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5 Reasons to Consider Buying Berkshire Hathaway

The stock's the cheapest we can remember seeing in a number of years.

The equity bull market that began more than a decade ago is likely to end sometime in the near to medium term, and some economic indicators are starting to point to a potential recession in the U.S. economy. We are highlighting wide-moat-rated Berkshire Hathaway BRK.A/BRK.B as a long-term investment idea that is likely to hold up better than most companies in a downturn, especially given its close to $100 billion in dry powder that could be committed to investments, acquisitions, and share repurchases.

We view Berkshire Hathaway’s decentralized business model, broad business diversification, high cash generation capabilities, and unmatched balance sheet strength as providers of opportunities that might elude other companies, as well as of some downside protection in any potential downturn. It is these advantages, in particular, that should allow Berkshire’s book value per share to continue to grow at a high-single- to low-double-digit rate in the near to medium term, comfortably above our estimate of the company’s cost of capital.

While CEO Warren Buffett laments the dearth of investment opportunities that has allowed a ton of cash to build on Berkshire’s balance sheet, it is a natural byproduct of the company’s disciplined approach to investing, a lack of a dividend, and a limited amount of share-repurchase activity over the years. We continue to believe that the company will eventually have to evolve from a reinvestment machine to one that returns more capital to shareholders.

With Berkshire currently trading at more than a 20% discount to our $380,000 (Class A) and $253 (Class B) fair value estimates and 1.2 times our estimate for year-end 2019 book value per share, it’s the cheapest we can remember seeing in a number of years, providing a good entry point for long-term investors.

We believe there are five good reasons for investors to look at Berkshire right now.

Broad Diversification First, we think Berkshire's broad diversification provides the company with additional opportunities and helps to minimize losses during market and/or economic downturns. Berkshire remains a broadly diversified conglomerate run on a completely decentralized basis, with a collection of moaty businesses operating in industries ranging from property-casualty insurance to railroad transportation, utilities and pipelines, and manufacturing, service, and retailing. The economic moats of these operating subsidiaries are built primarily on cost advantage, efficient scale, and intangible assets, with some of these businesses being uniquely advantaged as well by their ability to essentially operate as private companies under the Berkshire umbrella. The operating subsidiaries also benefit from being part of the parent company's strong balance sheet, diverse income statement, and larger consolidated tax return.

Berkshire’s unique business model has historically allowed the company to--without incurring taxes or much in the way of other costs--move large amounts of capital from businesses that have limited incremental investment opportunities into other subsidiaries that potentially have more advantageous investment options (or put the capital to work in publicly traded securities). The managers of Berkshire’s operating subsidiaries are encouraged to make decisions based on the long-term health and success of the business, rather than adhering to the short-termism that tends to prevail among many publicly traded companies. Another big advantage that comes from operating under the Berkshire umbrella is the benefit that comes with diversification not only within the company’s insurance operations, but also within the organization as a whole. In most periods, it is not unusual to see weakness in one aspect of Berkshire’s operations being offset by the results from another or from the rest of the organization.

Excess Returns Second, we continue to believe that Berkshire will be able to generate returns in excess of our estimate of its cost of capital. Understanding, let alone forecasting, results for the company's subsidiaries is complex undertaking. Operating as a completely decentralized conglomerate, the company has defied critics and skeptics for more than 50 years, expanding its book value per share at an 18.7% compound annual growth rate during 1965-2018, compared with a 9.7% annual increase for the S&P 500 TR Index. Book value per share, which we believe serves as a good proxy for measuring changes in Berkshire's intrinsic value, increased at a 9.6%, 11.7%, and 10.1% CAGR in the past 5-, 10-, and 15-year time frames. While growth has understandably slowed some during the past two decades as the size and complexity of Berkshire's operations have made it much harder for the company to generate outsize returns, the company has tended to beat the market on both a growth per book value per share basis and an annualized share return basis, despite not paying a dividend, with 2009-18 being the only exception.

Berkshire increased its book value per share at a double-digit rate annually 42 times during 1965-2018 and has reported declines in its book value just twice (2001 and 2008). Even though the 9/11 attacks and the 2008-09 financial crisis had an impact on its overall results, Berkshire still generated double-digit rates of annual growth in its book value per share seven times during 2001-10 (with annual book value per share growth averaging 14.8% and the median rate of growth being 13.0% during those years of double-digit growth), and it produced double-digit rates of annual growth in its book value per share four times during 2011-18. While we think the company is unlikely to consistently increase its book value per share at a double-digit rate going forward, given the ever-increasing size and complexity of its operations, we believe it can increase book value per share at a high-single- to double-digit rate.

