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Originally published on Gurufocus:
http://www.gurufocus.com/news.php?id=52509
Berkshire Hathaway is Misunderstood & Inexpensive
Buffett goes out of his way to make Berkshire Hathaway’s Annual Report as easily understandable as possible. However as Berkshire Hathaway has grown, complexity followed. This makes putting a price or value on Berkshire increasingly difficult for both the average and professional investor. Complexity coupled with Buffett’s advancing age, not to mention skittish markets, certainly play a role in Berkshire Hathaway’s depressed market price. I will try to break down Berkshire Hathaway’s separate components of value below. The discrepancy between price and value should become very apparent.
The 4 major sources of value may be specified as follows:
Insurance business Utilities and Energy Business Service, Manufacturing, and Retail Business Finance and Financial Products Business
The Utilities & Energy businesses and Service, Manufacturing, & Retail businesses are fairly straightforward as far as we are here concerned. The real complications derive from the insurance businesses and the Finance and Financial Products Businesses.
Part I Finance and Financial Products
Over the past 2-3 years, Berkshire made a few investments in derivatives contracts, which leaves many people scratching their heads. Mark-to-Market, “Fair Value” accounting (Used for Derivatives) causes wide variations in the balance sheet and income statement and produces misleading results. There are four different types of derivative contracts in which Berkshire has entered.
i) Equity puts ii) Credit Default Insurance on a high yield index of 100 companies iii) Credit Default Swaps on individual companies iii) Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives)
Equity Puts
Berkshire Hathaway sold equity puts. Equity puts are very similar to selling insurance-the purchaser pays a premium and in return is protected from future loss. The loss in this case is a decline in the general stock market.
Berkshire sold puts and collected premiums up front which Buffett invested. These premiums, like insurance, are invested until the contract expires. These are European style contracts, meaning the seller is liable only for losses that exist on the expiration date of the contract, which is in no less then 15 years. In the meantime Buffett gets the benefit of the use of this money.
Specifics:
2006 seems to be the first year that Buffett personally entered into equity puts. In 2006 the S&P 500 closed at around 1400, as of early March 2009, the S&P 500 stands at 830. Premiums received for these contracts, $4.9 billion. Max loss if the index is zero upon expiration, 15 years hence (at which point money would be all but worthless anyway,) $37 billion.
Credit Default Insurance on a High Yield Index of 100 Companies
First expiration is due in September 2009 and the last expiration due is in December 2013. Premiums received, $3.4 Billion. The amount of actual losses paid as of December 31, 2008: $542 million. Meaning, net, Berkshire has the benefit of the use of $3 billion. This might be considered as “Credit Default Insurance (high-yield index,) Float”. Estimated future losses (loss reserve) are $3.4 billion. These contracts seem the most likely, of the 4 types of derivatives, to produce a “Derivative Underwriting Loss”.
Credit Default Swaps (CDS) on Individual Companies
Counter party risk exists to the extent the purchasers of these contracts are able to pay the full $4 billion premiums over the 5 year life of the contracts. Annually Berkshire receives $93 million for premiums on these contracts. Berkshire is liable for 42 corporations. Should any of them default on their loans, Berkshire is liable for the decline in the market value of the debt relative to value of the debt specified in the CDS contract. I am confident that each of these corporations has substantial amounts of tangible assets or have sustainable earning power well in excess of their respective interest obligations, both of which protect Berkshire from loss. Asset protection protects the price decline in the market value of debt upon default and earning power from default.
Tax Exempt (Muni) Bond Insurance Contracts (Structured as Derivatives)
These are mostly second-to-pay contracts meaning Berkshire is liable to pay only what the first insurer cannot. Berkshire received premiums of $595 million in 2008 on contracts extending as far as 40 years. These premiums should be expected annually for the duration of individual contracts.
Berkshire has a total “Derivative Float” of about $8.1 billion primarily from Equity Puts and Credit Default Insurance (high yield index). Current accounting requires Berkshire to record an excessive liability on its balance sheet for the Mark-to-Market changes in the liabilities that accompany derivate float.
Accounting for Derivatives
Derivatives contracts not designated as a hedge, for example sold European Style Equity Index Puts receiving (premiums up front) are accounted by recording premiums as “other liabilities” on the balance sheet. Changes in the “fair value” of these contracts are adjusted quarterly with changes reflected in the income statement as derivative or “unrealized” losses and correspondingly in the in the balance sheet account as an increase or decrease in “derivative contract liabilities”. A more detailed discussion on Berkshire’s Derivatives and the accounting is discussed on page 8. What follows here is a more general, less confusing explanation.
