The Rational Walk
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When to Sell a Successful Investment July 20, 2015

“If the job has been correctly done when a common stock is purchased, the time to sell it is – almost never.” — Philip Fisher

“Those who believe that the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sums. Those who understand the pendulum’s behavior can benefit enormously. ” — Howard Marks

There are many approaches used by value investors to identify investment candidates but the obvious common theme is that one makes purchases only when the offered price is significantly below a conservative estimate of intrinsic value.  In times of significant pessimism, there are often far more investment candidates than one would wish to add to a focused portfolio.  This was the case for a number of years following the 2008-09 financial crisis, not only in retrospect but as a function of the opportunities clearly available at the time.  During such times of abundance, the purchase decisions are mainly a function of which opportunities within an investor’s circle of competence offer the greatest prospective returns with acceptable business risk.  Making such bargain purchases, assuming the availability of the necessary cash and the right mindset, is usually an enjoyable experience.

On the other hand, the decision to sell can frequently be agonizing for various reasons.  If a business unexpectedly deteriorates, one must determine whether the relationship between the lower stock price and lower intrinsic value still justifies ownership.  Numerous psychological pitfalls await investors who must decide whether to sell an unsuccessful investment.  Often times, the best approach is to pull the band-aid off quickly and move on.

The more interesting question, and the subject of this article, is when one should sell a successful investment.  This question is almost certainly timely for most readers as markets reach new highs and signs of investor optimism becomes more and more common.  In retrospect, we know that the pendulum referred to by Howard Marks reached its most pessimistic limit in early 2009 bringing with it the greatest opportunities for success.  We cannot know today where the pendulum is exactly located but it seems to be drifting more toward the optimistic end of the spectrum.  This necessitates careful consideration of when a successful investment has run its course.

Motivations for Selling

There are obviously a number of motivations that would lead an investor to sell a successful investment.  Many of the reasons are somewhat beyond the scope of this article.  It is possible that an investor seeks to raise cash for personal reasons such as increased consumption or purchasing a personal residence.  Such needs may be immediate or on the horizon.  Clearly it is not advisable to hold common stocks, regardless of valuation, if the time horizon for the remaining period of ownership is very short.  In such cases, with cash being necessary, one simply sells the investment, pays the required tax, and moves on.

Aside from time horizon constraints, an investor will often consider selling in order to fund the purchase of another investment.  This is the more interesting scenario for purposes of this article.  When does it make sense to sell a successful investment in order to purchase something that is perceived as “better”?

Assess Prospective Returns

Perhaps it goes without saying, but when tempted to sell a successful investment it is necessary to revisit the valuation again in considerable detail.  It is possible that an advancing stock price is in response to an unexpected positive development that was not considered in the original investment thesis.  Investors are subject to both good and bad luck.  When good luck takes the form of an unexpected positive surprise, it wouldn’t make sense to immediately sell and abort the benefits of that good luck.

Assuming the valuation has been revisited and the investment is indeed trading above a conservative estimate of intrinsic value, it is still important to consider the prospective returns of the investment from its current price level.  For example, a month ago, we posted an article on Markel trading above $800 per share for the first time.  Since that time, the stock has advanced an additional 10 percent and currently trades above the $840 intrinsic value estimate provided in the article.  As no obvious new developments have taken place over the past month, the stock appears to be trading about 5 percent above the intrinsic value estimate.

The intrinsic value estimate was based on requiring a 10 percent annualized prospective return over the next five years.  Although the stock recently traded at $875, it still offers the possibility of 9 percent annualized returns over the next five years, holding all other aspects of the valuation constant.

Consider Tax Consequences

Warren Buffett has often discussed the major benefit Berkshire Hathaway realizes by investing policyholder “float” in securities.  Float represents funds that Berkshire holds in anticipation of payment to policyholders, in some cases in the distant future.  However, Berkshire also benefits from another type of “float” represented by deferred taxes on appreciated securities.  Effectively, Berkshire is able to invest deferred taxes that will eventually be payable to the government.

All investors have the same opportunity to benefit from retaining highly appreciated investments with large deferred tax liabilities.  For example, consider an investor who purchased Markel shares at $400 approximately four years ago.  Of the $875 share price, $400 represents the cost basis and $475 represents embedded capital gains.  The current effective top Federal income tax rate on long term capital gains is 23.6 percent.  Assuming residence in a state without income taxes, the investor would have to pay taxes of around $112 per share leaving him with $763 to invest in new opportunities.  In contrast, holding on to the Markel shares will allow the investor to keep all $875 invested.

