Warren Buffett and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) have been getting significant flak of late for not deploying Berkshire’s huge cash pile significantly during March’s market slide and its immediate aftermath, and for selling out of airline stocks. Meanwhile, millions of new, mostly millennial users have signed up for Robinhood accounts (average user age 31) this year, with a good number of users trading stocks for their first time amidst the market roaring back from the March depths. Many of these new Robinhood traders have engaged in short-term trading, which in May and June helped fuel rallies in some of the most beaten-down areas of the market, as well as many penny stocks and companies under bankruptcy. Additionally, the popular acronym FANG/FAANGM stocks as well as “cult following” tech story stocks now trade at new highs. Proclamations by naysayers in the media have been abound especially frequently claiming the Oracle of Omaha is losing his touch.
And yet, for all the day and night contrast between the investment approach of Warren Buffett and the short-term trading by some of the newbie traders, there is to be an intersection between the two. Enthusiasm and intellectual curiosity amongst many of these new stock traders for stock investing is driving or will drive them to seek out greater investment knowledge, and many will ultimately build more long-term-oriented, broader sector portfolios. Some will find Warren Buffett’s investment philosophy. For the recent Robinhood users and similar transitioning from short-term trader to fundamental investor, a summary of Berkshire Hathaway, the investment philosophies of Warren Buffett that has culminated in Berkshire Hathaway today and therein the case for investing in Berkshire Hathaway now as a part of a longer-term portfolio, are in order.
Why invest in Berkshire now? A high-quality product at a nice discount
Bargain-hunting millennials (myself included) love a good discount for a high-quality product. And Berkshire Hathaway at its current level provides a very nice one. Berkshire trades at one of the lowest valuations in recent years by measure of Price to Book ratio presently, at 1.17x (on its net assets as at 31 March 2020). This compares with the five-year average of 1.37, or a 14.6% discount. This discount widens when one considers that the value of the equity portfolio Berkshire holds has risen with the market rebound since the time of the last valuation, with the forward Price to Book of Berkshire being at about 1.10x, or a 19.7% discount to the five-year average. This for a company which has consistently grown its book value per share steadily over the years.
Last 10 financial years’ book value per share
Source: Seeking Alpha
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Let’s move to what is the high-quality product we would be getting.
What is Berkshire Hathaway?
Put simply, Berkshire Hathaway’s earnings come from 1) its operating businesses, and 2) its investments in equity securities which had a fair value of $180.782 billion as at 31 March 2020 (now higher with the market rally since). Berkshire also has a cash and short-term investments pile of about $137 billion as at 31 March 2020.
Berkshire’s Operating Businesses
Berkshire’s operating companies are listed out below (additionally there is also the recently announced Dominion Energy (NYSE:D) acquisition in progress). All together, these operating businesses below generated $23.972 billion in net earnings in financial year 2019 and $5.871 billion in the first quarter of 2020. (Assuming an illustrative 18x multiple of FY 2019 earnings of the operating businesses alone, this would almost equal Berkshire’s current market cap, without taking into account its investments in equity securities and cash).
As we can see, Berkshire’s operating businesses comprise a cross-section of industries, sans technology. The largest part of its operating business is in insurance (GEICO, Berkshire Hathaway Primary Group, Berkshire Hathaway Reinsurance Group), which Buffett has described as “being the engine that has propelled our expansion since 1967.” Insurance companies make money from potentially two ways, the first being from the “float”, or the insurance premiums collected but not yet paid out in future claims. This float or pool of funds is invested by the insurer to earn a return for themselves, and in the case of Berkshire’s insurance businesses, has been used throughout its history to purchase other operating businesses and invest in equities. The size of Berkshire’s float has grown massively over its history, as shown below, demonstrating how it has indeed propelled its growth since its beginnings.
Source: Berkshire Hathaway 2019 Annual Report
The second way that insurance companies potentially make money, albeit not all the time, is from the underwriting insurance profit. However, it is common that many insurers regularly incur an “underwriting loss”, resulting from the insurance payouts being more than the premiums. Berkshire, however, has recorded an underwriting profit in 16 of the last 17 years through to financial year 2019, and made a total pre-tax gain of $27.5 billion over the 17-year span per annual report. Clearly, Berkshire’s insurance management is amongst the best in the industry. As described in Berkshire’s annual report, “disciplined risk evaluation is the daily focus of our insurance managers, who know that the rewards of float can be drowned by poor underwriting results. All insurers give that message lip service. At Berkshire it is a religion, Old Testament style.”
