Why Berkshire Hathaway
Read nearly any of my posts and you will most likely find some mention of Warren Buffett. He is my inspiration to take control of my money and invest on my own. Paying someone to manage my investments would most likely fall short of meeting average market returns. Alternatively, I could follow the advice of JL Collins, author of the amazing book, The Simple Path to Wealth. His solution is to invest in the Vanguard index funds Jack Bogle created. Staying fully invested and investing regularly in index funds will generate an average 7% return over time. Instead, I choose to immerse myself in the teachings and wisdom of Warren Buffett, his partner Charlie Munger, and other value investors and invest on my own. I desire to reap returns of 15% or more through this approach.
In order to generate greater than market returns, you need to know how to value a company. The essence of value investing is purchasing a company at a discount to the company’s value. Because Warren and Charlie are so important to me, I chose their company, Berkshire Hathaway, as the first company to value and share with you. Rather than purchase Berkshire Hathaway at a random price, purchasing it when Warren is willing to purchase it, should generate a better than average return.
Berkshire Hathaway is a conglomerate of over 70 companies and owns minority shares in many other companies. This potentially makes the company very difficult to value. However, we are fortunate that one of the best investors on the planet, Warren “The Oracle of Omaha” Buffett, gives us a significant clue to how we can value his own company and purchase it at a good price.
Berkshire Hathaway Stock
Berkshire Hathaway has a rich and fascinating history. The stock symbol for the company is BRK-A. Warren never wanted to split Berkshire shares because this ultimately reduces total individual ownership. He also believes the high share price attracts like-minded investors, those focused on long-term profits rather than on short-term price fluctuations. The unfortunate effect is that if you never split a stock and the value of the underlying business increases, the price of each individual share will eventually be too high for the average investor.
In 1996, Warren created a second class of stock to make investing in Berkshire more accessible for the average investor. The story is far more interesting than this statement suggests. There are a host of other benefits to creating the second class of stock, but I will leave it at that. The original shares trade as BRK-A and the second class of shares trade as BRK-B. The recent corporate filing 2019Q3 Form 10-Q shows that BRK-A has 707,755 shares outstanding and BRK-B has 1,383,414,987 shares outstanding. The current price estimate for BRK-A is $340,900 per share and for BRK-B is $226.62 per share. Initially, thirty BRK-B shares made up a single BRK-A share. After stock splits since the initial offering, each BRK-B share is now equal to 1/1500th of a BRK-A share.
In 2018, the government cut corporate taxes from 35 percent to 21 percent and reduced the tax rate on corporate income brought back from abroad. This plan was to benefit American corporations over the next ten years so they have more money to increase employee wages. The idea is that higher employee wages encourages people to spend more, which further stimulates and helps the market grow. Some companies raised wages, but many corporations chose to buy their own stock.
A stock buyback is when a company purchases their own stock in the open market. Investors typically see this as a good thing. Think of a pizza with 8 slices. If you own 4 of the slices you own 50%. If I instead slice the pizza into 6 pieces, and you still own 4 pieces your ownership increases to 66.6%. The same is true for a stock buyback. With fewer pieces of the pie, your share of the whole pie is greater.
Stock buybacks are good when the company can purchase their stock at a fair price, but are not good when a company purchases their own stock at a high price. Why? As share owners in a company, we want management to be as wise with their investments as we would. Purchasing stock at a high price may not be the best allocation of capital, especially if the company has debt they could pay off.
Berkshire Hathaway and Stock Buybacks
I explained stock buybacks because Warren agrees that purchasing his company’s stock helps long-term investors. The difference between him and many other CEOs is that he will not purchase the stock at any price. Understanding the price that Warren would pay, helps us calculate the price we may want to purchase Berkshire Hathaway stock. The insight into how much we should pay begins at the bottom of page 7 (6 of the PDF) of the 2016 Letter to Shareholders of Berkshire Hathaway. I separated the following text into paragraphs to make it easier to digest.
My suggestion: Before even discussing repurchases, a CEO and his or her Board should stand, join hands and in unison declare, “What is smart at one price is stupid at another.”
