Berkshire Hathaway

I own class B (BRK.B) shares of Berkshire Hathaway. In 2013 I had the privilege to attend the shareholders meeting and I wrote about my experience here. In this post I am writing about my understanding of Berkshire’s business, management and its valuation.

Business

Let us start with the balance sheet. Berkshire’s balance sheet as of Sep 30^th 2013 can be found here. I annotated the balance sheet with few questions that came to my mind.

A. Insurance and other businesses has $35.33 billion. Why does it need a lot of cash?
B. Equity and Fixed maturity investments from all its business segments comes to $163.34 billion. Where are they invested?
C. $91.09 billion is invested in Property, Plant and Equipment. Is this a capital intensive business?
D. Does the company pay any interest for the liability of $76.48 billion?
E. Can the company service the debt of $40.01 billion without any problems?
F. Why does the company defer the income tax of $50.85 billion. How long can they do?

Berkshire is a holding company headquartered in Omaha, Nebraska, that oversees and manages a number of subsidiary companies. Warren Buffett is the Chairman and CEO of the company and Charlie Munger is the Vice Chairman of the company. Its has five major business operations.

1. Insurance
2. Railroad and Utilities
3. Manufacturing, Service and Retailing
4. Investments
5. Finance and Financial Products

Let us look at each business operation in detail and in the process we will get all the 6 questions answered.

1. Insurance

A car cannot run without an engine. Likewise there is no Berkshire without its insurance business. Hence it is important to understand the insurance business. The two key concepts about insurance is float and its cost. In 2002 shareholder letter Buffett explained about it.

To begin with, float is money we hold but don’t own. In an insurance operation, float arises because premiums are received before losses are paid, an interval that sometimes extends over many years. During that time, the insurer invests the money. This pleasant activity typically carries with it a downside: The premiums that an insurer takes in usually do not cover the losses and expenses it eventually must pay. That leaves it running an “underwriting loss,” which is the cost of float. An insurance business has value if its cost of float over time is less than the cost the company would otherwise incur to obtain funds. But the business is a lemon if its cost of float is higher than market rates for money. Moreover, the downward trend of interest rates in recent years has transformed underwriting losses that formerly were tolerable into burdens that move insurance businesses deeply into the lemon category.

Let us look Berkshire’s float and underwriting profit/loss in 2002, 2007 and 2012. When we look at the changes over 5 year period we can clearly see the picture (contrast effect).

Year	Float (in Millions)	Underwriting Profit/Loss (in Millions)
2002	41,224	-411
2007	58,698	3,374
2012	73,125	1,625

In 11 years the float has grown at an annualized rate of 5.35%. In 2002 the cost of the float was 1% which is lesser than the market interest rate. In 2007 and 2012 the cost of the float is negative i.e. it had an underwriting profit. This is like having the cake and also eating it. In 2012 letter he wrote

If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it. That’s like your taking out a loan and having the bank pay you interest.

As of 2012, Berkshire has been operating with an underwriting profit for 10 consecutive years. What about other insurance companies? Their results are terrible. State Farm is the largest insurer and a well run company had underwriting loss in 8 out of 11 years ending in 2011. The lollapalooza combination that is working in Berkshire’s insurance business are

1. Huge float that is growing with time.
2. Zero or very low cost for the float.
3. The float is in the hands of Buffett who is the world’s best capital allocator. He uses this float to purchase other companies which in turn produces earnings which are then used for buying other companies. This feedback loop is happening at Berkshire for a very long time.

Now let us answer one of the questions that I had.

D. Does the company pay any interest for the liability of $76.48 billion?

This liability is the float. Hence the answer is no. In fact Berkshire is being paid (underwriting profit) for holding the float.

In banking business negative black swans proliferate a lot. Taleb writes

If you are in banking and lending, surprise outcomes are likely to be negative for you. You lend, and in the best of circumstances you get your loan back – but you may lose all of your money if the borrower defaults. In the event that the borrower enjoys great financial success, he is not likely to offer you an additional dividend.

Insurance business is different than banking. But the risks are similar. What if an unforeseen disaster like 9/11 happens and the loss incurred is several times more than the premiums collected? Buffett understands about the improbable and his insurance operations underwrite polices with extreme discipline.