Berkshire’s other operating businesses are grouped under Burlington Northern Santa Fe (railroads), Berkshire Hathaway Energy, Manufacturing, Service and Retailing and McLane Company. In brief summary:
Burlington Northern Santa Fe
Burlington Northern Santa Fe operates the largest freight railroad network in North America.
Berkshire Hathaway Energy
Berkshire Hathaway Energy is a 90.9% Berkshire-held holding company that owns 10 companies in renewable energy and electricity, operating across different renewable energy sources and across the energy value chain, as well as a real estate brokerage business.
Manufacturing, Service and Retailing
Manufacturing, Service and Retailing comprises diverse business operations. The Manufacturing group includes a variety of industrial, building and consumer products businesses, amongst which includes The Lubrizol Corporation, Precision Castparts Corp, Fruit of the Loom, Duracell. The service business group includes NetJets (fractional aircraft ownership), FlightSafety (training products and services to aircraft operators), Dairy Queen, Business Wire, Buffalo News and BH Media (newspaper ad publications), amongst others. Retailing includes Berkshire Hathaway Automotive (auto dealerships), See’s Candies, home furnishing businesses (Nebraska Furniture Mart, RC Willey, Star Furniture, Jordan’s), jewellery (Borsheims, Helzberg, Ben Bridge).
McLane operates grocery and non-food consumer product wholesale distribution to retailers, convenience stores and restaurants.
The contribution of each operating business segment in the recent quarter is shown below:
Source: Berkshire Hathaway quarterly report
Investments in Equity Securities
Berkshire has a portfolio of investments in equity securities. As at 31 March 2020, these had a fair value of $180.782 billion, segmented into 1) banks, insurance and finance, 2) consumer products, and 3) commercial, industrial and other. The portfolio has a concentration in a handful of holdings, with 69% contributed by Apple (NASDAQ:AAPL), Bank of America Corp. (NYSE:BAC), Coca-Cola (NYSE:KO), American Express (NYSE:AXP) and Wells Fargo (NYSE:WFC). Given that the fair value was as at 31 March, the value of the securities portfolio has risen significantly since with the market rally.
Source: Berkshire Hathaway quarterly report
Circle of Competence and Berkshire
The contribution from specific sectors amongst the operating companies is illustrative of Warren Buffett’s rule of investing in one’s circle of competence. That is, to invest in areas in which one has the greatest familiarity and avoid areas where one doesn’t.
Charlie Munger describes it “You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence. The size of that circle is not very important; however, knowing its boundaries is vital.”
Therein, Berkshire in its operating businesses offers very well-managed exposure to a cross-section of specific major industries, and whilst it has some tech exposure in its equity portfolio, it is overall underweight tech compared to the S&P 500. This does not preclude a new investor from additionally investing in their own circle of competence, such as into their tech picks alongside Berkshire in a broader-based portfolio.
The Investment Philosophy of Warren Buffett and the misnomer of Berkshire being strictly traditional value
There is a misnomer of Warren Buffett and Berkshire’s investment style as being traditional or classic value focused; that is to buy undervalued stocks with low Price/Earnings or low Price/Book valuation ratios but being non-growth businesses, or cheaply valued but underperforming businesses. This quarter-truth misnomer has been especially frequent with the underperformance of Berkshire vs. the S&P 500. Example: CNBC article describes “a lot of that (Berkshire’s underperformance) is due to stock investors’ continued preference for hot growth stocks, which the classic value investor like Buffett has largely avoided“, or this Financial Times’ article that is one of many publications questioning if Mr. Buffett has lost his touch. In a market where story stocks captivate investors’ imaginations and valuation multiples, a repeated misnomer narrative of bucketing Berkshire as being traditional value and being out of sync with the market cycle is likely contributing to its current low valuation multiple, but has created an attractive opportunity to buy in at these current levels.
Berkshire today is not the result of a purely traditional or classic value investment philosophy being practiced by Warren Buffett. Rather, it is a culmination of Mr. Buffett’s mastery of both “growth without paying too much” investing and traditional value investing, from the pioneers of their respective styles, Philip Fisher and Benjamin Graham. Intertwining with both styles is the “broad value” concept of buying significantly below the intrinsic value – “all investment is value investment in the sense that you’re always trying to get better prospects that you’re paying for” as Charlie Munger says.
As an analogy, I would liken Warren Buffett to being the pioneering Mixed Martial Arts, MMA, fighter of the investment world. In the earlier part of Warren’s career, his traditional value investing style of buying undervalued stocks (buying businesses worth a constant $1 for 50 cents, where time is the enemy to returns as the longer it takes to realise $1, the lower the time-adjusted return), swept away the competition in performance (think of BJJ’s dominance in the early style vs. style years of UFC). However, Warren evolved in the 1960s through his friendship and partnering with Charlie Munger, a master of Phil Fisher’s growth style, and this style inclusion better suited Buffett’s now larger investment size, diminishing Ben Graham style value opportunities and the market cycle. Concisely, Fisher’s style advocated finding a concentrated number of quality growth companies and holding them for potentially decades for the very long-term compounding benefits.
