Berkshire Hathaway: Don’t Wait For All-Time Highs (NYSE:BRK.B)

Berkshire Hathaway Inc. (NYSE:BRK.B) was one of the best-performing mega-cap stocks of 2022. Rising about 3.3% in a bear market, it outperformed most equities apart from pure-play oil and gas stocks.

This year, Berkshire Hathaway’s strong performance is continuing. It’s a little early to speak, but so far, the stock is up for the year, and many stocks in its portfolio are doing well too. For example, Apple Inc. (AAPL) stock is well ahead of the S&P 500 Index (SP500) year-to-date.

It’s pretty clear that Berkshire Hathaway has been performing well lately. The question is, can it continue to do so? BRK.B’s outperformance in 2022 was partially a product of its style being in favor that year. The value-focused Dow Jones Industrial Average (DJI) also beat the S&P 500 over the last 12 months – though not as much as Berkshire did, and not with a positive gain over the period. Berkshire’s heavy buying of oil stocks last year seems to have pushed it over the line for not just the market, but even for value stocks, which were the year’s top factor.

It’s likely that Berkshire will do well again in 2023, though it probably won’t outperform to the same extent that it did in 2022. Part of the reason Berkshire did so well last year was oil bets, and part of the reason oil went up so much was people hedging against high oil prices. The Ukraine war got people thinking that Russian supply would disappear from the market completely. Russian oil output did not collapse, though; it increased 2%, albeit with some interruptions in the first quarter. The run up to $123 happened because buyers saw oil prices rapidly cross $100, wanted to protect themselves against $380 WTI type scenarios, and used futures to do so. The prices at the summer highs never really reflected on-the-ground production.

Today, there is a foundation in place for decently strong oil prices, but probably nothing like what was observed last year. China is reopening and OPEC is cutting output – both of these forces support reasonably high oil prices. However, there is nothing to indicate that Buffett’s oil plays will do as well as they did in 2022. So, the dramatic outperformance observed in Berkshire Hathaway Inc. last year may not continue.

Nevertheless, there is reason to think that Berkshire will perform at least satisfactorily next year. In addition to its recent heavy betting on oil, Berkshire has built up a portfolio of financial, utility, and even tech stocks, along with a collection of sound operating businesses. It has more than enough cash on hand to help one of its subsidiaries should it stumble upon problems, without needing to borrow money. For this reason, it remains a better than average risk/reward setup in 2023.

Competitive Landscape

It’s challenging to assess Berkshire Hathaway’s competitive advantages because it operates in so many different industries, but a few of its qualities stand out.

The first is capital allocation. Warren Buffett has a proven track record of out-performing the S&P 500, having compounded at 20% annualized over 60 years, delivering 120 times the benchmark’s total return. Basically, Berkshire’s management is very good at making investments. Now, Warren Buffett is 92, and Charlie Munger is 99. They won’t be around forever. However, some of Buffett’s lieutenant’s are among the best investors in the world, too. For example, Ted Weschler managed to grow his retirement account by 300,000% over 29 years. So, there will be skilled capital allocators at Berkshire after Buffett departs.

The second is the nature of Berkshire’s operating businesses. Buffett picked Berkshire’s wholly owned subsidiaries based on their long term competitive advantages. Today, Berkshire has more than 60 operating businesses, it would be impossible explain all of their advantages. However, we can zero in on one specific one:

Insurance. Berkshire has a variety of different insurance businesses, all of them heavily focused on underwriting quality. Basically, Berkshire’s underwriting focuses on quality (i.e., likelihood of getting a positive return on the policy) rather than quantity (i.e., selling as many policies as possible). Many insurance companies view themselves as sales operations, encouraging their agents to sell policies even when the insured entity is extremely risky. Berkshire opts for fewer, better policies, and is better able to survive risky periods as a result.

