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Buffett's Berkshire Could Post Double-Digit Gains -- Barrons.com

20 May 2017 5:16 am
By Andrew Bary 

Berkshire Hathaway's annual meeting and love fest in Omaha, Neb., earlier this month drew fawning attention to the wisdom of Chairman and CEO Warren Buffett and his sidekick, Vice Chairman Charlie Munger. But the big question for investors is where this formidable conglomerate, with almost $20 billion of annual earnings, goes from here.

Berkshire's Class A shares (ticker: BRK.A), now trading around $245,000, look reasonably priced and could have 15% to 20% upside through the end of 2018, based on likely growth in the company's book value.

That's a decent return potential, considering the Standard & Poor's 500 index is at a near-record 2381 and trades for 18 times projected 2017 operating profits, its highest valuation since the tech bubble of 1999 and early 2000. Berkshire's advantages, notably its diversified earnings stream, long-term focus, and a balance sheet laden with $96 billion in cash and marketable securities, make it a good bet to beat the S&P 500 over the coming years, with or without Buffett, who turns 87 in August. Berkshire, now valued at $400 billion, is the market's sixth-largest stock.

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"Berkshire should benefit meaningfully from a recovering U.S. economy," says Barclays analyst Jay Gelb. "It generates substantial free cash flow that can be deployed in its operating businesses, acquisitions, or investments, and it offers an attractive valuation at 1.4 times book value" of about $178,000 a share.

Gelb sees book value rising at a 9% or 10% annual rate in the next two years. The stock historically has appreciated in line with book value. Gelb carries an Overweight rating and a price target of $286,500. Berkshire's B shares (BRK.B), now $163, carry a corresponding price target of $191.

Buffett's genius for capital allocation has driven the 884,000% rise in the stock -- 19% a year -- during his 52-year tenure at Berkshire's helm. His successor, however, should get some relief from that reinvestment challenge because the company is likely to pay a dividend in the post-Buffett era and be more aggressive in repurchasing stock. The company doesn't pay a dividend and has bought little stock in recent years.

Buffett hasn't revealed a successor, but our best guess is Greg Abel, the 54-year-old head of Berkshire Hathaway Energy, the company's big energy-transportation and utility business. Abel has overseen Berkshire Energy's growth for most of the past 19 years and is an experienced manager and deal maker -- two important qualities for the next Berkshire CEO. Buffett singled him out at the company's recent annual meeting for his "extraordinary" accomplishments.

BERKSHIRE STOCK is flat this year after gaining 23% in 2016. Berkshire surged in the postelection Donald Trump rally -- ironic, given Buffett's support of Hillary Clinton -- because of its economic exposure and its status as a major beneficiary of a lower corporate-tax rate. Berkshire is down 8% from its early March peak, reflecting the waning prospects for President Trump's legislative agenda.

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Book value is the easiest way to value Berkshire. Indeed, Buffett for years used it as a favorite yardstick. Berkshire's price/earnings ratio, now 21 based on estimated 2017 net income, makes the company appear richer than it is. Berkshire's earnings capture only the dividends, as opposed to the underlying earnings, of the companies in Berkshire's $134 billion equity portfolio. Adjust for this factor, and Berkshire's P/E is closer to 15.

Book value admittedly had more relevance two or three decades ago, when the bulk of Berkshire's value was lodged in its equity portfolio. The current holdings are dominated by six stocks: American Express (AXP), Apple (AAPL), Coca-Cola (KO), IBM (IBM), Kraft Heinz (KHC), and Wells Fargo (WFC).

The company's wholly owned businesses now loom larger, and many -- including the Burlington Northern railroad, Berkshire Energy, auto insurer Geico, and Lubrizol (chemicals) -- are more valuable than their carrying value on Berkshire's balance sheet. Its dozens of other operating businesses include Shaw Industries (carpeting), Benjamin Moore (paints), Dairy Queen (ice cream), and NetJets (fractional jet ownership).

The company's property and casualty insurance operations include Geico, reinsurer Gen Re, and a specialized reinsurance business focused on big-ticket policies that cover events like hurricanes and earthquakes. The catastrophe-insurance business is headed by Ajit Jain, one of the best underwriters in the world. In all, Berkshire had $223 billion in revenue last year.

