Gannon On Investing

Warren Buffett’s face graces (or disgraces) the cover of this week’s Barron’s. In big, bold print the weekly stock market mag says “Sell Buffett”. Inside, the message is equally gloomy: “Sorry, Warren, Your Stock’s Too Pricey”.

Is it?

Barron’s says:

The Street’s enthusiasm for Omaha-based Berkshire…might be excessive. Its stock now appears overpriced, reflecting a sizeable premium for the skills of the 77-year-old Buffett. What’s Berkshire worth? Our estimate, based on several valuation measures, is around $130,000 a share – about 10% below the current quote.

Valuation – In Five Minutes or Less

My estimate – admittedly based on only a single valuation measure (the one I would use to value any holding company / conglomerate / corporate hodgepodge) is around $141,000 a share. By the way, that’s an “ex-Buffett” measure – in other words, that number is my first stab at the value of any corporate hodgepodge – not a corporate hodgepodge with an investment legend at the helm.

I didn’t come up with a specialized measure just for Berkshire (BRK.B) – all I really did was “privatize” Berkshire at $141,000 a share. Of course, Berkshire’s too big to go private; Buffett’s continued leadership adds value; and Berkshire’s collection of businesses (both majority and minority owned) is far from average.

All those factors deserve special consideration.

But, before we consider those factors, it’s worth noting Barron’s is being a bit too cautious in valuing Berkshire. Even if Berkshire had a miserable 2007, the sum of the parts would still be greater than $125,000 a share which Barron’s sets as the low-end of the range ($130,000 a share is the high-end).

What’s Berkshire really worth? That’s hard to say. If you gave me five minutes, a pen, paper, and the 2006 annual report, I’d say $141,000 a share.

That figure is the result of taking Berkshire’s year-end 2006 businesses and securities, valuing Berkshire’s pre-tax earnings to yield 8% (an appropriate rate for excellent, but not necessarily fast growing businesses), valuing Berkshire’s securities at their market prices at the time of the 2006 annual report, and then correcting the combined value for the time elapsed since the 2006 annual report was published.

I did it this way so anyone could follow my logic without needing anything more than the 2006 annual report – you could look at Berkshire’s latest filings for more up to date earnings and portfolio data. But, there’s no real need to add so many complications merely to get an intrinsic value estimate that is nine months more timely.

Golden Years

Not surprisingly, Barron’s mentions Buffett’s age:

Buffett turns 78 next August, and his actuarial life expectancy is nine years. He’s likely to stay on the job for as long as possible, but in reality, few CEOs can handle the demands of the job much past 80. When Buffett departs, the stock is apt to drop as longtime Berkshire holders cash out and the investment community waits to see whether his successors can live up to his legend.

Buffett’s successors will not live up to his legend. At this point, not even Buffett can live up to his own legend – and he knows that. The amount of capital he needs to invest is just too big for anyone to provide the kind of returns Buffett once did.

However, the age angle is overdone in most media reports. People look at Buffett (like Bill O’Reilly recently did) and say “this guy’s old; he’s going to be dead soon”.

There are a few problems with this logic when applied to Buffett’s future services to Berkshire. One, CEOs don’t usually die in office. Even great CEOs retire long before they reach 77 – and 86 is never even contemplated.

Buffett will work for as long as he’s able. Taking Barron’s actuarial life expectancy of nine years, it’s obvious that Buffett is still expected to last longer at Berkshire than the average public company CEO appointed today. CEOs don’t make it much more than five years on average; so, Buffett’s expected future service time is actually above-average not below average.

He is old for a CEO; but, he’s not planning to retire. Most CEOs do retire – and quite early at that. In fact, I would put Buffett’s effective age (considering his commitment to stay at the helm of Berkshire) at more like 60-65 years rather than his actual age of 77.

You’ve heard of dog years. Well, now I’m introducing CEO years – and in CEO years, Buffett is at least twelve years younger than he appears to be. I know this sounds strange, but it’s not a contrivance by any means. Ask yourself this question: Do you really believe that a 60-65 year old public company CEO chosen at random is likely to significantly outlast Buffett in terms of years of service from this moment on? I don’t see that happening. I’ll take Buffett at 77 over the average CEO at 62.

Why? Not because Buffett is immortal, but because he’s not going to retire. Most great CEOs aren’t more likely to give you many years of service from age 60 on then Buffett is from this moment on. To a shareholder, should it matter if the CEO has 25 years of retirement or 25 seconds?

