34% year over year. Operating earnings per share were a solid $1.53. For the full year, operating earnings totaled $15.1 billion, which was up 20% year over year. Last year, there was Hurricane Sandy, which hurt insurance results and led to an easier comparison.
In 2013, Berkshire's insurance and other unit earned $17.3 billion in pre-tax income. This compares to $12 billion in 2012 and $10.1 billion in 2011. While the lack of catastrophes boosted income, the reinsurance sector has been growing increasingly competitive, which is negative for margins. Still, pre-tax margins were a superb 12.3% compared to 9.8% in 2012 and 9.1% in 2011. An investor can never know when a catastrophe is coming, and in years without one, results look unsustainably strong. Now, Berkshire has been adding scale and improving margins for years, but the 12.3% figure is amazingly strong.
For valuation purposes, I apply a catastrophe normalization, which cuts margins in good years but boosts them in bad years to smooth out year to year volatility. While insurance premiums earned increased by $2.1 billion in the year, insurance losses only increased by $1.1 billion. In a more normal year, that figure would be closer to $1.8 billion. In 2013, I cut margins to a still strong 11% or $15.4 billion.
Burlington Northern continues to perform well thanks to increased oil volume. Revenue jumped 6.5% to $34.76 billion, and pre-tax income was $7.7 billion compared to $7 billion last year. In total, Berkshire's operating companies earned a normalized $23.1 billion. Using the firm's effective tax rate of 31%, operating profits totaled $15.9 billion last year. That suggests Berkshire's operating unit is worth roughly $97 per share. With continued bolt-on acquisitions and organic growth opportunities, this value should continue to grow alongside earnings growth in the coming years.
Next, we have the investment portfolio. The company carries $42.6 billion in cash. At all times, Buffett aims to carry $25 billion in cash to maintain the liquidity needs of the insurance unit in case of a major catastrophe. This $25 billion is essentially part of the insurance unit and not available for shareholders, so there is a net cash value of $17.6 billion. Berkshire also boasts a $117 billion equity portfolio, $28.8 billion fixed income portfolio, and $12.3 billion in other investments. Now, if Berkshire were to sell its entire equity portfolio, it would incur significant tax liabilities.
Its equity portfolio has unrealized gains of $58.2 billion. Given this gain, investors must factor some tax liability. At 25%, taxes would total $14.5 billion. However, these taxes are not due until securities are sold. If we defer these taxes out over a decade, a fair present value would be about $10 billion. Berkshire's insurance unit carries $13 billion in notes payable and a float of $65 billion. This float is insurance claims it expects to pay in the future. When you buy insurance, you pay premiums upfront but don't receive benefits until there is a claim. During this time, Berkshire essentially borrows from you for free and invests the money. At some point, this float will be paid back. In total, these liabilities total $92.5 billion.
This would yield a fair investment value of around $33 per share for a total value of $130. It should be noted, Berkshire's railroad, utilities, and energy unit carries $46.7 billion in debt. A more conservative investor could use some of this debt to cancel out the investment value of the firm. Personally, I adjust for half of operating debt, which pushes fair value closer to $120. High debt load though is a norm in this business and is partially reflected in the operating value of $97 per share.
While Berkshire has performed well in 2013 and is valued at a discount to its parts, I am concerned Warren Buffett has lost his touch given the composition of the investment portfolio. For the first time in history, Berkshire's book value underperformed the S&P 500 over 5 years with book value growing 80% compared to the 128% rally in the S&P. In his letter, Buffett suggested looking over a six year cycle to factor in the 2008 crash. However, Buffett has consistently used a 5 year benchmark (as noted in the article linked above), and asking to move the goal posts is decidedly un-Buffett like. Within its portfolio, Berkshire's largest investment is in Wells Fargo (WFC) and totals $22 billion. It has $16.5 billion in Coca-Cola (KO), $13.7 billion in American Express (AXP), $12.8 billion in IBM (IBM), and $4.2 billion in Exxon Mobil (XOM).
Investors should recognize that when they buy Berkshire, they are buying a piece of each of these stakes. While I am a fan of WFC, AXP is extremely expensive while KO, IBM, and XOM have no growth. Soda consumption is declining, which is a negative for Coca-Cola. IBM revenue is lower than it was in 2008 as it struggles to compete with the cloud and new IT firms. Exxon hasn't grown production in years despite spending over $30 billion in cap-ex annually. Frankly, I do not see the rationale of having billions in shareholder money in these three firms which are in decline. In addition to lagging the S&P 500 over the past five years, Buffett noted in his annual letter (accessible via the 10-K linked to above) that he lagged the new portfolio managers he has hired. While his record over 50 years is unmatched, his record over the past 5 and 10 years is far less impressive, and recent purchases like IBM and XOM seem to me to be mistakes. Investors should ask whether Buffett can deliver the returns he has in the past or if his best investing days are behind him.
With a weaker portfolio, future results will be far less robust than in past years. While I expect operating results to continue to impress, I expect future investment growth to lag the market. Given these factors, I do not expect shares to trade past $120 and would rather own the S&P 500 going forward. By purchasing so many firms in various industries, Berkshire Hathaway is starting to resemble a mini-index. Combine this with a portfolio that holds increasingly low-growth or overvalued stocks, and Berkshire appears poised to underperform over the next 24 months.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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