How to analyze Berkshire Hathaway

Published on 08/10/23 | Saurav Sen | 3,847 Words

The BuyGist:

  • We send out The Buy Scan at least once a week.
  • We cover the most pertinent (and trending) topics in investing.
  • We rely heavily on our primary valuation tool - The Buycaster - to get actionable insights.
  • We hope that each Buy Scan provides at least one salient insight.

It’s a doozy.

We never covered Berkshire Hathaway in the Buycaster because it is a strange beast. We always thought that we’ll analyze it on a one-off basis if we needed to. In fact, we have analyzed BRKB in the past, resulting in us taking a position at that time. We sold our position since - when it reached our target price. These were pre-Buycaster days, when we operated under the old framework of precisely calculating intrinsic values even though we always knew that it was a mirage. However, that analysis was useful because it forced us to conclude that Berkshire can only be analyzed with a “sum of the parts” approach where we evaluate each business segment separately and add it all up. Sounds simple enough. But it’s not.

Berkshire is a different beast because it’s an insurance company that invests its proceeds into other companies - private and publicly traded - to increase the firm’s equity value over time. In its balance sheet, it splits its numbers up into these sections…

  1. Insurance & Other
  2. Railroad, Utilities and Energy

That’s how Buffett thinks about his business. That’s fine, but it makes our lives harder. The big headache (for us) is that Buffett & Team invest some of the proceeds from their insurance business into a public equity portfolio. On the balance sheet its listed as “Investments in Equity Securities” under the Insurance & Other section. That line item now stands at a whopping $353 billion! It includes some of Buffett’s famous stock holdings like Apple and American Express. The Railroads Etc. segment has their famous private investments like BNSF, See’s Candies etc. The $353 billion Public Equity portfolio is marked to market every quarter. The Railroads Etc. segment is valued by Management (we totally trust Buffett’s appraisal). But the whole thing’s a hodgepodge!

However, we found a “satisficing” way to put BRKB in the Buycaster! We stared at the numbers hard enough and decided to split up the business into Private and Public (instead of Insurance and Railroads Etc.). Fortunately, Buffett & Team have always been kind enough to split up the income statement into Private and Public segments. That’s all the help we needed. This is important - when we do our Buycasting in the Buycaster, we do it for the Private segment. For the Public segment (their awesome $353 billion public equity portfolio), we made some very reasonable assumptions about its future annualized return. We had to do it because we needed to put down a marker so that we could easily Buycast the Private segment. But we did finally toggle the Public segment as well as you’ll see below. More nerdy details in the next section.

We’ve definitely lost a few hairs (and grayed others) while adding this strange beast called Berkshire Hathaway in the Buycaster. But it was worth it because it allows us to keep track of an industry bellwether in a nuanced way and, most importantly, we think you’ll find it useful on an on-going basis through the next few months, quarters, and years.

Let’s dig in. Let’s Buycast.

Is it rational to buy BRKB?

We’ve reproduced the charts from the Buycaster. Below each chart, we’ve pasted the explanation that you see in the Buycaster. But before digging in, we should clarify a few things…

  1. We’ve added an extra layer of (nerdy) details below each Buycaster Explanation to help you navigate that Public-Private split. These are labeled as “Special Note” in italics.
  2. Remember that the Buycaster Rationality Rating is not an absolute statement on whether BRKB is a “good or bad buy”. It just quantifies how rational it is to expect BRKB to deliver our (and maybe your) Desired Return.
  3. Our Desired Return is 80% cumulative in 5 years (12.5% CAGR). That’s the objective from which we back solve to answer 3 specific questions…
    • What do we need to believe about Berkshire Hathaway to consider buying the stock today?
    • Is “what we need to believe”, well, believable?
    • What if we buy the stock anyway - what’s our risk?

OK. Let the Buycasting begin.

