WARREN BUFFETT HAS TAKEN ADVANTAGE of the past year's financial turmoil to make more than $20 billion of promising investments for Berkshire Hathaway, including preferred stock and warrants issued by Goldman Sachs and General Electric , and a convertible issue from Swiss Re, the European reinsurer.
Buffett's investment coups haven't registered on Wall Street, where Berkshire's class A shares (BRK.A) are languishing at around $85,000. Down 12% this year, and way below their late 2007 peak of $149,000, the shares haven't participated much in the stock market's rally since the end of March.
Yet Berkshire itself looks appealing, at just 1.2 times our estimate of its current book value of $72,000 a share. In the past decade, the stock has traded for an average of 1.6 to 1.7 times book value, a measure of shareholder equity per share. The current price-to-book ratio is near the low reached in early 2000, when Berkshire's stock bottomed at about $40,000.
One fan tells Barron's that the stock could top $110,000 in the next year. If so, it would trade for roughly 1.4 times our estimate of book value in 12 months: $80,000 a share. That price target doesn't seem outlandish in view of the projected price-to-book-value ratio. In a better economic and financial environment, Berkshire might even trade up to $125,000 a share, implying a multiple of book value closer to the 10-year average.
Berkshire's class B shares (BRK.B), worth 1/30th of the A shares, fetch about $2,750 each. The B shares look like a better buy than the A shares, because they sell at a 3% discount to their theoretical value. But the discount has persisted for some time, and could continue, as the B shares can't be converted into A shares.
Berkshire's book value, which stood at $66,250 per share as of March 31, likely has risen since then because of the market's powerful rally. That has lifted the value of the company's famed equity portfolio, which now totals more than $50 billion. The market value of Berkshire's equity and bond derivatives also has increased, and we assume the company earned more than $1,000 a share from operations in the second quarter, in line with reported first-quarter figures. That's how we arrive at an estimated book value of $72,000 a share.
Following Buffett's advice, most Berkshire watchers focus on book value as a measure of the company's valuation, as reported earnings can be distorted by realized investment gains and losses. Historically, Berkshire's shares have tracked changes in book value.
The sluggish performance of Berkshire's shares may owe to several factors. Investors recently have favored economically sensitive and other "offensive" stocks; Berkshire is perceived to be defensive due to its financial strength, including a cash position of $23 billion on March 31.
Also, investors remain concerned about Buffett's miscalculated sale of long-term put options on $35 billion of equity indexes, including the Standard & Poor's 500, when stock prices were much higher. The puts showed a loss of about $5 billion on March 31, and it is difficult to value them based on Berkshire's limited disclosure. Berkshire has taken a big hit, as well, on some of its own equity holdings, including large stakes in ConocoPhillips (COP) and American Express (AXP). Both stocks have fallen more than 50% from their highs.
IT ALSO DOESN'T HELP THAT SHARES of property-and-casualty insurers are out of favor amid concerns about weak insurance pricing. Berkshire owns Geico, the No. 3 domestic auto insurer, as well as reinsurer General Re and a specialized reinsurance business focused on hurricanes, earthquakes and other high-risk events shunned by many insurers. Some investors worry, too, that Berkshire's large size -- the company now has a market value of $132 billion -- makes it tough for Buffett to generate high returns. Then there is his age: The Great One turns 79 next month.
None of these issues, save Buffett's age, is significant. Buffett sounded upbeat at Berkshire's annual meeting in May, saying he thought Berkshire stock could best the S&P 500 in the coming years. He noted that the stock hadn't kept pace with the growth in retained earnings in recent years. Asked whether Berkshire's competitive advantage would die with him, Buffett replied that Berkshire's strengths, including a unique business mix and culture, long-term orientation and patient shareholder base, will outlive him.
Vice chairman Charlie Munger, 85, was more blunt about the difference between Berkshire's view and the short-term focus of much of Corporate America: "The stupidity of other companies' approach will likely give us a long-term advantage," he said, according to a meeting attendee. Buffett declined to comment for this story.
Barron's has written about Berkshire often in recent years, including a bearish cover story in late 2007, when the stock was near its peak. Last year, we were more bullish on the shares, and have speculated in other stories that Buffett's likely successor as CEO will be David Sokol, chairman of Mid- American Energy, Berkshire's big utility.
EVEN IF THE MARKET TANKS again this year, the downside in Berkshire stock seems limited due to its low price/book ratio and the company's earnings power. Despite its cyclical businesses, Berkshire's after-tax profits from operations could top $7 billion, or $4,500 a share, this year. Peak profits could approach $7,000 a share. And behind Berkshire's rising earnings are the shrewd investments Buffett has made in recent quarters (see table). The company bought $5 billion worth of 10% Goldman Sachs (GS) preferred stock; $3 billion of GE (GE) 10% preferred; and $2.75 billion of Swiss Re (RUKN.Switzerland) 12% convertible preferred. All likely have risen in value.
Berkshire's ability to nab these deals highlights the company's deep pockets, Buffett's willingness to make quick decisions, and the desire of many other companies to get Berkshire's money, with its implied vote of confidence from the world's greatest investor. These new investments will throw off more than $2 billion of annual income, much of it tax-advantaged.
The Goldman and GE preferred issues carry above-market yields, and came with stock warrants. The warrants to buy 43 million Goldman shares carry an exercise price of $115 and a maturity date of 2013. With Goldman shares above $140, the warrants are worth more than $1 billion. Given Goldman's improved balance sheet and profits since last fall, the firm might redeem the $5 billion of preferred this year by paying Berkshire a 10% premium. If that happens, look for Berkshire to exercise its warrants and become Goldman's single largest holder.
Berkshire would benefit from a stronger stock market and economy because of its large equity portfolio, derivatives holdings, and wholly owned businesses, including carpet maker Shaw Industries, paint producer Benjamin Moore, Acme Brick, Clayton Homes, and private-jet operator NetJets. Their depressed profits are likely to recover as business conditions improve.
Berkshire's large insurance operations are doing well, even in a weak economy. Geico picked up more than 500,000 new auto-policy holders in the first four months of 2009, 75% of its '08 total, as cost-conscious consumers gravitated toward the company, whose ads trumpet potential insurance savings of 15% or more for many drivers.
Berkshire's largest unit, MidAmerican Energy, owns electric utilities in the U.S. and Britain, and two big U.S. natural-gas pipelines. Both Geico and MidAmerican probably are worth at least $15 billion, although valuing them is academic, given Buffett's aversion to selling any businesses.
Some think Berkshire's best days are over and there isn't much money to be made in the stock, which was just $20 when Buffett took control in 1965. Yet the company looks stronger than ever, due to its promising portfolio and some top-flight businesses. Investors could now buy that package for a low premium to book value and get the talents of Buffett, who continues to demonstrate his incomparable investment skills.
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