Podcast Summary
Understanding Intrinsic Value and Normalized Profitability in Equity Valuation: To estimate a company's intrinsic value, investors need to consider the growth of profits, whether from organic growth, acquisitions, or capital retention and reinvestment. Normalized profitability requires examining a company's business model, management quality, and leverage.
Key takeaway from this conversation between Stig Brodersen and Chris Broomstern is the importance of understanding a company's intrinsic value and normalized profitability in equity valuation. Broomstern, a renowned investor from Sempra Augustus, shares his insights on Berkshire Hathaway, a company they have held as their largest investment for over two decades. He emphasizes that per share numbers are crucial in investing, as Berkshire's recent share repurchases have led to cash outflows that would have otherwise been reinvested. To estimate a company's intrinsic value, investors need to consider the growth of profits, which can stem from organic growth, acquisitions, or the retention and reinvestment of capital. Normalized profitability, on the other hand, requires examining various moving parts, including the company's business model, management quality, and leverage. Ultimately, the goal is to identify good businesses with sustainable profitability and a clear understanding of their intrinsic value.
Understanding accounting complexities for accurate analysis: Berkshire Hathaway's prudent management and effective capital allocation result in fewer write-offs and write-downs compared to the broader S&P 500. However, careful adjustments are needed to account for complexities like intangible assets and pension liabilities for an accurate picture of profitability and future cash flows.
Understanding the nuances of accounting and how it impacts a company's reported earnings is crucial for accurate analysis and valuation. Berkshire Hathaway, for instance, has a history of minimal write-offs and write-downs compared to the broader S&P 500, reflecting prudent management and effective capital allocation. However, accounting complexities, such as intangible assets and pension liabilities, require careful adjustments to get an accurate picture of a company's profitability and future cash flows. Berkshire's size and complexity make it a challenging case study, but focusing on the underlying cash flows and understanding the industry and investor metrics can help simplify the analysis.
Understanding Berkshire Hathaway's Business Segments: To estimate earnings power and intrinsic value of Berkshire Hathaway's operating businesses, investors can look to Chairman's letters and financial statements of energy, railroad, and insurance segments.
Berkshire Hathaway's business segments are complex and multifaceted, consisting of operating businesses, cash position, and equity portfolio. Operating businesses can be further broken down into subsegments like Berkshire Hathaway Energy, Manufacturing Service Retail, and Insurance. Each subsegment has its unique complexities, and Berkshire Hathaway does not disclose all the details investors might want. To estimate the earnings power and intrinsic value for the operating businesses, investors can look to Berkshire Hathaway's Chairman's letters to shareholders, which have provided clues over the years. The energy business and railroad are two substantial segments within operating businesses, each with substantial revenues and capital intensity. The energy business and railroad each have separate financial statements that provide a wealth of information. The insurance operation, which is still the largest part of Berkshire Hathaway, is more challenging to assess due to the lack of express financials. Overall, understanding Berkshire Hathaway's business segments requires a deep dive into their financials and a long-term perspective.
Berkshire Hathaway's Businesses: Energy, Railroad, and Diverse Group: Berkshire Hathaway's energy business is retaining and reinvesting profits, potentially undervalued in public markets, while railroad business focuses on optimizing assets. Diverse group's 7% ROE indicates insufficient returns, with some companies underperforming and others outperforming.
Berkshire Hathaway's regulated energy business and utilities have been retaining and reinvesting their profits to grow, while the railroad business has reached its growth limit and is now focusing on optimizing existing assets. The energy business, with its regulated returns on equity, has been able to retain and reinvest a significant portion of its profits, leading to potential undervaluation in the public markets. On the other hand, the railroad business, with its limited growth potential, has been returning its profits as dividends to the parent company. The manufacturing, service, and retail group, while diverse, has seen declining profitability due to the maturity of many of its businesses, and the managers are deferring to Berkshire's capital allocation decisions. The group's 7% return on equity is considered insufficient, indicating that some companies within the group are earning less than 7%, while others like Clayton Homes are earning much higher returns. The lack of detailed financial disclosures for the group makes it challenging for analysts to assess its performance accurately.
Berkshire's industrial subsidiaries might thrive under PE ownership: Despite potential gains, Buffett's attachment to subsidiaries and past commitments hinder major divestitures. Berkshire's cash represents a smaller percentage of assets, with only $70B available for deployment.
