Getting In on the 50th Floor

The process of compounding wealth is best characterized by an interesting paradox:  What is very exciting to observe, in retrospect, over long periods of time can appear to be relatively dreary and dull while actually living through the process.  The cumulative effect of many years of relentless progress will inevitably result in some staggering figures but many investors have trouble visualizing that eventual result when viewing business or their portfolios on a year-to-year or quarter-to-quarter basis.

It is quite common for investors to feel like they need to spot the “next big thing” and to score home runs on a frequent basis in order to compound wealth at an attractive pace but this is not necessarily the case.  We have seen multiple boom and bust cycles over the past twenty years that were driven by excitement over both very real and transformative new technologies as well as many transient fads.  We have seen massive wealth earned by the shareholders of companies such as Amazon.com, Google, and Facebook.  Most value investors, much to their regret, steered clear of these big winners — but also avoided many big losers in the process.

Getting in on the Ground Floor

One common misconception among investors is that it is somehow necessary to get in on the ground floor of a new industry, company, or concept in order to achieve a satisfactory long term result.  In truth, who wouldn’t have wanted to invest in the Buffett Partnership in the late 1950s?  Obviously, that opportunity was limited to people who knew Warren Buffett very well but anyone could have purchased Berkshire Hathaway stock for $18 per share when Mr. Buffett assumed control on May 10, 1965.

Let’s say you were in the market for a new car in early 1965 and settled on the Ford Mustang, which had just been released the prior year.  The typical MSRP was around $2,400 at the time.  But upon learning that Mr. Buffett had assumed control of Berkshire, you instead buy a $600 used 1958 Fairlane and purchase 100 shares of Berkshire for $1,800.  Today, those 100 shares would be worth $23.7 million.  Other than receiving a dividend of $10 on your 100 shares in 1967, however, you would have seen no cash from the investment over this timeframe.

The graph below represents a similar outcome resulting from an investment in Berkshire at the end of 1965 and held through November 2016.  Using a log scale allows us to better understand the experience of an investor living through this holding period.

brkpotogold

This is what achieving compound annual returns in excess of 20 percent over a half century would feel like.  But, of course, the example is ludicrous because Mr. Buffett was unknown in 1965 except to a small circle of investors and Berkshire Hathaway was a struggling textile company.  And although Berkshire’s stock price gains in the early years were very strong, one would have also lived through a fifty percent haircut during the 1973-74 bear market, even as book value and intrinsic value were going up.  Many people would have taken their $4,000 off the table at the very worst possible time.

The (Nearly) Impossible Dream

The search for the “next Berkshire” is a near obsession for many value investors.  We all want to get in on the ground floor of something great and compound wealth at 20 percent over a half century or more.  Who wouldn’t want to do that?  However, for the vast majority of us, that dream is pretty much impossible to achieve and there is a risk that costly mistakes might be made in the process of pursuing it.

Saying this might be easy from an intellectual standpoint, but we are taunted by the fact that extraordinary gains are, in fact, achieved on a recurring basis and we hear about these results.  We do not usually hear about the many cases of failure due to survivorship bias.  Perhaps more importantly, however, many of these extraordinary gains are achieved through breakthroughs in technology that would be nearly impossible for most of us to predict accurately in advance.  Even if predicted accurately in advance, selecting the right investment vehicles to capitalize on technology is fraught with risk.

There’s nothing wrong with aspiring to greatness but, for most of us, it is probably better to be more realistic.

Getting in on the 50th Floor

If we cannot reliably get in on the ground floor of a skyscraper, is it worth trying to identify companies that are already well on their way to dominance and get in at a higher floor?  In the case of Berkshire, those of us in Generation X or later were not even alive during the 1960s and obviously could not have participated in Berkshire’s early years.  On a positive note, however, Warren Buffett was already very well known within the investment community by 1990.  By the early 1990s, Berkshire had a share price in excess of $10,000.

