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Monday, December 17, 2007

BARRONS: Sorry, Warren, Your Stock's Too Pricey

WARREN BUFFETT'S STAR HAS NEVER BEEN HIGHER.

The Class A shares of his Berkshire Hathaway (ticker: BRK-A) have surged 30% since Aug. 1, to $143,000, after hitting a record $151,650 last week. Berkshire now has a stock-market value of $220 billion, ranking it sixth in the U.S., behind only ExxonMobil (XOM), General Electric (GE), Microsoft (MSFT), AT&T (T) and Procter & Gamble (PG) -- and above such heavyweights as Johnson and Johnson (JNJ) and Google (GOOG).

The Berkshire rally reflects the company's haven status; it's dodged the mortgage and credit problems that are causing billions of dollars of losses at financial institutions including Citigroup (C), UBS (UBS) and Merrill Lynch (MER). While many of these battered companies are being forced to raise capital, Berkshire enviably holds $39 billion in cash. Some of the recent strength in Berkshire reflects Wall Street's expectation that Buffett, its CEO and controlling shareholder, will put some of that in an attractive investment in a financial company. Buffett might even buy his long-sought "elephant" -- a $10 billion-plus acquisition -- on the cheap.

THE STREET'S ENTHUSIASM for Omaha-based Berkshire, however, might be excessive. Its stock now appears overpriced, reflecting a sizable premium for the skills of the 77-year-old Buffett. What's Berkshire worth? Our estimate, based on several valuation measures, is around $130,000 a share -- about 10% below the current quote.

Credit Suisse's Charles Gates, one of the few Street analysts covering Berkshire, values it even more conservatively. He carries a 12-month price target of $125,000 and rates the stock Neutral. "We consider the stock fully priced," he wrote in a client note last month. Gates cited the ages of Buffett and his long-time Berkshire partner, Charlie Munger, who turns 84 on Jan. 1. Gates also noted the "lack of clear management succession" at the company. Edward Jones analyst Tom Kersting recently cut his Berkshire rating to Hold from Buy, citing valuation.

There may be better values in the financial sector, including the depressed shares of quality companies such as American International Group (AIG), Wells Fargo (WFC) and American Express (AXP).

Barron's has been bullish on Berkshire in recent years when investors were paying little or no premium for Buffett's skills. We wrote a cover story ("Warren Buffett's Still-Golden Touch") in August 2003 when the stock traded at half its current price, and we've handicapped the prospects for Buffett's successor as CEO. Our bet is that Berkshire's board eventually will tap David Sokol, 51, an Omaha native who runs Berkshire's most valuable non-insurance business, Mid-American Energy. The choice hasn't been made public.

Buffett's talents as an investor are unmatched, but good things sometimes can cost too much. Given Berkshire's high value relative to its book value and earnings, the stock could be dead money for at least a year -- and it might even decline, as it did last week.

DESPITE BERKSHIRE'S PHENOMENAL long-term performance, there have been periods when the stock wasn't a great investment. In 1998, Berkshire topped $80,000 a share in the wake of the company's deal to buy reinsurer General Re for $22 billion. It traded below that level as recently as 2005. Berkshire has risen an amazing 7,000-fold since Buffett took control of the company in 1965. Buffett refuses to split the Class A shares. Berkshire's Class B shares, issued in 1996, fetch $4,760 a share. They're equivalent to 1/30th of an A share. The company pays no dividend and doesn't repurchase stock.

Barron's couldn't reach Buffett, but he told Fox Business correspondent Liz Claman last week that "the key to Berkshire's future is deploying the capital that comes in." Buffett has a big job because Berkshire earns around $10 billion annually. Asked what he has been buying, Buffett said: "You're irresistible, but I'll resist."

Says one Berkshire investor: "Buffett presumably has more irons in the fire than simply raising money for Hillary Clinton." Buffett was in San Francisco last week for a fund-raiser for the presidential candidate.

Wall Street is waiting for Buffett's next investment move. This year, Buffett hasn't made a significant deal. Instead, he has been pouring money into the stock market, adding $11 billion to Berkshire's equity portfolio. There have been rumors that Berkshire considered investing in capital-hungry Countrywide Financial (CFC), MBIA (MBI) and Bear Stearns (BSC), but nothing happened. Buffett is showing his customary patience, perhaps awaiting what he calls a "fat pitch" -- just as a power hitter might before blasting one out of the park.