If our insurance operations are to generate low-cost float over time, they must: (a) underwrite with unwavering discipline; (b) reserve conservatively; and (c) avoid an aggregation of exposures that would allow a supposedly “impossible” incident to threaten their solvency.

Now let us answer the second question that I had

A. Insurance and other businesses has $35.33 billion. Why does it need a lot of cash?

One reason for holding a lot of cash is to purchase quality business, if available at the right price. The other reason is margin of safety. Even if the worst of disaster happens he wants Berkshire to be solvent. Remember too-big-fail in 2009 when banks were bailed out by the government. He does not want to be in that situation.

There are 4 major insurance divisions and they engage in primary insurance and reinsurance of property/casualty, life and health risks.

1. GEICO – Is the low-cost auto insurer. It follows direct response methods in which customers apply for coverage via telephone or Internet. This helps it to save a lot of money and pass on the benefits to the customers. Low-cost is a huge moat. Tony Nicely runs this business and he joined GEICO when he was 18 years old. He is with GEICO for the last 52 years.
2. General Re – It is a reinsurer offering property and casualty and life and health coverages worldwide. Reinsurer assume risks of other insurer and reinsurers. Tad Montross runs this business.
3. Berkshire Hathaway Reinsurance Group (“BHRG”) – It is a reinsurer offering coverage for major catastrophes. Buffett refers to catastrophes as super-cats. Ajit Jain runs this business. In 2012, 47.6% ($34.82 billion) of the total float ($73.12 billion) came from this group. On 2008 this division had 31 employees and even today this number should be very low. What is the moat for BHRG? Major catastrophes can cause damages in the order of billions. Most of the insurance companies will go bankrupt if they need to pay out loses in billions. Hence they go to a reinsurer for cover. If you are an insurer which reinsurer will you go to? You will go to someone who will have money when the disaster happens. The only one out there with money to protect when the disaster happens is Berkshire. This is a huge moat.
4. Other Primary – It consists of wide varieties of independently managed insurance business.

Given below is the float and underwriting profit/loss for each division in 2002, 2007 and 2012

In Millons	2002		2007		2012
	Float	Underwriting Profit/Loss	Float	Underwriting Profit/Loss	Float	Underwriting Profit/Loss
BHRG	13,396	534	23,009	555	34,821	304
General Re	22,207	-1393	23,692	1,427	20,128	355
GEICO	4,678	416	7,768	1,113	11,578	680
Other Primary	943	32	4,229	279	6,598	286
Total	41,224	-411	58,698	3,374	73,125	1,625

As you can see BHRG float has grown at an annualized rate of 9.07% on a huge float base. No wonder why Buffett writes in his letter – If you see Ajit at our annual meeting, bow deeply.

2. Railroad and Utilities

For any country to prosper, it needs to have first class infrastructure. Railroad and Electricity are the two main infrastructure items. Berkshire owns both of them. Burlington Northern Santa Fe (BNSF) moves freight on railroad tracks. MidAmerican supplies electricity to millions of customers. Both of these business require a massive amount of capital to operate. Also the capital expenditure requirements are very high. Then why did Buffett buy them? Buffett believes that regulators in their self interest (incentive caused bias) will give capital providers with a decent return on capital.

Our confidence is justified both by our past experience and by the knowledge that society will forever need massive investment in both transportation and energy. It is in the self-interest of governments to treat capital providers in a manner that will ensure the continued flow of funds to essential projects. And it is in our self-interest to conduct our operations in a manner that earns the approval of our regulators and the people they represent.

The moat for both the business are (1) Highly regulated, (2) Huge amounts of capital needs to be employed, and. (3) Decent returns on capital. Now we can answer the 3^rd question that I had.

C. $91.09 billion is invested in Property, Plant and Equipment. Is this a capital intensive business?

Yes. BNSF and MidAmerican are capital intensive business. $53.58 billion in BNSF and $56.21 in MidAmerican with accumulated depreciation of $18.70 billion comes to total investment of $91.09 billion.

BNSF

In America 42% of all inter-city freight is moved on railroad tracks. Of which BNSF moves 37%, which means BNSF moves 15% (0.42 * 0.37) of all inter-city freight in the US. Moving freight on rail is both environment friendly and energy efficient. In 2010, BNSF moved each ton of freight it carried a record 500 miles on a single gallon of diesel fuel. That’s three times more fuel-efficient than trucking. This is a huge cost advantage for companies and it is another moat. Matt Rose manages the operations at BNSF. Since Berkshire acquired BNSF in 2009 all the data comparisons are going to be from 2010, 2011 and 2012.