Consider a young investor with a net worth of around $15,000 who had spent some time during 1992 studying Berkshire’s track record and was also in the market for a new car.  Berkshire’s share price at the end of 1992 was $11,750.  That presented a dilemma because Berkshire did not yet have Class B shares and buying even one share would consume over three-quarters of the investor’s net worth as well as make it impossible to buy the new 1993 Ford Mustang which had an MSRP of around $15,000.  Our frugal young investor decides to purchase one share of Berkshire and settles for a $3,000 1988 Ford Taurus rather than the new car.

The chart below shows the investor’s experience over the past 24 years:

Berkshire 1993-2016

The compound annual return in this chart is “only” 13.5 percent, well short of the phenomenal results experienced by someone who invested in Berkshire in 1965.  However, our second investor had the advantage of having a much clearer picture of what he was investing in and who was running the show.  However, there was nothing “obvious” about making this investment.  Warren Buffett was 62 years old.  Charlie Munger was 69 years old.  Both men could have retired at that point or shortly after and would still have been regarded as having one of the best investing track records in history.  It was not “obvious” that they would be running Berkshire nearly a quarter century later.  In fact, anyone who confidently predicted that they would be running Berkshire in 2016 would probably have been laughed at.

What about valuation?  By 1992, wasn’t Berkshire’s track record already so good that the shares would have traded at a completely unreasonable level relative to book value?

At the end of 1992, Berkshire’s shareholders’ equity was $8.9 billion and book value per share was $7,745.  At a price of $11,750 per share, Berkshire traded at 1.52x book value.  Although much more of Berkshire’s intrinsic value was represented by marketable securities carried on Berkshire’s balance sheet at market value, paying a 50 percent premium to book does not seem like it would have been a reckless move at the time.

We Don’t Know the Details…

It is easy to look at the chart and a figure like 13.5 percent compound annual returns from 1993 to 2016 but who could have predicted exactly how history would play out?  In the early 1990s, Berkshire’s intrinsic value was dominated by its  marketable securities portfolio, funded with shareholders’ equity and insurance float, as well as the value of several non-insurance subsidiaries.  Over the next several years, Berkshire would be completely transformed by the GEICO and General Re acquisitions.  In the 2000s, Berkshire would be further transformed with large non-insurance acquisitions including an electric utility and a railroad. And along the way, investors would have lived through large unexpected underwriting losses at General Re, the September 11 attacks, the 2008-09 financial crisis and countless natural disasters.

There is no way that an investor in 1992 could have had the slightest idea of the details of Berkshire’s next quarter century.

In many ways, however, we do not need to know the exact details.  What we need to know is whether the business model is sound and who is running the show.  Berkshire’s history is a story of intelligent and opportunistic allocation of capital.  In 1992, there is no way an investor could have know how the next quarter century would play out, but it was possible to know the principles that would guide the company.  All that anyone had to do was read Berkshire’s annual reports and Warren Buffett’s letter to shareholders.

Size Becomes an Anchor … Eventually

At some point, massive size does become an anchor.  With shareholders’ equity of $269.3 billion and market value of nearly $400 billion, it is nearly certain that Berkshire’s days of compounding wealth over long period of time at 20 percent or even 13.5 percent are long past.  Intrinsic value may increase at that kind of rate from time to time but not over a sustained multi-decade period.  Investors might be able to buy and sell Berkshire opportunistically to realize returns greater than increases in intrinsic value, but this has its own perils.  There is nothing wrong with high single digit to ~10 percent compound growth and Berkshire is likely to achieve this for some time, but many investors will not be satisfied with the pace.

We can choose to chase the (nearly) impossible dream of getting in on the ground floor of the “next Berkshire” or we can look at the investment universe as it stands today and try to get in on the 50th floor of a skyscraper that is already under construction.  The latter might not offer the chances for thrilling 20+ percent growth over 50 years but is still quite exciting for most of us.

Markel Corporation:  The Next Berkshire?

One of the reasons that 1992 was selected in the example above is because Berkshire’s shareholders’ equity of $8.9 billion was quite similar to the shareholders’ equity of Markel Corporation of $8.5 billion as of September 30, 2016.  Obviously these figures are not adjusted for inflation and these are two very different companies.  However, the comparison might be instructive.

