Thursday, November 23, 2006

Berkshire Hathaway – A Bargain?

At $100,000+ a share, billionaire Warren Buffett's Berkshire Hathaway Inc. could be the cheapest most-expensive stock around. Just before Thanksgiving Berkshire shares closed at $107,700. The stock is up 5,555 times since May 10, 1965, the day Mr. Buffett took control of the former textile company and the stock closed at $18 a share.

By contrast, the Dow Jones Industrials Average is up about 13 times since Mr. Buffett took over Berkshire.

The stock's eye-popping size is by design. Mr. Buffett, Berkshire's chairman, has long opposed a stock split on the theory that the high price tends to discourage buying by short-term traders. Still, Berkshire a decade ago started issuing lower-priced Class B shares, mainly to pre-empt the efforts of an entrepreneur in Philadelphia who planned to launch a fund offering investors fractional exposure to Class A shares. Today the Class B shares, each equivalent to 1/30th of a Class A share, closed at $3,593.

Despite its high price, some analysts say Berkshire, which now owns some 50 businesses ranging from underwear maker Fruit of the Loom to auto insurer Geico, has room to climb. "It's a 75-cent dollar right now," says Justin Fuller, an analyst at Morningstar in Chicago, meaning it is about 25% undervalued. Mr. Fuller, who says he doesn't own any Berkshire stock, values the stock around $129,000 a share.

Berkshire, of Omaha, Neb., trades at a relatively inexpensive 1.6 times its "book value," or its assets minus its liabilities. By comparison, American International Group Inc., the insurance giant, trades at about two times book value, while Citigroup Inc. trades at about 2.2 times book. (Like Berkshire, those two companies have large securities portfolios and sell financial products.)

One probable reason the stock isn't trading higher is that investors are concerned about who will run the business once Mr. Buffett, who is 76 years old, leaves or dies. Mr. Buffett has said he and his board have agreed on a successor, but the candidate could change as time wears on and Mr. Buffett is still alive. The name hasn't been released to the public.

Berkshire is sitting on a huge pile of cash -- about $42 billion as of the end of the second quarter. Even though Mr. Buffett has been aggressive this year about investing that war chest, the pile continues to mount, and that makes for smaller returns than if it were invested in operating companies, rather than short-term bond investments, for example.

Unlike companies that obsess over maintaining smooth earnings, Mr. Buffett is willing to tolerate swings in earnings, so Berkshire generates a higher return on its assets with less financial risk. Ratings firms have rewarded his strategy by giving Berkshire the only triple-A rating in the insurance industry. In contrast, many other companies choose to engage in the potentially risky practice of using borrowed money during periods of lower returns to magnify small investments to maintain earnings.

Berkshire's earnings growth also has momentum, analysts say. The company is expected to deliver strong earnings in the third and fourth quarters of this year and into 2007.

Berkshire's most profitable operating companies are usually its insurance operations. The reinsurance units, which underwrite catastrophe policies for other insurers, are likely to post their biggest profits ever this year. That's because Berkshire has been able to charge much higher premiums since hurricanes Katrina and Rita last year pushed up prices, producing big returns after this year's relatively mild weather resulted in no major losses.

"It'll be a banner year," says Tom Story, a portfolio manager at Chicago investment firm William Blair & Co. Mr. Story personally owns Berkshire shares and manages accounts that own the stock.

Geico is also a big driver of earnings. While the auto insurer accounts for just 7% of the nation's market share, it is signing up customers at a rate three to four times faster than the industry pace. And despite heavy spending on advertising -- it is on track to spend about $600 million on ads this year, much more than its industry peers -- Geico maintains among the highest margins in the industry, thanks to its lower cost structure and higher price.

If you want to save the money in car insurance it’s better not to sign up with Geico! They run catchy ads, but their price is just ridiculous. No wonder, Geico maintains the highest margin in the industry.

Analysts reckon all of Berkshire's insurance units, including Geico, will post underwriting profit of $2.5 to $3 billion for the full year barring any major losses before year end. That would be the group's all-time best performance.

Analyst estimates of Berkshire's full-year net income range from $7 billion to $8 billion, excluding investment gains, compared with about $5 billion last year.

Even Mr. Buffett is optimistic. While he declined to talk about the share price or the outlook for earnings, he did say in a recent interview that "so far, insurance has been quite good and Geico has been doing terrifically."


Anonymous said...

This was a pretty thoughtful post until you got to the point where you slammed GEICO's pricing. It's unfair and inaccurate for you to throw it out there that GEICO is much more expensive than other insurers, as if that was the case everywhere and for everyone. Insurance rates vary widely by state, region and individual customer. GEICO might not have the best rate for you in your location, but that doesn't mean nobody anywhere can get a good rate from GEICO. GEICO is the fastest-growing auto insurer nationally, and has been for several years. Yes, the ads are clever, but if the prices weren't competitive, the company wouldn't be growing like it is.

Bharathi said...

Hi, Thank you for the feedback. I lived in 3 states in the last 10 years. I always had highest quote from GEICO. As you said, it might be just a coincidence that those cities had other lower cost providers, GEICO didn't have the best rates. I had atleast $400 difference between the company I chose and GEICO.

Bottom line is to do more research before buying insurance from any company.