Berkshire Hathaway: Breaking The Traditional Rules Of Income Investing

Lately, I’ve been coming around to the notion that buying Berkshire Hathaway is on the short list of “very intelligent” moves you can make today if your time horizon is 15+ years out and you are looking for something that will eventually pay dividends, but are investing in a taxable account and don’t mind seeing a pile of money quietly build up as Buffett does his thing.

There’s a couple things that brought me to this point: Upon reflection on Buffett’s letter to shareholders that came out in the spring, we have a very rough gauge of what Buffett considers to be the fair value of Berkshire Hathaway stock (you should note that Buffett doesn’t spoon-feed information to his audience, so he makes you do just a little bit of independent thinking before you reach the conclusion that he desires).

In that letter, Buffett indicated that Berkshire would be repurchasing its own stock if it traded at 1.2x book value. Given that Berkshire’s book value is around $92 per share, that means there is a floor of $110 per share for the stock (if the price goes below that, Buffett would start gobbling up the shares so it would take 2008-2009 steep, general market decline to send prices below that mark to offset Buffett’s repurchase of his own stock on the company’s behalf).

So we know that Buffett considers $110 a cheap enough price that comes with a margin of safety to buy back the stock, but what’s the point at which Berkshire hits its fair value estimate? Well, Buffett’s mentor, Benjamin Graham, said that stock repurchases carry a margin of safety when they trade at a 1/3 discount to intrinsic value. Let’s assume that Buffett modifies that to reflect the superior quality of Berkshire’s operational companies and public stock portfolio investments (if this were the old textile mill days of the ‘60s, when the earnings quality at Berkshire was quite poor, it would make sense to insist on Graham’s 1/3 discount rule).

My guess is that Buffett repurchases the stock when it trades at 80% of intrinsic value (which is 1.2x book value in Berkshire’s case) so that a fair price to pay for Berkshire Hathaway stock is somewhere around 1.5x book value. Applying that to the current case, you are getting a fair deal anytime you can buy Berkshire stock below $138, such as we are able to do today.

Why, then, is Berkshire trading at a fair price when everything else around else seems to be expensive—not terribly so, let’s call it a “soft overvaluation” that characterizes the S&P 500 today?

First, Berkshire doesn’t pay a dividend. If you could go out and buy 7% yielding treasuries or 9% yielding corporate bonds (of companies that aren’t on the verge of bankruptcy), it would be no big deal. But when banks make you jump through hoops to check off a bunch of different monthly requirements so that you can get 0.75% from a high-yield, high net worth checking account, not a whole lot of people are going to be oriented towards saying, “Gee, let me put my money into a $200 billion conglomerate run by a 80+ year-old that offers a dividend yield of 0%.”

Therein lies the opportunity. If you buy Berkshire Hathaway and have a fifteen to twenty year orientation, you will likely see one of two things happen:

Berkshire will pay a dividend. This could be one of those situations where someone holding Berkshire in a taxable account will sit by and see their wealth quietly compound without having to pay anything to the tax man, and as they approach a point at which dividend income could prove useful, they may start getting just in time before or during the early years of retirement. It could be one of those situations where those buying today could have 10% yield-on-costs at the time Berkshire actually gets around to initiating a dividend payout.

Or you could have a lucrative breakup situation. Companies that are a disparate collection of operating businesses rarely remain intact after the brilliant founder is gone (Henry Singleton of Teledyne fame being the highest profile example). Sitting on a lucrative asset before a spinoff can be a life-changing experience as long-term shareholders of Abbot Labs (now Abbott Labs + Abbvie) andConoco Phillips (now Conoco Phillips + Phillips 66) can tell you. The most lucrative example in that regard came in 2008 when Altria decided to become Altria, Philip Morris International, and what is now Kraft and Mondelez.

Someone who made a $25,000 investment in Altria from over ten years ago has won at life. The collection of dividends and individual companies received has shown what happens when you buy a high-quality company that just happens to be that magical stock.

Berkshire Hathaway has the potential for spinoffs unlike any other company in the country, save for Procter & Gamble, Pepsi, Johnson & Johnson, and General Electric. What if new Berkshire management decided to spinoff GEICO? Applied Underwriters? Dairy Queen? Fruit Of The Loom? Benjamin Moore Paints? Lubrizol Chemical? Nebraska Furniture Mart? The Buffalo News? See’s Candies? Business Wire? The Burlington Northern Santa Fe Railroad? Netjets? Helzberg Diamonds? Borsheim’s Jewelry? Johns Manville? Clayton Homes? The Omaha Herald? The Pampered Chef? Wesco Financial? General Re? Heinz Ketchup?

The opportunities for significant spinoff wealth are overwhelming.

And imagine if the stock portfolio were partially dismantled through spinoffs? Imagine collecting outright ownership stakes in Coca-Cola, Wells Fargo, IBM, Procter & Gamble, American Express, or ExxonMobil because the new management team wanted to part with it but didn’t want to sell it outright in the conventional sense?

If you hold Berkshire Hathaway long enough, you’ll see a dividend. You’ll see something get spun off. That’s the nature of what happens to unrelated businesses that are held together by a cult-of-personality force with a 30% ownership stake in the whole thing. The model is so decentralized, that Buffett has been gradually removing himself from being necessary to Berkshire’s sustained success. He’s become old man river, where has different managers running each operational company with minimal oversight from him (Buffett has long said the only active decision he makes is setting the price of See’s chocolates for the upcoming year on the day after Christmas). He just collects the cash checks he receives from the management teams whose annual bonuses are tied to the amount of cash profits they are able to send Buffett. At some point, people who buy Berkshire today and hold for a long time will experience some kind of trigger event, be it a dividend or a spinoff, that will make them smile.


Originally posted 2014-08-25 08:00:17.

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One thought on “Berkshire Hathaway: Breaking The Traditional Rules Of Income Investing

  1. KeithX says:

    I have been reading your blog for quite some time now and just wanted to say “thanks”.  I don’t currently own Berkshire, but had a couple of B shares a while back that I should have held on to.  I think for a lot of people, Buffett’s and Munger’s age is a major concern.  Who knows how the business will be run when they are gone?  Your arguments for a dividend or spin-offs makes sense.  Unfortunately, I have worked for major corporations for almost 4 decades, and not all of the decisions made make sense.  Still, the potential for a major win is so great that it merits a second look.

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