Markel Corporation went public in December 1986 at $8.33 per share which probably seemed richly priced at the time relative to book value per share of $3.42.  Over the past 30 years, book value per share has advanced to $609.48 which represents compound annual growth of ~19 percent.  The share price has advanced at a compound annual rate of 16.8 percent. Growth has slowed at Markel over the past decade relative to its first twenty years as a public company but has still been respectable with ten year compound annual growth in book value of 12 percent through the end of 2015.

We have discussed Markel in the past, most recently in an article regarding Markel Ventures.  Markel is still primarily a property/casualty insurance company but almost everything about the way the company has been run over the past three decades seems to be inspired by the Berkshire Hathaway business model.  The growth of Markel Ventures, the company’s collection of non-insurance businesses, has been gaining momentum.

As with Berkshire Hathaway in 1992, we do not know exactly how Markel’s business will progress over the next 25 years.  In fact, management is very unlikely to have a good idea of the specifics either. In 1992, Warren Buffett and Charlie Munger did not know the specifics of how Berkshire would grow over the next quarter century either.  The specific details are impossible to know. But the guiding principles that would direct the company’s activities were known at Berkshire and the same appears to be the case at Markel today.

Conclusion

A prospective Berkshire Hathaway shareholder in 1992 had no way of knowing the specific actions Warren Buffett and Charlie Munger would take to build value over the next quarter century.

The same is true for a prospective Markel shareholder today, or a prospective shareholder of any company.

However, what can be known, and likely has predictive value, is how management views capital allocation, the quality of a company’s culture, and the general capabilities of the managers involved.

These factors can be known when you get in on the 50th floor of a skyscraper under construction.  But they cannot usually be known on the ground floor.

In 1965, very few investors would have had any idea about what Warren Buffett was capable of or how a failing textile mill would transform into a massive conglomerate.  In 1986, very few investors outside the Richmond business community would have known much about Markel and even fewer could have predicted the subsequent three decades.

In 2016, there is no doubt that there are companies one could invest in on the ground floor that will become phenomenal success stories in the decades to come.  There is substantial doubt that investors will be able to identify those companies.  However, today there are many candidates for investment where the companies are already well under construction and we can get in on a higher floor.  Markel is just one possible example.  Such investments may not realize 20 percent compound annual returns over 50 years but, for most people, far more modest compound returns are perfectly adequate to meet personal objectives.

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

Interesting Reading – November 15, 2016

In this series, we suggest worthwhile reading material on a variety of topics, not all of which are directly related to investing.  

Is Value Investing Broken? – Gannon on Investing, November 9, 2016.  Geoff Gannon argues that value investing is not dead.  There’s always a tendency for investors to view the world as uniquely different and unlike any prior age, but this is mostly incorrect.  Life was not necessarily simpler in the past which was, in many ways, more perilous than today from an investor’s standpoint.  There is much to be said for the argument that the value investing principles of Benjamin Graham and Warren Buffett are timeless in terms of their applicability.

The Quest for 10-100 Baggers – The Compounders, November 9, 2016.  This is actually a video of a talk given by Mohnish Pabrai at Peking University (rather than reading material) but it is quite interesting given the subject matter.  Many readers will want to subscribe to The Compounders in order to follow Mohnish Pabrai’s thoughts on investing.  Also, readers may want to follow his portfolio activity on dataroma which provides an easy way to keep up with 13-F filings.

The David Rubenstein Show:  Warren Buffett – Bloomberg, November 4, 2016.  This is a video of David Rubenstein interviewing Warren Buffett at Gorat’s Steakhouse in Omaha.  While there were no groundbreaking revelations in this conversation, it was interesting to hear Warren Buffett describe his use of computers.  In the past, he described his use of computers as primarily a tool for playing online bridge.  Apparently he is now using a computer quite extensively for research purposes.

