Berkshire: An Exceptional Company with an Attractive Valuation
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It´s no secret at all that Warren Buffett is one of the greatest investors of all times, and the fact that Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) has delivered outstanding returns through several decades is widely understood by investors all over the planet. However, there is still a lot to learn by digging deep into the company, and investors should not dismiss the possibility of investing in Berkshire at current, historically cheap, levels.
The Biggest of the Investing Giants
A recently published paper by Andrea Frazzini and David Kabiller finds some fascinating conclusions about Berkshire´s performance over the last three decades, especially when measured in comparison to other stocks or funds.
According to the authors:
A dollar invested in Berkshire Hathaway in November 1976 would have been worth more than $1500 at the end of 2011. Over this time, Berkshire realized an average annual return of 19.0% in excess of the T-Bill rate, significantly outperforming the general stock market’s average excess return of 6.1%.
Not only in comparison to market indexes has Berkshire been really fabulous, in terms of Sharpe ratio – a measure of returns adjusted by volatility – Berkshire comes ahead of each and every stock and mutual fund with more than 30 years in existence.
Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Berkshire has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years.
How He Does It
Buffett has not achieved this performance by investing in high risk companies; quite on the contrary, Berkshire´s portfolio is comprised mostly of big and stable businesses with rock solid competitive advantages.
Berkshire’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks.
The article estimates that Berkshire´s leverage ratio is in the 1.6 to 1 zone, but Buffett´s secret source when it comes to leverage consists on paying an almost ridiculously low cost on those funds. The estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate, according to the authors.
Buffett has been quite explicit on the utmost importance of low financing cost for Berkshire coming from its insurance operations. The Oracle states in his 2004 letter to shareholders:
The source of our insurance funds is “float,” which is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled.
Float is wonderful – if it doesn’t come at a high price. Its cost is determined by underwriting results, meaning how the expenses and losses we will ultimately pay compare with the premiums we have received. When an underwriting profit is achieved – as has been the case at Berkshire in about half of the 38 years we have been in the insurance business – float is better than free. In such years, we are actually paid for holding other people’s money.
Basically, Buffett capitalizes his access to ultra-low costs of capital to leverage his assets and put that money to work in reliable, high quality, companies. The strategy sounds quite simple, but the returns have been astronomical in comparison to other alternatives.
Berkshire is Cheap and Growing
One point worth noting is that Berkshire is currently trading at historically low valuations. The Price to Book Value ratio of the company is barely above 1.1, levels at which Buffett has expressed his belief that the stock is cheap enough to merit a share buyback plan. From this perspective, downside risk should be contained by the possibility of a buyback, and upside potential is quite high from a valuation point of view.
And the company is still fine tuning its portfolio for higher growth ahead. Positions like Kraft and Johnson and Johnson have been sold lately, while Berkshire has taken a big position of nearly 18% of its portfolio in IBM. Traditional holdings in conservative sectors like food and healthcare are being sold to fund new positions in businesses like technology consulting.
The fact that Buffett is venturing into new sectors bodes well for Berkshire investors over the following years. IBM has achieved a compounded annual growth rate in earnings per share of more than 16% over the last five years, while Kraft has delivered a much lower 3% and Johnson and Johnson shows negative growth figures for the same period.
Buffett has been expanding his “circle of competence” into new business area lately, and this brings new possibilities for higher growth ahead.
Berkshire is a truly exceptional company, and its long term performance is a clear expression about that. The stock is cheap from a historical perspective, and Buffett is still making some important investment decisions which could have positive effects for its shareholders for many years into the future.
There are some risks ahead, of course, and the Buffet succession is perhaps the biggest concern investors in Berkshire have right now. On the other hand, at current valuation levels, the stock price seems to be reflecting those uncertainties, so it may be a good time to consider adding some Berkshire to your portfolio.
acardenal owns shares of IBM. The Motley Fool owns shares of Berkshire Hathaway and International Business Machines. Motley Fool newsletter services recommend Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.