Berkshire Hathaway (BRK.B) Has Risen 7% in Last One Year, Underperforms Market

If you are looking for the best ideas for your portfolio you may want to consider some of Pershing Square Capital Management’s top stock picks. Pershing Square, an investment management firm, is bullish on Berkshire Hathaway Inc (NYSE:BRK.B) stock. In its Q2 2019 investor letter – you can download a copy here – the firm discussed its investment thesis on Berkshire Hathaway Inc (NYSE:BRK.B) stock. Berkshire Hathaway Inc (NYSE:BRK.B) is a multinational conglomerate holding company.

On August 13, 2019, Pershing Square had released its Q2 2019 investor letter. The investment firm bought  Berkshire Hathaway Inc (NYSE:BRK.B) stock in the second quarter of 2019. The stock has posted a return of 6.8% in the trailing one year period, underperforming fund’s benchmark the S&P 500 Index which returned 16.1% in the same period. This suggests that the investment firm was wrong in its decision to buy Berkshire Hathaway Inc (NYSE:BRK.B) stock. On a year-to-date basis, Berkshire Hathaway Inc (NYSE:BRK.B) stock has fallen by 3.7%.

Pershing Square fund posted a return of 45.3% during the first half of 2019, outperforming fund’s benchmark the S&P 500 Index which returned 18.5% in the same period. Let’s take a look at comments made by Pershing Square about Berkshire Hathaway Inc (NYSE:BRK.B) stock in the Q2 2019 investor letter.

“Recently, PSH acquired Berkshire Hathaway common stock representing approximately 11% of NAV. My interest in Berkshire began decades ago when I began following the company in 1988. I have attended the substantial majority of shareholder meetings since the early 1990s and followed the company and Warren Buffett—Berkshire’s Chairman, CEO and controlling shareholder—extremely closely since that time. Yet, funds I have managed have owned Berkshire only once for a brief period in late 1999 and 2000.

The catalyst for our current investment in Berkshire is our view that the company is currently trading at one of the widest discounts to its intrinsic value in many years, at a time when we expect the operating performance of its subsidiaries to improve as a result of certain managerial and organizational changes at the company. While Mr. Buffett has long been one of most high-profile and closely followed investors in the world, we believe that Berkshire Hathaway’s undervaluation is partially explained by the fact that it is one of the least followed and misunderstood mega-cap companies.

Berkshire is often described in the media as akin to an investment fund, leaving many with the impression that Berkshire’s shareholder returns are dependent on Warren Buffett’s extraordinary stock-picking ability. While this depiction of Berkshire was a better reflection of its reality in its earlier years, it no longer reflects the company’s current reality. Today, Berkshire is a $500 billion market cap holding company with about half of its value residing in its insurance subsidiaries, and the balance in controlling stakes in highly diversified operating companies. Mr. Buffett has clearly designed the company to succeed decades after he is no longer running the company. As a result, we believe that Berkshire should continue to generate high returns for shareholders from the current stock price even if the investment returns from the company’s large cash holdings and marketable securities portfolio are similar to that of the broad market indices.

Berkshire’s primary asset is the world’s largest insurance business, which we estimate represents nearly half of Berkshire’s intrinsic value. In its primary insurance segment, Berkshire focuses on the reinsurance and auto insurance segments. In reinsurance, Berkshire’s strong competitive advantages are derived from its enormous capital base, efficient underwriting (a quick yes or no), ineffable trustworthiness, and its focus on long-term economics rather than short-term accounting profits, all of which allows the company to often be the only insurer capable of and willing to insure extremely large and/or unusual, bespoke insurance policies.

We believe that Berkshire’s reinsurance business, operating primarily through National Indemnity and General Re, is uniquely positioned to serve its clients’ needs to protect against the increasing frequency and growing severity of catastrophic losses. In auto insurance, Berkshire subsidiary GEICO operates a low-cost direct sales model which provides car owners with lower prices than competitors that rely on a traditional agent-based sales approach. GEICO’s low cost, high quality service model has enabled it to consistently gain market share for decades.

The enduring competitive advantages of Berkshire’s insurance businesses have allowed it to consistently grow its float (the net premiums received held on Berkshire’s balance sheet that will be used to pay for expected losses in the often distant future) at a higher rate and a lower cost than its peers. While Mr. Buffett is best known as a great investor, he should perhaps also be considered the world’s greatest insurance company architect and CEO because the returns Berkshire has achieved on investment would not be nearly as good without the material benefits it has realized by financing these investments with lowcost insurance float.

For more than the last decade, Berkshire has grown its float at an 8% compounded annual growth rate while achieving a negative 2% average cost of float due to its profitable insurance underwriting, while incurring an underwriting loss in only one out of the last 15 years. These are extraordinary results particularly when compared with the substantial majority of insurance companies which lose money in their insurance operations and are only profitable after including investment returns. Furthermore, we believe that Berkshire’s cost of float will remain stable or even decline as its fastest growing insurance businesses (GEICO and BH Primary) have a lower cost of float than the company’s overall average.

Since the end of 2007, we estimate that Berkshire has averaged a nearly 7% annual rate of return on its insurance investment portfolio while holding an average of 20% of its portfolio in cash. Berkshire has been able to produce investment returns that significantly exceed its insurance company peers as the combination of the company’s long-duration float and significant shareholders’ equity allow it to invest the substantial majority of its insurance assets in publicly traded equities, while its peers are limited to invest primarily in fixed-income securities. We believe these structural competitive advantages of Berkshire’s insurance business are enduring and will likely further expand.

