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Berkshire Hathaway's Downside Protection

Daniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It took Warren Buffett four decades before he decided Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) was trading at a price that was worth repurchasing. But now Buffett is so eager to buy back his own company's stock that he has raised the requirement for repurchases from 110% of book value to 120% of book value. Even more important, he is following through; Yesterday Berkshire announced that the company had repurchased $1.2 billion of its own stock, up drastically from the $100 million spent on repurchases in September. Buffett has made up his mind: Berkshire Hathaway is undervalued when it falls below 120% of book value. Fortunately for Berkshire investors, this has created a solid source of downside protection.

Downside Protection = Greater Expected Return

Given Wall Street's resolute focus on price targets, it's easy to forget that downside protection is just as important as upside potential. Berkshire's average price target falls somewhere around $110 per share, leaving room for about 22% of upside. But successful buy and hold investors' don't profit by being right more often than they are wrong. Instead, the focus is on magnitude. Or in the words of Michael Mauboussin, Chief Investment Strategist at Legg Messon, "Focus not on the frequency of correctness but on the magnitude of correctness" (click to tweet this quote).

The concept of magnitude over frequency is often referred to as 'expected value.' Warren Buffett sums up the process:

"Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain. That is what we're trying to do. It's imperfect but that's what it's all about"

It's a simple concept. It might not always be necessary to calculate expected value mathematically but investors should at least keep the concept of expected value in mind and always remember to consider both upside potential and downside risk. To illustrate the concept of expected value, I'll use a mathematical example:

<img src="/media/images/user_13783/expected-value-calcuations_large.png" />

As you can see in the expected value calculations above, downside risk can have a very large effect on expected returns.

The above example is hypothetical, but investors face trade-offs like this all the time. Analysts have estimated considerable upside to Apple's stock at today's price around $515 per share. But due to the nature of the business it operates in, the downside risk is very real. If a competitor arises that can convince Apple customers to spend their money elsewhere, Apple could take a hit. Berkshire Hathaway, on the other hand, is not only diversified with wide-moat businesses, but now Buffett has announced intentions to buy back Berkshire stock if the it drops below 120% of book value. Furthermore, Buffett has put his money where his mouth is, to the tune of $1.2 billion dollars.

Double Checking

It was Buffett himself who coined the term "economic moat" and there is no doubt that many of Berkshire's subsidiaries and stock holdings fit the characteristics of "unbreachable castles." This diverse group of great businesses combined with Buffett's share repurchase program offer considerable downside protection. But I always like to double check my assumptions from other angles. So I'll take a close look at some of Berkshire's largest holdings to get a better idea of the value in Berkshire's stock.

Buffett's largest acquisition to date was Burlington Northern Santa Fe Railroad, a deal valued around $44 billion. Other large railroads, like Union Pacific (NYSE: UNP), are trading at 3 times book value, a significantly higher price-to-book ratio than the S&P 500 as a whole. In 2009, when Berkshire made the acquisition, it was quite another story; Railroads were trading below 2 times book value, a lower price-to-book valuation than the S&P 500. But despite railroad stocks' roaring return, you can still purchase Berkshire for 1.2 times book value.

Berkshire's two largest stock holdings, Coca Cola (NYSE: KO) and Wells Fargo (NYSE: WFC) both have mostly outperform ratings by The Motley Fool Caps community, the all-star players, and Wall Street analysts. Berkshire has an 8.9 percent stake in Coca-Cola with a $15.75 billion market value. Berkshire's 7.8 percent stake in Wells Fargo is worth $13.96 billion.

The Bottom Line

Berkshire Hathaway is made up of a diversified group of great businesses that will endure for decades. With Buffett's new commitment to buy Berkshire Hathaway any time the stock falls below 120% of book value, downside protection has increased. Furthermore, Berkshire's largest holdings offer Berkshire investors solid value. This downside protection from its all-star companies and the share repurchase program has a significantly positive affect on expected returns. Berkshire Hathaway, I believe, is a great long-term bet.

DanielSparks has no positions in the stocks mentioned above. The Motley Fool owns shares of Berkshire Hathaway. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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