The $8.1 Billion Berkshire received in premiums (“Derivative Float”) was initially recorded as a liability on the balance sheet and declines in the “Fair-Value” of “Mark-to-Market” securities are subtracted from earnings in the period of loss, irrespective of actual economic gains or losses. Due to Mark-to-Market changes in the derivatives that Berkshire holds, their liabilities increased to $14.6 billion in 2008 and as a consequence a pretax loss of $6.821 billion was recorded as negative revenue (expense) understating reported earnings in 2008. For similar reasons, earnings were overstated by $5.5 billion in 2007 and $2.6 billion in 2006 again due to the nature of Mark-to-Market ,“Fair Value” accounting.
Personally I believe markets will recover in a few years, let alone 15 years, but let’s first consider the contrary. In December 1929 the Dow Jones Industrial Index was at about 370. In 1934, 15 years later, the index had fallen a total of 60% i.e. a 6% annual loss. In equivalent terms, Berkshire’s Equity puts would require payment of about $22 billion. To break even on this transaction Berkshire Hathaway
would need to compound $4.9 billion at about 10.5%. Buffett’s track record is well above 15% over the last 50 years and his current investments are certain to out live him-and I expect will exceed the breakeven 10.5% (Note the yields on “Other Investments” below). If on the other hand in 15 years the stock market has at least recovered, there is no payment for loss and the derivative float will explicitly become equity. In this case, the value of “Equity Put Float” will have definitely compounded at a rate exceeding 15%. It appears reasonable to me that Berkshire’s “Equity Put Float” is today worth about $12.5 billion. In the event that the market closes down 60% in 15 years, while (assuming) Berkshire continues to compound investments as it has in the past, the Equity Put Float would have a current value between $4 billion and $5.5 billion.
The below table shows Earnings and Net Worth as reported and adjusted for the affects of derivatives:
Adjusting only for derivative gains & losses provides that earnings were understated for 2008 and overstated for 2007 and 2006.Part II Cash, Securities, & Investments
Berkshire Hathaway’s Insurance business:
Berkshire Hathaway has about $116 billion in Cash & Equivalents, Fixed Maturity investments, and Equities held within various insurance businesses. Primarily by National Indemnity, Columbia Insurance Company, GEICO, GenRe, National Fire and Marine Insurance Company, and Berkshire Hathaway Assurance Company. (These six insurance companies hold roughly $43 billion of Berkshire’s $56 billion (adjusted) equity investments.)
Investments - As Reported:
Other investments make comparing 2008 to 2007 more difficult than necessary and are itemized and reconciled for simplicity below:
Other Investments: (click to enlarge)
Adjustments to Other Investments:
For simplicity, Moody’s and Burlington Northern will be treated as equities and Goldman Sachs, GE, and Wrigley’s as Fixed Maturities:
It’s unclear how much new capital net was invested in or taken out of equities in 2008. My estimates are as follows: Equity sales of Johnson & Johnson, Conoco Phillips, and Proctor and Gamble provided about $2.78 billion, which Buffett used in part to pay for the $14.5 billion private placements of Goldman Sachs, GE, and Wrigley’s. After all sales and purchases that Berkshire made in equities, Berkshire would have received between $2.873 billion and $7.825 billion, an average of $5.349 billion, pre-tax. I am making the assumption that Buffett sold Anheuser Busch for the takeover bid offer of $70 US, which would have provided, $2.475 billion pre-tax.
Berkshire’s cash balance declined by $9.4 billion, adjusted earnings for the year would have contributed $9.6 billion, equity puts and other derivatives contracts sold would have also provided investable capital though exact amounts were not provided. A crude calculation implies that Berkshire would have put between 21.87 and 26.82 to use in various investing activities. We know for certain that Berkshire spent at least, $20.6 billion, $6.1 billion on operating business acquisitions and $14.5 billion on private placements, which is reasonably close. (Buffett stated that the $14.5 billion private placements were paid for with available cash. Cash Balance declined $9.4, meaning $5.1 billion was provided either via equity sales or from operating earnings. The remaining balance would have been used to pay for business acquisitions made throughout the year.)
Part III Berkshire Hathaway Insurers
The Basics (Readers already familiar with the basic economics of insurance businesses, skip to, “Getting to the Point” )
The value of an insurance company comes from the amount of investable funds it generates. Investable funds can come from underwriting profits or from investment income or from securities gains. In the simple sense, if insurance premiums are sufficient to cover the losses incurred over the insurable period the insurer produces an underwriting profit. These profits may be added to surplus, which allows the insurer to write additional business. The amount of business an insurer can write is generally limited to 3 times the insurers surplus - the Statutory Accounting Principles (SAP) definition for shareholders equity.
As stated above, the amount of business an insurer can write is dependent upon surplus. Investable funds are a combination of surplus and float.
