Berkshire Hathaway's Intrinsic Value And Takeaways From The 2021 Annual Meeting

Berkshire's annual meeting is always one of my favorite weekends of the year. Though Warren and Charlie say the same thing in different words, year in and year out, it never hurts to hear the gospel one more time.

Buffett began with a short monologue addressed to "new entrants to the stock market." Retail interest in the stock market has rarely been higher. Though RobinHood and Coinbase are ground zero for frenzied retail trading, it's a phenomenon happening in every geography and every asset class. Last week Interactive Brokers said:

"I have never seen anything like this in over 50 years on Wall Street… While we have had some other very active quarters in the past, there were two unique features about this one. First, that it seemingly happened in parallel and in tandem across all geographies around the globe; and second, that the feverish activity appeared to be led much more by individual investors than by institutions."
– Nancy Stuebe, Interactive Brokers Director of Investor Relations

New investors are rushing into the markets because they think they see an opportunity to make easy money. As Dave Portnoy, the founder of Barstool Sports, declared, "Stocks only go up." Incidentally, I don't recall anyone saying that in March 2020. Investors have short memories. Of course, Portnoy is a master marketer and troll. He know’s he’s joking, but do his 2.5 million Twitter followers?

Buffett's message to these new traders was, "There is a lot more to picking stocks than figuring out what's going to be a wonderful industry in the future."

To illustrate his point, he showed a list of American car companies operating in 1903 whose names begin with "Ma." The list was 40 names long because there were over 2,000 American car companies then. Back then, it was apparent that cars would be a massive part of life in the future, and everyone wanted to profit from this insight. Today, it's the same with electric vehicles, cryptocurrency, and green energy just like it was a few years ago with pot stocks and 3D printing.

Fast forward to the present, and their predictions were correct. Cars are a massive part of modern life. But, competition whittled the 2,000 American car companies that existed in 1903 down to 3. And recall that in 2009, two of those three went bankrupt.

Buffett's point can't be emphasized enough. It's not enough to invest in a growing industry. That can't be the extent of the analysis. Capitalism produces competition, and competition destroys profits. The trick is to invest in businesses with a "moat" that protects them from the competition and preserves profits. That's why we spend so much time on this blog discussing a company's competitive position and competitive advantages and whether or not those are strengthening or weakening.

Buffett also pointed out that extraordinary things happen all the time in markets. What looks like a foregone conclusion one day can look like a long shot the next. While some things that look obvious do come to fruition (e.g., cars), others don't (e.g., pets.com).

To illustrate this point, Buffett showed a list of the 20 most valuable companies in the world in 1989 and March 2021. There were zero overlaps between the two lists. Not a single one of the most valuable companies in 1989 are among the top twenty today. 1989 was an unusual year because it was near the apex of the bubble in Japanese stocks. So, Japanese financial firms dominate the list. Still, I think Buffett's point is valid. Creative destruction virtually ensures that today's winners won't be tomorrow's. Buffett hinted that some of today's top 20 might still be at the top in 2051, and I'd agree. But most won't be there.

Buffett emphasized that 1989 was not the dark ages. People felt they were sophisticated analysts back then, and we're probably just as confident that the then-winners then would continue to win. Just like many do today. Statistically, however, most of today's winners will not continue to head the list in 2051. Capitalism is designed to destroy profits through competition, and it is good at it. That's wonderful for society but will require investors to stay on their toes.

Creative destruction and the rise and fall of businesses and industries was a theme that came up throughout the meeting. Buffett pointed out that all three of Berkshire's original businesses failed. Nevertheless, Berkshire has been a massive success.

"We started with three businesses, Charlie and I. And Berkshire was textiles, Diversified Retailing was a department store, and trading stamps were Blue Chip's business. And those were the three companies we put together, and all 3 of the original businesses failed.
Which sort of gets me in terms of the people that are worried about don't we know that coal is going to be phased out over time? Of course, we know coal is going to be, but that doesn't mean we're going to be phased out over time. I mean that -- every business has there's some things to think about that way."

Just as it is possible to correctly predict the rise of the automobile but fail the profit from it, it's also possible to correctly predict the demise of an industry like coal while profiting from it.

Berkshire's recently acquired stake in Chevron illustrates this point. Buffett said:

"I think we're going to have a lot of hydrocarbons for a long time and we'll be very glad we've got them. But I do think that the world is moving away from them too."

Dan's Alimentation Couche-Tarde write-up follows similar logic. Though gasoline may not be as important in 50 years, there's still a lot of money to be made between now and then. The company's valuation ignores this and ignores any chance that they successfully pivot to electric vehicle charging.

