NEW YORK (TheStreet) — Warren Buffett is rightly famed for creating investor value, but as far as Berkshire Hathaway(BRK.B) shares are concerned, it’s harder to see what will trigger a sustained 2011 rally.This question doesn’t mean investors shouldn’t be paying attention to Berkshire Hathaway as a potential investment.
In fact, in 2010 many investors were asleep at the wheel while a major opportunity to recognise value in Berkshire Hathaway shares passed them.
The 2010 Berkshire Hathaway chart makes two compelling points:
First, Berkshire Hathaway received a huge boost at the beginning of 2010 which is not likely to be repeated in the coming year.
After Berkshire Hathaway’s purchase of Burlington Northern, the company had to increase its outstanding B share count to finance the transaction. As a result, Berkshire Hathaway was finally a liquid-enough stock to be added to the S&P 500 Index.
Once fund managers joined the Berkshire Hathaway party, the Buffett stock popped from a start of the year just under $65 up to the $80 level.
The problem for 2011 is that there is no single catalyst on the horizon — barring another major acquisition like Burlington Northern — to propel Berkshire Hathaway shares in a similar fashion as the S&P 500 inclusion accomplished. If Berkshire Hathaway shares are undervalued — as many investors still contend — it’s incremental value and not another big leap that seems embedded in the shares, and linked mostly to the still-recovering consumer-oriented aspects of the Buffett business empire.
One way of looking at the earnings impact of the big railroad acquisition is through the most recent Berkshire Hathaway quarterly report, in which operating earnings — which exclude the firm’s investment and derivative gains and losses — increased 35.6% to $2.8 billion. However, these results received a significant boost from the acquisition of Burlington Northern Santa Fe in February. Absent the contribution from this acquisition, operating earnings increased 1.3% year over year.
This is the second-compelling point made by the Berkshire Hathaway 2010 chart: it’s a range-bound stock.
The exogenous events that could cause a major move in shares of Berkshire Hathaway, other than another major acquisition, would be news related to the long-running speculation about Warren Buffett’s succession plans.
The much-discussed topic of what happens, “After Warren Buffett” can be looked at from two perspectives. First, investors expect a pullback in Berkshire Hathaway shares with any succession event. However, many investors also believe the pullback will just be a good opportunity to enter Berkshire Hathaway at a better price.
If that’s the case, it serves once again to highlight how difficult it will be to budge the Berkshire Hathaway stone in 2011 based on the core strengths and exposures of Buffett’s vast portfolio. The profile of Berkshire Hathaway stock mirrors the problem that Warren Buffett has commented on increasingly: as Berkshire Hathaway has grown into a huge conglomerate, separating itself from the pack in terms of returns becomes more difficult.
In 2011, the challenge for Berkshire Hathaway shares as a tradable investment is budging from the $80 range that has served as a stock ceiling.
“There’s probably nothing like the S&P 500 inclusion and the acquisition of Burlington Northern in 2011. It’ll be tough to match this year,” says Morningstar analyst Greggory Warren.
With Burlington Northern, Berkshire was able to add $14 billion in annual revenue. The Morningstar analyst thinks, as many do — and as Buffett has himself commented — that it becomes harder and harder to find deals of the size of Burlington Northern that meet Berkshire Hathaway’s investment criteria.
At the same time, there are several cushy investment generators for Buffett that are going away. Buffett has famously served as a personal banker to some big corporations, especially during the financial crisis when Buffett wrote big paychecks to bail out the likes of General Electric(GE), Goldman Sachs(GS), and SwissRe(SWCEY). Buffett also helped finance the candyland acquisition by Mars of Wrigley back in 2008. In all of these cases, the companies have begun or soon plan to repay Buffett for his investment and stop paying hefty interest rates to Omaha.
As Morningstar’s Warren noted in a recent Berkshire Hathaway outlook piece, these financing deals were unique situations and profits from the deals will most likely be reinvested in less lucrative offerings.
The Goldman Sachs repayment of $5 billion that Berkshire invested in the investment bank during the financial crisis is a concern, given the 10% coupon attached to these preferred securities. “Given current market conditions, we think the reinvestment of any redemption proceeds would generate significantly lower investment income than Berkshire has been earning on its Swiss Re and Goldman stakes. While some of this might be offset by increased dividends in the company’s equity portfolio, especially among the financial services firms that cut their dividends during the financial crisis, we think Berkshire will be hard pressed to find such lucrative investments in the near term,” Morningstar wrote in its recent Berkshire Hathaway stock outlook piece.
“I don’t expect significant multiple expansion because for that the market has to expect inherent growth above a traditional range, and we don’t see that for Berkshire Hathaway in the near-term,” the Morningstar analyst said.
Even so, Morningstar pegs fair valuation of Berkshire Hathaway at $90. A rise to $90 would represent a significant leg-up in Berkshire Hathaway shares next year, which remain hemmed in by the $80 ceiling.
The way that Morningstar arrives at its $90 for Berkshire Hathaway is another example of the rigidness of Berkshire Hathaway’s trading profile. Over the past decade, Berkshire Hathaway B shares have traded in a range between 1.1 times book value and 1.9 times book value. Morningstar is valuing the company at 1.5 times book value.
The company’s book value still increased 7.5% year over year, though. Long-term book value continues to be among the most compelling data points for Berkshire Hathaway shares — though it is backward-looking. Berkshire Hathaway’s book value per share increased at a compound annual growth rate of 20.3% from 1965 to 2009, compared to a 9.3% total return for the S&P 500 Index.