FreightCar America – Barel Karsan – Value Investing, November 9, 2016.  At the time this post was published, FreightCar America was apparently a “net-net” although the stock price is up quite a bit over the past few days.  Net-nets were a favorite hunting ground for Benjamin Graham as well as for Warren Buffett during his early years, and even made a few appearances during and after the 2008-09 bear market.  However, net-nets have been more rare recently so it is interesting to see an article discussing a current example.

Steve Ballmer Says Smartphones Strained His Relationship With Bill Gates – Bloomberg, November 4, 2016.  (Article and video).  Steve Ballmer discusses his working relationship with Bill Gates, his tenure as CEO, as well as the circumstances that led Microsoft to miss the smartphone revolution.  He does admit some mistakes related to his initial reaction to the iPhone which apparently did not factor in the possibility of carrier subsidies to defray the high sticker price of smartphones in the $500+ range.

Afraid of What Comes Next for the Markets and Economy?  Read This – The Wall Street Journal, November 9, 2016.  Jason Zweig argues that a time of political shock is not the right time to make major changes in an investment program.  Indeed, the events of the past week prove this point with stocks initially rising early last week in anticipation of a Hillary Clinton victory, then falling precipitously in the futures market when Donald Trump’s victory appeared certain, and then rallying strongly in the days that followed when nearly everyone expected a market crash in the event of a Trump win.

How to Invest When You Only Have an Hour a Day to Do It – Gannon on Investing, November 10, 2016.  Geoff Gannon receives a reader question regarding the strategies open to someone who has five to ten hours per week to devote to investing a portfolio under $1 million.  He argues for spending a very focused hour every day on security selection with an emphasis on stocks that can be held indefinitely so that there is no need to devote much thought to the selling decision.  The majority of investors with such a limited amount of time to devote to the endeavor should either delegate the task or purchase a market index but those who want to pursue an active strategy will find this advice interesting.

Becoming an Expert:  The Elements of Success – Farnam Street, November 7, 2016.  This article is a discussion of the factors that underpin success.  Is success driven by luck, innate talent, or hard work?  Or a combination of several factors?  The article refers to Malcolm Gladwell’s “10,000 hour” theory of deliberate and focused practice for those learning a skill.  Ultimately, those who want to develop world class ability in any field must not only attain but maintain a skill.  And in order to grow a skill, it is necessary to constantly strain to achieve a target just out of reach.  This seems intuitively true and applicable in broad areas of human endeavor.

Berkshire’s Post-Election Record High

In general, investors are best served by ignoring most headlines, tuning out the daily market chatter, and focusing on in-depth fundamental research into the factors that influence the long-term intrinsic value of a business.

If that actually comes anywhere close to describing your activities this week, it is safe to say that you have superhuman discipline!  Those of us who are less disciplined have been focusing on the United States presidential election and the wild market gyrations that took place once it became apparent that Donald Trump was on a path to victory.  The following Wall Street Journal chart from election night shows how extreme the reaction was when it became obvious that Mr. Trump was on a path to victory:

Election Night Stock Market Futures

On Wednesday and Thursday, stocks rose strongly which is precisely the opposite of the conventional wisdom put forth by market “experts” prior to the election.  Stocks were supposed to rally if Hillary Clinton prevailed and to fall if Donald Trump pulled out an upset victory.

There is no point in analyzing this situation in much depth other than to say that the intrinsic value of the overall market could not possibly have tracked the wild market gyrations that we have seen.  At a micro level, the same is true for Berkshire Hathaway which opened at $218,930 on Wednesday morning and closed at $233,750 today.  This represents a record high close for Berkshire and puts the total market capitalization of the company at $384 billion.

Fundamental Factors?