For more than three decades, Buffett has focused Berkshire investors on growth in book value per share, and more recently he has instructed shareholders to focus on growth in the value of Berkshire’s shares. In this past year’s annual report, Buffett pushed aside the focus on book value per share growth, saying it had (in his mind) lost the relevance that it once had and citing three circumstances that had made it so. Buffett noted that Berkshire had gradually morphed from “a company whose assets are concentrated in marketable stocks into one whose major value resides in operating businesses.” He also noted that the difference in reporting requirements for its credit and equity holdings (which are marked to market every quarter) and its collection of operating companies (which are recorded at the value they held when they were acquired) has created a mismatch in values that only gets larger as the value of its holding companies increases over time.

While we agree with the notion that the solid operating performance of many of Berkshire’s biggest subsidiaries since they were acquired leaves their reported book value trailing the intangible value of these assets, we would also note that the credit and equity portfolio is probably worth less than its market value at any given time, because in order to liquidate it, Berkshire would have to pay taxes on the gains in the portfolio, and it would be likely to encounter a price drag when trying to sell holdings where it has a 10% or greater stake or where any large sales are likely to cause a downdraft in the share price.

In addition, Buffett said that over time, Berkshire would probably be a significant repurchaser of its shares, with transactions expected to take place at prices above reported book value but below his (and our own) estimates of intrinsic value, which will create an even greater mismatch between book value per share and intrinsic value per share. While there is some truth in what he said, we'll believe it when we see it. Simply dropping the hint that Berkshire could buy back as much as $100 billion in stock, as Buffett did during a late April interview with The Financial Times, isn't enough to get us to move off of tracking changes in Berkshire's book value per share, which we still view as a useful gauge for tracking changes in intrinsic value. Also, given the fact that the insurer tends to retain all of its earnings (and self-funds most of its investment activity), it has tended to approximate return on equity.

Strong Balance Sheet Third, we believe that Berkshire's balance sheet strength continues to be a competitive advantage. The company has shown an ability to consistently create value for shareholders, so investors have afforded it a lot of leeway, including building up large amounts of cash on the balance sheet rather than returning it to shareholders. Berkshire has used its balance sheet strength to not only support the growth of its insurance operations, but also to make strategic investments and acquisitions when they come along (at reasonable valuations). Berkshire has benefited greatly as well from the "Buffett seal of approval," the proof of which was most evident during the 2008-09 financial crisis, when Berkshire was able to tap into the strength of its balance sheet, its large excess cash balances (with about $20 billion in dry powder coming into the fourth quarter of 2008), and the value that other companies (and their investors) place on having Buffett's approval attached to their businesses (or their actions) to extract large rents from those that lined up at the Bank of Berkshire.

Evolving to Return Capital Fourth, we continue to believe that Berkshire is evolving into a vehicle for returning capital to shareholders. With the company sitting on $122 billion in cash at the end of the second quarter and expected to generate $5 billion-$10 billion a quarter in free cash flow going forward, it will only be a matter of time before it hits the $150 billion cash threshold that Buffett said he would find difficult to defend at the 2017 annual meeting. While there have been repurchases of late, we're well off the $10 billion-$15 billion average annual run rate we believe will be necessary to keep Berkshire's cash balances in check and enhance shareholder value. While the timing of this transition remains difficult to pinpoint with any accuracy, Buffett did note in response to one of our questions at this year's annual meeting that the company is more likely to be down the path toward returning more capital to shareholders while he is still running the show.

Berkshire Is Undervalued Fifth, Berkshire's shares are undervalued in a market that is nearly fairly valued. At today's prices, Berkshire is trading at 79% of our fair value estimates of $380,000 (Class A) and $253 (Class B), relative to the universe of stocks we cover at 96%, implying a solid double-digit gain for Berkshire's shares should they reach our fair value estimate. On a price/book basis, the shares are currently trading at 1.28 times second-quarter book value per share and 1.20 and 1.10 times our estimates of book value per share at the end of 2019 and 2020, respectively. We believe that Buffett's willingness to buy back shares at prices between 1.2 and 1.4 times book value per share (and more aggressively below 1.3 times) should help to provide a bit of a floor for the stock in the near to medium term.

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