Berkshire Hathaway (BRK.B): Vast Outperformance Poised To Continue

Berkshire Hathaway (NYSE:BRK.B) is beating the market this year. Year to date, BRK.B is basically flat, while the S&P 500 is down 11.88%. So, Berkshire is outperforming by a significant margin.

This hasn’t always been the case. During the 2010-2021 bull market, Buffett was severely underperforming, because he avoided the ‘innovator stocks’ that drove much of the gains in that period. Although Buffett embraced tech with his famous 2016 Apple (AAPL) investment, he missed the multi-baggers that occurred in profitless tech stocks before this year’s crash. Names like Peloton (PTON), Zoom (ZM) and Teladoc Health (TDOC) never appeared in Buffett’s portfolio.

Because of the lack of high-growth names in his portfolio, Buffett trailed the markets for several years. He received ample criticism for refusing to gamble on speculative assets. However, when the tech bubble burst, Buffett’s emphasis on quality names started paying off. Most tech stocks fell this year, but high growth names fell harder than the pack, dragging the entire S&P 500 down with them. The NASDAQ-100 was at one point down 30%. By contrast, Berkshire was sitting on positive gains for most of this year, and is only slightly in the red today.

The question is, can Buffett keep it up?

Berkshire’s CEO is 91 years old, and he has said that he isn’t as sharp as he once was. He outperformed this year, but it remains to be seen whether he (or his successor) will be able to in the future. Certainly, Buffett has been beating the market for a long time, but that doesn’t mean that he’ll continue to do so. Even if Buffett’s age isn’t a problem, Berkshire’s sheer size makes outperformance difficult. If you have $1 billion in cash, invest it all in a $1 billion company that goes to $11 billion, you score a ten-bagger. If you have $100 billion and you make the same investment, you only get a 10% return on a whole-portfolio basis. As Warren Buffett says, “size is the anchor of performance.”

It’s not likely that Berkshire Hathaway will deliver wild outperformance from these levels. However, it should at least perform adequately, with occasional outperformance in periods of market weakness.

Two Signs of Good Things to Come

One of the challenges of analyzing Berkshire Hathaway is the fact that it has so many investments under the hood. According to CNN’s Portfolio Tracker, Berkshire holds 50 individual stocks. It would be impossible to go through all of them. However, Berkshire’s portfolio is very concentrated by market cap, and we know that the biggest concentrations are in:

• Oil and gas

• Banking

• Apple

All three of these have major catalysts on the horizon. To review:

Oil and gas

Berkshire’s oil and gas investments have been paying off this year. Buffett began buying Occidental Petroleum (OXY) common shares early in 2022, they have risen 118% since January. Since Buffett’s February 25 buy date, they’ve risen 75%. That doesn’t mean that Buffett has bagged 75% on the stock, he has bought at higher prices since February. However, he’s been buying OXY preferred stock since 2019. He still holds warrants from the 2019 deal that will allow him to acquire more common stock.

Lately, oil prices have been trending downward, but there’s reason to believe they’ll rise again. Chiefly, supply issues. The supply of oil is being held back by the conflict in Ukraine, but Biden’s strategic petroleum reserve (“SPR”) release is offsetting the effect somewhat. The U.S. government is releasing one million barrels of oil per day from the SPR. The reserve has 511 million barrels in total. The release can only continue about a year and a half from the start date, which was several months ago. So, the main thing keeping oil prices relatively modest will end soon, and that will leave the supply constraints to determine the market price. Once this happens, it’s quite possible that we’ll see another leg up in oil prices, which will be bullish for OXY and Buffett’s other oil plays.

Banking

Banking is another big sector for Warren Buffett. Bank of America (BAC) is Buffett’s second biggest holding after Apple, he also owns Citigroup (C) and U.S. Bancorp (USB). Banking is a classic Buffett sector, and it has a good chance to do well in the coming months.

The reasons for bullishness on banks are basically the opposite of the reasons for oil and gas: banks are severely beaten down. So much so that it wouldn’t take much at all to improve the picture for them. The 10 year/2 year yield curve is inverted by 34 basis points, home sales are down, tech IPO business has dried up. This is all bad news for banks, but it’s been going on so long now that bank stocks are priced like they’re going out of business. Financials are collectively down 12% for the year, despite the fact that banks traded at single digit earnings multiples at the start of it. If we see improvements in the yield curve or the housing market, that could give bank earnings a big pop. All it would take would be a few earnings beats from high profile banks to get their stock prices moving.

