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Berkshire Hathaway's Operating Businesses Have a P/E Less Than 5

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The surprising figure highlights a larger point about the apples-to-oranges way in which investors are looking at stocks and bonds right now.

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I'll admit it -- I got burned pretty badly by the first few months of the bounce in the spring of 2009. I had been so focused on leverage and credit spreads, not to mention macro data and off-balance sheet shadow banking exposures measuring in the quadrillions, that I was sure we were headed back to a world where physical dollars and pre-1965 US silver coinage would be the only methods of exchange. I had a wad of cash and some gold coins stashed away in my closet, and when I read stories about people buying sailboats, water purifiers, and industrial-size bags of beans and rice I envied their foresight. After that first 10% rally in March 2009, I gleefully pounced on a double inverse Russell 2000 ETF. Of course, by my logic, if I made the right bet, all of my counterparties would have failed and I wouldn't have been able to get paid anyway. Needless to say, it wasn't my wisest purchase.

In addition to a large dose of humility, it taught me the importance of incorporating fundamental data into a process that for me is driven by socionomics and the credit cycle. At some point, asset prices fall far enough where bearish flag patterns and a negative print in the ISM new orders minus inventories metric don't matter, and there are values to be had. In a world where news flow continues to increase in speed and intensity, 140 characters at a time, it's important to be especially cognizant of this.

Which brings me to Berkshire Hathaway (BRK-A). I bring to the table some negative feelings about the company. Despite his image as the "Oracle of Omaha," Warren Buffett encouraged and profited from the bailouts of 2008 just as much as those getting plenty of public scorn. After once calling derivatives "financial weapons of mass destruction," Berkshire became a sizable user of them, refusing to post collateral to boot. It may have been good business, but it tarnishes the legacy of integrity-grounded success that Buffett cherishes.

Still, when Whitney Tilson, a fellow-sufferer in Microsoft (MSFT) stock, highlighted Berkshire as his other great idea in addition to Microsoft, I took notice. In this May presentation, the Berkshire idea is laid out beginning on page 23.The gist of it is that Berkshire can be thought of as two entities: one, an investment management vehicle run by Warren Buffett that holds cash, fixed income, and equity securities like Coke (KO) and Wells Fargo (WFC). The other, a conglomerate portfolio of well-run, stable businesses like Dairy Queen and See's Candies. In theory, Buffett could spin off the investment management business, whose value, as Tilson points out, is the assets it holds, leaving the operating businesses as a separate company.

On Friday, Berkshire Series A stock closed at $111,000/share. The value of its cash, fixed income, and equity securities adds up to $89,500/share. This means that, roughly speaking, the operating businesses are being valued at the difference between the closing price of the stock and the market value of the securities, or $21,500/share.

To arrive at the earnings of that $21,500/share, we have to strip out any income attained from the investment portfolio. As this table from page 64 of the Berkshire Hathaway 2010 Annual Report shows, pre-tax earnings for 2010 were $19.051 billion.



Stripping out the $5.145 billion in investment income, and the $2.346 billion in investment and derivatives gains/losses, gets us to pre-tax earnings of $11.560 billion. Lop off 30% for taxes, divide by 1,648,677 (the number of series A-equivalent shares outstanding), and earnings per share for 2010 for the operating businesses were $4,908.

That price of $21,500/share divided by $4,908 EPS shows a P/E based on 2010 earnings of 4.39.

Berkshire's Q1 2011 earnings came in worse than those from Q1 2010, as insurance-related losses from earthquakes and typhoons cost the firm more than it gained from a full quarter's worth of earnings from its high-profile acquisition last February of Burlington Northern Santa Fe Railway. And I'm sure skeptics could point out other issues: i.e., the deferred taxes the company would owe were it to sell its equities with large realized gains, the uncertainty of the derivatives portfolio, the risk of a PIIGS-member default or a debt ceiling crisis, the fallout from Sokol-gate, and the lingering question of who will succeed Warren Buffett. But the stock is being treated like Warren Buffett will be replaced by Jimmy Buffett.

Which brings up a larger point about the apples-to-oranges way in which investors are looking at stocks and bonds right now. Ultimately, from a long-term valuation standpoint, what matters is the cost required to attain a given income stream. Yet equity investors look at P/E ratios while bond investors look at yields. The 10-year treasury note yields 2.97%, and treasury bulls argue that yield is likely to go lower after a month of bad economic data. And they may be right. But try looking at bonds in an apples-to-apples comparison to stocks. A 10-year treasury note can be thought of as a $100 stock earning $2.97/year that's paid out entirely as a dividend and has no growth in earnings power. It's like a stock with a 33.7 P/E ratio with no growth but a 2.97% dividend yield.

Meanwhile the S&P 500, on track to earn "$95 per share" this year, is trading at 1271. Equity investors say it's trading at 13.4 times 2011 earnings. But it would be equally accurate to say that it has an earnings yield based on 2011 earnings projections of 7.47%. Which, as it turns out, would be the cheapest the S&P 500 has been since 1988. A year in which the 10-year treasury note yielded closer to 9%. That linked table also shows that even during the lost decade of 2000-2010, S&P 500 earnings rose 50%.

I don't know what's going to happen with Greece's debt, or how the debt ceiling saga will play out. But I'm willing to bet that in 2020, most of us won't remember these events, S&P 500 earnings will be at least another 50% higher, and Berkshire Hathaway common stock will have more than doubled.
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