No. of Recommendations: 29
'I believe Berkshire's intrinsic value can be approximated by summing the value of our four asset-laden groves and then subtracting an appropriate amount for taxes eventually payable on the sale of marketable securities.' Warren Buffett
Most of you will have noticed that Berkshire's market value has dramatically increased in the last 3 years. It has doubled from around this time in 2020. Of course, such short term moves in the market price of Berkshire are of only mild interest to long term investors, who are more interested in the future rate of change in intrinsic value of this unusual company. That being said, we are value investors. We like to know what we own and what it might be 'worth' and we like to compare our situation to all options available and understandable to us. Fairfax Financial was recently discussed on Bill Brewster's podcast which inspired me to compare the two firms, at an albeit very crude high level.
Berkshire and Fairfax are similar in many respects but very different in others. They are both in the float business. Essentially they use float and deferred taxes to juice their returns. In many ways it is a simple business model as Charlie Munger once described it along the following lines ' we collect premiums up front, we earn an investment return on those premiums and we aim to break even or make a profit on underwriting. If done well, it's a hell of a business.
Certainly as 'risk free' interest rates have moved up above 5% combined with a hard insurance market resulting in prospects for underwriting profits, it is a different business to 3 years ago. No doubt these facts and Buffett's investment in Apple have contributed to the doubling of the Berkshire share price. But of course, the catch is that anyone can earn over 5% on the investment side but it takes an unusual set of skills and culture to report underwriting profits for 20 years (bar 2017) as Berkshire has done. And as Buffett points out, in his 2018 letter, future underwriting profit is far from certain. Berkshire's focus on long term results rather than arbitrary reporting deadlines which is supported by shareholders and understood by underwriters arguably suggests it has a better chance than most. There is evidence to suggest that Fairfax, like Berkshire takes long term underwriting profitability seriously. From the 2022 Fairfax annual report
'Our insurance businesses have produced on average a combined ratio below 100% for the last 17 years.'
With the backdrop to what makes a successful float-based business out of the way. How do the valuations of the two firms compare using Buffett's 5 groves. The numbers are by definition arbitrary. What is an appropriate multiple for BNSF based on depressed 2023 Q2 earnings. Or what is an appropriate multiple for Berkshire Hathaway Energy, given its growth potential. Or what multiple should be attributed to Fairfax Financial's operating companies. Despite the obvious fuzziness (to use a previous Buffett phrase) there is enough valuation contrast between the two firms to demonstrate very different market ratings. Spoiler alert. Fairfax is cheaper but Berkshire is a higher quality firm (better underwriting record and better investment track record, although it does have some relative disadvantages: older CEO and harder to move the needle size issue.)
Berkshire Hathaway
Grove 1 ' Non insurance businesses with ownership between 80% and 100%. Intrinsic value (IV) $354.1 Billion.
Main businesses, IV and multiple of profit after tax Q2 2023 run rate.
BNSF $76 Billion (15x)
BHE $53 Billion (17x)
Manufacturing ' Industrial Products $78 Billion (17x)
Manufacturing ' Building Products $63 Billion (17x)
Manufacturing ' Consumer Products $11 Billion (10x)
Services $37 Billion (15x)
Retailing $16 Billion (12x)
McLane $5 Billion (12x)
Pilot $15 Billion (35x?)
Other (Fx gains) zero
(Again, don't worry too much about the multiples. Overall groves 1 and 3 work out at about 15x Q2 2023 run rate PAT. Would Buffett sell the group for this, probably not. There is plenty of quality there compared to alternative uses of capital.)
Grove 2 ' Equity securities - IV $190 Billion.
30 June 2023 market value ($353 Billion) less a huge 50% Apple haircut ($89B) and taking off the $93 Billion of deferred taxes and adding back $19B deferred taxes on Apple haircut. Of course the taxes might not be paid for a very long time and Apple is probably worth more than 15x. We are being conservative and the purpose of this post is to compare the relative valuation of the two firms.
Grove 3 ' Non Controlled Group (Craft Heinz, Occidental, Berkadia Commercial Mortgage.) IV $28 Billion.
I am picking out this valuation from the balance sheet which shows 'Equity method investments' at publicly valued $27,493 Million at Q2 2023. That would equate to 13x.
Grove 4 ' Cash, US Treasuries, Fixed Income. IV $164 Billion.
Excludes cash and debt in rail and energy. Buffett has previously talked about $20 Billion minimum. Not sure if this is higher now. Leaving it in anyway. Berkshire has $166 Billion of insurance float.
Those 4 groves add up to an Intrinsic Value of $736 Billion v current market capitalisation of $776 Billion.
