Tuesday, December 4, 2012

Stock as a Currency

In 1998, Berkshire Hathaway (BRKa) had its per-share book value increase by 48.3%.

Must have been a good year, right?

Warren Buffett explains why it was less so than it seemed in the 1998 Berkshire Hathaway shareholder letter:

Normally, a gain of 48.3% would call for handsprings -- but not this year. Remember Wagner, whose music has been described as better than it sounds? Well, Berkshire's progress in 1998 -- though more than satisfactory -- was not as good as it looks. That's because most of that 48.3% gain came from our issuing shares in acquisitions.

To explain: Our stock sells at a large premium over book value, which means that any issuing of shares we do -- whether for cash or as consideration in a merger -- instantly increases our per-share book-value figure, even though we've earned not a dime. What happens is that we get more per-share book value in such transactions than we give up. These transactions, however, do not deliver us any immediate gain in per-share intrinsic value, because in this respect what we give and what we get are roughly equal. And, as Charlie Munger, Berkshire's Vice Chairman and my partner, and I can't tell you too often (though you may feel that we try), it's the per-share gain in intrinsic value that counts rather than the per-share gain in book value. Though Berkshire's intrinsic value grew very substantially in 1998, the gain fell well short of the 48.3% recorded for book value. Nevertheless, intrinsic value still far exceeds book value. 

Back in the mid-to-late 1990s, Berkshire was selling, at times, at 200% to 300% of book value.

At that kind of valuation*, I think it is fair to say that Berkshire's shares were anything but cheap and that made the stock useful as currency for acquisitions. Use of a company's stock as a currency for acquisitions is, as I noted in this recent post, something Henry Singleton did effectively during his time at Teledyne. Earlier this year, Singleton's approach was highlighted in a Bloomberg article:

...Henry Singleton, made acquisitions using the company's stock when its price was high. When the share price went down, Singleton bought back shares repeatedly.

So he was savvy about using the company's stock, when pricey, as a currency for acquisitions. If a high-priced stock** (high relative to its intrinsic value) is used to acquire generally sound businesses selling for cheap, good things are likely to happen over the long haul. Henry Singleton was just as smart about buying back Teledyne's shares when it was cheap. According to John Train's book The Money Masters, Buffett once said this about Singleton:

"Henry Singleton of Teledyne has the best operating and capital deployment record in American business."

The Bloomberg article noted that, starting in 1968, Teledyne's stock generated a 23 percent annualized return over the next two decades.

In contrast to the 1990s, Berkshire's book value sat at roughly $ 111,700 per Class A share at the end of the most recent quarter. As I write this, the Class A shares are selling for $ 131,022.

A premium of 17% or so over that last reported per-share book value.
(or 117% of book value)

Berkshire announced last year that the company will repurchase shares at a 10% (or less) premium over the book value:***

In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise. If we are correct in our opinion, repurchases will enhance the per-share intrinsic value of Berkshire shares, benefiting shareholders who retain their interest.

Buffett explained this further in the most recent Berkshire Hathaway shareholder letter. At that small premium...

...repurchases clearly increase Berkshire's per-share intrinsic value. And the more and the cheaper we buy, the greater the gain for continuing shareholders. Therefore, if given the opportunity, we will likely repurchase stock aggressively at our price limit or lower.

As I've said before, it's worth reading the Intrinsic Business Value and Share Repurchases sections in the latest letter for more of Warren Buffett's and Charlie Munger's thinking on this.

Check out pages 99-100 of the 2011 annual report and pages 4-5 of the owner's manual for good explanations of how they view intrinsic value. At a minimum, as the share price approaches that 10% premium over the book value, Buffett has made it easy to know when he thinks the shares are selling at an attractive discount to intrinsic value.

Also, unless something very large and attractive comes along, I'm guessing Buffett would rather not use Berkshire's stock as a currency anytime soon.

Adam

Long position in BRKb established at much lower than recent prices

Related posts:
Berkshire Hathaway's 3rd Quarter 2012 Earnings
Berkshire's Book Value & Intrinsic Value
Buffett: Intrinsic Value vs Book Value - Part II
Buffett: Intrinsic Value vs Book Value
Berkshire Hathaway Authorizes Share Repurchase
Should Berkshire Hathaway Repurchase Its Own Stock?

* Price to book value is an imperfect way to judge how cheap a stock is but, as Buffett has explained, it works okay, within limitations, as a rough measure for Berkshire Hathaway. From the Berkshire owner's manual:
Inadequate though they are in telling the story, we give you Berkshire's book-value figures because they today serve as a rough, albeit significantly understated, tracking measure for Berkshire's intrinsic value. In other words, the percentage change in book value in any given year is likely to be reasonably close to that year's change in intrinsic value.
In the Intrinsic Business Value section of the most recent shareholder letter, Buffett also explains why book-value -- a meaningless measure for most companies -- is a useful if understated proxy for Berkshire Hathaway's intrinsic value.
** When Teledyne stock was expensive -- 40, 50, or even 60 times earnings -- it was used as a currency to buy cheap assets. See page 48 of this Forbes article for more details. For the economic system as a whole, I happen to think if market prices generally fluctuated in a narrower range around intrinsic value, there would be less capital misallocation (even if it would make life harder for an executive like Singleton and those attempting to profit from mispriced securities) and, in the long run, the economy would be served better (but that's a subject for another day).
*** 10% premium over the book value or 110% of the book value. It's been described both ways in different publications.
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