What matters is how much work they have left in them – and on that count Buffett is not in a lesser position than a 60-65 year old CEO. So, it’s appropriate to talk about succession plans; but, certainly no more so than in the case of a CEO in his early to mid sixties. The situation at Berkshire is roughly equivalent to the situation at any public company with a star CEO in his sixties.

The $73 Billion Man?

So is Buffett really worth that much? Considering his age and Berkshire's massive capital constraints, how much more value can Buffett add to Berkshire? What do Berkshire’s shareholders stand to lose if Buffett is hit by a truck tomorrow?

My best guess is $73 billion. That’s the present value of Buffett’s “value over replacement player” (to use a baseball term) for nine years (his actuarial life-expectancy according to Barron’s). In other words, Buffett’s future services to Berkshire are quite possibly still greater than his own net worth.

Calculating the present value of Buffett’s future services is difficult, because you need to consider what kind of compound annual growth rate Buffett is capable of achieving on Berkshire’s net worth, what kind of CAGR a replacement investor would achieve, and what kind of discount rate to use on Buffett’s expected value over a run-of-the-mill replacement over the next nine years.

Again, my best guess is $73 billion or roughly $47,000 per share. Obviously, this is just a guess, based on the likelihood of Buffett going much shorter or much longer than nine more years at Berkshire, the likelihood of excellent investment opportunities appearing within Buffett’s circle of competence, etc., etc., etc.

The $73 billion number assumes Buffett can compound Berkshire’s investments and pre-tax earnings at a rate of 11.50% over the next 9 years while a run-of-the-mill replacement would do no better than 8.00% - the discount rate is also 8% (that’s a typical discount rate for me and has nothing to do with this specific scenario). Why 11.50%?

Because there’s a chance Berkshire will lose Buffett’s services long before nine years are up (like tomorrow for instance), due to the nature of compounding, this possibility greatly reduces the expected value of Buffett’s services. However, there’s also a chance Berkshire will keep Buffett’s services for much longer than nine years, but due to the nature of discounting, this possibility is somewhat less important than it first appears. Finally, there’s a chance that stock market valuations for mega-cap stocks will be elevated for much of Buffett’s remaining years of service. This possibility reduces the expected value of Buffett’s future services by making it more difficult for him to deploy capital.

On the other side of the scales, there’s the possibility that Buffett could finally bag his elephant (i.e., make a huge investment). There are (literally) a couple private elephants that Berkshire has some chance of bagging with Buffett at the helm and would have almost no chance of bagging without him. A huge investment in a publicly traded company is also a possibility – for that reason, Berkshire (especially with Buffett at the helm) offers some downside protection against an earnings multiple contraction in mega-caps (and the market as a whole). As price-to-earnings ratios decrease, Berkshire’s opportunities increase.

Putting all these factors together, my best guess is that the expected value of Buffett’s future services at Berkshire are derived from an expected 3.50% a year edge over a period of 9 years (though this takes into account the possibility of a larger edge over a shorter period of time). Is an 11.50% a year growth in net worth realistic considering Berkshire’s enormous size?

Buffett did this over the past decade – and that was during a very unfavorable market climate. In fact, the unfavorability of that market helps explain why Buffett has put more and more money into purchasing private companies outright; negotiated purchases of 100% of the earnings of private companies have generally been possible at more attractive terms than market purchases of a portion of the earnings of public companies.

But Berkshire is Slowing, Right?

Big time.

Berkshire was once a remarkably fast-growing investment company. For instance, Berkshire once had an eighteen year streak of beating the S&P 500 in terms of increase in book value per share versus that year’s return on the S&P 500 including dividends. From 1981 through 1998, Berkshire outpaced the S&P with the following relative results:

1981: 36.4%
1982: 18.6%
1983: 9.9%
1984: 7.5%
1985: 16.6%
1986: 7.5%
1987: 14.4%
1988: 3.5%
1989: 12.7%
1990: 10.5%
1991: 9.1%
1992: 12.7%
1993: 4.2%
1994: 12.6%
1995: 5.5%
1996: 8.8%
1997: 0.7%
1998: 19.7%

Since 1998, the record has been a lot spottier. First, Berkshire’s net worth was roughly flat in 1999, while the S&P 500 charged ahead, leaving Berkshire with a return 20.5% behind the S&P 500. Berkshire’s relative results have improved, but they haven’t returned to their best levels of the the ’81-’98 run: (20.5%), 15.6%, 5.7%, 32.1%, (7.7%), (0.4%), 1.5%, 2.6%.

What’s wrong?

