Ahead of Meeting, Berkshire Looks Fairly Valued

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We're getting ready for the 2017 Berkshire Hathaway annual meeting. I'm here with Gregg Warren, he is a senior stock analyst who covers Berkshire for us, to see if the shares look attractive today.

Gregg, thanks for joining me.

Greggory Warren: Thanks for having me.

Glaser: So, as we go into the meeting, obviously, we're focused probably more on what Charlie and Warren are going to say and what kind of insights we're going to get there. But a lot of investors want to know if this is a good time to get into Berkshire stocks. I thought we'd take a look at the valuation.

Warren: Yeah, it's interesting that the past two years going into the annual meetings the stock was relatively fairly valued--or not fairly valued, it was undervalued. We actually added it to our best ideas list back in May of 2015 ahead of the meeting based on sort of that undervalue position relative to our fair value estimate. But the stock has had a pretty good run post the election. We ended up actually pulling it off that list at the beginning of this year after about a 14% run. At this point right now, it's trading at around 98% of our fair value estimate. The stock is about 17% above that 1.2 times book value threshold that Buffett has insisted on when buying back stock. So, it's not necessarily a screaming buy from a valuation perspective at these levels.

There could be a case made for an increase an the fair value anywhere sort of in the 7% to 9% range if we start toying around with tax reform in the model. But it's really hard to sort of get a handle on that because Berkshire, unlike a lot of smaller, say, asset-light firms, it's not a matter of just adjusting the statutory tax rate. It's actually looking in at what the offsets might be. Will interest rate deductions go away? Will capital expenditures be immediately deductible from earnings? Will renewable incentives be taken away? So, there's a lot of different parts within the system overall. At the end of the day--Berkshire already right now has a blended tax rate of around 30%. So, it's not likely to benefit as much from firms that don't have as much complications within the structures or they are sitting at sort of a standard 35% statutory tax rate.

Glaser: When you're coming up with that fair value estimate, are you, kind of, building models for each of the segments, because they are obviously quite different in kind of bringing them up? What's your process?

Warren: Yeah, that's the whole process because we use a sum-of-the-parts valuation methodology. We strip out everything that's not insurance from the insurance operations. We run that through our valuation model. We work with the railroad analyst on the BNSF section; we work with our utilities analyst on the Berkshire Energy piece; we do sort of truncated DCFs the manufacturing, service, and retailing, the financial and financial products divisions and then we sort of combine all of that up. We actually also strip out Kraft Heinz because we get a good sort of standard fair value estimate on that from our analysts which is tied more to sort of a longer-term value as opposed to what the market might be looking at, at any given time.

So, from that perspective, we are looking at each of the pieces individually. That's why when we start looking at tax reform, it is kind of an issue because BNSF and the energy businesses are heavy, heavy, heavy capital-intensive businesses. And there's a lot of questions around--if you take away interest deductions how does that alter their capital allocation perspective, how do they think about capital, do they pay down the debt, do they continue to sort of invest as heavily in the business if they have straight CapEx depreciation?

So, there's a lot of moving parts there. That's why getting into sort of an easy answer is a little bit harder. But at the end of the day too, Berkshire tends to trade on book value per share. So, sort of the quick back-of-the-envelope tells you that there's going to be at least a 5% increase in book value if there is a drop in the statutory tax rate, because these are deferred tax liabilities which are tied to their investment portfolio, their stock investment portfolio, would actually go down by 5%, but that would be a 5% increase in equity.

Glaser: When you look across segments in terms of growth, what's really driving it today? Is it more balanced, is it the insurance operations? What's happening there?

Warren: Yeah, it's kind of a mixed bag right now. I mean, GEICO is still sort of the bigger growth vehicle there. I mean, earned premium growth is still low double-digits. The problem is, their loss ratios have been much higher than normal and much higher than historical norms. We are seeing the same thing with some of the other auto insurers out there. So, it's not worrying us too much, but we'd prefer to sort of see them work that down.

The railroad business is facing headwinds. I mean, coal is down on a secular basis as well as more sort of weather-related issues in the past couple of years. There's also concerns about intermodal, whether or not the opening of the expansion of the Panama Canal is going to impact West Coast shipping business and in turn, the carloads that BNSF and say, Union Pacific pull out of those areas. On the energy side, that's steady and stable. Good relationships with a lot of the states, decent increases where they need them. So, that's more sort of an anchor stable business there.

MSR, you've seen a lot growth in the past year, but that was really from the Precision Castparts deal being added in as well as Duracell. So, I think this year is going to be a little bit more sort of stable steady unless they do a big acquisition.

Glaser: Overall then, not a great entry point. But if you're a Berkshire holder, certainly nothing to may be worry about in terms of the share price getting into too lofty of a territory?

Warren: Yeah, yeah. That's why it's been hard for us to get too excited about it. I mean, it had a huge run off of the election, once Trump won the presidency because there was this big assumption that regulation was going to ease a lot and taxes were going to come down a lot. And it's getting that into sort of real sort of physical results is going to take time. And I think for a lot of shareholders they got to be happy with the run-up they've seen in the shares, but at this point, it's pretty much fairly valued.

Glaser: Gregg, thanks for the insights today.

Warren: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.