Why I think Berkshire Hathaway is a comfortable hold for long-term-oriented investors

Sensible people should regularly challenge their best-loved ideas – and be willing to amend them if necessary...

That's an admonition from my hero and mentor: the late Charlie Munger. So, consistent with that, in Friday's and yesterday's e-mails I laid out the bear case for Berkshire Hathaway (BRK-B) – one of my favorite stocks for more than a quarter-century.

To sum up the bear case, as I wrote yesterday:

Many of Berkshire's businesses are performing poorly, [Warren] Buffett appears to have lost his touch, his successors are largely unknown and unproven, an important insider just dumped more than half his stake, and the stock is fully valued.

So why do I continue to believe that Berkshire is a comfortable hold for long-term-oriented investors?

Let me count the ways...

It's important to keep in mind that Berkshire is enormous, with nearly 400,000 employees and trailing-12-month revenue of $370 billion.

It's also highly diversified, so it's easy to miss the forest for the trees and focus excessively on certain businesses that are underperforming.

In Friday's e-mail, I shared a critique that Berkshire's two largest business – auto insurer Geico and railroad BNSF Railway – are poorly managed. To this, I have two responses...

First, they only accounted for 14% and 12%, respectively, of Berkshire's pretax earnings in the first half of this year.

More importantly, I'm happy to hear that these subsidiaries (and many others) aren't perfectly managed because that means there's likely lots of low-hanging fruit – levers that can be quickly pulled to improve profits. I suspect this won't happen, however, until Greg Abel takes over as CEO for Berkshire. He has a reputation as being more hands-on and operationally tough.

Regarding Geico, I've heard it's a "mess" operationally, in particular with outdated computer systems that impact its ability to price policies properly, resulting in Progressive (PGR) taking share from it.

That said, Geico's combined ratio (a measure of total costs and claims, so a lower number is better) improved from 96 in 2019 to 91 in 2023 and was down to 82 in the first half of this year. For comparison, the industry was 102 in 2019, and rose to 105 in 2023. If Geico performs this well despite many operational issues, imagine how well it will do once it fixes them.

The story is similar for BNSF. Every other major railroad in North America has dramatically boosted its earnings by adopting "precision railroading," so I eagerly await BNSF's adoption of it.

It's also important to understand that while there can be costs to Berkshire's extreme decentralization – it has only 30 people at its Omaha, Nebraska headquarters – there are also huge benefits, as Buffett and Munger have outlined over the years:

• "By the standards of the rest of the world, we overtrust. So far it has worked very well for us. Some would see it as weakness." – Munger, May 2014 
• "A lot of people think if you just had more process and more compliance – checks and double-checks and so forth – you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust." – Munger, May 2007
• "We will have a problem of some sort at some time... 300,000 people are not all going to behave properly all the time." – Buffett, May 2014

As a 2014 New York Times article about Berkshire noted:

Behavioral scientists and psychologists have long contended that "trust" is, to some degree, one of the most powerful forces within organizations.

Mr. Munger and Mr. Buffett argue that with the right basic controls, finding trustworthy managers and giving them an enormous amount of leeway creates more value than if they are forced to constantly look over their shoulders at human resources departments and lawyers monitoring their every move.

If we step back, we can see that Buffett has built one of the greatest businesses of all time. Very simplistically, every business creates value by generating a higher return on capital than its cost of capital. And the wider this gap is – and the more it can be scaled – the better.

An average business might, say, have an 8% cost of capital (a blend of debt and equity) and generate a 12% return on it. That's a four-point spread.

But most of Berkshire's capital comes from insurance float which, because the company has been a good underwriter, has been better than free over time. In other words, because Berkshire's insurance operations consistently have a combined ratio well below 100, Berkshire's cost of float is negative (let's call it negative 5%).

Then, consider Buffett's investing prowess over the past half century – let's say he has been able to generate an 18% annual return. That means Berkshire's spread between its cost and return on capital is 23 points.

Finally, consider that Buffett has been able to scale Berkshire dramatically – for example, its float was a staggering $169 billion at midyear – while maintaining a wide spread.

Now you can see how Berkshire has grown from almost nothing to nearly $1 trillion in value...

Ah, but what about the future?

Let's stress test it and assume that Buffett no longer runs Berkshire and his successors are merely average, such that the combined ratio rises sharply to 100 and return on capital falls sharply to 12%. That's still a 12-point spread – triple that of the average business.

To the extent one thinks Apple (AAPL) is overvalued and/or too large of a position, Buffett recently sold more than half of it, and Berkshire now holds an astounding $277 billion in cash and short-term investments (equal to about 28% of the company's market cap).

This gives Buffett (and his successors) a massive war chest to make smart investments or repurchase large amounts of stock if the market tanks – and, if not, perhaps start paying a dividend.

Lastly, let's look at valuation...

When my team and I recommended Berkshire in our flagship Stansberry's Investment Advisory on December 1 last year, we calculated that it was trading at a 14% discount to intrinsic value. (Subscribers can see the full issue right here. If you aren't a subscriber, you can find out how to become one – and gain access to the entire Investment Advisory portfolio of open recommendations – by clicking here.)

The stock has risen 28% (versus 26% for the S&P 500 Index) in the 10 months since then, but its intrinsic value has only risen about half that amount. As a result, using the valuation methodology I outlined in my May 8 e-mail and updating Berkshire's stock portfolio to current prices, I peg intrinsic value today at $695,000 per A-share and $463 per B-share.

With the A-shares and B-shares closing yesterday at $691,180 and $460.26, respectively, Berkshire is basically trading at its intrinsic value.

Does this mean it's time to dump it if you've owned it for a while and are sitting on nice gains?

No.

It simply means you should have modest expectations right now – namely, that Berkshire will likely perform in line with the S&P 500 rather than beating it by two to three percentage points annually, which was the case when my team and I recommended it last year in the Investment Advisory.

So, while Berkshire isn't a stock I would recommend putting new money into at this price... I still believe long-term-oriented investors should be comfortable continuing to hold it.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.