Buycaster Explanation: We consider buying stocks with ratings of 9 and above. BRKB's rating is much lower. The LOW Rationality Rating  tells us that it is IRRATIONAL to expect the stock to deliver 80% cumulative return in 5 years (12.5% CAGR). The current stock price is just too high to deliver that return in the next 5 years - given the business economics of the company today. To consider buying the stock, we would need to believe that Berkshire Hathaway Inc.'s business economics – revenue growth, cost structure, and profit margins – will improve drastically over the next 3 to 5 years. The sliver lining is that BRKB has a HIGH Safety Rating (discussed later), so we wouldn't lose sleep if we had the stock in our portfolio. Just to reiterate, this analysis does not make an absolute proclamation like "BRKB is a good or bad buy" ; instead it quantifies the likelihood of BRKB delivering 80% cumulative return in 5 years (12.5% CAGR). Everything starts with that Desired Return. From there, we back-solve towards "what needs to happen in the business" to - RATIONALLY - expect our desired return. That's what the rest of the dashboard is about.

Special Note - We’ll unpack this rating over the next few charts.

Special Note - This chart is, unfortunately, a mix of the Private and Public segments. The Market Cap number is for the entire company - Public & Private. It’s just here for informational purposes, so it makes sense to give you the whole picture. However, the other numbers shown below Market Cap are for the Private (Insurance, Railroads, Utilities & Energy) segment only. That’s because, when we Buycast, we do it only for the Private segment - which exists in the income statement as a roll up of the income statements of all the underlying private holdings. The Public Equity Section is listed separately in the Income Statement as “Investment and derivative contract gains” - Buffett has done this precisely because he knows that this is a highly volatile, marked-to-market line item that doesn’t mean much on a quarter-by-quarter basis. It can (and will) distort the overall revenue number if lumped together with the Private numbers. Added up over the long-term, this Public line item has been value-accretive.

Buycaster Explanation: BRKB has a BUYCAST of 13.8% – our measure of ‘what we need to believe about the business to consider buying BRKB today’. The BUYCAST is measured in terms of future Annualized Revenue Growth (ARG). So, to consider buying BRKB, we need to believe that Berkshire Hathaway Inc.'s revenue will grow at an average of about 13.8% per year for the next 5 years. Compared to the company's actual historical revenue growth numbers, this BUYCAST looks like an irrationally exuberant scenario. But we need more information to quantify the believability of the Buycast...

Special Note 1 - This number represents just the Private segment. We’ve started with our Desired Return and time frame. So, it’s easy to get to our Desired Market Value (DMV) from the Current Market Value. But this DMV would be for the entire company. To analyze the strange beast that is Berkshire Hathaway, we needed to split up the company into Private and Public. The Public segment is basically Berkshire Public Equity portfolio - this segment is not “modelable” like a normal company. The Private part of the business is modelable. It’s a roll-up of businesses that sell products or services, have operating costs, and profit margins - they are not subject to the vagaries of fear and greed in the stock market.

Special Note 2 - For Buycasting, we’ll focus on the Private segment. After all, that’s the segment that has reported numbers for revenue and costs. But to back solve to the Private Buycast, we had to put down a marker for the Public segment. So, here’s what we did - we got the latest mark-to-market value of the portfolio from the balance sheet - $353 billion - and tacked on an 8% CAGR for the next 5 years (that’s our time horizon). That amounts to about $552 billion. We then deducted this value from the original DMV to get the new Private DMV. With the Public segment out of the scene (for now), we could back-solved to get the Buycast for the Private segment. The historical revenue growth numbers, shown here for reference, are of the Private segment as well (not the entire company), so they are comparable.

Buycaster Explanation: We measure SANITY by quantifying the believability of the Buycast against the company's historical performance. But we've also introduced 2 new variables here: 1) The average Wall Street Analysts' 5-year Revenue CAGR forecast, and 2) The DOWNCAST, which is our best estimate of a pessimistic revenue CAGR. The Downcast takes into account the actual historical revenue growth numbers and the Wall Street number. We usually apply a margin-of-safety discount to those numbers to get the Downcast. The believability of the BUYCAST depends on the DOWNCAST. BRKB's DOWNCAST is 5.4%, which is uncomfortably low compared to its BUYCAST of 13.8%. The gap between 'what we need to believe' and 'what could happen in a pessimistic growth scenario' is uncomfortably large. The Downcast is dragged down primarily by relatively low Wall Street Analysts' expectations of future revenue growth. This is why BRKB gets a LOW SANITY RATING. More on SANITY later. But first, let's quantify RISK. The Downcast is also the fulcrum between the Buycast and Risk.

