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Thursday, June 12, 2014
Warren Buffett is one of the most successful investors in history...
And every value investor can learn a lot from reading his annual shareholder letters and hearing him speak.
But, as I showed you in yesterday's essay, you shouldn't worship him... or let that influence your valuation of his business, Berkshire Hathaway. As you can see, he makes mistakes, just like anybody else.
So consider me totally out of the Buffett-worship business. To best serve my readers, I need to remain objective, rational, and risk averse... and make my sell decisions based on that.
So let's take a look at the three main reasons I recommend selling Berkshire today...
Read these reasons carefully. If you're an owner of Berkshire, they might not all apply to you, and you might wish to continue holding the stock. That's up to you. You might not lose money if you continue to hold, but you won't make much, either.
Will Berkshire's Double-Digit Performance Continue?
First, Berkshire Hathaway has crushed the stock market in the time I've held it in my Extreme Value model portfolio. I initially recommended Berkshire in July 2005. It was my first "World Dominator" recommendation.
Since then, the stock is up 124%, compounding investors' money at around 9.7% per year. The S&P 500 is up 54% during the same time period, compounding investors' money at just 5% per year.
Buying Berkshire in 2005 and holding it until now has about doubled the S&P 500 return – a truly phenomenal performance.
But will Berkshire rise another 124% in the next nine years? Will your money keep compounding at close to 10% per year?
Buffett says changes in Berkshire's intrinsic value are roughly mirrored by changes in its book value. Book value was less than $56 billion when we first recommended the stock in 2005. Now it's around $138 billion, a 146% increase. Will it rise another 146% to $340 billion by 2023? I wouldn't count on it.
Remember... the company's value rose with a lot of help from the biggest market crash in 80 years, and the biggest credit crisis ever. Those events created enormous opportunities for Buffett to deploy large sums of money at high rates of return.
I doubt, for example, that he'll get another opportunity to lend billions of dollars to Goldman Sachs and General Electric at 10% interest plus stock warrants (like he did during the 2008 credit crisis).
Unless you believe there's another enormous crisis coming – one Buffett will be able to use to push tens of billions of cash into at high rates – you should lower your expectations for the stock.
Berkshire compounded your money at twice the rate of the S&P 500 for nearly a decade. We don't know where Berkshire's share price will go from here. But we do know its business is unlikely to continue growing at double-digit rates... and the stock market should reflect that. We can do better.
Based on valuation, it doesn't look like Berkshire is the best place to grow your wealth in the coming years...
Buffett has implied over the years that we should value Berkshire Hathaway by adding up investments per share, applying a modest multiple to pre-tax earnings, and putting the two together.
Let's do the math using a modest multiple of eight times pretax earnings. We'll calculate Berkshire "A" shares. To get the value for "B" shares, simply divide our numbers by 1,500.
Using Buffett's method, Berkshire is trading about 29% below intrinsic value today. That's a sizeable discount, especially if you believe it's one of the greatest businesses ever and will remain so for years to come. But I've begun to rethink this, too...
We shouldn't let any CEO – even Warren Buffett – tell us how to value his business. So instead of Buffett's implied-valuation method, let's evaluate Berkshire with the tried-and-true standby metrics of valuing insurance companies. (Insurance is Berkshire's biggest business, accounting for one-fifth of its sales last year.)
Insurance companies are generally worth float plus book value. Buffett told us at his latest shareholder meeting that Berkshire now has $77 billion of float. We know from its latest earnings report that its book value is approximately $228 billion. That makes a total value of $305 billion. Berkshire's market cap is around $308 billion today. By this method, Berkshire is fairly valued.
The belief that Berkshire should trade at fair value by this measure is not unwarranted. It's a great business. But I'm re-thinking whether it's wise to own Berkshire at a sizeable premium to book value...
Today, for example, Berkshire's share price is around $192,000, and its book value is around $138,000 per "A" share. So it trades at around 1.4 times book value per share, a 40% premium to book value.
That's a big premium to book value. The primary reason for the premium is the market expects Buffett to keep making great investments. But with interest rates still ultra-low and the S&P 500 near all-time highs, there aren't as many great investments available today as there were in 2008-2009.
If Buffett makes a bad investment, the market could wipe out a substantial amount of that premium, taking Berkshire's share price down hard.
Only Buffett's preferred valuation measure suggests the shares are undervalued. The other two approaches indicate shares are either fully valued or maybe even overvalued. This data suggests the stock is at least fully valued. Given my concerns about Berkshire's future expectations, I'm comfortable protecting our outsized gains here and moving on.
Other Stocks Can Bring Us Better Long-Term Returns
I'm paid to find my readers safe ways to grow their wealth. I recommend cheap, undervalued stocks that promise to compound my subscribers' money significantly over time. Berkshire is no longer one of those stocks. Sure, you could continue to hold it forever. But like I said, you won't make much money that way from here on.
You're unlikely to lose money holding onto Berkshire for several more years, either. Our first job is always to make sure our recommendations won't lose you money. But we can do that and help you make a lot more of it, too.
I know from experience you can make fat, double-digit annual returns from large-cap stocks. But Berkshire isn't one of them anymore. It's time to move on and put your money elsewhere.
Dan is a world-class business analyst. Last year, he shared his "cheat sheet" with DailyWealth readers... the five clues he uses to find great businesses. Learn all five in these must-read essays:
OUR LATEST TAKE ON GOLD
Keep an eye on the $1,200-$1,250 level for gold. It's where buyers start really liking it.
Longtime readers know that when we started publishing DailyWealth in 2005, we were outspoken bulls on gold. (We were gold owners and gold bulls years before that.) Since then, we've published hundreds of essays on the right ways to own it. We even published a book on the stuff.
What's our take on gold now? We say the $1,200-$1,250 level is the new "floor" for gold.
As you can see in the four-year chart of gold below, gold suffered a big fall in 2013. It dropped from $1,700 per ounce to $1,200 an ounce. Since then, gold sellers have tried to punch it below the $1,200 area several times... only to meet strong buying power. This is the area where large buyers like Asian central banks are stepping in to buy gold. Thanks to these buyers, the $1,200-$1,250 area is now a hard "floor" for gold.