UCPLF - Berkshire After Buffett What To Expect?

2024-01-15 03:08:37 ET

Summary

• Uncertainty surrounds the future of Berkshire Hathaway after Warren Buffett departs.
• Berkshire currently trades at net asset value, suggesting that the market believes in Buffett's stewardship. The next generation of leaders does not have such trust.
• The strong businesses owned by Berkshire Hathaway will continue growing.
• Buybacks will help the next generation of leaders to steady the ship during the transition.

Intro:

Berkshire Hathaway ( BRK.A , BRK.B ) is a well-known financial conglomerate run by the most popular investor of all time - Warren Buffett. The stock has delivered excellent long-term returns and is bellowed by many long-term holders. Unfortunately, the future prospects of the Company are somewhat uncertain as the tenure of Mr. Buffett is coming to an end. In this article, we will look into the likely courses of action that Berkshire might take after the Chairman departs and assess whether it is worth holding on to the stock given this future risk.

Late last year many keen Berkshire observers were deeply saddened by the departure of Charlie Munger, the long-term adviser and deputy to Mr. Buffett. Mr. Munger has not been actively involved in Berkshire for the last few years so the immediate effect on operations of Berkshire was minimal. On the other hand, many long-term observers started wondering about the future of Berkshire without the 93-year-old Chairman at the helm, as the next generation of leaders is very likely to take over Berkshire within the next 5 years.

The Company has been communicating how simple the operating philosophy and underlying businesses of Berkshire are and that anybody following Buffett’s and Munger’s teachings can run the operation as well as the founders. We believe this assumption is overly optimistic. The new generation of leaders will face unique challenges and doubts while the markets will scrutinise their every action and every mistake, as they do not have a decades-long track record. The passing of Mr. Buffett will no doubt affect the share price of Berkshire.

The Value of Berkshire Today

Berkshire is a diversified conglomerate of wholly-owned operating subsidiaries and public market investments. The portfolio is made up of high-quality businesses operating in mature industries, it is well diversified and well-seasoned as Buffett has assembled it carefully over the prior decades. Apple is the largest asset, representing about 20% of Net Asset Value of the Group.

Operating subsidiaries can be split into five main categories: a) Manufacturing; b) BNSF railways; c) Services and retailing; d) BHE and utilities; e) Insurance and reinsurance underwriting. The majority of Berkshire's businesses would be well-regarded even as stand-alone entities and would command above-average valuation multiples in their respective industries. Berkshire adds further value to the group by providing a long-term management outlook and capital reallocation from mature to growing businesses. The famed See's Candies, for example, did not grow all that much under Berkshire, but its free cash flows were used to fund many profitable acquisitions. In the hands of Mr. Buffett, Sees was essentially converted from a mature enterprise to a growth business as its earnings were redeployed at attractive rates of return. The value of Sees’ earnings within Berkshire is probably as much as double their stand-alone value. The same holds for all other capital-light long-term holdings.

The operating businesses of Berkshire generated after-tax earnings above $21 billion in the financial year 2022. Note that we exclude investment income when estimating operating earnings. Applying a conservative valuation multiple of 15x on the earnings of Berkshire we would obtain a value of over $300 billion for the operating subsidiaries. Note that the S&P500 currently trades at an average PE of 21x , thus a 15x multiple is cheap compared to the current market. It looks even cheaper when considering the capital relocation mechanism of Berkshire described above. We believe such conservatism is justified because of the rise of long-term interest rates as well as the uncertainty about the returns the next generation of managers will be able to achieve.

The corporate costs of Berkshire are minimal and Mr. Buffett does not charge management or performance fees, we, therefore, do not have to subtract capitalised operating costs when estimating the group value.

The investment portfolio of Berkshire is worth about $520 billion and includes equity securities as well as fixed-income instruments and cash. The latter makes up about 40% of the portfolio. Cash and debt instruments soften the blow to overall value when equity markets decline. Adding the investment portfolio to the value of operating businesses we can estimate that a conservatively assessed value of Berkshire is close to $840 billion. The market capitalisation of Berkshire today is close to $790 billion; thus the holding currently trades slightly below Net Asset Value.

Berkshire Hathaway financial statements and our estimates

The Value of Berkshire after Buffett

Berkshire is made of a diversified lineup of great quality businesses and their conservatively assessed value does not fluctuate drastically, especially when major systematic events, such as Covid, do not happen. Having said the price can under some circumstances deviate from the value. Mr. Buffett has kept the value and the price of BRK married together, but this might not be the case when he is not around.

Currently, Berkshire trades at a small discount to the Net Asset Value of its parts, as per our estimates. This suggests to us that the market believes Mr. Buffett is a good steward of capital and liquidation of the holding is not desirable. The Chairman has delivered competitive and stable long-term returns and most shareholders are happy to stay invested as long as he is running the show.