Continuing this example, if the investor retains Markel shares at $875 and the share price compounds at 9 percent over the next five years, the ending share price would be $1,346.  At that point, taxes of $223 would be owed on the capital gain (assuming no change in tax rate policy) and cash raised on sale would be $1,123.

If the investor instead sells Markel today and reinvests the $763 proceeds, it will be necessary for the new investment to compound at nearly 10.1 percent to match the after tax proceeds realized by holding on to the Markel investment.  At that rate of return, the new investment will be worth $1,234 in five years.  Of this amount, $471 will represent a capital gain and taxes of $111 will be owed to the government  resulting in net proceeds of $1,123.

(As an aside, one must also overcome transaction costs, both explicit in the form of commissions and implicit in the form of bid-ask spreads.  We have ignored transaction costs for purposes of simplicity.)

The Hurdle May Be High

As we can see from the example, the tax friction associated with selling a successful investment and purchasing a new one can be considerable.  In this case, it would be necessary to find an investment offering a return 1.1 percent higher than Markel in order to make the switch pay off.  Furthermore, one would need to be satisfied that the level of business risk is similar or, better yet, lower.  Markel also could have upside above and beyond the intrinsic value estimate if the company succeeds in emulating Berkshire Hathaway’s business model.

It might still make sense to sell Markel and find another investment if it can be done in a tax exempt or tax deferred account.  In such cases, the tax friction disappears, but the other issues remain.  Ultimately, each investor must make an educated decision when it comes to the question of selling appreciated securities.  It goes without saying that frequent activity on a short term basis is almost always ill advised.  The same is often true in the long run, as Philip Fisher pointed out.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Markel.  Since publication of the article on Markel on June 18, fifteen percent of the Markel shares held on that date were sold in tax exempt and deferred accounts and invested in Berkshire Hathaway with no plans to sell the remaining Markel shares.  See also general disclaimer.

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How to Read the Berkshire Hathaway Annual Report February 27, 2015

Berkshire Hathaway Mill - New Bedford, MAThe release of Warren Buffett’s annual letter to shareholders is one of the most important events of the year for value investors.  This year, the significance of the letter is accentuated by the fact that fifty years have passed since Mr. Buffett took control of Berkshire Hathaway. Mr. Buffett is effectively the “founder” of Berkshire in its current form as an investment holding company and conglomerate of operating subsidiaries.

Berkshire Hathaway’s annual report, scheduled to be released tomorrow morning, has long followed a format leading off with a table documenting Berkshire’s annual and cumulative performance followed by Mr. Buffett’s letter to investors and Berkshire’s financial results for the past year.  This year, Mr. Buffett’s letter is expected to focus on his view of Berkshire’s potential evolution over the next fifty years.  In addition, Charlie Munger has written a separate letter to shareholders outlining his view of Berkshire’s next fifty years.  According to recent interviews, there has been no collaboration between Mr. Buffett and Mr. Munger when it comes to presenting their thoughts on Berkshire’s future.

Form Your Own Opinion

From the moment the report is posted online at 8 am eastern time tomorrow, social media and news outlets will be flooded with various opinions regarding the annual letter and Berkshire’s results.  Sometimes one has to wonder how it is possible for anyone to form instant opinions but it is a virtual certainty that at 8:01 am, declarative judgments of the contents of the material will already be prevalent online.  To immunize yourself against this intellectual assault, simply print the annual report on actual paper, turn off your computer, and disconnect from all social media and news until after finishing a review of the report.  Failure to do so will inevitably pollute your own judgment regarding the contents of the report and, even worse, may do so in a subliminal manner as the opinions of others act in subtle ways to alter your own thinking.

First Things First

As a general rule, it is best to review the actual results of a business prior to reading management’s assessment of the results.  In most cases, the reason behind doing so is to avoid being unduly influenced by management teams (or more frequently PR consultants) who are trying to spin results in some way.  With Berkshire Hathaway, we do not have to worry about Mr. Buffett trying to mislead shareholders but if we read his letter prior to reading about Berkshire’s results, we will invariably be influenced by his conclusions anyway.  Since it will be very difficult to read the entire financial report before peeking at Mr. Buffett’s letter, at least resolve to conduct a thirty minute review of Berkshire’s important business segments and overall financials before delving into the letter.

