Portfolio manager’s Letter October 2002
This is my attempt to rearrange the numbers published in Berkshire Hathaway’s Annual Reports for the last ten years. The numbers are the same but hopefully they are presented here in a fashion that provides some new insight into value of the Berkshire Hathaway.
One question is an attempt to try to find a logical basis to place a value on Berkshire Hathaway’s float and to decide if all or a portion of this float should be added to Berkshire Hathaway Cash Flow 2002 when trying to arrive at a figure for Berkshire Hathaway intrinsic value.
One of the ironies of studying Berkshire Hathaway is that while Warren Buffett’s loves simple companies that are easy to understand, he has as his masterpiece created one of the most complex business structures in American business.
Don’t get me wrong. I’m not complaining, I love analyzing Berkshire Hathaway, the things you learn struggling through the Berkshire Hathaway annual report make it easier to understand all the other companies you own.
Table One is an attempt to show total revenue and estimate the rate of growth of this revenue. Estimates of this year’s revenues are basically six months figures times two.
“Berkshire Hathaway’s Revenue has grown at and average rate of 30.8% per year over the last 10 years. Compared to 30.5% for Microsoft, 21.5% for Intel and 4% for General Electric”.
|Year||Mid-America 80%||Berkshire Hathaway||Total|
To the revenue figures from the annual report I have added 80% of the revenue of Mid-American Energy since that represent Berkshire Hathaway equity percentage.
The average growth rate of Revenue the ten year period is 30.8%, not bad for Berkshire Hathaway the represents an eclectic bunch of boring businesses.
It is interesting to note that Microsoft’s revenue growth for the last ten years has averaged 30.5%; General Electric’s revenue has grown at 4% per year, and Intel’s at 21.5%.
A lot of this growth has come from two insurance acquisitions, GEICO in 1996; and GenRe in late 1998. I do not expect Berkshire Hathaway’s Revenue to continue this rate of growth. Warren Buffett has said that he does not expect Berkshire Hathaway to be able to grow at 15% in the future. The biggest problem is size, cash is pouring into Omaha at a rate (maybe $200 million per week) that it will make it impossible to invest that money as fast as it comes in. On the other hand but Berkshire Hathaway does have a huge pile of cash ready for large acquisitions, and a good bear market could easily add a bunch of new revenue.
In this connection I consider Berkshire Hathaway an almost perfect long term hedge against a market crash. The worse the market gets the more it allows Warren Buffett to add long term value to Berkshire Hathaway.
Table Two shows the growth of Berkshire Hathaway’s investment Income for the last ten years. This is basically dividend and interest income for the portion if the float th at has been invested in Stocks and fixed income securities. It includes only money actually received and does not include any look through earnings for the common stocks.
The growth rate for this investment income has be en 21% per year.
Table Three lists the total income from Berkshire Hathaway’s 40 some odd operating businesses. We separated these items on these two tables from the information provided in the Annual Reports. Since 1998 and the merger with General Re Buffett has been raising reserves for the insurance business and that has tended to obscure the growth the operating businesses.
Table Three includes all of the profit from the operating businesses plus 80% of the profit of Mid-American Energy. This Income has compounded for the last ten years at an annual rate of 33%. If you look at these three tables together, you can begin to get a clue about the value of the contribution of Berkshire Hathaway’s Insurance float to its intrinsic value.
“Investment income is growing at 21% per year and the income from operating businesses is expanding at 33% per year”.
What you see is an enterprise made up conservative business, none of which any inclination toward rapid growth yet the overall enterprise is growing very rapidly.
This magic is possible because of low cost leverage provided by the float, and without it, it is difficult to see how the enterprise would be able to grow any faster than the under – lying pieces.
It is impossible to arrive at a figure for the internal growth of the pieces, but I doubt that it is over 12% – 13%. This would seem to be about the level of growth Warren Buffett is comfortable with from an operating company. Any attempts to grow a business faster than this, can lead to mergers that do not work or other capital allocation blunders.
“For the ten years listed the cash flow from items on Table Four exceeded net income by $7.18 billion”.
Table Four shows totals for annual cash generated by three sources, but does not include any operational earnings from the insurance business, or any look through earnings from the stock portfolio.
|Year||Investment Income||Operating Business||Realized Gains||Total|
Realized gains totaled $8.56 billion for the ten year period, for an average of $856 million per year. For the five years from 1997 to 2001 realized gains totaled $6.38 billion or and average of $1.28 billion per year.
The total cash generated over this period from these three sources was $22.18 billion, where as the GAAP net earnings were $14.99 billion.
This leaves us with the question, what happened to the rest of the cash? Part of the answer to this question can be found in Table Five. Losses and Loss Adjustment Expenses are listed on the Earnings Statement as Expense but it is not all a cash expense. It includes not only expenses that where paid during the current year but also an estimate of all future payments that will have to be made for losses that occurred during the current year.
|Year||Losses & Loss Adj. Expenses||Claims Paid||Non-cash Insurance Expenses|
“Claims paid” is the actual amount of cash payments that were made during the year both for losses that occurred this year and also for payments made for losses that occurred in prior years (It is taken from a table on page 37 of this Years Annual Report).
If we subtract the first column from the second column we get column three, Non Cash Insurance. This not exactly the same as the growth of float during the year butit is close.
“So how do we value insurance float? Lets make it easy and just say that when it gets to Omaha it turns into cash flow”.
Clearly insurance accounting is a strange vehicle were liabilities may, or may not be liabilities, and after tax cash flow can become an expense.
Float which Buffett uses to buy stocks, bonds, and companies, shows up on the balance sheet as a liability, but acts like an asset. It seems as thought Buffett is an accounting alchemist, he can turn a liability into an Asset.
Buffett made the following comment at the 2001 Annual Meeting, “… we don’t look atinsurance float 100% the same as we look at equity, but we look at it as largely tantamount to equity because we had so much equity that we could afford to do it that way.”
In other words Buffett can use the cash flow he gets from float the same as uses cash flow he gets from any other source. The reason he can do this is because he has so much cash. He has the money he gets from writing new insurance, the cash flow from investments, and operating companies, even in a bad year like last year the cash paid out for insurance claims is only a fraction of the money coming in. In 2001 actual claims paid ($9.8 bi llion) was only 40.3% of the inflow from premiums, pre tax investment income, realizes gains; and income from operating companies ($24.3 billion).
So how do we value float? I say lets make it easy and just say that when it gets to Omaha it turns into Cash flow.
Table Six shows Omaha Cash Flow or money flowing into Kiewit Plaza from all different sources. It is estimated at 9.7 billion for 2002 and shows a growth rate of 25% per year. Maybe we can use this figure to estimate intrinsic value, it is not perfect but it does value the insurance float, and it is certainly better than trying to discount per share net.
This method shows that Berkshire Hathaway, even at present levels is not overvalued. We know that Berkshire Hathaway was overvalued in 1998 at $80,000+ because Buffett was using the stock as currency to buy GenRe, and we know that it was undervalued in March 2000 at $45,000 because Buffett was offering to buy it for that. Three years of 25% growth of cash flow would put that point of under valuation at somewhere around $90,000 in the first quarter of next year.
|Year||Earnings before investment gain||Increase In Float||Omaha Cash Flow|