It's sort of a shame that Berkshire Hathaway's annual meeting Saturday is almost certainly going to focus on Warren Buffett taking heat over his one-time heir apparent David Sokol's sketchy trading in Lubrizol stock. Berkshire's in the S&P 500 now (ever since it split the B-class shares to affect the purchase of a railroad last year), meaning that any indexed investor with a pulse owns a piece of the company, too.
So whether we make the annual pilgrimage to Omaha or not (and more than 30,000 people do), we're all hippies in the so-called Woodstock for Capitalists now.
Given that's the case it would be nice to focus on how our investment is doing rather than on ripping Buffett. Berkshire's board has roundly condemned Sokol's actions as a violation of company policy. Buffett has promised to address the Sokol affair in full and I'm sure that he will, in that folksy, charming, Teflon-coated way of his. Whatever the case, Buffett clearly put his faith in the wrong guy, and I'm not downplaying his mistake.
For a moment, however, let's not discuss Berkshire as if it's King Lear or even King Ralph for that matter (sorry, I've got royal wedding on the brain) -- but as a stock. That is to say, how's the valuation?
Berkshire's a tough one to figure. It's a holding company, operating mainly in the property & casualty and reinsurance businesses. But it also owns nearly 70 other companies, ranging from Dairy Queen to Fruit of the Loom underwear. It also employs hedging strategies, meaning it uses derivatives. So it's been characterized as everything from a hedge fund to a private equity shop to a mutual fund to a whatever.
So What's it Really Worth?
If you look at Berkshire Hathaway as a mutual fund, as some folks do, it does indeed look overpriced. Class A shares currently trade north of $125,000, but the company's investments are worth about $95,000. You probably wouldn't pay that kind of a markup for a fund, when you could buy many of the underlying companies without a premium. Of course some of the holdings are wholly owned by Berkshire -- if you want exposure to See's Candies, you'll have to buy BRK.
But there's a different way to look at the company.
At more than 6 percent of the portfolio, Berkshire is the top holding at BBH Core Select Fund. Co-managers Rick Witmer Michael Keller and Tim Hartch make a cogent case for Buffett's genius at allocating capital from insurance premiums and the firm's other businesses to build book value and -- by extension -- increase the share price.
"We view Berkshire as a collection of very good operating businesses, the largest of which would be the insurance businesses," Hartch told me by way of email. "With respect to investing, Berkshire has used the stable and growing float from its insurance operations to purchase good operating businesses and shares in similar publicly traded companies."
You see, most insurance companies take their proceeds from premiums and invest in bonds and other conservative instruments. This is where Berkshire differs, and has allowed it to excel, in Hartch's view:
Owning those businesses has generated higher returns over time for Berkshire than would have been achieved buying only fixed income assets. Importantly, Berkshire has always operated with a liquid and conservative balance sheet, which is a competitive advantage in reinsurance and one of the reasons it has been able to make equity investments.Finally, just for kicks, let's just look at good old relative valuation. The stock looks cheapish but hardly a screaming bargain. Shares currently offer a 5 percent discount to their own five-year average on a forward earnings basis, according to data from Thomson Reuters. By trailing price/earnings, shares offer a discount of 7 percent. And as for price/earnings-to-growth (PEG), the stock is about in line with its own five-year average. (PEG measures how fast a stock is rising relative to its growth prospects.)
At this point in any analysis of Berkshire Hathaway, we probably do need to circle back to L'Affaire Sokol. If Berkshire deserves a premium, it's partly because of Warren Buffett's judgment. Clearly, it suffered a lapse, even if it was nothing more serious than trusting a top lieutenant who didn't deserve that faith. And maybe the stock price should reflect that failing. I'm not stockpicking here. I just hope to get more out of Saturday's Buffett-palooza than a mosh pit with the Sokol scandal in the middle.