What to Look For in the Letter

Mr. Buffett’s letters typically follow a format where he presents his overview of Berkshire’s recent results and follows up with essays on various topics.  Sometimes the topics are directly relevant to Berkshire’s business units but often they also involve much broader topics.  It is likely that the letter will, to some degree, follow the format of prior years but we can perhaps expect a more lengthy review of how Berkshire’s fifty year record came about since this forms the foundation of what Berkshire is today.  Once that foundation is well understood, we can look to the future and we can expect Mr. Buffett’s views on how Berkshire might evolve over the next fifty years.

There are a number of key topical areas that shareholders should look for:

Management Succession

There is no reason to believe that Mr. Buffett has changed his mind regarding continuing to lead Berkshire Hathaway as long as he is fit to do so and recent television interviews provide no reason to suspect any deterioration in his physical or mental condition.  However, as the recent passing of Berkshire Hathaway Director Donald R. Keough at age 88 reminds us, the health of a man in his eighties can often change for the worse very quickly.  Berkshire’s succession plan may not be needed for another ten or twenty years or it could be needed in the near future.

Mr. Buffett is nearly certain to not name the current frontrunner to be Berkshire’s next CEO but he could very well expand upon his thoughts regarding the necessary qualities and characteristics that will be needed.  At this point, there are a number of Berkshire executives who are often named as potential future CEOs but, as time passes, many of these men are getting into their 60s or 70s.  Mr. Buffett might drop clues regarding the desired duration of his successor’s tenure.  He has previously hinted that the next CEO should have a long tenure and, if this is reinforced, one might tend to believe that the top candidate could be in his 50s rather than in his 60s or 70s.

Capital Allocation

Mr. Buffett’s prior letters have often gone into great detail regarding his views on the role of a CEO as capital allocator.  This will be one of the most important roles for the next CEO in addition to maintaining Berkshire’s unique corporate culture.  A key decision that the next CEO will face will involve whether to return capital to shareholders or to continue Mr. Buffett’s practice of retaining all earnings.

Shareholders who might otherwise agitate for a return of capital have long been content to allow Mr. Buffett to retain all earnings since having a large amount of cash on hand provides him with a great deal of optionality when it comes to future deals.  Given Mr. Buffett’s long demonstrated mastery of the art of capital allocation, having long periods of near-zero returns on a pile of cash is viewed as an acceptable trade-off to preserve the optionality of a major deal that would be facilitated by the cash.  No matter how accomplished Mr. Buffett’s successor will be, shareholders are unlikely to have the same patience.  Some words of wisdom regarding how much flexibility Mr. Buffett’s successor should have in this regard might be useful.

It will be virtually impossible for Mr. Buffett to paint a picture of Berkshire in fifty years without at least implicitly rendering a verdict on Berkshire’s ability to continually deploy cash internally at attractive rates of return.  If Berkshire retains all earnings for the next fifty years and is able to reinvest those earnings into attractive new subsidiaries and investments, the market capitalization of the company would be truly mind boggling.  For example, if Berkshire can compound its market capitalization at 5 percent in real terms over the next five decades, its market capitalization would exceed $4 trillion in current dollars.  At some point, Berkshire will clearly have to return capital to shareholders.  Mr. Buffett might provide clues regarding when that day is likely to arrive.

Organizational Structure

Berkshire has a reporting structure where nearly all of the major subsidiary CEOs report directly to Mr. Buffett.  This is partly due to the history behind many acquisitions and Mr. Buffett’s ability to inspire subsidiary managers to the point where they need hardly any “oversight” at all.  Berkshire’s future CEO, regardless of accomplishment, is not going to be Mr. Buffett’s equal in terms of inherent capabilities or in terms of his ability to inspire unquestioned loyalty from his subordinates.  However, it is critically important for Berkshire to retain a decentralized structure that empowers subsidiary managers.  How should this balance be achieved?  While the exact approach may be one that Berkshire’s next CEO will have to formulate, perhaps some clues will be provided in Mr. Buffett’s letter.

“What Would Warren Do?”

At some point, Berkshire’s next CEO is going to face a crisis or some event that leads shareholders and, perhaps even the Board, to start obsessing over “what Warren would do” under the same circumstances.  While it is very important to take lessons from Mr. Buffett’s life and business track record, nothing could be more harmful for Berkshire’s next CEO than to be a slave to the inferred decisions of a past leader.

Apple’s current CEO, Tim Cook, had the seemingly impossible task of taking over for an ailing Steve Jobs in 2011.  Mr. Jobs was adamant that Mr. Cook should not be haunted by constantly asking “what would Steve do?” but should simply do what he thought was right.  Obviously, it would be foolish for Tim Cook to make decisions without considering the lessons he learned from Steve Jobs, but ultimately he has to make his own decisions.  The same will be true for Mr. Buffett’s successor.  Mr. Buffett might choose to paint a picture of how Berkshire shareholders should think about evaluating the next CEO in this light.


