Friday, September 2, 2011

Answering a comment on Berkshire

I received this comment on my Berkshire post.

Hey Kevin, good post.

Do these positions account for the insurance float that is used in the investment portfolio, since the money is not really ours then? Also, the stock portfolio and the businesses that you refer to are all on the asset side of the equation, but we still have to subtract the liabilities right?



 I thought I would make the response into a post as it is much too long of a response for a comment. 

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Hi Anonymous,

You are correct.  As for the float, here is what Warren Buffett said in the 2010 shareholder's letter. 

Insurance float – money we temporarily hold in our insurance operations that does not belong to us – funds $66 billion of our investments. This float is “free” as long as insurance underwriting breaks even, meaning that the premiums we receive equal the losses and expenses we incur. Of course, underwriting results are volatile, swinging erratically between profits and losses. Over our entire history, though, we’ve been significantly profitable, and I also expect us to average breakeven results or better in the future. If we do that, all of our investments – those funded both by float and by retained earnings – can be viewed as an element of value for Berkshire shareholders.

I fully agree that a full accounting of assets and liabilities needs to be done and I believe that the net difference makes the stock very attractive.  Berkshire owns also $35 billion of debt securities that I have added either.  I will leave the reader to do his or her own accounting, as I don’t want to do someone else’s homework.

Secondly, although the float is a liability it is not a $66 billion liability.  How can this be?  To answer that question, ask yourself the following.  What is the value of a $66 billion loan at 0% interest (and sometimes negative interest) for an indefinite term?  

Thirdly, the liability side also includes some significant deferred tax liabilities.  These aren’t really liabilities.  Berkshire has $13.4 billion in deferred taxes from capital gains in Coca-Cola, American Express and others.  So if Coca-Cola stock is never going to be sold the tax liability is really zero.  As of the end of the year the total deferred tax liability was $35 billion, although I wouldn’t use all of that. 

An Alternate Way of Valuing Berkshire (Quick and Dirty)

If you read on p.3 of the 2010 letter to shareholders Buffett openly declares the earnings power of Berkshire to be $17 billion pre-tax and $12 billion after-tax in a “normal” operating year. 

If you skip down to page 17, under investments, Buffett says that the undistributed earnings of the companies they own is currently $2 billion.  This would be about $3 billion pre-tax.  So the total earnings power of the company and investments is about $20 billion pre-tax and 14 billion after-tax. 

So if you apply a 12 times pre-tax and 18 times after-tax multiple to the "normal" earnings power, the value of Berkshire is somewhere between $240-250 billion.  Currently the company’s market cap is $173.5 billion, giving a 28-31% discount.

Conclusion

Why I really like Berkshire, besides the obvious discount, is that the company is very conservatively run and the assets are top quality.  Moreover, the exposure Berkshire give you to a number of very large cap stocks is compelling because I believe a number of them to be significantly undervalue.  The market for these large caps has gone sideways for the past decade while the earnings (per share) have doubled, tripled or quadrupled.  I expect Wells Fargo to double over the next couple years so that alone will add $10 billion to Berkshire.

Thanks for the comment.


Best Regards,

Kevin


Disclosure – Long BRK.b

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