(In Millions)	2010	2011	2012
Operating Earnings	4495	5310	6000
Interest	507	560	623
Interest Coverage	8.87	9.48	9.63

MidAmerican

Berkshire started its acquisition of MidAmerican in 1999 and in 2012 it owned 89.8% of MidAmerican. Today it serves electricity to customers in 10 states. It also accounts for 6% of the country’s wind generation. Three projects are under construction, when completed it will own about 14% of U.S. solar generation capacity. Greg Abel manages the operations at MidAmerican.

(In Millions)	2010	2011	2012
Operating Earnings	1,862	1,982	1,958
Interest	353	336	314
Interest Coverage	5.27	5.90	6.24

Now we can answer my 4^th question.

E. Can the company service the debt of $40.01 billion without any problems?

Yes it can. BNSF has an average interest coverage of 9.33 and MidAmerican has an average coverage of 5.80. Should I be concerned with MidAmerican as it only has a cover of 5.80? No. Remember it is in utility business and hence it is recession proof. People need electricity all the times. BNSF business is cyclical as companies move less freight during recession. Hence a coverage of 9.33 has a good margin of safety built in. On top of this, Berkshire does not guarantee any debt or other borrowings of BNSF, MidAmerican or their subsidiaries. So as a shareholder we should not be concerned.

Let us take a look at Berkshire return on the capital deployed in BNSF and MidAmerican. I got the capital deployed by subtracting goodwill and liabilities from assets. Why did I subtract goodwill? Imagine a company which has assets of $100 generating $25 in pre-tax income. If you want to buy the company you will pay more than $100. Why would the owner sell you the business that is generating 25% returns at the cost of assets? You need to pay more so that he will have an incentive to sell. If you pay $125 for the company the extra $25 is the goodwill. Hence I removed the goodwill to see the true earning potential of the asset. Why did I subtract liabilities? Some of the liabilities will have cost in the form of interest payment. Pre-tax earnings is arrived after subtracting the interest. Hence I have removed the liability.

(In Millions)	2010	2011	2012
Pre-Tax Earnings	5150	6400	7021
Capital Deployed	49,528	51,725	54,426
Return on Capital	10.39%	12.37%	12.90%

3. Manufacturing, Service and Retailing

Buffett and Munger acquire businesses that are (1) Easy to understand (2) Have durable moat (3) Run by able and honest management and (4) Fairly priced. Over the years they have purchased several companies which met their criteria. Some of them are Marmon, McLane Company, See’s Candies, Fruit of the Loom, and, Nebraska Furniture Mart. You can look at the full list here. Given below are the total assets deployed in this segment along with the pre-tax earnings for 2008, 2010, and 2012. Since Berkshire acquired 64% of Marmon in 2008 hence I am using 2008 as the base year for comparison. For arriving at capital deployed I subtracted goodwill and liabilities from the assets. Most of the business will have less capital expenditure. Hence some portion of their earnings can be used to buy more businesses.

(In Millions)	2008	2010	2012
Pre-tax earnings	4023	4274	6131
Capital Deployed	14264	14574	22640
Return on Capital	28.20%	29.32%	27.08%

4. Investments

Now it is time to answer my 5^th question

B. Equity and Fixed maturity investments from all its business segments comes to $163.34 billion. Where are they invested?

The investments are made into three different groups. The value of all these investments are marked-to-market. As of Sep 30th 2013 whatever price these securities are selling for is reflected in the balance sheet.

1. Fixed Maturity Investments – $29.54 billion is invested in Treasuries, Corporate, State and Municipal bonds, Mortgage Backed Securities, and, Foreign Government bonds.
2. Equities – $106.76 billion is invested in equities of publicly traded companies. Of which 55%($58.71 billion) is invested in the shares of four companies (highly concentrated).  The companies are American Express, Coca-Cola, IBM, and, Wells Fargo. The same four criteria used for acquiring companies is applied here.
3. Other Investments – $29 billion is invested in this category. This includes preferred stock and warrants in Wrigley, Dow Chemical Company, Bank of America and H.J. Heinz Holding Corporation. $12.05 billion is invested in Heinz which was done in June 2013.

