Wednesday, August 7, 2013

Berkshire Hathaway's Second Quarter 2013 Results

The following summarizes what Berkshire Hathaway's (BRKa) operating earnings looked like compared to a year ago in its latest quarterly earnings release:
                                                  Second Quarter                 First Six Months
                                                  2013        2012                    2013        2012
Operating earnings         $3,919     $3,720               $7,701    $6,385

Unfortunately, short-term changes in operating earnings at Berkshire (and, for that matter, most businesses) reveals only so much about how the company is doing in terms of changes to its intrinsic value.

It turns out that book value is a far more useful measure -- even if understated and far from perfect -- when it comes to roughly estimating the percentage change to Berkshire's intrinsic business value.

This should seem at least somewhat odd because book value as a measure tends to be pretty useless with most other companies.

From the 2011 Berkshire Hathaway shareholder letter:

"We have no way to pinpoint intrinsic value. But we do have a useful, though considerably understated, proxy for it: per-share book value. This yardstick is meaningless at most companies. At Berkshire, however, book value very roughly tracks business values."

So, if book value were to increase by several percent, for example, chances are intrinsic value increased by roughly the same amount.
(As Buffett points out, it's impossible to know intrinsic value within any precision. It's necessarily approximate but, with some work, a rough but meaningful estimate of value can be made.)

Berkshire's intrinsic value is generally higher than book value.

This happens to be the case primarily because many of the businesses Berkshire owns are intrinsically worth more than the carrying value on the books.

Economic value exceeds accounting value. A reflection of the inherent limitations of accounting more than anything else.

The company's latest results did reveal a noteworthy increase in activity in the area of equities. It turns out that Berkshire bought $ 4.64 billion in equities in the second quarter of 2013.*

That compares to just $ 1.85 billion in the second quarter of 2012.

Also, $ 781 million in equities were sold during the most recent quarter. That number is much lower than the $ 3.01 billion in the second quarter of 2012.

Overall, net purchases of equities for the first six months of 2013 was $ 4.60 billion compared to $ 1.45 billion for the first six months of 2012.

Berkshire also completed the Heinz deal during the quarter. That represented another $ 12 billion plus of investment in equity securities by the company (though not publicly traded).

We should know more about the specifics of the publicly traded equities (at least those listed on exchanges inside the U.S.) that were bought during the quarter when the second quarter 13F-HR is released later this month.**

Though a detailed summary of the specific stocks bought and sold is not provided in the quarterly results, Note 5 in their 10-Q does summarize Berkshire's investment in equity securities under three categories:

- Commercial, industrial and other
- Consumer Products
- Banks, insurance and finance

Well, which specific stocks were bought and sold may not be knowable, but it's worth pointing out that Note 5 shows a nearly $ 4 billion increase to the cost basis of the Commercial, industrial and other category during the 2nd quarter.
(The cost basis for this category during the 1st quarter of 2013 was little changed. So the change in cost basis for the category since the beginning of the year is pretty much the same.)

Note 5 also shows a more modest but still meaningful roughly $ 900 million increase to the Banks, insurance and finance category (a ~ $ 1.66 billion increase since the beginning of the year) along with a $ 102 million drop in consumer products category (a ~ $ 274 million decrease since the beginning of the year).

So it at least hints at the direction they went during the quarter with common stocks. Again, the 13F-HR should reveal much more.

Back to book value. Since the beginning of this year, Berkshire's book value per Class A equivalent share increased 7.6% and now sits at $ 122,900 per share.

Warren Buffett and Berkshire's Board of Directors have made it clear that they are willing to pay up to 120% of the company's book value.

This equates to $ 147,480 per share based upon Berkshire's end of quarter book value. That's what they're willing to pay not what they think the shares are worth.

Naturally, $ 147,480 is not where Warren Buffett and Charlie Munger would peg Berkshire's approximate per share intrinsic value as of now. They'd only be willing to buy the shares at 120% of per share book value if they viewed that resulting price to be cheap compared to current per-share intrinsic value.

Buffett and Munger clearly think intrinsic business value is more than the 120% of book value and, of course, quite a bit more than book value.

So, for a variety of reasons, Berkshire's per-share intrinsic value per share is nicely higher than per-share book value. Still, estimated per-share intrinsic value shouldn't be thought of as an exercise in precision. Intrinsic value is, instead, more likely always a range.

In estimating intrinsic value, the best that can be expected is getting it roughly correct yet meaningful.

Check out the Berkshire owner's manual for a further explanation of why estimation is necessarily imprecise and why Berkshire's intrinsic value exceeds its book value.

"...intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover – and this would apply even to Charlie and me – will almost inevitably come up with at least slightly different intrinsic value figures."

Precision, especially when it is of the false variety, is neither needed nor desirable. This necessary imprecision is where margin of safety comes into the investment process.

More 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."

Though very important, if a stock sells at a nice discount to value, that isn't, in itself, a sufficient reason to repurchase shares.

As Charlie Munger previously explained, investment decisions always come down to opportunity costs.

"About the 20th page of [Greg] Mankiw's famous book, which succeeded [Paul] Samuelson's famous book, the guy says smart people make their decisions based on opportunity costs. Well, that was the last time opportunity cost was discussed in 1,000 pages. I want to tell you that compared to the other drivel that was discussed, opportunity cost deserves more than one sentence." - Charlie Munger***

The reality is, a repurchase only makes sense if a company is in a comfortable financial position, the business itself has what it needs to remain well-fortified against competitors, and that use of capital is truly superior to well understood investment alternatives.

Berkshire's stock closed yesterday at $ 176,855 per share. So it is selling well above where a buyback would even be considered.

That doesn't mean it's necessarily selling above per-share intrinsic value but, at a minimum, it probably does mean the margin of safety is insufficient.

It also likely means that repurchases are less attractive against alternatives.


Long position in BRKb established at much lower than recent market prices

* See Consolidated Statement of Cash Flows. The second quarter 10-Q shows the first six months of operating, investing, and financing cash flows. Well, that means that under cash flows from investing activities the total purchase of equity securities during the first six months has to be subtracted from purchase of equity securities found in the first quarter 10-Q (which, of course, shows the same number for the first three months). The same is true for the sale of equity securities, of course.
** Though there is no guarantee since Berkshire can, at times, obtain approval to delay disclosure under certain circumstances. Occasionally, the SEC allows the company to temporarily keep certain moves in the portfolio confidential. The permission is granted when a case can be made that the disclosure may cause buyers to drive up the price before Berkshire makes its additional purchases.
*** Munger is referring to the leading textbooks in introductory economics written by Mankiw and Samuelson. He also said the following about opportunity costs back in 2006: "In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That's your opportunity cost. That's what you learn in freshman economics. The game hasn't changed at all. That's why Modern Portfolio Theory is so asinine."
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