Monday, March 3, 2014

Intrinsic Value

According to the latest letter, Berkshire Hathaway's (BRKa) per-share book value increased to $ 134,973.

In comparison, 49 years ago -- when Warren Buffett began running Berkshire --  per-share book value stood at just $ 19 (no zeros missing here). So that's an overall gain in per-share book value of 693,518% compared to roughly 9,841% for the S&P 500 (or 19.7% annualized gain compared to 9.8% for the S&P 500 over that time).

Now, that S&P 500 performance isn't exactly shabby even if it looks unimpressive by comparison.

Changes to per-share book value compared to the S&P 500 has been the Berkshire performance measurement of choice for some time.

It's a useful measure though far from perfect as is explained on page 107 of the annual report:

"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."

Buffett explains that the gap between intrinsic value and book value has actually been increasing in recent years. In other words, increases to per-share intrinsic value is almost certainly greater than the already astonishing -- I think it's fair to say -- increases to book value over the past 49 years.

In the latest Berkshire shareholder letter (released over this past weekend), Buffett also explains -- as he has on prior occasions -- how he thinks about book value as it relates to intrinsic value:*

"What counts, of course, is per-share intrinsic value. But that's a subjective figure, and book value is useful as a rough tracking indicator."

He goes on to add...

"As I've long told you, Berkshire's intrinsic value far exceeds its book value. Moreover, the difference has widened considerably in recent years. That's why our 2012 decision to authorize the repurchase of shares at 120% of book value made sense. Purchases at that level benefit continuing shareholders because per-share intrinsic value exceeds that percentage of book value by a meaningful amount. We did not purchase shares during 2013, however, because the stock price did not descend to the 120% level. If it does, we will be aggressive.

Charlie Munger, Berkshire's vice chairman and my partner, and I believe both Berkshire's book value and intrinsic value will outperform the S&P in years when the market is down or moderately up. We expect to fall short, though, in years when the market is strong – as we did in 2013. We have underperformed in ten of our 49 years, with all but one of our shortfalls occurring when the S&P gain exceeded 15%."

Buffett goes on to say this later in the new letter:

"As much as Charlie and I talk about intrinsic business value, we cannot tell you precisely what that number is for Berkshire shares (nor, in fact, for any other stock). In our 2010 annual report, however, we laid out the three elements – one of them qualitative – that we believe are the keys to a sensible estimate of Berkshire's intrinsic value."

He then provides an update for the two quantitative elements:

- Per-share investments: $129,253 per share

- Pre-tax earnings from businesses other than insurance and investments: $9,116 per share

"Since 1970, our per-share investments have increased at a rate of 19.3% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the 43-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but we will most strongly focus on building operating earnings."

Those two quantifiable elements provide a more straightforward starting point (though far from sufficient) for estimating Berkshire's per share value. Even so, no two people are likely to come up with the same estimate.

There are more messy aspects of estimating per-share intrinsic value -- and, yes, in some ways more challenging to judge though no less important -- that shouldn't be ignored. Things that are tough or impossible to quantify but of significance.

With Berkshire specifically, there's what Buffett has called the "'what-will-they-do-with-the-money' factor".
(The importance of this factor is explained on pages 109-110 of the latest annual report. It was initially covered in 2010.)

There's also the performance of Berkshire's float over time.**

Both can have an impact on value, favorable or not, that's very real.

Some might be inclined to minimally consider (if at all) what is, more or less, difficult to calculate or quantify -- and instead, in this case, maybe emphasize the two more quantitative elements -- but for many investments that's a good way to make a costly misjudgment. At times, looking at an entirely different discipline for perspective can be useful way to illustrate the point. Well, consider the following from Freeman Dyson as he writes about Lord Kelvin's large miscalculation of the earth's age. Dyson describes "Kelvin's wrong calculation of the age of the earth" as resulting from "blindness to obvious facts." He then added:

"Kelvin based his calculation on his belief that the mantle of the earth was solid and could transfer heat from the interior to the surface only by conduction. We now know that the mantle is partially fluid and transfers most of the heat by the far more efficient process of convection, which carries heat by a massive circulation of hot rock moving upward and cooler rock moving downward. Kelvin lacked our modern knowledge of the structure and dynamics of the earth, but he could see with his own eyes the eruptions of volcanoes bringing hot liquid from deep underground to the surface. His skill as a calculator seems to have blinded him to messy processes such as volcanic eruptions that could not be calculated."