The best approach for reading Berkshire’s annual report, or the annual report of any company, is to make your own judgments and avoid being influenced by others until after you have first reached your own preliminary conclusions.  On Saturday morning, the best approach is to print the report on actual paper and to go off-line to avoid even the temptation of considering the views of others prematurely.  Spend the better part of the day reading the report and considering what Mr. Buffett and Mr. Munger have to say about Berkshire’s future and then, if you choose to, engage in discussions with other Berkshire shareholders or review what the professional pundits have to say.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway.

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Book Review: Berkshire Beyond Buffett November 5, 2014

I love running Berkshire, and if enjoying life promotes longevity, Methuselah’s record is in jeopardy.

-Warren Buffett, Berkshire Hathaway Owner’s Manual

Berkshire Hathaway will soon reach an important milestone with the fiftieth anniversary of Warren Buffett’s control of the company.  Nearly forty percent of Mr. Buffett’s tenure at Berkshire has been accomplished as a senior citizen and he is clearly not ready to retire anytime soon.  However, Berkshire shareholders are faced with the fact that an 84 year old man has an life expectancy of approximately six years.  It is prudent to consider succession issues carefully.  Mr. Buffett has assured shareholders that the company is well prepared but how can shareholders be certain?

BerkshireBeyondBuffettWarren Buffett almost certainly has higher name recognition in the United States today than all but a small number of public figures.  Even individuals who have no background in business and investing recognize Mr. Buffett’s name but what is interesting is that he is almost always characterized as an investor rather than as a manager.  In Berkshire Beyond Buffett, George Washington University Professor Lawrence Cunningham paints a compelling portrait of Berkshire’s culture that demonstrates how Mr. Buffett’s skills as a manager have been key to the company’s growth over the past two decades.

Berkshire Hathaway’s portfolio of common stocks attracts a great deal of attention, but the bulk of the value of the company has resided in wholly owned subsidiaries for quite some time.  Mr. Buffett has assembled a diverse group of businesses over the years and has characterized his management approach as delegating “almost to the point of abdication”.  While Mr. Buffett has involved himself in operating decisions in rare cases, his primary role is to allocate free cash flow generated by the non-insurance subsidiaries as well as “float” obtained from the insurance businesses.  Berkshire’s subsidiary managers have generally proven to be very capable with many of the original family owners continuing to run businesses even with no financial need to do so.

The Economist published a skeptical article on Berkshire earlier this year questioning how Mr. Buffett will “play his last hand”.  This article is useful in that it outlines many of the concerns skeptics typically point to when it comes to succession planning.  Specifically, it is alleged that Berkshire’s business model is simply not scalable or sustainable in the absence of the man who built the company.  Would a break-up of Berkshire create more long term value for shareholders after Mr. Buffett leaves the scene?

Professor Cunningham’s book is perhaps the most comprehensive examination of this question that has been published up to this point.  The book examines the origins of today’s Berkshire Hathaway and attempts to paint a picture of how Mr. Buffett has gone about building the conglomerate seemingly “by accident”.  Whether by accident or by design, over the years, Berkshire Hathaway developed a culture that ties together seemingly unrelated business units in a manner that makes Mr. Buffett’s extreme decentralization work.  Charlie Munger likes to describe the culture very succinctly as a “seamless web of deserved trust”, and Professor Cunningham’s work provides insight into how this web has developed and can be sustained.

The core of the book investigates how Mr. Buffett has balanced autonomy and authority through the examination of several Berkshire subsidiaries.  Professor Cunningham conducted numerous interviews with subsidiary CEOs as well as shareholders so the book is based on primary research and unprecedented access.  While some of the businesses have been analyzed in depth elsewhere in the past, the book also covers smaller subsidiaries that have received less attention such as the Pampered Chef.

One of the most interesting chapters goes into detail regarding the evolution of the Marmon Group, one of Berkshire’s wholly owned subsidiaries.  Marmon is a diversified conglomerate that was built by brothers Jay and Robert Pritzker. The company was considered too unwieldy and diverse to be successfully managed after the Pritzkers left the scene, but it turns out that little changed in terms of the company’s decentralized management approach.  John D. Nichols was CEO from 2002 to 2006 and Frank Ptak has been CEO since that time.  Both CEOs spent most of their careers at ITW, a diversified conglomerate with a structure similar to Marmon.  Mr. Nichols did introduce ten division presidents to logically group together Marmon’s subsidiaries but otherwise left the units mostly unchanged.