To recap Berkshire’s own repurchase policy: I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.
The authorization given me does not mean that we will “prop” our stock’s price at the 120% ratio. If that level is reached, we will instead attempt to blend a desire to make meaningful purchases at a value-creating price with a related goal of not over-influencing the market. To date, repurchasing our shares has proved hard to do. That may well be because we have been clear in describing our repurchase policy and thereby have signaled our view that Berkshire’s intrinsic value is significantly higher than 120% of book value. If so, that’s fine.
Charlie and I prefer to see Berkshire shares sell in a fairly narrow range around intrinsic value, neither wishing them to sell at an unwarranted high price – it’s no fun having owners who are disappointed with their purchases – nor one too low. Furthermore, our buying out “partners” at a discount is not a particularly gratifying way of making money. Still, market circumstances could create a situation in which repurchases would benefit both continuing and exiting shareholders. If so, we will be ready to act.Warren Buffett on Share Repurchases from the 2016 Letter to Shareholders of Berkshire Hathaway
The board authorized Warren to purchase shares of Berkshire Hathaway stock at 120%-of-book-price, because this price is a significant discount to Berkshire’s intrinsic value. What is intrinsic value? The easiest way to think of it is if you owned the whole company, sold off all the assets, and paid off all the debts it would be the amount of money you have remaining. Buffet states that 120%-of-book-price is a significant discount to intrinsic value. This provides us with a clue to calculating how much we should pay for a share of Berkshire and invest like Warren Buffett.
That’s great, but what is the book price of a stock? Book price is another way of saying shareholders’ equity. You can find this number on the most recent quarterly or annual report in the financial statement called the Balance Sheet. The most recent report, as of this writing, is 2019Q3 Form 10-Q. We find the shareholders’ equity section at the bottom of page 3 (4 of the PDF) of this report.
These numbers are in millions, so the current book price is $401,558,000,000. Next, we need to know how many shares are outstanding so that we can calculate book price per share. The financial statement called the Earnings Statement found on page 4 (5 of the PDF) of the same report provides this information.
Calculating Book Price per Share
We can use either of the equivalent shares outstanding to calculate book price per share, but since we would like to purchase the more reasonably priced Class B shares, we will use this number.
The calculation, as described, is Book Price per Share which equals Book Price / Shares Outstanding. Taking the values from the financial statement excerpts above we arrive at the following calculation.
$401,558,000,000 / 2,449,502,430 = $163.93
Calculating our Purchase Price
Warren stated, “By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value…” We can use this information to calculate this significantly discounted price as follows.
$163.93 * 120% = $196.72
We believe that purchasing Berkshire Hathaway stock as a long-term investment would be a good choice. When Warren Buffett took over Berkshire Hathaway in 1964 the price per share was $12.37. As I mentioned earlier, these shares are now worth $340,900 per share. Anyone investing just $10,000 in 1964 would now have $275,586,095. Compare this to someone investing the same amount in the S&P 500 at the same time. The lowest price that year was in January at $76.45 and is currently trading for $3,327.66. Therefore, this same $10,000 investment would be worth only $435,272. That’s not too shabby for such a small investment, but I would rather have the $275 million.
Today, BRK-B shares trade at $226.62. Warren Buffet has $128B in cash. We, like Warren Buffett, believe in the two rules of investing. Therefore, he will only purchase wonderful businesses and even shares of his own company when he can be reasonably certain he will not lose money.
When the stock price drops below $196.72, Warren will begin buying his shares back. If we want to own this stock, we should also purchase shares below this price or a calculated price based on future financial statements.
We are owners of Berkshire Hathaway stock and believe Berkshire Hathaway is a good long-term investment. When the stock drops below 120% of intrinsic value, we plan to purchase more. Before investing in any individual company, please perform your own research and do not blindly follow the advice of others.
If you own Berkshire Hathaway stock and plan to be at the Annual Shareholder Meeting in May, please let us know. We will be there and would enjoy meeting you. Best wishes with your investments!