Convection was important but not easily calculated, so Kelvin instead focused on what could be more easily calculated. Dyson points out that this led to Kelvin's estimate being short by something like 50-fold.

Certainly enough to matter.

The error of focusing too much what can be more easily quantified over what cannot applies to investment just as it applies to science.***

For example, if Berkshire's float remains a low cost (or, as has often been the case for Berkshire, better than free) and stable (i.e. a minimal need to post collateral especially at inopportune times/can't be called away or withdrawn when needed most) source of funds, it will have a significant positive impact on intrinsic value. Fortunately, estimating the impact float has on value isn't as difficult as estimating the earth's age. That's the good news. The bad news it's still not easy to more than roughly figure out what kind of economic value should be attached to it.

From the letter:

"If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces. When such a profit is earned, we enjoy the use of free money – and, better yet, get paid for holding it."

If, instead, significant ongoing underwriting losses were to occur in the future, then Berkshire's intrinsic value would end up being much reduced. Buffett goes on to say that he expect Berkshire's float to be "both costless and long-enduring".

Those who are confident that Buffett is roughly right should come up with at least a somewhat different valuation than those who think he might be too optimistic about how the characteristics of Berkshire's float will change over the long run.

"The value of our float is one reason – a huge reason – why we believe Berkshire's intrinsic business value substantially exceeds its book value."

Two reasonable investors could rightly have differing views on the value of Berkshire's float. But those who think the value of float can be nailed down with some level of precision would be kidding themselves.

What's important to remember is that this cuts both ways when it comes to estimating value. The more difficult -- in some cases even nearly impossible -- to quantify but important stuff can both just as easily subtract from as add to value (and, depending on whether it subtracts or adds, lead to either errors of omission or commission).

So, when it comes to estimating value, the significance of certain elements are tough to specifically pin down beforehand. The value of float may be more easy to roughly quantify than the "'what-will-they-do-with-the-money' factor", but that's not saying much. 

Spreadsheets, no matter how complex and/or thoughtfully done, just won't provide many insights on this.

So, while it may not be easy to figure out the impact on value with any kind of precision, it may be possible to understand it, more or less, directionally. In other words, it's sometimes wise to admit that it's only possible to judge whether the impact is likely to be positive or negative, while maybe not knowing by just how much. Some will surely be uncomfortable with this kind of messiness but, to me, it's an inevitable part of the investment process. It just means the investor has to allow for a somewhat wider range of outcomes and pay a price that takes the low end into account.
(Others might attempt to overcome the messiness by making a complex model that's built on lots of questionable assumptions. Well, the simple and well thought out usually beats the complex. Overly complex models are a great way to create something that appears precise -- falsely so -- and, maybe, creates unwarranted overconfidence in their reliability and utility. Those who possess the ability to think critically, reduce unnecessary errors, and truly know their own limits will probably be more effective in the long run.)

That's where margin of safety comes into play. It may not be very useful to someone who is attempting to estimate the age of the earth. Yet it works just fine, at least up to a point, within an otherwise sound investment decision-making framework. An investor has the luxury of choosing to not invest at all (and moving on to something else) if they're not comfortable with not knowing the hard to quantify stuff. The key thing is to not make the equivalent of Kelvin's mistake: that is, stubbornly continuing to focus on what lends itself to calculation and ignoring what's harder to calculate but possibly, in some cases, more important. This behavior will eventually end up being expensive for those who make it a common practice.

Flexibility beats being rigid.

For investors, choosing not to invest at all works just fine; acting like Kelvin does not. There are plenty of investment alternatives so there's no need to purchase something that's not well understood (necessarily unique to each investor). There's never a good reason to do otherwise.

Those who choose to emphasize what can be quantified in lieu of what matters a whole lot more but just happens to be mostly subjective, qualitative, or difficult to calculate will likely make unnecessary mistakes; they'll also likely miss opportunities.