Special Note - The Downcast shown here is also just for the Private segment, so it is comparable to the Buycast. We suspect the Wall Street Average Revenue Growth forecast shown here is for the Private section as well because that’s the part that’s modelable. But even if they somehow include forecasts of gains or losses from the Public Equity Portfolio of Berkshire, it makes the Downcast more conservative anyway. So, we’re comfortable with (possibly) erring on the side of conservatism. We’ll take Buffett’s advice on this one - we’d rather commit a mistake of omission than commission.

“Risk comes from not knowing what you’re doing.” – Warren Buffett

Buycaster Explanation: What if we buy BRKB today by BELIEVING its HIGH SANITY Rating...only to see the stock price drop precipitously because our investment thesis (or leap of faith) did not pan out? What sort of losses should we expect if we we're wrong? In BRKB’s case, we estimate the POTENTIAL LOSS to be around -15% (cumulative, within 5 years), which is DIGESTIBLE for us in a diversified portfolio of at least 20 stocks. This is why BRKB has a HIGH SAFETY RATING.. More on the SAFETY RATING in the next chart.This Potential Loss estimate is a direct consequence of the DOWNCAST scenario. If that low-growth scenario comes to pass, the chart above depicts the only risk that matters to us investors - permanent loss of capital. We start wit the Downcast Revenue Growth Scenario and work our way down the cash flow waterfall to finally arrive at a Downcast Price. The Downcast Price of BRKB is around $304.3. The last closing price was $358. Therefore, the POTENTIAL LOSS estimate is -15%. For more details, please see the Appendix Section.. Now that we've got all the insights we need to calculate an overall Rationality Rating. One more step.

Special Note - The Potential Loss number shown here is for the entire company - Private + Public. BRKB’s current price, of course, corresponds to the entire company. So, BRKB’s loss estimate should also correspond to the entire company. And it does. We made one adjustment when calculating this loss number. As we moved from the Downcast (for the Private segment) down the cash flow waterfall to Free Cash Flow and then on to the Downcast Market Value (Private), we added back a more pessimistic version of the future value of the Public Portfolio to sum it all up to the Downcast Market Value for the whole company (Public + Private). Recall that we had assumed an 8% CAGR return on the portfolio in the Buycast. In this case, we adjusted that down to 5% CAGR. Even so, you’ll notice that the potential loss number is very palatable.

Buycaster explanation: 

Mechanically, the SANITY RATING is just a scaled up (to a scale of 10) number representing the gap between the BUYCAST and the DOWNCAST - it quantifies the believabiity of the BUYCAST. In BRKB's case, the SANITY RATING turns out to be 4.9 out of 10, which is LOW on our scale. Remember, it all starts with our desired or required return. The Sanity Rating quantifies how, well, sane it is to believe that this stock will get us our required return. A Sanity Rating of 9/10 is considered "High", above 8/10 is conseidered "OK", and anything below 8 is considered "Low". Generally, we don't consider potential investments with Low Sanity Ratings. The SAFETY RATING is a scaled up number (on a scale of 0 to 10) representing the severity of that -15% loss number from the previous chart. Mechanically, it's a simple scaling exercise. The POTENTIAL LOSS estimate of -15%  falls within the SAFE ZONE on our Potential Loss Scale, which ranges to -10% to -80%. -10% corresponds to the best Safety Rating (10.0) whereas -80% corresponds to the worst rating (0.0). It’s easy to get from BRKB's Potential Loss estimate of -15% to its HIGH SAFETY Rating of 9.3 out of 10. For more details, please see the Appendix Section.

BRKB's LOW Rationality Rating of 7.1/10 is the average of its Sanity Rating (4.9/10) and Safety Rating (9.3/10).

Special Note - Berkshire falls short of our “buy zone”, which is ratings of 9 or above. As you can see, that’s mainly because of the Sanity Rating. And that’s low mainly because of a rather tepid Wall Street Revenue Growth forecast. We’d like to reiterate that this is not an absolute proclamation about Berkshire Hathaway as a company or BRKB as a stock. The low Rationality Rating simply tells us that given the economics of the business, we cannot - rationally - expect the stock to deliver 80% within the next 5 years.

So, what would Buffett think?