It might be tough, however, for Buffett to land an elephant. Despite his easy-going demeanor, he's a tough negotiator who shuns corporate auctions. This makes it difficult for public companies to sell to him because corporate boards are obliged to get the best price for shareholders. Buffett's acquisitions in recent years have been skewed toward private companies. In its giant $77 billion equity portfolio, Berkshire already has significant exposure to financials through its ownership of an $8 billion stake in American Express and a similarly sized stake in Wells Fargo. Berkshire also holds $2 billion of US Bancorp (USB) and $1.8 billion of Moody's (MCO), the rating agency. It's tough to say what businesses Buffett would like to own, but one that could appeal to him is Marsh & McClennan (MMC), the depressed insurance broker with a $13 billion market value whose shares are half their 2004 high.

Berkshire isn't easy to analyze because of its complexity and because Buffett communicates little with investors save for his appearance at Berkshire's annual meeting in May. Berkshire's quarterly 10-Q reports provide no detail on many of its non-insurance units. There's scant coverage of Berkshire on Wall Street because analysts typically want access to management.

While Berkshire is often viewed as Buffett's investment vehicle, it has evolved in the past decade into a conglomerate with over a dozen sizable operating units. Insurance remains central at Berkshire. Its best division is fast-growing Geico, now the nation's third-largest auto insurer. Reinsurer General Re, however, has been disappointing. Berkshire also operates a lucrative specialty insurer run by the talented Ajit Jain. It provides big-ticket policies for catastrophes, such as earthquakes and hurricanes.

The largest non-insurance unit is Mid- American Energy, which owns electric utilities in Iowa, the Pacific Northwest and Britain. Berkshire also controls Shaw Industries (carpeting), Benjamin Moore (paints), International Dairy Queen, NetJets (private jets) and See's Candies, and it paid $4 billion last year for an 80% stake in Iscar, an Israeli maker of metal-cutting tools.

GAUGING BERKSHIRE'S INTRINSIC VALUE -- the discounted value of the cash flow from its businesses -- is difficult. Buffett refuses to divulge his estimate of that value and rarely comments on the stock price. The last time he said anything notable was in July 2006, when he decided to give away about 85% of his Berkshire stake, then valued at $44 billion, to a group of charities, mainly the Bill and Melinda Gates Foundation. With the stock then around $90,000, Buffett wrote that Berkshire was "an ideal asset" to underpin a foundation and that over time, the increase in its share price "may be substantial." Buffett's current 28% stake is worth $60 billion.

WITHOUT BUFFETT'S GUIDANCE on intrinsic value, investors rely on Berkshire's shareholder equity, or book value, which Buffett tracks yearly in the annual report. Book value, Buffett notes, understates intrinsic value because most of Berkshire's businesses are worth more than their carrying value. However, changes in book value tend to track shifts in intrinsic value. The big question is what premium above book Berkshire stock deserves. Over the past 20 years, Berkshire generally has traded at one to two times book value.

Currently, it's at 1.8 times its Sept. 30 shareholder equity, or book value, of $77,800 a share. That's above its average of 1.6 in the past five years. It's also valued at 23 times estimated 2007 operating profits of $6,300 a share. Next year's profits are expected to be similar to this year's. If Berkshire were valued at 1.7 times book value, a premium to its five-year average, the stock would trade at $132,000.

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Some Berkshire watchers value the company by assessing its insurance units on book value and its other businesses on profits. Using this approach, we come up with a value of about $130,000 a share. This calculation is based on using a price/book ratio of 1.7 on Berkshire's insurance units' estimated Sept. 30 book value. We're assigning a price/earnings multiple of 15 to projected 2008 operating profits of $2,800 a share for the non-insurance businesses.

Assigning a P/E of 15 to Berkshire's non-insurance businesses is generous, given that the premier U.S. conglomerate, General Electric, also is valued at 15 times next year's estimated earnings. So is the Standard & Poor's 500 index. Many of Berkshire's divisions face headwinds from a weakening housing market. Insurance pricing also has been eroding. That's now reflected in historically low valuations of many property and casualty insurers, including AIG and Allstate (ALL).