Berkshire also owns a collection of high-quality, non-insurance businesses, which include market-leading industrial businesses, the largest of which are the Burlington Northern Santa Fe railroad and Precision Castparts, an aerospace metal parts manufacturer. While Berkshire’s non-insurance portfolio is comprised of highly diversified businesses that have been acquired during the last 50 or so years, we estimate that the portfolio derives more than 50% of its earnings from its largest three businesses: Burlington Northern (>30%), Precision Castparts (~10%), and regulated utilities (~10%).

Burlington Northern is North America’s largest railroad which benefits from strong barriers to entry, industry-leading scale, and long-term secular growth due to rail’s cost advantages over trucking in moving freight over long distances.

Precision Castparts has a strong competitive position in complex metal parts and components manufacturing due to the stringent regulatory requirements in the aerospace industry, and an excellent future growth outlook due to a nearly decadelong backlog of aircraft deliveries that are required to support the world’s growing travel needs.

Berkshire’s regulated utilities business primarily consists of a handful of well-managed, highly efficient energy utilities that earn a reasonable return on equity while satisfying their customers’ and regulators’ desire for low energy prices. Berkshire’s regulated utilities business is relatively insulated from economic downturns due to the essential nature of the service it provides, which has allowed it to steadily grow its earnings during all phases of the economic cycle.

While we have utilized a number of different approaches to our valuation of Berkshire, we believe it is perhaps easiest to understand the company’s attractive valuation by estimating Berkshire’s underlying economic earnings power, and comparing the company’s price-earnings multiple to other businesses of similar quality and earnings growth rate. Using this approach, we believe that Berkshire currently trades at only 14 times our estimate of next 12 months’ economic earnings per share (excluding the amortization of acquired intangibles), assuming a normalized rate of return of 7% on its insurance investment portfolio. While generating a 7% return on such a large amount of investment assets is not a given—particularly in an extraordinarily low-rate environment—we believe that Berkshire’s ability to invest the substantial majority of its insurance assets in equity and equity-like instruments and hold them for the long term makes this a reasonable assumption. Based on these assumptions, we believe that Berkshire’s valuation is extremely low compared to businesses of similar quality and growth characteristics.

Berkshire’s current earnings are also meaningfully understated in the currently low interest rate environment as the company is earning a minimal return on its approximately $100 billion of excess cash which is invested in short dated, risk free assets.

Net of its excess cash, Berkshire currently trades at less than 12 times our estimate of earnings per share over the next year. Given the company’s strong competitive position, solid future growth prospects, large degree of excess cash and superlative track record of value creation, we believe that Berkshire should be valued at a large premium to its current valuation. Moreover, we believe an investor’s downside is limited due to the company’s fortress balance sheet, highly diversified business portfolio, and significant earnings contribution from recession-resistant businesses such as insurance and regulated utilities.

Furthermore, we expect that certain recent positive developments will highlight and enhance the per-share value of Berkshire’s business over the next several years. First, we believe that it is likely that management will intelligently deploy some of its $100 billion of excess cash into value-enhancing large-scale business acquisitions and/or a greater than historical amounts of share repurchases. We believe that this can be achieved because Mr. Buffett has built a deep bench of managerial and investment talent and a durable culture of character and performance.

Second, Berkshire created a new managerial structure in 2018 to elevate two long-time managers, Ajit Jain and Greg Abel who now directly oversee the insurance and non-insurance businesses. Both managers have a track record of improving operations under their purview. We expect this new management structure will empower them to enhance the operational performance of Berkshire’s businesses that have underperformed their peers. For example, Burlington Northern’s current operating profit margins are nearly 500 basis points below the average of its North American peers, and nearly 800 basis points below that of its best-in-class peer despite BNSF’s industry-leading scale. In Berkshire’s insurance subsidiaries, GEICO’s loss ratio is more than 800 basis points higher, and its underwriting profit margin about 400 basis points lower, than its closest competitor, Progressive Corp., and General Re’s expense ratio offers the potential for significant improvement based on our due diligence.

We expect that Berkshire’s enviable competitive advantages and the positive underlying growth trends in most of its businesses will allow the company to sustainably grow its earnings at a high-single digit rate without any operational improvement at its larger businesses, and without including the benefit of the productive deployment of excess capital.

If Berkshire can improve its operations and intelligently deploy a substantial portion of its excess capital over time, we estimate that the company’s earnings per share should grow at a mid-teens’ compounded annual rate over the intermediate term. In light of the company’s currently depressed valuation, understated near-term earnings, and the potential for significant future earnings per share growth, we believe that Berkshire’s share price is likely to increase substantially over the coming years.”

In Q1 2020, the number of bullish hedge fund positions on Berkshire Hathaway Inc (NYSE:BRK.B) stock increased by about 2% from the previous quarter (see the chart here), so a number of other hedge fund managers seem to agree with Berkshire Hathaway’s growth potential. Our calculations showed that Berkshire Hathaway Inc (NYSE:BRK.B) is ranked #16 among the 30 most popular stocks among hedge funds.

The top 10 stocks among hedge funds returned 185% since the end of 2014 and outperformed the S&P 500 Index ETFs by more than 109 percentage points. We know it sounds unbelievable. You have been dismissing our articles about top hedge fund stocks mostly because you were fed biased information by other media outlets about hedge funds’ poor performance. You could have doubled the size of your nest egg by investing in the top hedge fund stocks instead of dumb S&P 500 ETFs. Below you can watch our video about the top 5 hedge fund stocks right now. All of these stocks had positive returns in 2020.

Video: Top 5 Stocks Among Hedge Funds

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Disclosure: None. This article is originally published at Insider Monkey.