This is a strange, meta concept that we’ve depicted in the Buycaster - how would Buffett analyze Berkshire? Would he consider buying the stock? Our analysis suggests that at the current BRKB price, he may look for better deals out there. Here are 2 charts that we provide for each of the 3,500 stocks that we cover in the Buycaster.

Buycaster Explanation: 

How does The Rationality Rating stack up against other rating systems – ones that have, presumably, helped generate market-beating returns over the long-term; or maybe they're just popular because they’re quoted in media every day? We’ve provided 2 alternative rating systems for context: The Buffett-Munger Rating and The Wall Street Rating. The latter is a scaled up version of surveys conducted by major financial data vendors such as Bloomberg and Thomson Reuters - we use it as a proxy for "market opinion". The Buffett-Munger Rating is more interesting to us.

It turns out that BRKB has a LOW BUFFETT-MUNGER Rating. As you saw in the previous charts, the Rationality Rating is also LOW, which is a nice coincidence. The Buffett-Munger Rating tells us that this company definitely does not have the type of financial profile that Mr. Buffett and Mr. Munger like: High Quality ROE, demonstrated Pricing Power, and the stock trading at a reasonably low free cash flow multiple. The two legends of investing would probably reject BRKB as a potentially NEW investment candidate at this time, unless they believe that the current financial profile of the company is not sustainable; for example, their subjective analysis could conclude that the business will improve drastically in the next few years. More details on the Buffett-Munger Rating in the Appendix.

Please be aware that 1) In the last 5 years or so, some of Mr. Buffett’s lieutenants (who run Berkshire Hathaway's public equity portfolio) have modified Mr. Buffett's style in a way that appears to be philosophically closer to our methodology, 2) This Buffett-Munger Rating represents the traditional Buffett process that has helped make Mr. Buffett his fortune; but it could easily be superseded by a subjective thesis from the man himself, and 3) If the stock already exists in their portfolio, the calculus is different; the risk – chances of a permanent loss of capital – are significantly lower if a stock that’s already in the portfolio has clocked in considerable gains over the years; indeed, some holdings serve as low-risk placeholders until a new idea pops up.

We can’t possibly leave you with these charts without raising a few points…

  1. Unlike the Rationality Ratings, the Buffett-Munger ratings are ranking-based, meaning the rating is a relative number - relative to the 3,500-ish stocks in our coverage.
  2. Buffett’s investment universe of investable publicly traded companies is restricted, mostly because of size. He will probably not take a thousand small positions - that’s against his focused investment style. But to have a focused portfolio, he can only take small enough (minority stake) positions in Large Cap or Mega Cap companies.
  3. His equation for Risk is different, especially on the Private side. He prizes management quality over all else. He also gets a direct line to the CEOs of private companies. These things are hard to quantify. A direct line to a CEO throws any risk model out of the window.
  4. We were surprised with the relatively low ROCE (return on capital employed) rating. The ROCE rating shown here corresponds to the Private portfolio. We know that Buffett looks closely at ROCE, ROIC and ROE when he analyzes potential investments, so we expected this number to rank high. But then it occurred to us that Berkshire’s ROCE number is partly diluted by the humongous cash balance that’s not earning much in terms of return on capital. Berkshire currently has about $142 billion in cash and short-term US Treasury Bills. That’s about 14% of Berkshire’s total assets - that’s a lot of dry powder.
  5. Now that BRKB has appreciated more that 20% over the last 12 months and about 70% over the last 3 years, there’s a chance that Buffett will agree with our rating (if he’s looking) and stop buying back more Berkshire Hathaway shares. He’s been buying back a lot over the past couple of years or so…

Key Takeaways

  1. The low Buycaster Rationality Rating tells us that we cannot - rationally - expect BRKB to meet our require return threshold (of 80% in 5 years or 12.5% CAGR). If BRKB’s price dips another 20% or so, the rating will be a lot more optimistic.
  2. The tepid Buffett-Munger Rating tells us that Buffett would probably avoid BRKB stock if he were analyzing it as a neutral analyst for his public equity portfolio. However, as mentioned earlier, his restricted public equities universe and unfettered access to some juicy private deals (that we mere mortals don’t have) changes his equation.

Congratulations! You now know significantly more about Berkshire Hathaway than 99% of investors out there. Don’t follow the hype. Stay calm. Stay centered. Stay rational.

We hope you found this analysis useful.

Many Happy Returns.

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