Berkshire Hathaway's industrial subsidiaries, which make up 25% of the company's value, could potentially be better off under private equity ownership due to their earning potential with increased leverage. However, Warren Buffett's attachment to these businesses and promises made to their previous owners may prevent significant divestitures during his tenure. Regarding Berkshire's cash balance, it's important to note that cash represents only 12% of the company's total assets and has averaged around that percentage since 1997. Furthermore, only around $70 billion of the reported $133 billion in cash is available for deployment, considering the need to cover insurance losses and maintain a reserve for unexpected expenses. The media and investors often criticize Berkshire for holding such a large cash balance, but in context, it's a smaller percentage of the overall enterprise value.
Berkshire Hathaway's Cash Management Strategy: Berkshire Hathaway maintains a large cash reserve for operational needs and investments, aiming for a 10% return. Buffett normalizes earnings by assuming a 7% return on cash balance and invests in sectors with consistent demand.
Berkshire Hathaway, under the leadership of Warren Buffett, maintains a significant cash reserve for various operational needs and potential investments. This cash, estimated to be around $70 billion, is not all spendable, as some of it is earmarked for holding company purposes or tied up in regulated assets. Buffett aims to normalize the profitability of the business by investing this cash in opportunities that yield a return of at least 10%. He views share repurchases, acquisitions, and CapEx in the same light. For instance, when Berkshire spent $10 billion on energy assets from Dominion, $4 billion was in cash, which could potentially earn a 10% return. Buffett prefers not to adjust his earnings estimates every time Berkshire makes an investment, as he assumes a 7% return on the cash balance. This normalization technique allows him to maintain consistency in his analysis. Additionally, Berkshire has shown a willingness to invest in sectors with consistent demand, such as natural gas as a backup to renewable energy. Overall, Berkshire's cash management strategy is centered around maintaining a strong financial position and deploying capital in opportunities that meet or exceed their hurdle rate.
Focus on operating earnings for accurate assessment of Berkshire Hathaway's value: To evaluate Berkshire Hathaway's equity portfolio, look beyond reported profits and focus on operating earnings of each segment, especially the insurance operation where profits come from underwriting and investments. Understanding the earning power of each segment provides a more accurate assessment of the company's intrinsic value.
When evaluating the value of Berkshire Hathaway's equity portfolio, it's important to look beyond reported profits and focus on the operating earnings of each segment of the business. Buffett himself emphasizes this, as accounting rules now require mark-to-market changes to be reflected in the income statement, making earnings volatile. Stig Brodersen further explains that when analyzing the insurance operation, profits come from two areas: underwriting and investments. In the case of Berkshire, the insurance group represents 45% of the company's value, and the stock portfolio within that group was approximately $270 billion at the end of the year. It's essential to understand the earning power of each segment, rather than just focusing on the cash and debt. This approach can provide a more accurate assessment of Berkshire Hathaway's intrinsic value.
Understanding Berkshire Hathaway's Profitability through Insurance and Investments: Berkshire Hathaway earns profits from insurance operations and investments. To assess profitability, adjust for stock portfolio changes and add back retained earnings. Berkshire's insurance underwriting earns a 5% pretax margin, while the stock portfolio earns around 10%.
Warren Buffet's Berkshire Hathaway earns a significant portion of its profits from its insurance operations and its invested assets, particularly its stock portfolio. However, the accounting rules have changed, making the income statement less useful for understanding the operating businesses' profitability on a quarterly basis. To get a clearer picture, it's necessary to adjust for changes in the stock portfolio's value and add back retained earnings. Berkshire's insurance operations underwrite more than $60 billion in premiums, earning a long-term 5% underwriting pretax margin. The stock portfolio, which includes retained earnings and dividends, earns around 10%. Buffet adjusts for overvalued or undervalued stocks in the portfolio by capitalizing or de-capitalizing the underwriting profits at a multiple. This normalization technique helps reduce volatility and provides a clearer view of Berkshire's overall profitability. It's important to remember that Buffet is not a stock picker but a great businessperson. Since 1998, Berkshire's equity portfolio has had a CAGR of 7.6%, slightly outperforming the S&P 500's 7.2% CAGR.
Buffet's acquisition of Gen Re in 1998 diversified Berkshire's portfolio and reduced reliance on stocks: Buffet's acquisition of Gen Re in 1998 allowed Berkshire to decrease stock reliance, increase float, and diversify investment portfolio, ultimately benefiting the company in the long run.