1. $354B (subs)
2. $190B (equities)
3. $28B (20% to 50% interest)
4. $164B (cash and bonds)
Total $736 Billion
Essentially this is Rail, BHE, MSR and the non control group at around 15x after tax. The equity portfolio at 30 June 2023 with Apple haircut of 50%. Deferred taxes taken off. Insurance business valued at cash and bonds only. It is conservative, too conservative on an absolute basis.
My understanding of the really fuzzy bit about valuing the insurance business, is that Berkshire has $166 Billion of float. Which is about equal to the cash and bonds. Groves 1, 2 and 3 are easy to value. We might disagree on the multiples; the growth potential; which trees are dying, but their IV can be reasonably be stated: certainly within a range. Insurance is a whole different matter of uncertainty. In my mind (and this is where I need some help and the reason for this post), by valuing the insurance business at only the cash and bonds we are fully ignoring the 'potential' underwriting future profitability. Is that correct? I can understand the value of the cash and bonds. If I had $164 Billion I can invest that easily and get 5% or $8.2 Billion. It is clearly worth $164 Billion at least. I say at least, as it is in the hands of capital allocators with a history of getting more than 5%. It may not look that way now but even with the huge size of Berkshire there is a good chance it earns even 9% some fine day. But for now its IV is $164 Billion. That is the investment side of the insurance business sorted.
So, what is the value of the underwriting side of the business worth. In the 2018 letter Buffett references the 16 year pre-tax underwriting gains of $27 Billion, with only one loss year. With the scale of insurance operations growing the average over such a long period may be an inadequate starting point for a multiple. Buffett even alludes to that by saying 2018 was a $2 Billion u/w year. But as Buffett and all of us know all too well, insurance underwriting is not so easy as the more recent years have shown (u/w pre tax profits 2019: $400M, 2020: $657M, 2021: $728M and 2022 $90M loss). Although, the first six months of 2023 are currently at an u/w profit of $2,258M going into hurricane season and global warming'). Lots of uncertainty and there is always the big event that wipes out several years. However, it is reasonable to assume that u/w breakeven over a long period is more than possible and touch wood, likely due to the unusual Berkshire characteristics'
'For the entire 16-year span, our pre-tax gain totalled $27 billion, of which $2 billion was recorded in 2018' Warren Buffett
Warren Buffett may value the u/w side of Berkshire conservatively at zero. All things considered maybe he is right. He usually is. Maybe breaking even over the next 20 years would be a good outcome. Ajit Jain is 72. I have no doubt, there are lots of individuals at Berkshire, that together with the culture and shareholder support, can keep the u/w flywheel going for a very long time. I only learned recently, about the Buffett instruction, pre 9/11, about concentration of risk in the twin towers, being ignored by GenRe. That tells me, that individuals with decision making power, can and do, have a material impact on underwriting success, or otherwise. Anyway, I am rambling here.
In summary Berkshire's Intrinsic value on the above basis (importantly with zero value attributed to u/w profit) is $736 Billion compared to $776 Billion market cap, or 5% over valued on a conservative basis. (I much prefer that to the valuation of the S&P 500 which is clearly pricing in a very rosy future for many large firms. Capitalism and competition has a way of humbling financial projections. My preference is for a track record of free cashflow Berkshire style. Call me old fashioned but that's the way I like it).
Let's look at Fairfax.
Fairfax
Berkshire is such a huge organisation and a retail investor, such as me, can only have a veneer knowledge, although many others will know the firm in much more detail. However, the deserved trust in Buffett and Munger makes it possible to be an investor. I can say with a lot of confidence that I know almost nothing about Fairfax Financial. I first looked at the company yesterday after listening to a podcast. So bear that in mind and please do enlighten me where I have made errors in my description.
I have done an intrinsic value of Fairfax using Buffett's groves analogy for comparison. My limited understanding of the company makes that IV calculation suspect. I am probably being overly conservative.
The percentage components of IV for the two firms are described below and demonstrate the Fairfax concentration in cash and bonds:
Groves 1 & 3 (subs and non control group) Berkshire 52% (Fairfax 21%, with 13% being non control group).
Grove 2 (equities with Apple haircut and after D'Tax) Berkshire 26% (Fairfax 12%). Berkshire has way more relative deferred taxes evidencing either Buffett is a better allocator (he is) or Berkshire does less trading and paying taxes.
Grove 4 (Cash, US Treasuries, Fixed Income) Berkshire 22% (Fairfax 67%). My understanding, is that because of Berkshire's long history of success, it is over capitalised, in the eyes of insurance regulators and can allocate to higher return assets, like operating companies and equities. Whereas Fairfax, like most insurers has to tilt more towards 'less risky' bonds. The really important thing Fairfax has done in recent years, compared to other insurers, is that they were in short dated bonds. They did not suffer price declines in bonds when interest rates whet up and are now in the strong position of having a huge 67% bond portfolio earning over 5%. Probably why the shares have done well of late, much like Berkshire but to a bigger extent. Berkshire 'only' has $164 Billion in cash and short dated bonds or 22%, whereas Fairfax has 67%. Higher interest rates are benefiting Fairfax in a major way.
