Yahoo Finance Berkshire Hathaway: A Premium Business Deserves a Premium Multiple
A few weeks ago, I wrote an article looking at the difference between Warren Buffett (Trades, Portfolio) and Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).
As I noted in that article, over the past few years, Buffett's stock-picking skill has become increasingly less relevant to Berkshire's success as the various operating divisions of the business, notably the insurance division, have come into their own.
As a result of this development, I concluded at the time that analysts should be looking at Berkshire as an insurance giant today, rather than the investment vehicle of Buffett, and evaluate the conglomerate on its success in this sector rather than continuing to compare its performance to that of the S&P 500. Such a comparison is no longer relevant.
The competitive advantage
It's really quite challenging to put into words the competitive advantage Berkshire has as an insurance business compared to the rest of the industry.
As I wrote previously, the fact that the conglomerate owns one of the largest railroads in the United States as well as a significant utility business, which are both treated by regulators as permanent capital, means it stands head and shoulders above all of its peers when it comes to having the capital required to write large risks.
At the 2005 Berkshire annual meeting, Buffett gave an example which helped illustrate the size of this competitive advantage:
"Just the other day -- and nobody else will write this stuff, basically, because they would want to reinsure it with somebody else and they're not set up to do it -- but one large airport, one large international airport, came to us and we wrote a policy for $500 million, excess of 2 1/2 billion, from any action that was not caused by nuclear, chemical, or biological sources...
We insured the NCAA Final Four down in St. Louis against being canceled, not postponed, or having the games, those final four games, moved to another city. But if it was canceled totally, and again, not through nuclear, chemical, or biological, we would have paid $75 million. Same thing at the Grammys. I mean, we take on risks that very few people want to write. But in the end, we're willing to lose a lot of money in one day, but we're not willing to do anything that causes us any discomfort, in terms of writing checks the following morning."
Berkshire's book value
So, what does this mean from an investment perspective? It suggests that placing a value on Berkshire based purely on its book value is not relevant. It also supports my earlier thesis that the group should not be viewed as Buffett's investment vehicle any longer.
Rather, Berkshire should be valued and analyzed based on its competitive advantages in the global insurance and reinsurance markets. Of course, the hard part is trying to understand how much this competitive advantage is worth, but we can draw from other examples to try and put a value on the business.
For example, most average insurance companies trade at around book value. However, a select few that have a good track record of profitable underwriting command valuations in the 1.5 to 2 range. You could make a strong argument that Berkshire deserves this multiple, especially considering the quality of its assets. The nature of the insurance industry makes it difficult to value these businesses based on cash flows, which is my go-to financial data point when looking at valuation.
This is not designed to be a rigorous analysis of the business and how much it could be worth. Rather, it is just a starting point for further research based on the assumption that Berkshire is different from Buffett, and, as a result, should be valued as such.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.