Buffett's preferred valuation measure is what he calls "intrinsic value, " which is based on the projected discounted cash flows that will be generated by the company. He has said intrinsic value "far exceeds" book value, but won't reveal his estimate of the figure. Longtime Berkshire holder David Rolfe of Wedgewood Partners estimates it at about $300,000 per share.

At the meeting in Omaha, Buffett estimated that intrinsic value has risen at a 10% annual clip for the past 10 years. And he's hopeful for a similar result in the coming decade. If Berkshire can achieve something close to that growth, the stock could double in the next 10 years.

Barron's has written favorably on Berkshire several times in recent years, including a cover story (" Berkshire Hathaway's Bright Future," July 25, 2015), when the stock traded at around $214,000 a share. Since then, the stock is up 15%, trailing the S&P 500's total return of 19%.

An engaged Buffett shows no desire to retire and seems intent on finding what he has called an "elephant"-size acquisition to put a dent in Berkshire's cash hoard and boost the company's earnings power. Munger, his longtime Berkshire partner, said at the annual meeting -- perhaps jokingly -- that Buffett has seven good years left. Buffett has said his longevity model is the biblical Methuselah.

BUFFETT'S ALWAYS ASTUTE OBSERVATIONS on business and investments were on display at the annual meeting, where he and Munger, 93, answered shareholder questions for five hours.

Among the high points was Buffett's comment that he may re-evaluate Berkshire's refusal to pay a dividend or lift the current cap on stock buybacks from the current 1.2 times book, if Berkshire's cash continues to grow. Buffett said it would be hard to come back to the shareholder meeting in three years with Berkshire sitting on potentially $150 billion in cash and say that the company should not return some of it to shareholders.

Rolfe considers this a "first-class problem" and thinks the company should lift its buyback threshold now, which would still allow it to repurchase stock at a discount to his estimate of intrinsic value.

The current buyback threshold of 1.2 times book, now about $214,000 per Class A share, has effectively put a floor under the stock, since investors figure that Berkshire stands ready to aggressively buy stock at that level. Looking out toward the end of 2018, book could hit $200,000 a share, putting a potential floor on the shares around current levels if book-value growth pans out. Barclays' Gelb projects year-end 2018 book at about $204,000 a share.

Munger said Berkshire could do a $150 billion deal. Buffett responded that he's a "little more conservative," but allowed that Berkshire is capable of a "very, very big deal." Finding a big deal won't be easy, given Buffett's valuation discipline, an elevated stock market, and the company's refusal to participate in auctions. Munger said Berkshire probably needs to look on "higher branches" because there isn't much low-hanging fruit.

Risks with Berkshire include a sharp stock market selloff that would depress its equity portfolio and book value, although Berkshire probably would hold up better than the market in a downturn, due to its financial strength and ability to invest when others are fearful, as was the case in 2008.

Buffett also addressed a longstanding investor fear: that the stock will plunge immediately after his death. "I think the stock is more likely to go up if I die tonight," he said, explaining that Wall Street might start speculating about a breakup of the vast, decentralized company based on the view that the sum of the parts would be worth more than the whole. Buffett has resisted unloading businesses.

The unwritten compact that Buffett has made with business sellers is that Berkshire would treat their operations like the Mona Lisa, in contrast to what he and Munger see as the more rapacious, buy-and-flip approach of private equity. The likelihood is that a post-Buffett Berkshire won't break up, given a Buffett-friendly board that includes Microsoft co-founder Bill Gates.

BUFFETT ALSO COULD CROW about Berkshire's big, new successful investment in Apple, now worth $20 billion. That's a nice change, given that Berkshire's longstanding major equity investments, including American Express, Coca-Cola, IBM, and Wells Fargo, all trail the S&P 500 in the past five years. Berkshire has cut its IBM stake by a third. The company's $28 billion investment in Kraft Heinz has been a big winner and now is worth almost three times Berkshire's cost.

"Berkshire exemplifies, better than any company I know, a willingness to make investments that involve short-term pain in return for long-term gain," says Thomas Russo, a partner at Gardner Russo Gardner. Russo, a longtime Berkshire holder, says that approach is illustrated by Berkshire's recent move, in Buffett's words, to "put our foot to the floor" and rapidly expand Geico's customer base this year.

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May 20, 2017 01:16 ET (05:16 GMT)

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