Earlier this year it became (and to a large extent still is) far too cheap. It’s not a stock that has huge upside, but it is a stock that has no downside. (That said, I do think there is enough upside to get plenty excited.) In proper investment parlance, the risk/reward of Berkshire Hathaway is tremendous.
Berkshire Hathaway is one of the most talked about stocks in the value investing community. I was hesitant to even put a post together, but as I read through the annual report and 10-K a couple of weeks ago, I jotted down four main reasons why Berkshire is an attractive investment at these prices.
I’ll outline some comments in this post stating why I like the company and the current stock price, and then in a future post or two I might discuss in more detail a few things I noted while reading the annual report and 10-K.
Berkshire is attractive for four general reasons:
- Cash-rich balance sheet.
- Strong earning power.
- Capital allocation (Warren Buffett’s potential to capitalize on downturns).
- Current stock price — Almost $100 of cash and investments per share and less than seven times earnings for good businesses with above average ROEs and a history of strong earnings growth.
Note: Everything related to per share numbers will be in B shares (which are 1/1,500th of A shares).
Cash-rich balance sheet
Adjusting for the recent Precision Castparts (NYSE:PCP) acquisition which was finalized after Dec. 31, 2015, Berkshire has $98 per share in cash and investments. The balance sheet has an excess cash hoard of around $40 billion, and this cash pile grows at a rate of around $1.25 billion per month (this adds up to around $15 billion, or $6 per share of cash to the balance sheet each year that Buffett can reallocate or just let build).
Consider this: at the current rate that free cash is building up inside Berkshire, it will take just over five quarters to make back the entire amount of cash used to fund the Precision Castpartsacquisition (the largest in Berkshire Hathaway history).
The balance sheet is one huge competitive advantage for Berkshire. Should trouble develop in the economy or if markets fall apart, Berkshire has the opportunity to create enormous value for shareholders by lending money to firms in need (and extracting a heavy toll for such funding), making acquisitions, buying stocks on the cheap or even using a few months’ worth of free cash flow to buy back Berkshire Hathaway stock if it trades much lower than the current quote.
Strong and diversified earning power
Unlike many conglomerates, Berkshire Hathaway has built a collection of quality compounding machines that produce copious amounts of cash flow that grow over time at a steady clip.
Berkshire’s insurance business (with over $110 billion of stated net worth) is not only the largest insurance company in the world but also one of the most profitable. It has produced 13 consecutive years of underwriting profits, and while this yearly streak will come to an end at some point as insurance markets continue to soften, over time these assets will remain profitable. Over this 13-year run the insurance businesses have produced a total of $26 billion of pretax profits for Berkshire and currently hold $88 billion in float — money that has been paid by policyholders and reserved by Berkshire for future claims.
This float is listed on the balance sheet as a liability, but in reality — as long as the insurance business continues to collect premiums and underwrite profitably — it is a valuable asset.
Buffett illustrates this value by calling float a revolving fund — each day Berkshire pays out millions of dollars of claims, which reduces float. But each day millions of dollars of new business is written, which adds to float. As long as policies are written profitably (premiums collectively offset claims and operating expenses) and as long as new premiums coming in replace claims going out, then float will be interest-free and won’t have to be paid back.
As Buffett said in the recent letter: “Owing $1 that in effect will never leave the premises — because new business is almost certain to deliver a substitute — is worlds different from owing $1 that will go out the door tomorrow and not be replaced.”
So $1 of float is listed on the liabilities side of the balance sheet alongside $1 of debt — but the former is not only free but actually produces profits and will never have to be paid back. This is one reason why Buffett feels the book value (which counts this $88 billion as a full liability) understates the economic value of Berkshire.
— Guru Focus