When Mr. Buffett leaves the scene at Berkshire, it is likely that the next CEO will need to create divisions since it would be very difficult to handle over eighty direct reports.  The Marmon model might offer a potential roadmap for how this can be accomplished in a manner that does not erode the operational autonomy that Berkshire has granted to subsidiaries.

Professor Cunningham concludes his book by conceding that some “slippage” is inevitable at Berkshire:

At Berkshire after Buffett, expect slippage.  Deals may not come Berkshire’s way. Offers Berkshire makes may not be on terms as agreeable as they have been.  Negotiations may be less favorable.  Getting through the screen may be a few more subpar businesses or disappointing managers.  If the big deals do not come or the great managers do not follow, returns will be lower.  But absent some extraordinary disruption, returns will not be so disappointing as to warrant dismembering Berkshire or some other radical change.  Its design for sustainability is more powerful than that.

Indeed, Berkshire Hathaway will not be the same after Warren Buffett leaves the scene.  But that is not really the question that needs to be answered.  The question really boils down to whether Mr. Buffett’s creation is worth preserving over time.  The litmus test is not going to be evaluated based on Berkshire’s stock price in the short run but based on growth of intrinsic value over many years and decades.  Logically, intelligent capital allocation across subsidiaries can remain extremely powerful even if the capital allocator in question is not Mr. Buffett.  If subsidiaries can continue to operate well in the future without significant oversight and capital allocation between subsidiaries remains intelligent, there is no reason for the model to fail anytime soon.   Professor Cunningham’s book provides ample evidence to believe that Berkshire’s business model should outlast Warren Buffett.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

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Revisiting Berkshire Hathaway’s Valuation September 18, 2014

Berkshire Hathaway

Berkshire Hathaway HeadquartersOver the past five years, Berkshire Hathaway has been a frequent topic on The Rational Walk easily surpassing the coverage of any other company.  In retrospect, there have been many reasons for this lopsided treatment of one company in a universe of thousands of publicly traded businesses.  What motivated this unusual focus on Berkshire Hathaway?

Perhaps the most important reason is the clear fact that Berkshire Hathaway is a unique company driven by a very uncommon management philosophy which has led to extraordinary results for shareholders. The record of Warren Buffett and Charlie Munger’s management of Berkshire Hathaway over the past fifty years is unique in business history and certain to be examined for decades to come.  Both investors and managers naturally seek to better understand this extreme outcome and the approach that was used to achieve it.

However, another important motivation involved the market’s valuation of Berkshire in the aftermath of the tumultuous events of 2008 and early 2009.  For a number of years, it appeared that the market had permanently reassessed Berkshire’s intrinsic value relative to valuation levels that had prevailed for a long period of time.  In recent weeks, Berkshire’s stock price has reached record highs, but more importantly the valuation of the stock has returned to levels that might have been considered within the bounds of “normalcy” prior to late 2008.  In this article, we revisit Berkshire’s current valuation relative to historical ranges and assess whether a return to normalcy is justified.

Berkshire’s Price-to-Book Ratio

There are a number of approaches that analysts have used to estimate Berkshire Hathaway’s intrinsic value, many of which have been discussed in some detail in past articles as well as in more extensive reports published in 2010 and 2011 (both of which are now available at no cost).

Following Berkshire’s price-to-book ratio is one of the more straightforward approaches and does have some important limitations.  However, it does have the advantage of being easily calculated based on market prices and figures published on a quarterly basis in Berkshire’s SEC filings and there is at least rough correlation between valuations derived from the price-to-book ratio and more sophisticated approaches.  Additionally, it is often cited by market participants and analysts and is therefore a good way of looking at investor sentiment with respect to Berkshire shares.  Perhaps most importantly, price-to-book is the criteria upon which Berkshire’s repurchase plan is based indicating that Warren Buffett regards this metric to be an important, albeit understated, measure of Berkshire’s intrinsic value.

The chart below presents the closing price of Berkshire Hathaway Class A shares for each trading day since December 31, 1999 along with the then-current book value per A share which is published on a quarterly basis.  Additionally, Berkshire’s repurchase threshold, which was introduced in September 2011, is charted since the date of its introduction.  The repurchase threshold was initially set at 110 percent of book value in September 2011 and subsequently raised to 120 percent of book value in December 2012.