High Price Earnings valuation multiples on a stock alone were not a deterrent to buy into growth companies as other considerations had to be factored – as Fisher put it “the further into the future profits will continue to grow, the higher the price-earnings ratio an investor can afford to pay.” Therein, what we find across Berkshire’s investments and acquisitions made in its history is a mix of quality growth investing (e.g. Apple, BYD (OTCPK:BYDDF), Coca-Cola, and See’s Candies to name a few), modern value investing (e.g. buying financials, GE (NYSE:GE) during the financial crisis, etc.) and distressed investing (e.g. Fruit of the Loom). Some of the decades-held holdings are of course now in their matured but high cash flow generative stage, but they had enjoyed many years of high growth following Berkshire’s purchase; as Phil Fisher espoused, great businesses can be held for potentially for decades. Like a champion MMA fighter, Warren waits for the opportunity for his multi-style mastery – the perfect submission or roundhouse to score his win (or as Mr. Buffett describes, waiting for the fat pitch), and avoids being vulnerable to a big hit from his opponent (the market) by sticking to his circle of competence.
Some argue that Berkshire will continue to miss out on tech growth opportunities. This neglects that Berkshire’s largest unrealised gain in an equity investment by quantum in its history (about $55 billion currently) comes from Apple, which was first initiated in 2016 and in which Warren increased significantly subsequently. Whilst Berkshire did not invest in many of today’s other tech giants – Warren and Charlie have readily admitted that they missed investing in Google (NASDAQ:GOOG) (NASDAQ:GOOGL) in its earlier stages – there is no reason to think that Berkshire will not continue to identify and allocate in quality tech growth. Berkshire’s two investment managers, Todd Combs and Ted Weschler, have a broader circle of competence in tech in their Fisher-Graham style. Berkshire’s initial investment in Apple, its investment in Amazon (NASDAQ:AMZN) in 2018 (a favourite of short-sellers at the time many of which have value style tilts), and its investment in Brazilian digital payments company StoneCo (NASDAQ:STNE), are attributable to Todd and Ted. Charlie Munger is of course the original proponent of Fisher style growth investing and responsible for its investment in China electric automaker BYD, which has been a multi-bagger return for Berkshire.
Berkshire in a portfolio with your other selections and the more appropriate benchmark to measure Berkshire against
There is also much written about Berkshire’s underperformance over the past 5 and 10 years compared to the S&P 500. However, due to Warren’s circle of competence discipline, Berkshire has significantly lower exposure to pure technology companies compared to the S&P 500. The S&P 500, with its component weightage by market cap, has seen a sizeable proportion of its five-year gains driven by the outsized contribution from the tech sector and four FANG/six FAANGM stocks. Therein, we should consider whether the S&P 500 is actually the best benchmark for comparison, given that one is selecting Berkshire as but one of the holdings for a broader based portfolio. Looking at the five-year performance, the S&P 500 is up 53.70% over the period compared to Berkshire’s 33.48% rise. However, when we take Invesco’s S&P 500 Equal Weight ETF (NYSEARCA:RSP) as the comparison, which tracks all the S&P 500 components but each being equally weighted in position size (thus lowering the outsized contribution from a concentration of tech giants), we see that Berkshire’s 33.48% rise has outperformed the S&P 500 equal weight’s 29.33%. Again, the previous point repeats that the new investor can buy Berkshire together with their favorite tech or other picks for their broader-based portfolio.
Berkshire Hathaway five-year chart
Invesco S&P 500 Equal Weight ETF five-year chart
S&P 500 five-year chart
In conclusion, think of investing in Berkshire Hathaway now in a sports bet context with the odds in your favour
To conclude, think of investing in Berkshire Hathaway at this current level as making a sports bet where in time:
- If one is right, they will win a better than benchmark return as the payout.
- If one is wrong on Berkshire, the overwhelming odds are that they will receive back their full wager or full wager and a below expectation return as the payout.
Therein, making a bet where the overwhelming odds are in your favour looks like a pretty attractive bet to make to me. Hopefully, all the other bets in your portfolio of sports bets also have the odds strongly in your favour.
Disclosure: I am/we are long BRK.B. 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.
Additional disclosure: This article is for informational purposes only and is not investment or financial advice.