An investor might wonder why Berkshire Hathaway isn’t deserving of the 1.9 times book valuation that represents the upper end of its market range, and it comes down to the one aspect of the Buffett portfolio that has the most uncertain outlook: business related to the U.S. consumer in which Buffett has heavily invested, from retail stores to housing.
The big movers in the Berkshire portfolio are the vast insurance operations — the largest chunk of Berkshire’s value — and Burlington Northern and energy investments led by MidAmerican Energy. For example, Morningstar assigns $55 of its $90 Berkshire Hathaway value to insurance and $19 to the railroad, utilities and energy operations. That’s $74 locked up between two business segments of Berkshire Hathaway that have a fairly predictable profile, even if insurance and transportation remain beholden to sector cyclicality.
Morningstar expects the revenue growth potential of both insurance and the railroad and energy businesses to be limited to 5% growth per year.
These modest assumptions leave Berkshire’s consumer-related businesses, which Buffett defines as Berkshire Hathaway’s manufacturing, service and retail segment — and which is assigned a value of $12 in the $90 Berkshire Hathaway price — as the primary wildcard in Berkshire Hathaway performance.
“Any sort of big positive or negative surprise will come from the manufacturing or finance units of Berkshire Hathaway. These are the less predictable parts of the business, but also the smaller parts,” notes Morningstar’s Warren.
Berkshire’s noninsurance operating subsidiaries were a source of strength in the most recently reported third quarter, with the manufacturing, service and retailing segment a large driver of internal profit improvement, but it’s not clear to what extent those profit improvements were similar to improvements across corporate America, driven by cost reductions, layoffs, and achieving more productivity with less.
Therein lays the rub for Berkshire Hathaway as a stock to bet on in 2011. Any type of big surprise to the positive or negative from the actual operating businesses — and not from a mega acquisition or succession event — will come from a Berkshire Hathaway business segment that only represents $12 worth of its full value of $90.
It’s also hard to bake in too much improvement in this segment. For one, there are no guarantees that the tax cut stimulus package leads to increased consumer spending. Rather, consumers may continue to pay down debt or save as opposed to spend, limiting any boost to the consumer businesses in the Buffett portfolio.
Additionally, Berkshire Hathaway is linked to the U.S. housing market through home construction, home furnishing and mortgage businesses, and no one is expecting a rosy scenario for housing in 2011. In fact, a double dip in housing prices was back among the major market fears as the year drew to a close, after the latest S&P/Case-Shiller home price index data was released.
“If you think that it’s really three to five years for the housing market to clear out, and just as long for linked industries to get back on a normal trajectory, to say Berkshire Hathaway shares are worth two times book doesn’t make sense,” Morningstar’s Warren contends.
Berkshire Hathaway is the poster-child for business stability, but explosive growth isn’t in the cards.
So it’s no surprise that again in 2011 the primary mover for Berkshire Hathaway performance will be the insurance, railroad and energy segments, and revenue growth coming from each sector (this of course excludes the large swings in quarter-to-quarter Berkshire Hathaway performance based on value of derivatives contracts).
Yet it’s the Berkshire Hathaway manufacturing, service and retail top line that needs to keep improving. As with the U.S. corporate sector as a whole — which reached record profit levels in the past quarter — Berkshire Hathaway has had enough layoffs and cost-cutting measures across its various businesses to see some top-line improvement, but there are still lots of grey areas within the manufacturing, service and retail portfolio.
“The real top line improvement in many of these businesses could happen next year or three years from now,” the Morningstar analyst said, following up on his comments about the housing sector specifically.
There have been improvements across the board in the U.S. economic outlook, and the main economic indicators have looked much more positive of late. Berkshire Hathaway is as close to a proxy for the U.S. economy as any single company can be.
Berkshire Hathaway shares gained roughly 21% in 2010. The S&P 500, meanwhile, gained near 13%. Another win for Buffett versus the indexes, but a win that’s getting harder to achieve year-in, year-out, and especially without a one-time event like the S&P 500 market inclusion to buoy shares.
A new analysis of Berkshire Hathaway from Barclays Capital analyst Jay Gelb predicts some hefty gains from Buffett’s stock holdings in Wells Fargo(WFC) and Coca-Cola(KO), which rallied in the last quarter of 2010 and could have created a gain of $6.3 billion in the value of Buffett’s public stock portfolio.
While the rally in two of Buffett’s favourite stocks — that represent almost one-third of the value of his stock portfolio — might make for hefty unrealized gains, the stock portfolio is the smallest piece of the Berkshire Hathaway empire in terms of moving the needle of its share price higher. Berkshire’s equity portfolio remains concentrated among its top 10 positions, which accounted for more than 90% of the total dollar value ($48.6 billion) of its holdings at the end of the third quarter.
Wells Fargo was one of three stocks, alongside Johnson & Johnson(JNJ) and Bank of New York(BK) where Buffett made big bets in the third quarter, while closing out positions in a number of less core Berkshire Hathaway stocks. Buffett bought an additional 16.3 million shares of Wells Fargo during the third quarter.
For the past two months, Berkshire Hathaway shares have been hemmed in by the $79-$81 range. Berkshire Hathaway shares reached their annual high water mark in September, just short of $86. Yet since it’s been the $80 price that has served as the trading tether.
Indeed, all the discussion of the predictable and less predictable businesses among Buffett’s empire raises the question for investors looking into the crystal ball for 2011: Where Will Berkshire Hathaway trade in 2011?