Berkshire Hathaway 2000-2014

From this simple chart, we can see that Berkshire has almost always traded at a significant premium to reported book value except on a few occasions.  In early 2000, Berkshire was out of favor as the dot-com bubble reached its peak and briefly traded at only a small premium to book value.  This situation prevailed for only a short time before Warren Buffett indicated an interest in repurchasing Berkshire shares at $45,000, which was 118 percent of book value at the time.  During the depths of the panic in the fourth quarter of 2008, Berkshire briefly approached book value as reported at the end of the third quarter;  however, this was during a time when market participants were not only in a state of panic but also correctly anticipated that depreciation in Berkshire’s large portfolio of marketable securities would lead to a drop in book value.  During the third quarter of 2011, Berkshire shares approached book value which prompted the introduction of Berkshire’s repurchase plan.

The following chart represents the same underlying data but in a form that allows a more clear examination of the price-to-book ratio trend over time.  We simply take the closing price of Berkshire’s Class A shares and divide by the last reported book value figure provided by Berkshire’s annual and quarterly SEC filings.  The dark red line represents Berkshire’s repurchase authorization threshold introduced in September 2011 and revised in December 2012.

Price to Trailing Book Value

From just a brief look at the chart, it is quite apparent that the market’s assessment of Berkshire Hathaway changed six years ago.  For most of the decade up to that point, Berkshire traded in a range between 150 and 200 percent of book value.  Following the financial crisis, Berkshire’s range has been between 100 and 150 percent of book value.  The recent appreciation of Berkshire shares has increased the valuation to 147 percent of book value as of September 17.  This is at the top of the post-financial crisis range, but toward the bottom of the range that prevailed prior to the crisis.

Was the Lower Range Justified in late 2008 and early 2009?

It is important to recognize the fact that Berkshire Hathaway was not alone in the market’s valuation adjustment of “financial” companies following the financial crisis.  The level of perceived risk in financials increased dramatically in the aftermath of September 2008 and for the most part, the market was justified in its reaction at the time given the uncertainty that prevailed.  Mr. Buffett himself has commented extensively regarding the importance of government intervention at the time, and it was not clear whether officials were up to the task required.  Regardless of one’s views on the specifics of the various “bailouts”, it is quite clear that the carnage in the financial sector would have been far worse had there been less intervention at the time.

Despite the rationality of the market’s overall aversion to financials in late 2008, it is important to point out that Berkshire itself was in remarkably good shape compared to other companies.  Furthermore, Berkshire was a conglomerate engaged in diverse business activities even though it was perceived and valued as a financial.  Berkshire was in a position to provide financing to others at a time when lack of liquidity threatened to sink firms that were previously seen as rock solid.  One could argue that the market’s failure to differentiate Berkshire from its perceived peers was irrational on the part of Mr. Market.

On the other hand, investors had a wide array of choices as the market hit its lows in early 2009 and Berkshire Hathaway stock is necessarily evaluated against other alternatives.  In short, looking at the situation in retrospect, it is no surprise that Berkshire shares were roughly cut in half in less than six months even though intrinsic value couldn’t have possibly dropped by that much.  Indeed, Berkshire suffered a drop of less than 15 percent in book value per share over the course of Q4 2008 and Q1 2009 while the share price dropped over 50 percent from September 19, 2008 to its low on March 5, 2009.

Is a Lower Range Still Justified?

While hindsight might appear to justify the market’s initial reassessment of Berkshire’s intrinsic value in late 2008 and early 2009, it is much harder to make the same case as the United States economy began to recover from the financial crisis.  Even long after market participants had overcome the shocks of 2008 and early 2009, Berkshire shares continued to trade at very low price-to-book ratios.  The implication was that Berkshire’s many franchises were not collectively worth much more than the carrying value of the businesses despite the fact that Berkshire had proven itself to be resilient throughout the downturn.

The post-recession years also brought major changes to the composition of Berkshire itself with the most notable example being the acquisition of Burlington Northern Santa Fe in early 2010.  While property-casualty insurance remains Berkshire’s most important business today, the acquisition of BNSF significantly transformed Berkshire’s earnings stream.  If we also consider the acquisition of Lubrizol, additions to the Berkshire Hathaway Energy portfolio, purchasing the minority interests of Marmon, and many “tuck-in” acquisitions, Berkshire has become far more diversified over the past five years.