Valuations for one. You may recall from my series of posts on 15-year normalized earnings for the Dow that 1996 was the year everything changed. It’s no exaggeration to say that starting in 1996 the market entered uncharted territory as far as normalized P/E ratios – uncharted territory from which it has yet to return. In all his years of investing, Warren had never seen (normalized) valuations this high – at least among the biggest stocks in the U.S. He admitted nearly as much in his 2002 annual letter to shareholders:

We continue to do little in equities. Charlie and I are increasingly comfortable with our holdings in Berkshire’s major investees because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don’t yet believe their shares are undervalued.

In our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge.

The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks – if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless, however, we see a very high probability of at least 10% pre-tax returns (which translate to 6½-7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.

The idea that Warren is an over-demanding investor by historical standards is easily refuted by the bolded statement above (“In my 61 years of investing, 50 or so years have offered that kind of opportunity”). That’s more than four out of every five years.

Warren’s statement is consistent with my series of posts on normalized P/E ratios – stocks may have been too cheap in the past, but they have been more expensive since 1996 than they ever had been in the preceding 66 years (1930-1995). In every year since 1996, the Dow has had a higher normalized P/E ratio than it had in any year from 1930-1995.

In terms of (normalized) valuations, not even the tops of those markets could rival the bottom of this market since 1996. This time, valuations may have reached a permanently high plateau. Regardless, we must recognize that the last decade was clearly a poorer hunting ground for Buffett than the previous five had been.

It’s been ten years of pricey stocks. That’s not fun for a company (and an investor) that depends on devouring them. It’s a cost of living increase that’s hard to overcome.

Still, Berkshire has managed. Over the last ten years, net worth has grown more or less in line with the stock price, with compound growth in net worth of just under 12% a year and a stock price performance of just over 12% a year. Needless to say, the S&P 500 hasn’t fared so well.

It’s hard to say what Berkshire’s worth. But, here’s a good guess of where things stand today:

Stock Price: $143,000

Intrinsic Value with Buffett: $188,000

So, should you buy Berkshire? That’s a bit more complicated. Let’s look at what Berkshire will be worth in nine years (again using Barron’s actuarial life expectancy for Buffett) under different scenarios:

If Berkshire grows both investments and pre-tax earnings by 6% a year over the next nine years, investors buying today should expect something like a 5.84% annual return. If Berkshire grows both by 8% a year, the return will be 7.84%; if Berkshire grows by 10%, expect 9.83%; if Berkshire grows by 11.50% a year, expect 11.33%; if Berkshire grows by 12.50% a year, expect a 12.33% return; and if Berkshire grows by 15% a year, expect a 14.83% return.

You may have noticed a pattern among all these numbers. The important thing isn’t my own arbitrary guess of what Berkshire could do with nine more years of Buffett (grow by 11.50% a year, and provide an 11.33% annual return for shareholders); rather, it’s the simple fact that Berkshire is very close to fairly valued today.

You can ride with Buffett for free. Berkshire is worth close to $141,000 a share without Buffett and it’s trading for $143,000 a share today. Trust me; $2,000 on a $143,000 stock is well within the margin of error on any intrinsic value estimate. So, tomorrow, you can choose to have Buffett manage your money for no extra charge.

There are some serious constraints here. Buffett has far too much capital to deploy to be as effective as he should be. He won’t run circles around today’s best money managers.

If you think my very rough guess of 11.50% a year growth with Buffett at the helm is a reasonable one, you can buy Berkshire today for roughly seventy-five cents on the dollar ($143,000 vs. $188,000 with nine more years of Buffett).

Is Berkshire a screaming buy?

No.

Is it the best place to put your money?

No.

Is there a margin of safety?

Yes.

Without Buffett, Berkshire is worth almost exactly what you’re paying for it today. With Buffett, it’s probably worth quite a bit more.

There is no Buffett premium in Berkshire's share price. That doesn’t mean the stock won’t drop if Buffett kicks the bucket tomorrow – but long-term investors can still ride with Warren Buffett for free.

You won’t do as well as his partners did back in 1956, but you may do better than the S&P – and you won’t have to pay for the privilege of having Warren Buffett manage your money.

On the downside, you’re buying into what amounts to the world’s biggest mutual fund. For a fund this big, success forges its own anchor.

You can’t expect miracles, but you can expect something like 6% - 12% a year plus a “call” on any market mayhem that causes mega-cap valuations to decline and fat pitches to once again fall within Warren’s sweet spot.

Simply put, Berkshire is fairly valued. Buy it, hold it, or sell it – but don’t think you’re getting in at a discount or paying some big Buffett premium – you’re not.

At $143,000 a share, you’re paying par; the rest is up to Buffett.