Three Pillar of Berkshire’s Intrinsic Value – What do we Learn?

I am not a hardcore follower of Buffett’s investing philosophy. It is not because I do not agree with Buffett’s/Graham’s investing philosophy, but primarily because, my situation is different. The environment which influences my investing decisions is quite different than in which Buffett makes his decisions. Having said that, I like to understand his thought process to see if there is anything that I can use. I may not be able to use them on ‘as is’ basis, but at least the notion behind them can be applied. For example, I like Buffett’s practice of asking its holding companies to share a significant portion of earnings in the form of dividends. He believes he is in a better position to use this capital than company management.


Buffett’s letter to shareholders is released as a part of Berkshire Hathaway’s (BRK) annual reports. In almost all cases, I completely ignore CEOs/MDs letters in annual report. They are pure garbage in a sense they do not tell you anything. That is not a case with Buffett’s letters. Each and every year, his letters provide an insight in his thought process. This year was no different.


This year’s highlight was a brief discussion on three pillars of BRK’s intrinsic value. Anybody who practices value investing knows that calculating intrinsic value is highly dependent on future assumptions. According to Buffett, these three pillars are:

  1. Investments per shares: BRK derives its value in the form of investments funded by shareholder equity and insurance float. BRK has $158 billion of investments in stocks, bonds and cash equivalents. Of which $66 billion is funded by insurance float. This insurance float is total funds held by BRK insurance companies. This total fund (i.e. float) is represented as liability on the balance sheet. According to Buffett this float is has the utility of equity for shareholders. Why? Because BRK’s insurance businesses are operating on break-even basis or on profit-basis. Hence, they need not dive into this float for balancing the operating losses.
  2. Value of earnings per share for non-insurance businesses: BRK also derives its value from value of operating earnings of all of its non-insurance businesses. All non-insurance business has certain earnings e.g. Coca-Cola, Wells Fargo, Johnson & Johnson, etc. All these companies are profitable and generate earnings. All of these operating earnings have certain value for BRK’s shareholders.
  3. Deployment of future retained earnings: This forms third pillar in valuing BRK (and probably any other company?). This is subjective and is the source of differences in intrinsic value estimates. Let us discuss this more.

 

On ‘as-is’ basis, or present day situation, a company generates income, and hence one can value based on its current earnings. What about future? Will company management deploy this capital, i.e. earnings, for future growth? In most cased managements either hoard cash, deploy in building business empires, and reinvesting in sub-optimal business ventures. Buffett notes that, quote, “t…urn these retained dollars into fifty-cents pieces, others into two-dollar bills”.

This “what-will-they-do-with-the-money” factor must always be evaluated along with the “what-do-we-have-now” calculation in order for us, or anybody, to arrive at a sensible estimate of a company’s intrinsic value. That’s because an outside investor stands by helplessly as management reinvests his share of the company’s earnings. If a CEO can be expected to do this job well, the reinvestment prospects add to the company’s current value; if the CEO’s talents or motives are suspect, today’s value must be discounted. The difference in outcome can be huge. A dollar of then-value in the hands of Sears Roebuck’s or Montgomery Ward’s CEOs in the late 1960s had a far different destiny than did a dollar entrusted to Sam Walton.

 

In essence, Buffett is saying, how earnings are re-deployed has significant impact on how company’s existing stream of earnings is evaluated. We all know item (1) and item (2) above. But what value would you assign to its earnings stream deployment?

 

The answer to this question is very subjective and will depend upon the context. In case of BRK, Buffett likely considers the earnings that are paid out to shareholders. The shareholders (in this case BRK) can estimate the cash flows they will personally receive from these earnings. This is because Buffett, on behalf of BRK shareholders, is more confident of allocating capital in optimal way.


What do I learn?

The point being, Buffett considers expected cash flow from its investments as a part of its valuation when buying any company shares.


Do I practice this?