Are there any fundamental reasons behind Berkshire’s price behavior since the election?  One possible explanation is that the policies of the Trump administration are expected to result in significant fiscal stimulus which could lead the Federal Reserve to increase interest rates at a faster pace.  With $85 billion of cash on the balance sheet, Berkshire would benefit materially if interest rates normalize over the next couple of years.  Another possible explanation has to do with the gains recorded in Berkshire’s equity portfolio, especially the recovery in the share price of Wells Fargo which has reached levels that prevailed prior to news of the fake account scandal that broke in early September.  Additionally, many of Berkshire’s subsidiaries could benefit from Mr. Trump’s infrastructure spending plans.  BNSF could benefit from a resurgence in the coal industry as well as increased transportation of oil if new land is opened to drilling.  On the other hand, the energy business could be negatively impacted if the Trump administration proves less friendly to renewable energy initiatives.

It is not productive to speculate too much regarding how Berkshire’s business will be affected by the election.  However, given the fact that Berkshire is at a record high, it is interesting to revisit the valuation to determine whether the stock price remains reasonable.  Let’s take a quick look at where things stand.

Price to Book Value

Price to book value is a longstanding measure that Berkshire Hathaway investors typically follow closely.  One reason is that Warren Buffett has set the threshold for repurchasing Berkshire stock at 1.2x book value.  Since the turn of the century, Berkshire’s average P/B ratio is 1.48x.  However, since 2008, the average ratio is only 1.34x.  Based on reported book value of $163,783 as of September 30, 2016, Berkshire’s current P/B ratio is 1.43x.  This is slightly below the average since 2000 but above the average that has prevailed since 2008.

The exhibit below provides a long-term view of this measure of value.  The dark red line on the second chart shows the repurchase threshold which was originally set at 1.1x book value in 2011 and later raised to the current 1.2x book value.

Berkshire P/B November 2016

From a price-to-book ratio perspective, it seems like Berkshire is well within a “reasonable” range of value if one looks at the average level that has prevailed since 2000.  It is interesting to note that shares trade toward the lower level of the range that existed prior to 2008.  The financial crisis marked a shift in the average P/B ratio assigned to Berkshire stock.  However, over time, the gap between fair value and book value should increase rather than decrease because more of Berkshire’s value resides in wholly owned subsidiaries rather than marketable securities.  The economic goodwill of growing wholly owned subsidiaries will never be reflected in book value whereas marketable securities are carried at full value.

Two Column Valuation

The price-to-book ratio is not really a valuation methodology but simply represents an easily calculated number that we can track over time.  There are many other approaches for calculating Berkshire’s intrinsic value, many of which have been discussed on The Rational Walk over the years.  For purposes of our discussion today, let’s take a look at another easily calculated measure of value.  The two-column valuation approach assigns an earnings multiple to Berkshire’s pre-tax earnings (excluding investment income and investment gains and losses) and then adds the market value of investments and cash on the balance sheet.

The exhibit below provides a low, medium and high valuation scenario using different pre-tax earnings multiples:

Two Column Valuation

Keep in mind that the multiples shown above are on a pre-tax basis with the medium scenario pre-tax multiple of 10x roughly translating to an after tax multiple of 15x.  At the bottom of the exhibit, we can see the P/B ratio that each scenario translates to.  The low scenario roughly matches the long term P/B ratio since the turn of the century while the other scenarios are more in line with Berkshire’s typical P/B ratio prior to the financial crisis.

Conclusion

This brief article is not sufficient to fully think through Berkshire’s valuation and both methods are relatively crude.  Berkshire’s non-insurance subsidiaries are so diverse that a more in depth sum-of-the-parts valuation is clearly warranted.  Nevertheless, there is some value in coming up with “ballpark” figures to see if today’s record high signals some kind of exuberant sentiment on the part of Mr. Market.  Both the price-to-book and two column methods suggest that Berkshire’s price is not unusually high.

Only time will tell how the new administration reshapes U.S. economic policy and what effect this will have on American business generally and on Berkshire specifically.  For now, we can only conclude that the “Trump Rally” has not created any irrational exuberance in Berkshire’s stock price even as it breaches prior record highs.

For further insights regarding valuation methodologies for Berkshire Hathaway, please review In Search of the Buffett Premium.  This report is several years old but the information regarding the two-column approach is still applicable today.

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

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