Fairfax Financial IV
Grove 1 ' Non insurance businesses > 80% ownership IV $5 Billion. Take this with a pinch of salt. I picked up somewhere that these businesses were making $500 Million p.a. and put a 10 multiple on them. I gave Berkshire's subs a 15 multiple on the basis that they are generally higher quality. I have no idea about the quality of the Fairfax subs.
Grove 2- Equities and Preferred Stocks. IV $7 Billion. Market value from the 31 March 2023 accounts less deferred taxes $1 Billion.
Grove 3 ' Non Control Group. IV $8 Billion. 31 March 2023 investments in associates $6 Billion plus Fairfax India $2 Billion. (India is potentially interesting ' around 50% is Bangalore Airport which is planning an IPO. Bullish case is that Bangalore is the Silicon Valley of India + air travel rebounding + general India economic prosperity with a respected business orientated president. Bear case ' illiquid private companies)
Grove 4 ' (Cash & short dated bonds) IV $40 Billion. This is the most important number on the Fairfax balance sheet. Fairfax has insurance float of $31 Billion.
Those 4 groves add up to an Intrinsic Value of $61 Billion v current market capitalisation of $28 Billion.
1. $5B (subs)
2. $7B (equities & preferred)
3. $8B (20% to 50% interest)
4. $40B (cash and bonds)
Total $60 Billion
In summary Fairfax's Intrinsic value on the above basis (with zero value attributed to u/w profit) is $60 Billion compared to $28 Billion market cap. The market cap is 54% of the IV estimate calculated above.
Earnings Power
Another way to look at both firms is earnings power.
I have Berkshire at $57 Billion p.a.
Assumptions:
+ Operating companies and non control group Q2 2023 PAT annualised $25.7B
+Equities owner earnings $23.6B (this needs more work! Based on Q2 2023 market value divided by 15x guess. Although I note Chris Bloomstran referred to $17.7 Billion 'retained profits' from the Berkshire equity portfolio. Grossing that up for a 25% dividend payout ratio is not far off my wild guess of £23.6B.)
+ Interest income from cash, US Treasuries and Fixed Income at 5% $8.2 Billion.
Total owner earnings of Berkshire $57.5 Billion. This equates to a multiple of the current market value ($776B) of 13.5x. (Add in $2 Billion of u/w profit gets you to a multiple of 13.1x. Not much difference.)
I have Fairfax at $3 Billion (before u/w profit).
+ Operating companies and non control group $500 Million
+Equities owner earnings $543 Million (Based on market value divided by 15x guess.
+ Interest income from cash, US Treasuries and Fixed Income at 5% $2 Billion.
Total owner earnings of Fairfax $3,067 Million. This equates to a multiple of the current market value ($28B) of 9.1x.
Add in $1 Billion of u/w profit, gets you to a multiple of 6.9x. Big difference.
Fairfax CEO, Prem Watsa, said this in the Fairfax March 2023 annual report ''this has resulted in our expected future annual operating income of more than $3.0 billion: $1.5 billion from interest and dividend income, more than $1.0 billion in underwriting profit and more than $0.5 billion profit from non-insurance companies.'
Since then, interest rates have increased further adding more interest income on the $40 Billion bond portfolio.
Anyway, there you go. Fairfax looks cheaper than Berkshire on a quantitative basis. It is smaller and will find it easier to grow in future but it does not have an investing track record like Berkshire. Impressive u/w record I have to say, but I don't know much about the quality of the firm compared to Berkshire. An argument could be made that Fairfax is cheaper and will grow faster than Berkshire.
Let me know what you think about the valuations and how you think about valuing the insurance side of the business.
EVBigMacMeal
Below are extracts from Warren Buffett's 2018 annual letter to shareholders of Berkshire Hathaway where he commented on valuing Berkshire.
'Investors who evaluate Berkshire sometimes obsess on the details of our many and diverse businesses -- our economic "trees," so to speak. Analysis of that type can be mind-numbing, given that we own a vast array of specimens, ranging from twigs to redwoods.
A few of our trees are diseased and unlikely to be around a decade from now. Many others, though, are destined to grow in size and beauty.
Fortunately, it's not necessary to evaluate each tree individually to make a rough estimate of Berkshire's intrinsic business value. That's because our forest contains five "groves" of major importance, each of which can be appraised, with reasonable accuracy, in its entirety.
Four of those groves are differentiated clusters of businesses and financial assets that are easy to understand. The fifth -- our huge and diverse insurance operation -- delivers great value to Berkshire in a less obvious manner, one I will explain later in this letter.