Warren Buffet's decision to acquire General Reinsurance (Gen Re) in 1998 was a pivotal moment for Berkshire Hathaway, allowing the company to diversify its investment portfolio, reduce its reliance on highly appreciated stocks, and increase its float. Buffet made this move when Berkshire's stock portfolio was trading at an inflated price, making it difficult for him to sell without paying substantial taxes. By acquiring Gen Re, Berkshire gained a large bond and cash portfolio, which helped decrease the percentage of stock in Berkshire's book value and assets. This deal also led to an increase in Berkshire's shares outstanding, making Jinri shareholders a significant part of the combined entity. Despite Buffet's later comments that the Gen Re transaction wasn't a great deal, it was a brilliant move that materially changed Berkshire's investment strategy and helped the company navigate the challenges of a highly valued stock market.
Warren Buffett's investment in Berkshire's insurance business created significant value: Buffett's decision to invest in undervalued operating businesses instead of stocks led to over $200 billion in surplus value for Berkshire shareholders.
Warren Buffett's decision to invest heavily in Berkshire Hathaway's insurance business and divert capital from the stock market into operating businesses in the late 1990s was a seminal transaction that created significant value for Berkshire shareholders. Although it appeared that Buffett had given away billions of dollars by not realizing the full potential of Berkshire's stock portfolio at the time, the reality is that this decision allowed Berkshire to take advantage of undervalued operating businesses and compound at a higher rate than the stock market. Buffett's ability to understand the intrinsic value of businesses and use his stock as currency enabled him to create over $200 billion in surplus value for Berkshire shareholders. Regarding the share repurchases in 2020, it is too early to determine their full impact, but they could represent another brilliant pivot by Buffett. By repurchasing shares, Berkshire was able to buy back undervalued stock and return capital to shareholders, potentially creating additional value. Conversely, issuing shares can also be an effective tool for companies to raise capital for growth opportunities. It is essential for investors to consider the context of these transactions and understand their impact on the company's intrinsic value.
Warren Buffett's strategic use of Berkshire Hathaway shares in acquisitions: Buffett uses Berkshire Hathaway shares wisely in acquisitions, depending on market conditions. He learned from past mistakes and avoids overpaying when stocks are expensive.
Warren Buffett's use of Berkshire Hathaway's shares as currency in acquisitions has been strategic and dependent on the market conditions. Buffett learned from past experiences, such as the overpayment in the Precision deal, and has acknowledged the current expensive stock market. He has historically used shares when the stock was undervalued, like in the 1960s when he bought National Indemnity, and avoided using them when the stock was expensive, like in the 1990s when he spent billions on acquisitions. Buffett's recent large spending on acquisitions could indicate an acknowledgment that the capital markets are overvalued. The history of Berkshire Hathaway's share usage in acquisitions shows a prudent approach, taking advantage of undervalued stocks and avoiding overpaying.
Berkshire's conservative approach to capital deployment: Berkshire prioritizes accretive growth through 10% ROE and share buybacks, despite investor calls for more aggressive cash usage during downturns. Potential dividends may arise if shares become unattractive.
Despite the competition and modest premiums to book value for Berkshire Hathaway's elephant targets, buying at a 10% return on equity and shrinking share count through buybacks leads to accretive growth. Berkshire's investors, including Stig Brodersen, have felt that the company could be more aggressive with its cash during market downturns, but Buffett prioritized the permanence of Berkshire and the uncertainty of the economic recovery. Additionally, investors like Stig prefer Berkshire to keep its capital and invest at a 10% return rather than paying taxes on dividends and reinvesting at a potentially higher cost. The possibility of a dividend may arise if Berkshire's shares become unattractive as an investment and opportunities in common stocks and control positions in businesses decrease.
Buffett's stance on cash returns and dividends: Buffett prefers deploying excess cash into investments rather than paying dividends, with an estimated fair value of $335/share based on book value and a 1.75 multiple.
Buffett's Berkshire Hathaway may consider returning excess cash to shareholders, but Buffett strongly opposes the idea of a regular dividend due to his role as a capital allocator. Instead, he believes in deploying cash into better investment opportunities. The estimated fair value of Berkshire Hathaway is around $335 per share using a 1.75 multiple of book value, but this number is dynamic and expected to increase as Buffett acknowledges that book value may become less useful as a proxy for value due to the resetting of cost basis in certain industries and the presence of intangible assets.
Impact of Factors on Book Value: Buffett emphasizes the importance of considering various factors when estimating a company's intrinsic value, including write-offs, share buybacks, inflation, and margin of safety. He suggests using multiple methods such as GAAP adjusted financials and the 2-pronged approach to get a more accurate estimate.