WHAT'S THE BULL CASE? Fans call Berkshire the stock market's ultimate haven and say the stock still is attractive after being undervalued for several years. Buffett seems to be getting better with age. And growth in Berkshire's book value has accelerated in the past two years. If book value can grow at a 15% rate over the next three years, it would top $120,000 a share by the end of 2010. And if Berkshire can maintain its current price/book ratio, the stock would exceed $200,000, just in time for the Great One's 80th birthday in August 2010.

In a recent presentation, investors Glenn Tongue and Whitney Tilson of T2 Partners called Berkshire "A High-Quality, Rapidly Growing 80-Cent Dollar." They peg year-end 2007 intrinsic value at $167,000 a share and say that intrinsic value could approach $190,000 in a year. They cite growth in Berkshire's operating profits and Buffett's varied investment skills. Bulls say Berkshire's reported profits understate its potential earnings power because the company's $143 billion investment portfolio is tilted toward lower-yielding stocks rather than bonds. Buffett continues to score in the stock market, notching a $3.5 billion gain in recent months on a $500 million bet on PetroChina.

Berkshire ultimately should get a lift from inclusion in the S&P 500, sometime in the next decade. "Liquidity is the main issue," says David Blitzer, the head of the index committee at S&P. "Berkshire's absence from the index is in no way a comment on the investment attractiveness of the stock." Trading volume is low because institutional ownership is small and many long-time holders are disinclined to sell and suffer a big tax hit.

The Berkshire bull case may be overblown because it's tough for a company with $120 billion of shareholder equity to boost its book value 15% annually. It may also be a stretch to assume that Berkshire can maintain a high price/book ratio as Buffett approaches 80. The ratio could contract in the coming years as investors anticipate the end to Buffett's tenure as CEO.

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Buffett turns 78 next August, and his actuarial life expectancy is nine years. He's likely to stay on the job for as long as possible, but in reality few CEOs can handle the demands of the job much past 80. When Buffett departs, the stock is apt to drop as longtime Berkshire holders cash out and the investment community waits to see whether his successors can live up to his legend. Berkshire's current business model, which essentially involves having dozens of disparate businesses send profits to Omaha for Buffett to invest, may not look as attractive without the master investor at the helm. What Buffett now calls a group of "wonderful businesses" may be viewed in the future as a hodge-podge of unrelated companies.

Buffett plans to split his job in two, with one of his successors acting as CEO and the other running investments. Initially, Lou Simpson, the top-notch investment chief at Geico, might run the investment side, but he's 70 and thus not a long-term solution. Buffett has launched a search for a new chief investment officer.

The Bottom Line

Everything has a fair value. For the shares of Berkshire Hathaway, it's $125,000 to $130,000, not the current quote of $143,000.

As noted, Berkshire looks pricey relative to many financial companies. Take AIG, the world's largest property and casualty insurer. Depressed by its exposure to subprime mortgages, AIG has seen its shares fall 21% this year, to 57. It's now valued at eight times projected 2008 profits. AIG has two-thirds of Berkshire's market value and 50% more earnings. It may be a better bet than Berkshire in coming years, as could Wells Fargo, American Express and Allstate.

One alternative to Berkshire is Loews (LTR), the conglomerate run by the Tisch family that also combines insurance and investments. Loews has had a great record in recent years and now trades at 47, 12 times projected 2007 profits and a discount to its net asset value of about $62 a share. Loews is sitting on $3 billion in excess cash. It's easier for the Tisches to move the needle than Buffett because Loews has 1/10th of Berkshire's market value.

Buffett's investment genius is undeniable, but his talents seem well reflected in Berkshire's rich price. Looking out a few years, Berkshire stock probably will be higher. But our bet is that financial companies like AIG, and even the S&P 500, will do even better, especially if Buffett's glorious tenure ends. And, remember, Buffett didn't build the Berkshire powerhouse by paying much more for acquisitions than they were worth. That's a lesson worth pondering by anyone considering buying his stock.



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