Tuesday, September 20, 2011

Should Berkshire Hathaway Repurchase Its Own Stock?

*** Update — Well, l ess than a week after this post on the merits of a buyback for Berkshire, the following news release came out announcing: Berkshire Hathaway Authorizes Share Repurchase ***

In 1999, Warren Buffett considered making some share repurchases of Berkshire Hathaway’s (BRKa ) stock.

Lately, he and Charlie Munger have more than hinted that they think the stock is cheap. Something they’ve said infrequently.

So, if Buffett was considering a buyback of the stock in 1999, it seems worthwhile to compare how valuation now compares to back then.

Let’s first look at what Buffett said about repurchasing the stock in the 1999 Berkshire Hathaway shareholder letter :

Recently, when the A shares fell below $45,000, we considered making repurchases. We decided, however, to delay buying, if indeed we elect to do any, until shareholders have had the chance to review this report. If we do find that repurchases make sense, we will only rarely place bids on the New York Stock Exchange (NYSE). Instead, we will respond to offers made directly to us at or below the NYSE bid. If you wish to offer stock, have your broker call Mark Millard at 402-346-1400. When a trade occurs, the broker can either record it in the third market or on the NYSE. We will favor purchase of the B shares if they are selling at more than a 2% discount to the A. We will not engage in transactions involving fewer than 10 shares of A or 50 shares of B.

Please be clear about one point: We will never make purchases with the intention of stemming a decline in Berkshire’s price. Rather we will make them if and when we believe that they represent an attractive use of the Company’s money.

Back then the dominant driver of Berkshire’s intrinsic value* was investments per share funded to a great extent by insurance float.

Since the letter was written, investments per share have increased from roughly $ 47k to $ 95k. Not bad but also hardly explosive.

On the surface, the fact that the A shares have gone from the $ 45k/share Buffett refers to above to $ 105k/share it now sells at may makes it seem, even if still cheap, not much more of a bargain now.

Here’s what’s wrong with that.

A bit over a decade ago, by far the biggest driver of Berkshire’s intrinsic value was investments funded, in part, by cheap and stable float (along with Buffett’s future ability to deploy capital). Now it is increasingly the earnings from non-insurance businesses that Berkshire owns outright. In other words, businesses like Burlington Northern increasingly drive intrinsic value.

To quantify how this has changed, look at what has happened to pre-tax operating earnings from the non-insurance businesses:

In 2000, Berkshire’s per share pre-tax earnings was $ 919k.

In 2010, Berkshire per share pre-tax earnings was $ 5,926k.

Source: 2010 Berkshire Hathaway shareholder letter

So it has grown more than 6-fold in a decade, a compounded annual increase in earnings of 20.5%.

Not bad, and, it’s not like earnings should be shrinking in the coming years (even if there will certainly be year to year fluctuations considering some of the cyclically oriented businesses owned by Berkshire).

Now, Berkshire does often earn money in the insurance businesses but I’m excluding that to be conservative.

I’m assuming they break even on average going forward in insurance underwriting (even though that has not typically been the case). Of course, if they do make some underwriting profits that will be additional intrinsic value creation.

Also, I’d point out that many of the securities in the Berkshire equity portfolio (Coca-Cola; KO comes to mind) were selling at market values that were optimistic relative to intrinsic value a decade or so ago. The net effect being to inflate the book value of Berkshire’s investments per share just a bit.

That’s not the case these days. The multiples of many Berkshire equity holdings is anywhere from single digits to mid-teens. Back then, Coca-Cola sold for more like 50x earnings while others like American Express (AXP ) were selling for 25-30x.

If Buffett thought Berkshire’s stock was cheap back then it is easy to see why he (and Munger) have hinted or explicitly said lately that they think Berkshire shares are, once again, cheap right now.

So should they buyback stock? It makes a lot of sense to me.

Whether it happens is a different story and comes down to what other investing alternatives are available for Berkshire Hathaway.