Not exactly on ‘as-is’ basis. But I do use expected dividend cash flow in my valuations while buying shares for my long term buy and hold portfolio. I tend to look for companies that are likely to sustain their dividends over longer term. When a newbie is starting his investment journey, it may seem that these dividends are very minuscule. Such small amounts do not have any significant impact on overall portfolio. I agree they are small. But I do not agree with the notion that they are insignificant. It is a matter of perspective.

It has taken me about nine years to build my core portfolio that generates Rs 20000 as annual dividend. I have not determined the impact of re-invested dividends for last seven years. However, for last two years, these dividends have funded my opportunity portfolio. These dividends (i.e. capital for me) are now a continuous stream.

 

Readers, who have closely followed this blog and TIPBlog’s facebook page, should be able to extrapolate the impact this opportunity portfolio has had on overall returns on cost-basis.

 

While I still allocate capital to core portfolio from my primary full time source of earnings, I no longer have to worry about funding my opportunity portfolio. This opportunity portfolio is now on auto pilot!









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10 Responses to “Three Pillar of Berkshire’s Intrinsic Value – What do we Learn?”

  1. Raja says:

    Recently i finished reading ‘Poor Charlies Almanack’, this book is a kind of compilation of few (around 10 i guess) talks given by the other half of BRK, the vice chairman Mr. Charlie Munger at different points of time. I must admit he has lot of clarity of thought and it’s hard not admire him. So, few points from the book which i thought are relevant to this post are like this.

    1. While Mr. Buffet is widely believed to be Graham kind of investor, he has matured with age and now no longer follows the typical graham style of buying undervalued securities and selling them at fair price. He is now more of buy and hold kind of investor(he did that early in his career). And Charlie is believed to be the major influence in this shift in thinking.

    2. In the book Mr. Charlie also talks about the point or rather his dislike of companies which need to bury major part of their earnings back into business to expand their earnings. He gives the example of See’s candy as an example in for of the argument and construction equipment companies against it. Typical the later need to bury their earning in buying updated equipments, is his argument. Whereas the candy company once a good brand is established keeps reaping the benefit for long period by investing in increasing the franchise.

    3. Another point which he also mentions, is his willingness to pay a fair value for such businesses and not necessarily waiting for undervalued opportunities. He talks about Gillette and See’s candy as example of such buys as far as i remember.

    Overall a very interesting and captivating read.

    Regards

    • TIP Guy says:

      Hello Raja,

      I like that book too. Charlie has a much more broader view of “What Value means?”. Based on what I have read about Charlie’s thoughts, he gets the notion of value in qualitative terms. AND then translates them to accounting/mathematics. While rest of world seems to restrict value investing to accounting/mathematics alone.

      Best Wishes,

  2. Govind Gadiyar says:

    Dear Tipblog,

    What you are saying is save more and invest more regularly and reinvest the dividend received too.

  3. My Income Portfolio says:

    Hello TIP Guy
    After a long long period, I am writing on your blog. I am doing good. I have seen you are doing very good with your opportunity & core portfolios. Keep performing.

    I should appriciate you when it comes to writing blog. Writing regularly is a tough task and i admit that i succumbed to it. I feel that I have become lazy writing my page.

    Kind regards
    MIP

    • TIP Guy says:

      Hello MIP,

      Nice to hear back from you. Happy to read you are doing good, and hope you are successful in your investing endeavor. On a selfish note, I would like read your update note on how “house equity loan vis-a-vis investing returns working out ?” Very curious about it.

      W.R.T my portfolios, I am confident that core portfolio will do good, not too worried about it. On the opportunity side, I think I still have some qinks to iron out. It is easy to succeed once, specifically, when the tide is rising.

      As you know, I chase consistency over a period of time. So I will wait couple of years more before I conclude opportunity process that I have set will work :-). I am happy that it started off well. However, I do have an acknowledgement that the results are likely biased by rising tide.

      I have struggled to keep up, when it comes to writing on the blog. Since we had baby, my time allocation to blog has become practically zero. Not only that, as a whole, my overall time allocation to investing has also reduced quite a bit. Reading has reduced quite a bit. When I am not confident enough, I keep building the war chest instead of making half heart’d buy/sell decisions. I am in process of re-tooling myself on many different aspects such as personal finance allocations, investing/blog writing, lifestyle, etc. Blog writing is in priority group of activities. All of these require adjusting one’s lifestyle which takes little time.