BNSF is an interesting case in point when looking at Berkshire’s price-to-book ratio.  At the time of the acquisition, Berkshire used a combination of cash and stock to acquire BNSF and the purchase price was allocated to various accounts on Berkshire’s balance sheet and included substantial goodwill.  As we revisited the BNSF acquisition in late 2013, it became clear that if BNSF had remained a stand-alone company, the market’s assessment of its intrinsic value would have dramatically increased from 2010 to 2013.

The following chart shows the stock price performance of Union Pacific, BNSF’s closest comparable company, from the date of Berkshire’s acquisition of BNSF to September 18, 2014 (click for larger image):

Union Pacific Stock ChartClearly, if Berkshire Hathaway had waited until today to acquire BNSF, a much higher purchase price would have been required.  Yet, Berkshire’s book value continues to reflect the acquisition cost of BNSF in February 2010 unadjusted for any subsequent reassessment in the eyes of Mr. Market.  If we were to adjust BNSF’s carrying value on Berkshire’s balance sheet to reflect the same level of appreciation as Union Pacific shares, Berkshire’s book value would increase by over $50 billion, or in excess of $30,000 per A share.  However, none of that hypothetical increase in value is reflected in Berkshire’s reported book value.


The example of BNSF discussed above is illustrative not merely because of the rather extreme nature of the potential valuation discrepancy between its carrying value on Berkshire’s balance sheet and its likely market value.  It also alludes to the fact that many of Berkshire’s other businesses have similarly appreciated over time.  The most extreme examples involve companies like See’s Candies that were purchased decades ago at a cost that is a tiny fraction of today’s true market value.  Over long periods of time, one can expect the difference between fair value and carrying value of wholly owned subsidiaries to rise rather than fall, implying that Berkshire’s price-to-book ratio might be expected to increase over time rather than decline.

This article focuses on Berkshire’s price-to-book ratio rather than utilizing a broader set of tools such as the float based, “two column”, or sum-of-the-parts approaches that have been discussed on this site and elsewhere over the years.  Although the price-to-book ratio has its important limitations, enough evidence exists to believe that Berkshire’s valuation based on this measure should not be appreciably lower than it was prior to the financial crisis.  Furthermore, one could reasonably expect Berkshire’s price-to-book ratio to increase at a slow pace over a period of several years.

It appears that Berkshire’s stock price has finally returned to the lower end of a “range of normalcy” in recent weeks.  While no longer as severely undervalued as it was for most of the past six years, there is no evidence to suggest that Berkshire’s share price has reached irrational levels even though it is at a record high.  Given today’s share price, Berkshire shareholders are likely to achieve returns commensurate with the growth of intrinsic value plus perhaps some additional increase in the market’s assessment of the stock.  Fortunately, Berkshire has prospects for intrinsic value growth that are quite attractive in today’s investment environment.

Disclosure:  Individuals associated with The Rational Walk LLC own shares of Berkshire Hathaway. 

Correction to Article

September 20, 2014

A reader brought up an error in the article related to Burlington Northern Santa Fe.  The article, which remains as originally posted, stated that BNSF remains on Berkshire’s balance sheet at the approximate valuation paid for by Berkshire in February 2010.  While this is technically accurate, the statement ignores the fact that BNSF has remitted dividends to Berkshire on a consistent basis over the years.  BNSF had aggregate net income of $14,012 million from the date of Berkshire’s acquisition through the end of the second quarter of 2014.  During that same period, BNSF paid $14,250 million in cash dividends to Berkshire.  So while BNSF’s book value has remained roughly the same, Berkshire’s overall book value has grown due to cash dividends remitted to the parent company.

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Munger’s Prescription for Corporate Governance March 21, 2014

“The compensation committee relies on its own good judgment in carrying out its duties and does not waste shareholder money on compensation consultants.”

–Daily Journal Corporation 2013 Proxy Statement

David Larcker and Brian Tayan of the Stanford Graduate School of Business recently published a paper entitled Corporate Governance According to Charles T. Munger which concisely outlines the governance philosophy that Mr. Munger has presented on a number of occasions.  While the article will not reveal much new information for longtime students of Berkshire Hathaway, it does explore the key points and asks whether Mr. Munger’s prescription might apply to an average corporation.

Seamless Web of Deserved Trust

Mr. Munger’s approach would be considered radical by most conventional companies for a number of reasons.  Perhaps the most radical concept is the idea of a “seamless web of deserved trust”, as quoted in the Stanford paper:

A lot of people think if you just had more process and more compliance—checks and doublechecks
and so forth—you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust.