Of course, a focus only on Berkshire's per-share investments and pre-tax earnings (from businesses other than insurance and investments) to determine intrinsic value wouldn't exactly be the same as the mistake made by Kelvin.

The investor might just decide to view the qualitative stuff as it relates to Berkshire as upside. In other words, pay a discount to value based only on the easy to quantify stuff.

This works when confident that the qualitative stuff won't be some kind of investment wrecking ball.

So that approach might work for a Berkshire investor but, for many others, the hard to quantify but important stuff just might overwhelm everything else. For example, misjudging something like how sustainable the competitive advantage of a particular business is -- not at all an easy thing to measure but terribly important -- could end up being very costly.

The lesson of Kelvin's blunder (and similar) will remain very relevant to investment decision-making.


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

Some related posts:
Berkshire Hathaway's Second Quarter 2013 Results - August 2013
Berkshire's Manufacturing, Service and Retail Operations - April 2013
Berkshire's Regulated, Capital Intensive Businesses - April 2013
Buffett on Buybacks, Book Value, and Intrinsic Value - December 2012
Berkshire's Book Value & Intrinsic Value - May 2012
Buffett: Intrinsic Value vs Book Value - Part II - May 2012
Buffett: Intrinsic Value vs Book Value - April 2012
Discount Rate - August 2009

* See page 107 and page 109-110 of the annual report for more on intrinsic value.
** Buffett's explanation of Berkshire's investments (stocks, bonds, and cash equivalents) -- the first of the three key components for estimating intrinsic value -- includes the following: "...underwriting results are volatile, swinging erratically between profits and losses. Over our entire history, though, we've been significantly profitable, and I also expect us to average breakeven results or better in the future. If we do that, all of our investments – those funded both by float and by retained earnings – can be viewed as an element of value for Berkshire shareholders." So float is is seen as part of the investments component when it comes to estimating value. Now, an investor might reasonably decide that the current essentially costless (or, in fact, often less than costless) and long-enduring characteristics of Berkshire's float will meaningfully change in the future. If so I'd offer that, in effect, that means in some ways it becomes a separate element when considering estimated intrinsic value. (Buffett does provide a useful explanation, as he has previously, of float's value in the Insurance section of the latest letter.) On the other hand, those comfortable with Buffett's future expectations of Berkshire's float can more or less focus primarily on the value of the investments themselves (in addition to the other two components of value).

Of course, even a modest multiple of the per-share pre-tax earnings from businesses other than insurance and investments when added to per-share investments hardly looks unreasonable compared to current market prices. That doesn't, in itself, mean Berkshire is a cheap stock because, for example, an investor might have a pessimistic view of the future prospects of the assets that make up both elements. In addition, this ignores important but more difficult (if not impossible) to quantify things that effect value both positively and negatively. Just some of the reasons why intrinsic value is necessarily a range of values and never a precise number. It's worth mentioning that the 1.2x Berkshire's book value (the level Buffett says he'd buy at aggressively) equals:

$ 161,968 per Class A share ($ 134,973 multiplied by 1.2)


$ 107.98 per Class B share ($ 161,968 divided by 1500)

As I write this, the Class A shares sells for ~ $ 173,000 or just over $ 115 per Class B share.

So it's not quite down to where Buffett says he would buy aggressively, but it's also hardly selling for a big premium to that price.

In any case, it seems rather likely that Buffett wouldn't be buying aggressively at 1.2x book if he thought the stock was selling at only a slight discount to its intrinsic value.

*** Blunders like Kelvin's are a part of progress in science, but there just happens to be a useful lesson in it. Charlie Munger had this to say about the tendency to focus on what can be calculated at the 2002 Wesco annual meeting:

"Organized common (or uncommon) sense -- very basic knowledge -- is an enormously powerful tool. There are huge dangers with computers. People calculate too much and think too little."

More recently, at last year's Berkshire annual meeting, here's an exchange between Warren Buffett and Charlie Munger that was captured on The Wall Street Journal's live blog:

Munger: "You really have to understand the company and its competitive positions. ...That's not disclosed by the math.

Buffett: "I don't know how I would manage money if I had to do it just on the numbers."

Munger, interupting, "You'd do it badly."

Munger also said the following back in 2003:
"...practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that."
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