The interest cost on all of our debt has been deducted as an expense in calculating the earnings at Berkshire's non-insurance businesses. Beyond that, much of our ownership of the first four groves is financed by funds generated from Berkshire's fifth grove -- a collection of exceptional insurance companies.
Our property/casualty ("P/C") insurance business -- our fifth grove -- has been the engine propelling Berkshire's growth since 1967, the year we acquired National Indemnity and its sister company, National Fire & Marine, for $8.6 million. Today, National Indemnity is the largest property/casualty company in the world as measured by net worth.
And how it has grown, as the following table shows:
Year / Float (in millions)
1970 / $39
1980 / $237
1990 / $1,632
2000 / $27,871
2010 / $65,832
2018 / $122,732
Q2 2023 $166,000
We may in time experience a decline in float. If so, the decline will be very gradual -- at the outside no more than 3% in any year.
The nature of our insurance contracts is such that we can never be subject to immediate or near-term demands for sums that are of significance to our cash resources. That structure is by design and is a key component in the unequaled financial strength of our insurance companies.
That strength will never be compromised. If our premiums exceed the total of our expenses and eventual losses, our insurance operation registers an underwriting profit that adds to the investment income the float produces. When such a profit is earned, we enjoy the use of free money -- and, better yet, get paid for holding it.
Unfortunately, the wish of all insurers to achieve this happy result creates intense competition, so vigorous indeed that it sometimes causes the P/C industry as a whole to operate at a significant underwriting loss. That loss, in effect, is what the industry pays to hold its float. Competitive dynamics almost guarantee that the insurance industry, despite the float income all its companies enjoy, will continue its dismal record of earning subnormal returns on tangible net worth as compared to other American businesses.
Nevertheless, I like our own prospects. Berkshire's unrivalled financial strength allows us far more flexibility in investing our float than that generally available to P/C companies.
The many alternatives available to us are always an advantage and occasionally offer major opportunities. When other insurers are constrained, our choices expand.
Moreover, our P/C companies have an excellent underwriting record. Berkshire has now operated at an underwriting profit for 15 of the past 16 years, the exception being 2017, when our pre-tax loss was $3.2 billion.
For the entire 16-year span, our pre-tax gain totaled $27 billion, of which $2 billion was recorded in 2018. That record is no accident: Disciplined risk evaluation is the daily focus of our insurance managers, who know that the benefits of float can be drowned by poor underwriting results.
All insurers give that message lip service. At Berkshire it is a religion, Old Testament style.
In most cases, the funding of a business comes from two sources -- debt and equity. At Berkshire, we have two additional arrows in the quiver to talk about, but let's first address the conventional components.
Beyond using debt and equity, Berkshire has benefitted in a major way from two less-common sources of corporate funding.
The larger is the float I have described. So far, those funds, though they are recorded as a huge net liability on our balance sheet, have been of more utility to us than an equivalent amount of equity. That's because they have usually been accompanied by underwriting earnings.
In effect, we have been paid in most years for holding and using other people's money. As I have often done before, I will emphasize that this happy outcome is far from a sure thing: Mistakes in assessing insurance risks can be huge and can take many years to surface. (Think asbestos.)
A major catastrophe that will dwarf hurricanes Katrina and Michael will occur -- perhaps tomorrow, perhaps many decades from now. "The Big One" may come from a traditional source, such as a hurricane or earthquake, or it may be a total surprise involving, say, a cyber attack having disastrous consequences beyond anything insurers now contemplate.
When such a mega-catastrophe strikes, we will get our share of the losses and they will be big -- very big. Unlike many other insurers, however, we will be looking to add business the next day.
The final funding source -- which again, Berkshire possesses to an unusual degree -- is deferred income taxes. These are liabilities that we will eventually pay, but that are meanwhile interest-free.
As I indicated earlier, about $14.7 billion of our $50.5 billion of deferred taxes arises from the unrealized gains in our equity holdings. These liabilities are accrued in our financial statements at the current 21% corporate tax rate, but will be paid at the rates prevailing when our investments are sold.
Between now and then, we in effect have an interest-free "loan" that allows us to have more money working for us in equities than would otherwise be the case. A further $28.3 billion of deferred tax results from our being able to accelerate the depreciation of assets such as plant and equipment in calculating the tax we must currently pay.
The front-ended savings in taxes that we record gradually reverse in future years. We regularly purchase additional assets, however. As long as the present tax law prevails, this source of funding should trend upward.
Over time, Berkshire's funding base -- that's the right-hand side of our balance sheet -- should grow, primarily through the earnings we retain. Our job is to put the money retained to good use on the left-hand side, by adding attractive assets.'
