At current market levels, I expect Berkshire Hathaway’s (NYSE:BRK.B) book value to exceed $600 billion this quarter – dwarfing the value of any other global corporation. I have written extensively about how I value Berkshire in the past, and while I don’t use book value as an input in my valuation formula, I do use it as a guidepost to check my valuation against. In the past, I have found that my valuation process almost always works out to a price-to-book ratio of around 1.6x. Using my approximation of Q2 book value of $605 billion, or $281 per class B share, this works out to an overall estimate for intrinsic value of $450 per class b share.
At the current share price, I find Berkshire to be moderately cheap on an absolute basis and extremely cheap relatively to the S&P 500 at 20x+ forward price-to-earnings. They say you cannot eat relative performance, but I certainly know where I want my money to ride out the storm. I don’t have anything earth-shattering on the valuation front, but I wanted to share a few observations I find interesting.
Addressing the elephant in the room, the majority of Berkshire’s q/q gains in book value will come from appreciation in the share price of AAPL. Apple’s share price has appreciated by $43 quarter-to-date, and Berkshire owns 789 million shares, notching a $34 billion gain. At a fair market value of $170 billion, AAPL represents about 15% of Berkshire $1.1 trillion in assets, However, this modest 15% of assets disproportionately accounted for 70%+ of the gain in book value during the quarter.
This type of volatility is bound to happen going forward as Berkshire’s assets are comprised of both mark-to-market assets (e.g., AAPL) and wholly-owned assets accounted for at their historical purchase price and subject to much more modest subsequent adjustments (e.g., BNSF). Overall, the market seems relatively indifferent to Berkshire’s gain in AAPL, Berkshire’s share price is down modestly during the quarter despite having an asset that is worth $34 billion more. Perhaps that is a mistake.
In following Berkshire for well over a decade at this point and given the rise in passive investing over this period, I have come to recognize that Berkshire tends to trade with a relatively high correlation to financials, or the XLF index, of which it is the largest constituent. The market narrative recently has been that the Federal Reserve will keep rates high in the short term and lower them in the long term; hence the yield curve has become inverted. This is difficult for banks, who tend to make money by borrowing via deposits and lending out money longer term.
Said another way, their cost of funding has gone up while their yield on lending has not. In industry parlance, this is referred to as net interest margin compression. Mention it at your next cocktail party, and nobody will talk to you for the rest of the evening. Anyways, because this is negative for banks, and Berkshire is included in the financials index, it appears there has been some “guilt by association” in terms of trading levels.
However, this association is misguided and factually incorrect – what is negative currently for banks is positive for Berkshire. See, Berkshire has nearly $200 billion in cash and T-Bills. T-Bills are “short-duration” assets, meaning they mature frequently. I suppose cash could be deemed a “zero-duration” asset. While higher short-term rates are a headache for banks as they have to pay depositors more, it represents a bonanza for Berkshire as they can deploy huge amounts of cash into T-Bills at relatively high rates of return and virtually zero risk (the borrower owns the printing press).
The longer short-term rates stay elevated, ironically, what the market has been worried about recently, the longer Berkshire gets to deploy this capital into this favorable scenario. This both increases earnings and lowers the need for Berkshire to find ways to make acquisitions, as excess capital can now earn a reasonable risk-adjusted return for the first time in well over a decade. You’ve seen this manifest on Berkshire’s income statement in the “investment income” line item. Again, by being lumped in with the banking industry despite a very tenuous underlying economic connection, it appears the market is showing both complacency and laziness in terms of fundamental economic drivers.
While we’re comparing Berkshire to banks, perhaps it makes sense to look at the balance sheets slightly more closely. In Q1, Berkshire had $1.07 trillion in assets and $575 billion in equity (book value). Meanwhile, JPMorgan (JPM), the largest bank globally by both market capitalization and balance sheet, had assets of $4 trillion and equity of $329 billion. If we define leverage as assets/equity, Berkshire leverage is under 2x, while JPMorgan’s is over 10x. This is not to imply that JPMorgan is excessively leveraged, clearly they’ve been the most prudent and well-run large bank this century, rather, it is to demonstrate the conservatism by which Berkshire runs their operation. As I mentioned at the outset, Berkshire’s conservatism in both liquidity and leverage makes it appealing in terms of riding out a storm, particularly given I feel it is already moderately cheap relative to what I see as a market that is fundamentally overextended.
Market participants are both lazy and greedy until the point where being both simultaneously becomes untenable. My recent observations indicate we are fairly close to reaching that point. Eventually, the economics of the businesses that you own will determine the security prices they underlay, rather than sloppy narratives underwritten by an extended bull market and a limited amount of critical thinking. My periodic check-ins with Berkshire give me comfort that it is still both conservative in its operations and financing, and it is valued with a lazy pessimism relative to the Pollyannaish lens by which the broader market is viewed.
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