The amount of float depends upon the amount of business written. The amount of business written depends upon the amount of surplus. The amount of surplus depends upon underwriting profit or loss, investment income from interest and dividends, and/or capital gains on investments. The underwriting of insurance policies and the investment of surplus and float are separate operations. When both are done well an insurance business compounds capital at VERY attractive rates of return. Such is Berkshire Hathaway.
Berkshire Hathaway has on average earned an underwriting profit. Float to date is about $58 billion and I am of the impression that this number will grow this year. Most insurers earn underwriting losses for reasons I will not go into. These losses must be made up for by interest income and securities gains. If this does not happen, surplus declines (for reasons discussed above) and the amount of business written must also decline. The past year was not a good one for the general stock market. As a result, many insurers suffered large declines in their Statutory Surplus Accounts. In 2008 Berkshire wrote insurance business of about $25 billion on surplus of $51 billion. That is, they are very well capitalized and well positioned to take market share while still generating underwriting profits in 2009.
Getting To the Point
Berkshire Hathaway’s $58 billion of Insurance Float is reasonably worth not less than $70 billion. The $58 billion float is basically invested in Fixed Maturities and Cash Equivalents:
Berkshire’s $56 billion in equities, valued at market are worth substantially more in rational economic terms. Each individual will arrive at different estimates, but they are not economically worth less than the currently quoted market values. Berkshire’s Float and Equity holdings (at market) taken together must be worth at least $126 billion (Fiscal Year 2008).
Part IV It Doesn’t Get Much Easier Than This
Net Worth:
Manufacturing, Service, & Retailing
Working Capital $ 5,497
Fixed and Other Assets 17,586
Total Tangible Assets 23,083
Term Debt and other Liabilities 6,033
Net Worth 17,050
Utilities & Energy
Total Tangible Assets $ 36,290
Total Liabilities 24,448
Net Worth 11,842
Finance & Financial Products (adjusted for Equity Puts)
Total Tangible Assets $ 22918
Payables, Accruals,
& General Other Liabilities 16044
Derivatives Liabilities
(Less $10 billion Equity Put Options
Liability) 4612
Total Liabilities 20656
Net Worth 2,262
Net Worth Manufacturing, Service, & Retailing, Utilities & Energy, Finance & Financial Products
Manufacturing, Service, & Retailing $ 17,050
Utilities & Energy 11,842
Finance & Financial Products 2,262
Net Worth(s) 31,154
Minimum Value, Berkshire Hathaway:
$31.15 billion+ $126 billion = $157.15 billion
Market Value (3/11/09) = $131.76 billion
Market Value (3/10/09) = $ 113.45 billion
Part V A more reasonable value of Berkshire’s non-insurance operating businesses
Berkshire’s Manufacturing, Service, & Retail businesses earned $4023 pretax, a 17.5% return on Total Tangibles, and 23.6% on Net Worth.
Manufacturing, Service, & Retail
2008
Pre-tax income $ 4023
Total Tangibles 23,083
Return on Assets 17.5%
Net Worth 17050
Return on Net Worth 23.6%
Finance and Financial Products
Berkshire’s Finance and Financial Products business using Clayton’s pretax income earned 3.43% on assets in 2008-that’s a 35% return on Net Worth. (A 2% Return on Assets for a bank is considered extraordinary.)
2008
Clayton’s Pre-tax income $ 787
Finance and Financial Products
Total Tangible Assets 22,918
Return on Assets 3.43%
Finance and Financial Products
Net Worth 2,262
Return on Net Worth 35%
I am certain the best method of appraisal and determination of earnings for the Utility and Energy businesses are via the balance sheet. This information is not provided in Berkshire’s annual report and I have not spent enough time digging for it. Therefore I cannot say how much I think it is reasonably worth. Therefore well just take it at book value.
Without going into great detail, I think the non-insurance businesses are reasonably worth no less than $46 billion, which would Value Berkshire Hathaway in its entirety at $172 billion not adjusting for the intrinsic value of equity investments held by its insurers.
Appendix: ("Click Me" links not functional but click images for larger view)
“Fair Value” & Accounting For Berkshire’s Derivatives Book
The charges against net income ($6,821) and the increase in Derivative liabilities ($7,725) are not offsetting. The footnote providing for the exact charges against net income ($7,461) does not match the liability increase in the Balance Sheet either, though it does provide helpful information. Part of the confusion: liabilities appear as though they are specific to Berkshire’s Finance & Financial Products Businesses, but there are “Fair Value” related charges against earnings that are specific to “Insurance & other” as explained in the footnote. The confusion is nearly resolved by comparing the actual amounts charged to earnings against increases in the “Fair Value” of these securities as on the Balance Sheet. As will be found below, there is an $18 deficit that is related to change in the Counter-Party Netting/Collateral. And the books can be closed. Thanks FAS 133!
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