Quite naturally not all investment holding companies have a good track record and not all of them take care of their shareholders therefore Market Cap does not always approximate Net Asset Value. Poorly managed holdings often trade even below 0.75X NAV, reflecting the potential after-tax liquidation proceeds, liquidation costs, and uncertainty of whether liquidation can be enforced. United Corporations ( UCPLF ) - a Canadian closed-end fund, for example, trades at 0.61X NAV, even though its asset base is made up of public market investments. United trades at such a steep discount because the management of the fund refuses to liquidate, while the insiders are gradually increasing their ownership.

United is an extreme example, and such a low valuation multiple would never apply to Berkshire, but it helps to illustrate that holding companies can trade at a significant discount on assets. It might also happen to Berkshire, especially after the current chairman departs. Mr. Buffett has been incredibly consistent over a long period and therefore has built an ironclad reputation, which he maintains even as he ages. The next generation of leaders does not have that level of trust of shareholders. Quite the contrary, Todd Combs’ and Ted Weschler’s track records at Berkshire have not been disclosed. Bill Ackman’s Pershing Square ( PSHZF ), for example, currently trades at 0.7X NAV because of a couple of bad bets he has made. If an all-star investor such as Ackman could lose the trust of shareholders, we would not be surprised if Todd and Ted did.

The Margin of Safety in Berkshire

Warren Buffett is the greatest investor of all time and an absolute genius. All his life he has worked incredibly hard to compound shareholder capital and build a diversified and lasting enterprise. Mr. Buffett spends most time pondering worst-case scenarios and risks when evaluating investments, therefore we would not be surprised if he has given thought to the risks surrounding the succession at Berkshire and how to mitigate them best.

We believe it is one of the main reasons why Mr. Buffett has been careful with buybacks so far and instead chose to build up a $150 billion war chest of cash. It is the best margin of safety that Berkshire has and it will help the next generation of leaders to steady the ship over the years following management transition. The war chest will allow Berkshire to engage in sizeable share buybacks once the market price falls significantly below NAV, thus increasing per-share value and forcing the price back up.

Berkshire Hathaway each year generates a significant amount of free cash flow that has to be reinvested. The businesses produce over $20 billion in after-tax operating earnings as well as over $6.4 billion of dividend and interest income. Considering the war chest of cash, Berkshire could probably spend $30 billion, or even more, per year on buybacks for a long time. If the share price falls to say 0.7X Net Asset Value, 5% of shares could be bought back each year with this sum of money.

The additional 5% per share return would supplement any underlying returns delivered by the stock portfolio and the growth of operating businesses and this would enable BRK shares to outperform the market by a comfortable margin. Todd and Ted might not have the experience and the acumen of Buffett but we are quite sure that they are the type of guys who would not miss a chance to buy 1 dollar bills for 70 cents. This low-risk arbitrage trade would enable Berkshire to outperform consistently. BRK will not trade below value for a long as market participants seeking better returns will eventually come back to the outperforming stock and bid its price up.

We do not see Berkshire trading at NAV after the departure of Mr. Buffett but the discount to NAV will be capped at a rather low level using buybacks. It’s hard to say at which level the discount will settle as it will also depend on the performance of the next generation of leaders, but a 10-20% range would seem reasonable.

Buy, Hold, or Sell?

Currently, Berkshire is trading at a 6% discount to NAV, and in the absence of Mr. Buffett, this discount could expand somewhat. A potential price downside in the low teens is not a good motivation to sell, especially because we are unsure how long Mr. Buffett’s tenure will continue. We intend to hold on to the BRK stock we currently own.

Having said that, the Chairman’s departure will be a very significant event for Berkshire and share price can be quite volatile then. We believe this will not be interpreted as positive news by Berkshire holders therefore the share is likely to underperform the market in the aftermath. Investors could sit and wait for this to happen and try to enter a position at a more favourable price but would risk losing out on value growth in the meantime. The extent of the potential price decline is also uncertain, given the likely size of the buyback programme.

We believe that investors wanting to buy and hold BRK should do so when the Price to Book of Berkshire falls to a lower bound of a 5-year Price to Book range. A 1.4X book would be an attractive level, but even the current price is not all that expensive. The longer the expected holding period the smaller the significance of the initial entry price. The short-term traders, on the other hand, might want to wait for doom and gloom.

Conclusion

The returns that Berkshire delivers over the next 10 years will most likely not be as attractive as those during the last 10, but we are close to certain that the per-share value of Berkshire will be considerably greater and continue increasing in years to come. Berkshire will most likely continue being a secure and profitable place to invest hard-earned funds even after Mr. Buffett departs.

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