Why I own Berkshire Hathaway shares (Part II)

Why I own Berkshire Hathaway shares (Part II)

Previously, I shared about my thesis for investing in Berkshire Hathaway, focusing on Berkshire's team and its balance sheet. As a continuation of my overall thesis, this article will focus on Berkshire's revenue streams, ability to grow, the firm's market valuations as well as investment risks involved. 

4. REVENUE STREAMS THAT ARE RECURRING IN NATURE, EITHER THROUGH CONTRACTS OR CUSTOMER-BEHAVIOUR

There are two main components to Berkshire's operating businesses: Insurance, and non-insurance companies.

The insurance part consists primarily of GEICO, Berkshire Hathaway Reinsurance Group, and Berkshire Hathaway Primary Group. Insurance is a service that organisations and individuals require on an ongoing basis, so there's high levels of recurring activity there. GEICO, in particular, focuses on auto insurance, and that's something drivers need every year.

For the non-insurance portion, two big entities are Burlington Northern Santa Fe (BNSF) and Berkshire Hathaway Energy. The former runs railroads in North America and the latter is an energy utility.

Physical products will regularly need to be transported across the continent while energy (such as natural gas and electricity) is something that organisations and individuals require daily.

5. A PROVEN ABILITY TO GROW

Buffett is quite possibly the best capital allocator the world has seen to-date. The table below is taken from Berkshire's 2018 annual report, and it shows the incredible 18.7 per cent annual growth in the company's book value per share since 1965, the year Buffett assumed control. 'Nuff said.

In my explanation of this criterion, I mentioned that I'm looking for "big jumps in revenue, net profit, and free cash flow over time." So why the focus on Berkshire's book value per share? That's because Berkshire's main assets for many decades were public-listed stocks.

Although, it's worth pointing out that the company's book value per share is increasingly losing its relevance as a measure of the company's intrinsic economic worth  - Berkshire's main value now resides in its subsidiaries.

It must also be said that Berkshire's no slouch when it comes to free cash flow. The table below shows the record of the conglomerate's annual growth in free cash flow of 11 per cent going back to 2007.

I picked 2007 as the starting point to show that Berkshire was still gushing out cash even during the Great Financial Crisis of 2008-2009.

6. A HIGH LIKELIHOOD OF GENERATING A STRONG AND GROWING STREAM OF FREE CASH FLOW IN THE FUTURE

[[nid:192309]]

Berkshire has excelled in producing free cash flow from its businesses for a long time and has The American Tailwind on its back. So, I don't see any reason to believe that Berkshire's ability to generate cash from its businesses will change any time soon.

VALUATION

In Berkshire's 2018 shareholders' letter, Buffett wrote:

"I believe Berkshire's intrinsic value can be approximated by summing the values of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities."

The four groves Buffett mentioned refers to Berkshire's 

  1. insurance operations, 
  2. non-insurance businesses, 
  3. ownership stakes in a quartet of companies - Kraft Heinz, Berkadia, Electric Transmission Texas, and Pilot Flying J - that it shares control with other parties, and 
  4. treasury bills, cash, and fixed-income investments

I like to keep things simple in the valuation process, so I'm going to use an even simpler but sound heuristic to value Berkshire: Its price-to-book (P/B) ratio.

Earlier, I mentioned that Berkshire's book value per share is losing relevance in being a proxy for the company's true economic worth, so there's a contradiction.

I believe the contradiction can be resolved by simply allowing Berkshire to be seen as a bargain even if its PB ratio is significantly higher than 1. Buffett's recent actions suggest this makes sense too.

For several years, Buffett had a standing order for Berkshire to repurchase shares if its P/B ratio fell below 1.2. But the order was amended by Buffett in July 2018: Now Berkshire can repurchase its shares at any time when he and Munger believe that the share price is "below Berkshire's intrinsic value."

[[nid:362157]]

Buffett publicly stated in his 2018 shareholders' letter that over time, Berkshire is likely "to be a significant repurchaser of its shares, transactions that will take place at prices above book value but below our estimate of intrinsic value."

From the third quarter of 2018 to the third quarter of 2019, Berkshire has spent a total of US$3.48 billion (S$4.72 billion) to repurchase 2,744 Class A shares and 12.04 million Class B shares. These buybacks have happened when the company's PB ratio was clearly higher than 1.2 and averaging around 1.4.

THE RISKS INVOLVED

Succession is the biggest risk I'm watching with Berkshire. Buffett and Munger are both getting on in years - I will be truly sad the day they are no longer around.

Berkshire has very capable senior leaders who are supporting Buffett and Munger, including Ajit Jain (head of all insurance operations), Greg Abel (head of all non-insurance operations), and the investing duo of Todd Combs and Ted Weschler.

All four are much younger too, with ages ranging from 46 to 67. Buffett has also tasked his son, Howard Buffett, to assume a non-executive chairman role in Berkshire when Buffett-senior eventually departs. The younger Buffett would be responsible for protecting and nurturing Berkshire's culture.

[[nid:177700]]

I am confident in Buffett and Munger's succession plan. But it remains to be seen whether Berkshire's dealmaking prowess, competitive advantages, and culture will diminish when the octogenarian and nonagenarian leave the scene.

A massive catastrophe is another key risk I'm watching. I mentioned earlier that Berkshire is able to brush off a US$400 billion industry-wide catastrophe event in the US. It will take a huge disaster to result in insured losses of US$400 billion.

For context, the sum is nearly four times the highest amount that the US has suffered since 1980, as I already mentioned. But there's no upper limit to Mother Nature's wrath, especially given the alarm bells that scientists have been ringing in recent years on climate change.

THE GOOD INVESTORS' CONCLUSION

Berkshire is not the fastest-growing company around, and its rapid-growth days are clearly over. But what it lacks in pace, it makes up for in stability.

The conglomerate excels against my investment framework by having:

  1. The American Tailwind behind its back;
  2. a diverse collection of excellent businesses;
  3. a robust balance sheet and finances;
  4. strong recurring revenues;
  5. a great track record of growth; and
  6. two brilliant leaders at its helm who have been there for decades - Warren Buffett and Charlie Munger - and who are as safe a pair of business-hands as anyone can find.

Every investment has risks, and so does Berkshire. Succession (because of the advanced age of Buffett and Munger) and major disasters (because a big part of Berkshire's business is in insurance) are two big risks for the conglomerate that I'm watching.

But on balance, I believe that Berkshire is one of the lowest risk stocks there are in the world for producing a long-term annual return in the low-teens range. 

This article was first published in The Good Investors. All content is displayed for general information purposes only and does not constitute professional financial advice.

This website is best viewed using the latest versions of web browsers.