Martin Sosnoff
Contributor
There was a lot not to like in the yearend report of Berkshire Hathaway. But, the stock’s trajectory, up 28%, made it unmistakably a 2014 absolute and comparative winner. All this in a year when hedge fund operators woefully underperformed the S&P 500 Index as did the majority of big capitalization stocks and managers benchmarked by this index.
How do you explain or at least rationalize Berkshire’s stock as a contrapuntal mover to its equity portfolio and what appears as cyclical if not deep seated operating problems in its insurance businesses and railroad property, Burlington Northern Santa Fe?
Although operating earnings for 2014 rose almost 10% and book value 8.3%, using Buffett’s measurement, book value, Berkshire substantively underperformed the S&P 500 for 2014 as well as its stellar, annualized long term book value enhancement of 19.4%.
Fourth quarter results showed notable operating slippage. Insurance underwriting declined materially while investment income sloughed off. But, nonfinancial operating businesses carried the company, rising 11% for the year. The issue for me is fire and casualty underwriting today is very price competitive, as is the reinsurance sector. There is too much underwriting capacity in the business. By now, Berkshire’s operating entities in terms of earnings contribution outweigh insurance by 2 to 1. The Burlington Northern woefully underperformed rail operators like Union Pacific Railroad and Canadian Pacific Railway.
I wouldn’t put more than a 15 multiple on Berkshire’s operating sector and at most 12 times earnings for its underwriting capacity. My plays in rails are Union Pacific and Canadian Pacific. Allstate gets my money among insurance underwriters. All 3 handily outperformed the market last year.
How does this bumblebee that’s too heavy to fly maintain such elevation and endurance? Good question! I’m searching anxiously for what I’ve missed. Certainly not Berkshire’s equity portfolio which bores me to tears.
Yes! They threw ExxonMobil out the window before yearend, but what about American Express, Coca-Cola, IBM and Wells Fargo? Hard to see them as sprinters this year, although Wells Fargo last year did outperform other large capitalization bank stocks.
Last year, Berkshire’s $140 billion equity portfolio increased 8.4%, underperforming the S&P 500 by over 500 basis points. Clearly, the locus of earnings has shifted from its equity portfolio to operating properties. You don’t want Buffett for money management prowess but for his deal-making capacity and the wherewithal to make sizable acquisitions, anywhere from $10 billion to $50 billion or more on an asset base over $500 billion.
On a yearend equity portfolio of $117 billion, 59% was concentrated in the 4 stocks mentioned above. Some $50 billion covered the financial sector, about 44% of its total portfolio. This is a weighting nearly 3 times its sector in the S&P 500. No conventional money manager could get away with such concentration. Financials underperformed last year and probably need a more angled yield curve to excel in 2015.
Buffett makes a good point on intrinsic value vs. book value – the gap has widened but that in the long term a stock’s price and its intrinsic value converge. By my using a price-earnings ratio of 15 on its earnings base from operations of $16.5 billion, I come up with a back-of-the-envelope asset value of $247.5 billion. Add in over $50 billion in cash available for deal-making and we’re above $300 billion in estimated valuation. My earnings multiplier of 15 is quite generous for insurance properties, railroads, utilities and energy properties.
If Warren were hit by a drunken driver, how would the courts estimate earnings capacity for this octogenarian? ¿Quién Sabe? I would assess Buffett’s deal-making capacity by using cash assets today and a 15% ROE on future acquisitions. Actuarially, men who pass 65 live to be 86.5 years. So, Warren. You’ve got at least 3 years to make hay in the sunshine. Then, throw in 3 years of future cash flow, I’d put Warren’s earnings capacity at a $10 billion jury award. Let’s hope this doesn’t bankrupt the insurance underwriter of the miscreant, and let’s hope he hasn’t left the scene of the accident.
All in, the market’s valuing BRK at $370 billion. Using my yardstick, Berkshire Hathaway is worth $310 billion, at best an average investment. Consider the portfolio custodial in nature, carrying huge unrealized gains with serious tax consequences.
Apple came from nowhere 10 years ago to reign now as a $700 billion market capitalization. Facebook and Alibaba tick as $200 billion properties. I wonder whether Buffett woulda bought them when he was in his thirties, back in the sixties. After all, Geico nearly flamed out, early seventies, from too aggressive insurance premium discounting. I bought Geico for $2 a share then but unlike Buffett didn’t hold on for the next 50 years.
What I find so incongruous but telling is Buffett operates with a 24-person home office. No art museum rests on the ground floor, but Berkshire’s market capitalization is ExxonMobil’s equivalent and they’ve been around twice as long.
You may be fully priced on my ciphering, Warren, but I wish you one big upside surprise before time’s winged chariot overtakes both of us.
Sosnoff owns personally and / or Atalanta Sosnoff Capital, LLC owns for clients the following investments cited in this commentary: Union Pacific Railroad, Canadian Pacific Railway, Allstate, American Express, Wells Fargo, Apple, Facebook and Alibaba.