Apple

Last but not least, we have Apple. This one stock makes up 40% of Berkshire’s portfolio. I covered this stock in detail in my second most recent article. To sum it up briefly, Apple is certainly expensive, but it falls squarely into the “wonderful business at a fair price” category, thanks to its:

• Economic moat (brand identity + lucrative ecosystem).

• Fattening margins.

• Massive community of fans who give it free publicity on YouTube and elsewhere.

People have said that Apple is getting too expensive, but when a company has a solid competitive position, it merits a premium price. Nobody else has an ecosystem quite like Apple’s, and that’s an advantage that can go a long way in ensuring the company a bright future.

Berkshire’s Wholly Owned Businesses

As we’ve seen, Berkshire’s biggest holdings are great businesses that have big catalysts on the horizon. They stand a good chance of taking BRK.B to new highs this year. But there’s more to the story than that. In addition to stocks, Berkshire has dozens of wholly owned operating businesses, and many of them are great as well.

Berkshire’s main operating category is insurance. GEICO provides car insurance, which is less affected by natural disasters and other unpredictable events compared to other types of insurance. This ensures a relatively steady flow of claims leaving much of the float to be invested in equities.

The second biggest part of Berkshire after that is Burlington Northern Santa Fe Railroad (“BNSF”). Railroads in general are facing issues this year, including rising fuel costs and lower volume. Nevertheless, BNSF saw its operating income climb 10% in the second quarter. The fact that BNSF’s earnings grew so much amid a challenging environment speaks to a competent management team that will be fully able to capitalize on better economic conditions in the future.

As for the rest of Berkshire’s operating companies:

They vary quite a bit in their character, but we know that they were acquired on the basis of the margin of safety principle, and that they enjoy economies of scale by being part of Berkshire. Berkshire has $106 billion in cash on hand, which can be used to negotiate cheaper prices for the company’s subsidiaries when they need to make investments. Over time, that advantage can really add up, and make a difference to Berkshire’s bottom line.

Valuation

Having looked at its investments and businesses, we can now turn to Berkshire’s valuation. At today’s prices, BRK.B trades at:

• 2.6 times sales.

• 1.5 times book value.

• 19 times operating cash flow.

Clearly the markets believe that Buffett’s skill is worth investing in: Berkshire itself doesn’t trade at the “deep value multiples” it acquires businesses at. For Berkshire, it might make sense to value equity by a discounted cash flow model rather than by multiples, as its earnings fluctuate dramatically with its stock portfolio.

From 2016 to 2021, Berkshire’s operating cash flow grew from $32.64 billion to $39.41 billion. That’s a 3.8% CAGR growth rate. If we assume that growth continues for five years, slowing to 0% after the five years are up, and discount at the 2.9% current treasury yield, we get to an intrinsic value of $1.34 trillion for the whole company. That’s approximately double the current market cap, implying an end value of $540 for the class ‘B’ shares. Significant upside.

Risks and Challenges

As we’ve seen, Berkshire Hathaway has some great holdings, and is reasonably modestly valued. Nevertheless, there are some risks and challenges for investors to keep in mind, including:

• Stock portfolio fluctuations. Berkshire holds a lot of publicly traded stock. Because of GAAP accounting rules, stock price fluctuations heavily influence Berkshire’s reported earnings. For example, in the second quarter, the company reported a $43 billion net loss, even though operating cash flow was solidly positive. These kinds of things don’t affect Berkshire’s day to day performance, but investors sometimes take them to heart, which can lead to selling during bear markets.

• Succession. Warren Buffett is 91 years old. He won’t be able to run Berkshire Hathaway forever, and it’s an open question whether his successor will do as well as he did. It’s known that Greg Abel has been tapped to take over the CEO role after Buffett leaves. It’s not clear whether Abel or Ted Weschler and Todd Coombs will take over the investment portfolio. Abel runs one of Berkshire’s operating businesses, Ted and Todd independently manage some of its investments. Ted Weschler continuing as an investment manager would be a good sign: he grew his Roth IRA from $70,000 to $264 million over 29 years, a 33% CAGR return.

The risks and challenges above are worth taking seriously. The succession thing, in particular, has been a longstanding pain point for Wall Street. Nevertheless, Berkshire stock looks like a pretty good value. The combination of growth and value it offers today won’t deliver the kinds of returns seen in past years, but it should deliver a basically adequate return. For my money, that makes Berkshire worth owning.