The trust based system, in contrast to one driven by enforced compliance, can clearly be superior because of the greater efficiency competent and trustworthy individuals realize by operating in the best interests of the company without being constantly burdened by bureaucracy.  Berkshire Hathaway is the perfect example of a company that historically violated many “good governance” principles such as separating the Chairman and CEO roles yet has delivered exceptional results due to both the ethics and skill of Warren Buffett.

The idea of selecting a CEO and then delegating to him or her nearly to the point of abdication obviously carries a great deal of risk.  The most obvious risk is that the board of directors might make a serious mistake in judgment in the CEO selection process.  The board might wrongly attribute an executive’s track record to skill when it could have been driven by luck or other external factors or, even worse, the confidence the board places in the executive’s integrity might be terribly misplaced.  The seamless web of deserved trust can be broken even in the best corporate cultures.  This was most dramatically demonstrated three years ago when David Sokol’s misconduct at Berkshire Hathaway resulted in the removal of a top executive widely thought of as a likely successor to Warren Buffett.

Skin in the Game

A special case of the “seamless web of deserved trust” occurs when the manager of a business owns all of the economic interest as well.  In this special case, there are no agency problems and no need for trust since the manager and owner are one and the same.  In the world of public companies, even those admirably run, there are always agency issues to be aware of.

A system in which the individuals making decisions do not bear the consequences of those decisions seems incompatible with a seamless web of deserved trust.  One of Mr. Munger’s favorite examples, as cited in the Stanford paper, involves the method the Romans used to ensure that engineers had skin in the game.  Upon completion of a bridge, the engineer would stand under the arch when the scaffolding was removed.

Actual ownership of equity in the business purchased by the CEO with his or her own money can serve to align interests with shareholders in a way that option grants or restricted stock given to the executive can never match.  Mr. Munger advocates restraint in executive compensation and finds it particularly admirable when executives agree to accept below market compensation because they are already rich and have enough of an ownership interest in the business to create automatic shareholder alignment.  Obvious examples include Mr. Buffett and Mr. Munger who have received virtually no compensation for their work at Berkshire Hathaway:

Berkshire Executive CompensationSource: Berkshire Hathaway 2013 Proxy Statement

This restraint in executive compensation is only possible because of Mr. Buffett and Mr. Munger’s large holdings in Berkshire Hathaway stock which, along with the rest of the directors, creates a shareholder orientation absent at most large corporations:

Berkshire Ownership 2013 ProxySource: Berkshire Hathaway 2013 Proxy Statement

Is it possible to implement a trust based model for corporate governance without the management having a very large economic interest in the company, both relative to the size of the company and to their own net worth?  It is doubtful that such a model could be implemented widely without management having much skin in the game, although there could always be exceptions to a general rule.

Applicability to Investing Decisions

The Stanford paper and our brief commentary does not encompass all or even most of Mr. Munger’s thoughts on corporate governance which might appear simple compared to the conventional approach.  However, these ideas are by no means simplistic.  Readers who are interested in more of Mr. Munger’s thoughts on corporate governance and many other subjects would be well served to carefully read Poor Charlie’s Almanack.

At the risk of oversimplifying the issue, it does appear almost self evidently attractive to hire intelligent, capable, and ethical managers who personally paid for large economic interests in the businesses that they run.  Such managers would require modest executive compensation and could be counted on to advance the interests of all shareholders and to see their net worth rise or fall along with all other shareholders.

The authors of the Stanford paper appear to be interested in whether Mr. Munger’s approach could be widely applied to corporations and the answer is anything but clear.  We know that the approach has worked well at Berkshire Hathaway, Costco, The Daily Journal, and a number of other unusual cases but could one hope to achieve the same culture at an existing large company with a conventional structure today?

This question is no doubt interesting to corporate governance experts and academics as well as to entrepreneurs who are setting up a corporate structure and want to emulate Mr. Munger’s approach.  However, the lesson for passive minority shareholders without direct influence over corporate governance is a bit different.

In addition to paying attention to executive compensation and corporate governance in general, we should actively look for companies that partially or fully emulate Mr. Munger’s preferred model and give preference to such companies as investment candidates.  For those who utilize investment checklists, it is important to include one or more items designed to gauge whether corporate governance seems rational and whether the CEO truly has skin in the game.

Rather than seeking to create companies that have these features, which is bound to be very hard to do, investors have the liberty to not worry so much about how to implement the culture and more about how to identify companies that already have positive shareholder friendly cultures in place.  It seems much easier to identify exceptional cases than to create them.

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