Most of the investments are managed by Buffett. Todd Combs (2010) and Ted Weschler (2011) joined Berkshire to manage the investment portfolio. As of 2012 they both managed $5 billion each.  Both are smart and honest and have beat S & P 500 in 2012 by double digit margins. They will be managing the entire investment portfolio after Buffett and Munger.

Now it is time to answer my final question.

F. Why does the company defer the income tax of $50.85 billion. How long can they do?

Let us see what Buffett thinks about this. In the owner manual he writes

Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $117 billion. Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its drawbacks.

Imagine you purchased one share of a company for $100. After one year the value of the share is $200. If you sell the investments you will pay taxes on capital gains for $100 ($200 – $100) at say 15%. The tax comes to $15 which is the deferred tax liability if you hold the investment. By not selling you get an interest free loan of $15 from the government which is put into use.

To make this concept very clear let us assume that you invested $1 in 1980 and every year the investment doubles. You held onto it for 10 years. Let us call this strategy as buy-and-hold. At the end of 10 years you have a gain of $512 and a total deferred tax of $76.80.

Year	Amount	Deferred Tax (15%)
1980	1
1981	2	0.15
1982	4	0.30
1983	8	0.60
1984	16	1.20
1985	32	2.40
1986	64	4.80
1987	128	9.60
1988	256	19.20
1989	512	38.40

Now consider another scenario. The investment doubles every year and at the end of each year you sell your holding at 15% tax. You did this for 10 years. You made 253.83 just half of what you made in buy-and-hold. Also the total taxes paid to the government is $44.62. In the buy-and-hold case the deferred tax comes to $76.65. Even the government got benefited in the buy-and-hold strategy. Why? This is the power of compound interest. You let the deferred tax liability compound.  Buffett has been doing the buy-and-hold strategy for a very long time. In the process he did not pay taxes to the government and this comes to $50.85 billion. As long as Berkshire holds these companies it need to not pay any taxes. Buy right and sit tight.

Year	Amount	Tax at 15%
1980	1.00
1981	1.85	0.15
1982	3.42	0.28
1983	6.33	0.51
1984	11.71	0.95
1985	21.67	1.76
1986	40.09	3.25
1987	74.17	6.01
1988	137.21	11.12
1989	253.83	20.58

Given below are the investment market value of Berkshire in 2002, 2007, 2012, and, 2013.

(In Billions)	2002	2007	2012	2013 (9 months)
Investments Market Value	87.35	106.57	139.76	163.34

5. Finance and Financial Products

This is a small segment of Berkshire. There are 2 rental companies. CORT rents furnitures and XTRA rents trailers. Clayton Homes is the country’s leading producer of manufactured homes and it also services mortgage loans. In 2012 it serviced 332,000 mortgages, totaling $13.7 billion. Remember the financial crisis of 2008? Lots of people defaulted on their loans and several banks went bust in the process. Clayton Homes lends money for people to buy their homes. How did their loans perform? It was very stable. How did they achieve this? Clayton gave mortgages by lending money to people with manageable debt-to-income ratio. Buffett wrote about this in 2010 letter.

If home buyers throughout the country had behaved like our buyers, America would not have had the crisis that it did. Our approach was simply to get a meaningful down-payment and gear fixed monthly payments to a sensible percentage of income. This policy kept Clayton solvent and also kept buyers in their homes.

Year	Net loss as a percentage of average loans
2006	1.53%
2007	1.27%
2008	1.17%
2009	1.86%
2010	1.72%

In 2012 this segment had a pre-tax earnings of $848 million.

We have looked at all the 5 business segments of Berkshire. Let us look at the net earnings and book value in 2002, 2007, 2012, and 2013 (9 months). In 11+ years book value has grown by 11.32% and net earnings grew by 11.72%.

(In Billions)	2002	2007	2012	2013(9 months)
Net Earnings	4.28	13.21	14.82	14.48
Book Value	64.03	120.73	187.65	208.38

Management

Berkshire management is able, open, honest, and, share holder friendly. Buffett has explained 13 owner-related business principles here. By reading this we can understand about Berkshire management. In that principle no 9 is

We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.