Insurance is just one industry among many that Berkshire is in, but the company tends to follow the same basic logic in all of its deals: durable competitive advantages are a must. In insurance, the “advantage” is superior underwriting, in other industries the advantages may be things like branding, pricing power or barriers to entry. The point is that Berkshire’s subsidiaries were picked for having an edge over competitors, and going by Buffett’s track record, they were picked well.

Valuation

Having looked at Berkshire Hathaway’s long term competitive advantages, we can now turn to its valuation. In general, Berkshire is not as cheap as the companies it invests in, but it’s not outrageously expensive, either. In fact, it is more modestly valued than the average S&P 500 stock, as I’ll show momentarily.

At today’s prices, Berkshire Hathaway trades at:

• 22 times earnings.

• 2.4 times sales.

• 1.5 times book value.

• 20 times operating cash flow.

These are high multiples for financials, which trade at 12 times earnings on average (about 10 for banks and 20 for credit card companies). However, they are low by the standards of the S&P 500. At today’s index level, the S&P 500 is at 19.17 times earnings and 3.7 times book value. So, Berkshire is about average going by earnings and far below average going by the net value of assets. Therefore, it is cheaper than average.

Another approach to valuing a company like Berkshire is to discounted cash flows (“DCF”). For a company with as many moving parts as Berkshire, it’s quite difficult to project business performance into the future. However, we can do a limited version of a DCF model which simply discounts the last 12 months’ free cash flow (“FCF”) at a chosen discount rate, with no growth assumed. This is called terminal value, the formula is simply FCF divided by the discount rate.

In the last 12 months, BRK.B produced $9 in free cash flow per share. The terminal value of that amount at different discount rates is:

• 4.5% (current treasury yield): $200.

• 8% (Berkshire’s WACC): $112.5.

• 10% (a common discount rate used by analysts these days): $90.

These terminal values don’t support Berkshire’s current share price, but keep in mind that I have skipped any growth forecast here. Most likely, Berkshire will achieve some positive growth in cash flows, for reasons I outlined in the section on competitive advantages. If Berkshire can grow its cash flows by 10% CAGR for the next 10 years, then it’s worth $454 at a 4.5% discount rate. I’m not saying that it will grow by precisely that much, but it’s a relatively modest growth target that many companies not nearly as well run as Berkshire are able to hit.

Risks And Challenges

As we’ve seen, Berkshire Hathaway has many competitive advantages and a “not-crazy” valuation. It looks like a decent buy. However, there are risks and challenges to be aware of, including:

• Rising interest rates. Berkshire Hathaway is valued richly enough that it could stop being worth it if rates go much higher. As I showed above, it’s not worth it based on terminal value alone: at today’s rates, it has to achieve some growth in order to be worth buying. If interest rates go even higher than they already are, then ever higher amounts of growth will be needed for Berkshire to beat a treasury bill. So, keep an eye on rates, and maybe wait until after the tightening cycle is done before taking a position in Berkshire.

• Succession. Greg Abel will be taking over as CEO of Berkshire after Buffett is gone. It remains to be seen how good a job he’ll do. He has done well as the head of Berkshire’s energy business, but he doesn’t have Buffett’s capital allocation track record. Ted Weschler does have a proven long term track record of outperformance, though, so Berkshire should do well if he stays on the investment team.

The Bottom Line

The bottom line on Berkshire Hathaway Inc. is that it’s a solid company whose stock is still far from the most expensive out there. I certainly wouldn’t call Berkshire a “value stock” of the sort that its managers like to acquire, but it’s not as richly valued as even the average S&P 500 stock. It should do well if you have a very long time horizon.

As far as short-term bets on Berkshire Hathaway Inc. go, I’d leave those alone. Berkshire has run up enough now that a bad earnings release, or a bigger than expected hike by the Fed, could easily trigger a short term decline in the Berkshire Hathaway Inc. stock price. This is certainly not a “deep value” situation. Berkshire Hathaway Inc. is definitely a company worth investing your money in, though, provided you plan to dollar cost average and hold on long term.