Note to Readers: In this article, we cover selected highlights from Warren Buffett’s letter to shareholders which was released this morning as part of the company’s 2010 annual report (pdf). We have provided a separate article with a brief summary of Berkshire’s 2010 results. Next week, we will publish The Rational Walk’s comprehensive report on Berkshire Hathaway, In Search of the Buffett Premium, which is currently available for pre-order.
Warren Buffett and Charlie Munger have made it a habit to never directly state their estimates of Berkshire Hathaway’s intrinsic value. Due to the fact that intrinsic value estimates are heavily dependent on assumptions made regarding the future, even Mr. Buffett and Mr. Munger come up with somewhat different estimates of Berkshire’s intrinsic value. However, Mr. Buffett has often provided shareholders with the criteria he uses to arrive at intrinsic value estimates. At times, he has either strongly implied or directly commented on his views regarding Berkshire’s stock price versus intrinsic value. In this article, we will take a brief look at additional details Mr. Buffett provided in his 2010 annual letter to shareholders regarding how shareholders should go about calculating intrinsic value.
Two Column Approach
In previous annual reports, Warren Buffett has often commented about Berkshire Hathaway’s two sources of value: Investments per share and the capitalized value of earnings per share of the non-insurance businesses. This approach has been described as the “two column” method for calculating Berkshire’s intrinsic value. Essentially, Berkshire is being viewed as having one area of value in the form of investments funded by shareholders’ equity and insurance float and another source of value represented by non-insurance operating companies.
Mr. Buffett describes Berkshire’s $158 billion of investments in stocks, bonds, and cash equivalents and notes that $66 billion is funded by insurance float. Float represents funds held by Berkshire’s insurance subsidiaries that is carried as a liability on the balance sheet. However, as long as Berkshire’s float can be obtained through insurance activities that run at a break-even level or, better yet, at an underwriting profit, float has the utility of equity for Berkshire shareholders in the sense that the investment income emanating from these funds belong to the shareholders.
Viewed in this manner, Berkshire had $94,730 per A share of investments as of December 31, 2010. Overall per-share pre-tax earnings of the non-insurance operating companies was $5,926 for 2010. Mr. Buffett notes that investments per share and earnings can be calculated in a precise manner, but these only form two of the three pillars of intrinsic value. The third is more subjective and is the source of differences in intrinsic value estimates even among those who buy into the “two column” method.
The Third Pillar: Deployment of Future Retained Earnings
Berkshire Hathaway has never paid a dividend or repurchased stock and, as a result, all earnings have been reinvested in various businesses. In most cases where managements hoard cash, poor returns can result if funds are deployed in suboptimal ways either due to the tendency of managers to want to build empires or the fact that most businesses tend to reinvest in the same lines of business where the earnings were generated to begin with irrespective of the availability of acceptable incremental returns on capital.
Mr. Buffett notes that some companies can “turn these retained dollars into fifty-cent pieces, others into two-dollar bills”:
This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.
A shareholder’s individual view of how earnings will be redeployed dramatically impacts the manner in which a company’s existing earnings stream should be evaluated. In the case of Berkshire Hathaway, we know the value of investments per share and we have last year’s figure for pre-tax earnings but what capitalization is appropriate to assign to this earnings stream?
The answer depends on the degree to which earnings are paid out to shareholders, in which case shareholders can estimate the cash flows they will personally receive from the company. In the case of Berkshire, however, 100 percent of earnings are reinvested. The power of Berkshire’s business model, other than the fact that Mr. Buffett is the capital allocator, is that businesses that generate significant cash (such as See’s Candies or Business Wire) but lack reinvestment opportunities can have their cash flows directed to more attractive opportunities.
While there are no easy answers regarding how to evaluate the stream of future earnings that Berkshire will reinvest, some estimates can be made based on management’s track record and views regarding future prospects for internal reinvestment and acquisitions. This is one of the valuation models that will be discussed in our upcoming report: In Search of the Buffett Premium.
Bullish on the Long Term Economic Outlook
Mr. Buffett’s letter returned to some old themes such as Berkshire’s history with GEICO, the economics of the insurance business, and an expansion on the discussion of freight rail due to Berkshire’s acquisition of Burlington Northern Santa Fe last year. The letter also reiterated Mr. Buffett’s bullish long term outlook for the United States economy and noted that much of Berkshire’s capital investment has flowed toward opportunities in America over the past two years. All of Berkshire’s increase in capital investment in 2011 will be directed toward opportunities in the United States.
Berkshire’s Unusual Insurance Business
Berkshire’s insurance companies have now operated at an underwriting profit for eight consecutive years after several years of large underwriting losses following Berkshire’s 1998 acquisition of General Re. Mr. Buffett emphasizes how unusual Berkshire’s insurance operations are by highlighting the fact that Berkshire has posted $17 billion in underwriting profits over the past eight years while State Farm, a well run insurer, has incurred underwriting losses in seven of the past ten years and posted aggregate underwriting losses of $20 billion over that period. This long run record bolsters Mr. Buffett’s view that Berkshire should enjoy cost free float over the long run.
Record Earnings at Four Subsidiaries
Four of Berkshire’s businesses in the manufacturing, service, and retail group set record earnings in 2010: TTI, Forest River, CTB, and H. H. Brown shoes. Additionally, Mr. Buffett believes that NetJets is now “fixed” due to David Sokol’s management. NetJets is a topic that we will cover in great detail in our upcoming report.
Mr. Buffett commented briefly regarding Todd Combs who was hired in 2010 to run $1 to $3 billion of Berkshire’s vast securities portfolio. While Mr. Buffett will continue to manage the majority of Berkshire’s investments as long as he is CEO, he anticipates hiring “one or two” more managers if he can find the right individuals. Mr. Buffett is looking for investors who can anticipate the effects of economic scenarios not previously observed rather than simply showing good past track records.
The Rational Walk will publish selected thoughts on Berkshire’s Q4 and full year 2010 results later today. Next week, we will publish The Rational Walk’s comprehensive report on Berkshire Hathaway, In Search of the Buffett Premium, which is currently available for pre-order.
Disclosure: Long Berkshire Hathaway