The book value of a company, which is often used as a simple valuation metric, can be distorted by various factors such as write-offs, share buybacks at a premium to book value, and inflation. Buffett's letter to shareholders discussed how Berkshire Hathaway's book value has been impacted by these factors and how they can affect the calculation of intrinsic value. The larger the premium paid for shares, the more decline in book value and book value per share. Buffett also emphasized the importance of margin of safety when buying stocks and using multiple methods to estimate intrinsic value. While the simple price to GAAP book value is a commonly used method, Buffett also suggested using other approaches such as GAAP adjusted financials and the 2-pronged approach, which includes the marketable securities per share and operating earnings per share. By considering these different methods and making appropriate adjustments, investors can get a more accurate estimate of a company's intrinsic value.
Assessing Berkshire Hathaway's Financials: The Sum of the Parts and GAAP Adjusted Approaches: To accurately evaluate Berkshire Hathaway's financials, use both the sum of the parts method and GAAP adjusted financials approach. Adjust GAAP earnings by removing unrealized gains, underwriting profits, and pension fund liabilities for a more accurate representation of profitability.
Understanding the intricacies of Berkshire Hathaway's financials requires a multi-faceted approach. The speaker emphasizes the importance of both the sum of the parts method and the GAAP adjusted financials approach to accurately assess the value of Berkshire. The sum of the parts method focuses on the earning power of each subsidiary, while the GAAP adjusted financials method offsets volatility caused by quarterly changes in stock prices. Both methods are essential for gaining a comprehensive understanding of Berkshire's financials. The speaker also highlights the importance of making adjustments to GAAP earnings, such as removing unrealized gains, underwriting profits, and pension fund liabilities, to arrive at a more accurate representation of the company's profitability. By using these methods and adjustments, investors can gain a more reliable and complete understanding of Berkshire Hathaway's financial situation.
Assessing Berkshire Hathaway's Intrinsic Value: Different methods, including book value and normalized earnings, can help assess Berkshire Hathaway's intrinsic value, but may be influenced by one-time events and economic cycles.
The intrinsic value of Berkshire Hathaway can be calculated using different methods, including the book value method and the normalized earnings method. The book value method uses the balance sheet to determine the value of the company, while the normalized earnings method adjusts earnings to account for one-time events and economic cycles. The TCJA tax code change in 2017 and Berkshire's write-off of Precision Castparts in 2020 are examples of such events. These methods can help normalize the balance sheet and provide a more accurate assessment of the company's intrinsic value. However, they may overstate or understate intrinsic value during certain market conditions. Despite this, the speaker finds his methods to be conservative. As for Berkshire's future earnings power, the speaker has confidence in the company's leadership and the team in place to maintain profitability after Buffett and Munger's departure.
Berkshire Hathaway's succession planning and core principles, as well as its investments in regulated businesses, are key areas to watch.: Speakers admire Berkshire Hathaway's bench strength and ability to navigate regulatory environments, but caution political and regulatory changes could pose risks, particularly in energy sector. Keep an eye on Berkshire's relationships with regulators and potential shifts in policy.
Berkshire Hathaway's succession planning and core principles, as well as its investments in regulated businesses like energy and railroads, are key areas to watch. The speakers expressed admiration for the company's bench strength and its ability to navigate regulatory environments. However, they also cautioned that political and regulatory changes could pose risks, particularly in the energy sector where investments in renewable energy and grid infrastructure are significant. The speakers recommended keeping an eye on Berkshire's relationships with regulators and monitoring potential shifts in policy that could impact returns on past investments. Additionally, they suggested following Jerome Maldonado and Sempra Augustus for insights on Berkshire Hathaway and valuation.
The Importance of Long-Term Thinking in Tech Investing: Long-term thinking is crucial when investing in tech companies, as demonstrated by Microsoft's valuation extension in 2000. This perspective allows for a better understanding of the market and financial independence.
Key takeaway from this conversation between Chris and Stig is the importance of long-term thinking when it comes to investing in tech companies. Chris shared an article from 2000 that discussed Microsoft's valuation extension, which he believed applied to many tech companies at the time. This long-term perspective is a valuable lens for understanding the market, as opposed to trying to fit thoughts into short social media posts. Additionally, Stig reminded listeners to subscribe to their podcast and enter the raffle for a chance to win William Green's book, Richer, Wiser, Happier. This conversation was just one of many informative and insightful discussions that The Investors Podcast provides for those interested in investing and achieving financial independence. Remember, before making any investment decisions, consult a professional. This podcast is for entertainment purposes only and is copyrighted by The Investors Podcast Network. Don't forget to tune in next week for another insightful conversation with Manus Paparai. To access show notes, transcripts, or courses, visit theinvestorspodcast.com.