The only constant is change, and change only seems to be accelerating. Software is eating the world and turning every company into a tech company. No moat will hold off technologic change forever. Good managers and culture are increasingly necessary to ensure a company can navigate this change. We wouldn't be interested in Alimentation Couche-Tarde if not for its culture and management team. The same is true of Facebook without Zuck or Schmitt without Zapata.

Buffett seems to agree when he said that a company's biggest risk is having the wrong CEO.

"The main thing about Berkshire is how do they preserve the culture. How do you make sure that if you get the wrong person as the CEO, you can do something about it. That's the biggest risk a Board has is if you pick the wrong CEO."

This is why Dan and I spend so much time talking about incentives and understanding a management's philosophy and track record. There are few businesses left that the proverbial "ham sandwich can run," so it's best to invest alongside honest and able managers with your best interests at heart.

Source: Eagle Point Capital Presentation and inspired by Connor Leonard

Berkshire's cash position came up a few times throughout the meeting. Buffett said he'd prefer to hold less cash but is having trouble finding responsible ways to deploy it. Private equity and SPACs generate fees when they deploy capital, making them relatively price insensitive. Nevertheless, investors continue to shovel cash their way. They're bidding up prices beyond what Buffett is comfortable paying.

Still, Buffett said he had bought a few stocks as cash substitutes. He didn't name names, but I'd guess they're Chevron and Verizon. He said that they're good businesses he understands but doesn't have any particular insight into.

Dan and I concluded that the opportunity cost of holding cash is too high when we expect our portfolio to produce mid-teens returns. Why hold cash when you could buy more of these stocks? So, we've decided to stay fully invested. It sounds like Buffett would agree, at least to a degree, but can't as easily buy because of Berkshire's size.

Estimating Intrinsic Value

With a K, Q, and the meeting behind us, I took a stab at estimating Berkshire’s intrinsic value. My back-of-the-envelop math suggests it's worth $276 per class B share. Shares currently trade at $287.

This baseline uses Buffett's Five Groves method to value the company and makes few adjustments to reported values. It's fairly conservative and is more likely a lower bound estimate than a center-of-target hit. I capitalized operating earnings at 17x pre-tax, which translates to 22x after-tax using a 21% tax rate, which is in line with the market's median right now.

This values all of Berkshire's owned businesses at $157 billion. But, Union Pacific, a nearly identical company to BNSF, currently trades for $150 billion. Recently, BNSF has underperformed Union Pacific. But, it has outperformed before too. Buffett said:

"We know we're larger than the Union Pacific. I mean we will do more business than they do. And we should make a little more money than they do, but we have in the last few years."

So, it doesn't seem crazy to think that BNSF is worth at least $150 billion alone. That means Buffett's $44 billion purchase in February 2010 has compounded at 11.8%. Not bad!

Of course, just because Union Pacific's market cap is $150 billion doesn't mean its intrinsic value is $150 billion. Railroads are hot right now, and I don’t think buyers at today’s prices will match Buffett’s 11.8%.

If you bump up BNSF's value to $150 billion, Berkshire's intrinsic value rises to $307 per class B share. That's about 7% higher than shares currently trade.

You could make a lot of other adjustments, but I'm going to leave it here today. No matter how you slice and dice it, Berkshire is not ridiculously cheap. The stock price approximates intrinsic value, plus or minus 10-20%.

If you want to wade into the weeds and learn about all the adjustments you could make to Berkshire's IV, read Semper Augustus's letters. Be warned, they run north of 100 pages. His simple methods put Berkshire's IV's below mine, while his more complicated ones place it 10-20% higher. This is well within the standard error of uncertainty. If a back-of-the-envelope valuation suggested Berkshire was 30%+ undervalued, I'd dig deeper.

I think it's more important to think about Berkshire's incremental return on freshly deployed capital than to worry about what multiple to capitalize earnings at. Here, I have some concerns.

Buffett's recent investments into energy and utilities tell me he prefers decent returns (8-10%) that are relatively certain and durable (will produce cash for decades) to potentially higher return but less certain alternatives. This will give his successors easy decisions and a straightforward place to allocate capital.

This isn't silly. 8-10% returns are respectable and should approximate the market's return. Importantly, Berkshire's returns in this area will last decades. Something that can compound at nearly 10% per year for, say, 50 years is incredibly valuable and rare.

Investors who want a "one-decision" stock and don't want to buy an S&P 500 index fund should consider Berkshire. I'd warn active managers who think they can outperform that Berkshire probably won't beat the S&P 500 by much. As Berkshire gets bigger, its return will converge to the average. Even Buffett can’t overcome the math. Active management fees will probably eat up any outperformance and might push the investor below the average.