Shifting Sands at Berkshire
BENJ GALLANDER, BEN STADELMANN, and PHILIP MACKELLAR
Thursday, April 4, 2019
We are major fans of Warren Buffett and his long-time partner Charlie Munger, who are surely two of the best investors in history.
Several years ago, we went to the Berkshire Hathaway annual meeting in Omaha to get a better sense of the two gentlemen. It is definitely worth taking the trip on the first weekend of May. Be aware that accommodation will be tight.
The two men have been remarkably disciplined on how they have measured Berkshire’s success, with book value being at the heart of the valuation for over half a century. Reading Warren’s annual letters year after year, this key metric of assessment has been the same.
But last year, that all changed, with the designated evaluation becoming the stock price. This does not make sense to Benj.
First of all, one should understand why book value has been nixed. Accounting rules evolve over time and there is no question that the progression does not always make sense.
Warren and Charlie suggest the recent mark-to-market transformation causes “wild and capricious swings in our bottom line.” Without a doubt it does, but is that enough to alter how the corporation values success?
In 2018, while a $2.8 billion capital gain (all figures USD) was realized from the sale of securities, the bottom line was dinged to the tune of $20.6 billion by a reduction of unrealized capital gains. Ouch! Goodbye book value.
Stock markets, as we all know, vary in valuation dramatically over time. Of course, individual companies do the same.
If one assumes that the stock price is the best means of measuring a stock’s value, then one is effectively backing the efficient market hypothesis, as espoused by Eugene Fama, which suggests that stocks always trade at fair market value as the prices encompass all information. This makes it impossible to beat the market.
When Benj was taught this hypothesis during his MBA studies, he had a long debate with his professor, who believed it to be true. Benj disagreed. Which likely did not help his grade in that class.
If this hypothesis is true, how does one account for the 22.6 percent one-day decline in 1987? Just a rough day at the office?
It is tough to rationalize that stock prices under that scenario remained perfectly efficient. The word poppycock comes to mind.
This also seems to contradict that last year, Berkshire started buying back shares. After all, if the principals behind this outfit are bargain hunters, why would they buy something where the stock price approximates the value?
Perhaps to understand the why behind Berkshire’s decision, you have to start with a core investing concept Buffett has discussed for years: the idea of buying productive assets when they trade at or below what is believed to be “intrinsic value.”
This is a difficult number to calculate, but at its core, if the intrinsic value is 25 percent above the trading price, then a stock could be worth buying. Previously, the goal was to purchase a stock well below book value.
The Buffett methodology has changed in other ways over the last few years. Previously, buying into airlines was verboten. In 2017, stakes in four airlines were disclosed. Tech was also not on the buy list. Now Apple is in the portfolio.
Benj conjectures that Charlie and Warren are less involved in decision making than previously. He believes that more of the investments are being designated by his two most likely successors, Ajit Jain and Gregory Abel.
While it certainly appears that these two gentlemen are very able, he questions whether they will be able to approach Warren’s returns as their idea of value and Berkshire’s historical idea of value differ markedly.
If Benj still owned Berkshire Hathaway, strong consideration would be given to selling. Warren and Charlie will not be the headliners for much longer, being 88 and 95 years old respectively.
Wise investors may wish to go to the AGM soon and check out the company and principals more closely and do their own analysis while gathering their wisdom. Proper due diligence goes beyond Benj’s opinion.