      Best Wishes,

      • Hi TIP Guy

        Pleae visit my page, I have tried to put the facts as you asked. I am still trying to achieve good numbers. I admit that I do not have very good patience like to hence I end up paying more brokerage & fees. However cautious & choosy approach has helped me till date. I do not hold more than 4 stocks. I do not trade daily or in F&O. I try to keep my average holding period upto 9 months. This the period I think where I can get in /out of a stock. I have mainly chosen good dividend yield/paying stocks which run before dividends & fall after dividend payout. Following are some good dividend stocks which I intend to get in & out for dividends (Yiled at CMP in bracket)

        1) Nippo Batteries (5%)
        2) Gillanders (4.55%)
        3) Clariant (3%)
        4) Balmer & Lawrie (4%)
        5) Balmer & Lawrie Investments (5.25%)

        Except #2 all are almost 0 debt companies and good dividend players.

        Please comment on my page as weel as on above list.

        Warm Regards
        MIP

        • TIP Guy says:

          Hello MIP,

          I will read your note and comment accordintly.

          I like Clariant and BL. I recently bought BL. Still for Clariant. Rest of them, I pass.

          Best Wishes,

        • Raja says:

          Hi MIP,

          Very sorry to be posting a thought for you here in TIP blog. But your blog for some reason doesn’t allow me to post a comment there. So, here I go.

          Basically i have few points on your post on “House equity loan vis-a-vis investing returns “:

          1. I think the calculation should take into account the break up between your orignial loan & the top up loan amount. This break is important from the perspective up breaking up the interest payment for the year and hence the point of bringing up tax exemption in your return calculation. Let me explain, assume if you have taken 9.5 lacs of top up then it’s interest will be roughly 95k for the year @10%, hence your interest payment for the original loan part will be 113046/- (208046 – 95k) and this portion would have been eligible for tax exemption anyways irresective of the top-up. So, we should ideally consider only 20% of the remaining 37k (150-113k) i.e., 7.4k as the tax exemption we have earned for the year and not the whole 30k (20% of 150k).

          2. I think we should consider the cost of funds in the return calculation. What i mean is the same 95k as in the example above should be subtracted from your return figure to arrive at the actual return earned. Because you have paid this amount to the bank and that is a real hard cash outgo.

          Having said these 2 points you deserve kudos and lot of praise for earning the return you have earned just based on your skills :)

          Regards
          Raja

          • My Income Portfolio says:

            Thanks Raja for your kind words.

            You have valid points.

            Please consider this

            1) Out of 950k, my loan amount is 420k, rest 530k is my savings & borrowings from parents and wife, where i don’t have to pay interest.
            2) Assume that i have homeloan of 20L out of that 420k is deployed in market, rest 15.80L is homeloan. My bank doesn’t treat two different components. They give me combined interest statement on 20L. So i do not know how mcuh interest is for 420k. all is one & only One.
            3) since my bank is generous in giving me combined interest statement i can produce it for my IT exemption. So interest on 420k is also eligible for IT exemption. but total exemption can be 150k max So i calculated 30k@20% (I fall in 20% tax bracket)
            4) For calculation’s sake, if we calculate interest on 420.@10.75% then monthly interest comes around 3700 & yearly 44k..I am doing much better than 44k, that will give me false satisfaction.
            5) In earlier blogs i have written that my goal is to earn 5% better than Bank FDs and over the period this topup amount (and my savings) will help me generating enough income equal to my home loan interest payment.
            6) I assume “cost of funds” is interest on my homeloan (homeloan+topup). Currently my net income is less than cost of funds. (208k interest on total homeloan, 181k income from investing activities) but i will try to match or exceed the income to breakeven.
            7) It would be real tough thing to maintain above cost of funds constantly for a longer period.

            Hope you have understood my calculation. I will try to see why my page is not accepting any comments

            Thanks

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