Why should $1 of retained earnings should at least have a gain of $1 in market value? There are two ways for shareholders to make money (1) Dividends and (2) Price appreciation. Berkshire does not pay any dividends and it retains all the earnings. If for every $1 retained earnings results in a $1 gain in market value, we can get the retained earnings by selling the stock. Prof. Sanjay Bakshi explained about it here. Let us do the same for Berkshire.

Year	Retained Earnings (In Billions)
2002	4.286
2003	8.151
2004	7.308
2005	8.528
2006	11.015
2007	13.213
2008	4.994
2009	8.055
2010	12.967
2011	10.254
2012	14.824
	103.595

Berkshire retained $103.59 billion. Now let us look at the market capitalization.  I used wolfram-alpha for getting the market cap of Berkshire hence not very sure of its accuracy.

Date	Market Cap (In Billions)
2-Jan-02	115.5
30-Dec-13	291.24
	175.74

During the same period the market cap grew by $175.74 billion. For every $1 of retained earnings the market price went up by $1.69. Hence there is a definite value that is getting created for every $1 retained.

Total earnings retained = $103.59 billion
Delta market cap = $175.74 billion

Market price increase for $1 retained = Delta market cap / Total earnings retained
Market price increase for $1 retained = $175.74 / $103.59  
Market price increase for $1 retained = $1.69

If I do the same on a 5-year rolling basis how does the data look? For 3 out of 7 rolling periods the market value was higher than retained earnings. During the period from 2008 to 2011 the market was undergoing enormous turbulence. Hence we cannot get any useful information for the period ending from 2008 to 2011.

5 Year Rolling Period	Retained Earnings (In Billions)	Beg Market Cap(In Billions)	End Market Cap(In Billions)	Delta Market Cap(In Billions)	Market Value for $1 retained
2002 – 2006	39.288	115.5	169.7	54.2	1.38
2003 – 2007	48.215	111.6	219.1	107.5	2.23
2004 – 2008	45.058	129.4	149.7	20.3	0.45
2005 – 2009	45.805	135.2	153.4	18.2	0.40
2006 – 2010	50.244	136.5	197.7	61.2	1.22
2007 – 2011	49.483	169.7	188.6	18.9	0.38
2008 – 2012	51.094	219.1	219.3	0.2	0.00

Valuation

Buffett treats book value as intrinsic value to measure Berkshire’s performance against S & P 500. He knows that book value is much lower than Berkshire’s intrinsic value. Why? Here are the reasons

1. Insurance float is treated as a liability and hence it reduces the book value. This is a revolving fund and as long as the cost of this is close to zero it is a huge asset for Berkshire. On 30^th Sep 2013 it was recorded at $76.48 billion.
2. The deferred tax liability is booked as a liability and hence it reduces the book value. Taxes are due only when the investments are sold. On 30^th 2013 it was recorded at $50.85 billion.
3. On 30^th 2013 the market value of top four equity investments comes to $58.71 billion. These terrific companies retain their earnings and they are not reflected in the book value.

Now how do we measure the value of Berkshire? We can get the answer from Buffett himself. In 2012 letter he wrote

The third use of funds – repurchases – is sensible for a company when its shares sell at a meaningful discount to conservatively calculated intrinsic value. Indeed, disciplined repurchases are the surest way to use funds intelligently: It’s hard to go wrong when you’re buying dollar bills for 80¢ or less. We explained our criteria for repurchases in last year’s report and, if the opportunity presents itself, we will buy large quantities of our stock. We originally said we would not pay more than 110% of book value, but that proved unrealistic. Therefore, we increased the limit to 120% in December when a large block became available at about 116% of book value.

Buffett will buy back stock if it is selling for less than 120% of the book value. On Sep 30^th 2013 the book value of Berkshire is $208.38 billion. Multiplying it with 1.2 we get $250.05. The current market cap is $291.24 billion and this is 16% more than his buy back limit.

Let us look at it another way. Investments of $163.34 billion plus insurance float of around $76.48 billion comes to $239.82 billion. If you subtract $239.82 billion from the the current market cap of $291.24 billion we get $51.42 billion. For $51.42 billion we can buy [BNSF, MidAmerican, 75+ terrific businesses, Buffett, Munger, Ajit, Tony, Todd, Ted, …]. What do you think?