Buffett's Berkshire Hathaway is undervalued

The release of Berkshire Hathaway's 2015 annual report and shareholder letter over the weekend is cheering investors who did some math and figured the stock looks appealing.

Berkshire Hathaway's class A shares (BRKA), which gained over $4,000, or 2 per cent, to $202,555 on Monday, still look attractive trading for 1.3 times the company's year-end 2015 book value of $155,501. That's a modest premium to the level of 1.2 times book at which chief executive Warren Buffett wrote in the latest letter that Berkshire “would be delighted to repurchase our shares.” Berkshire's class B shares (BRKB)  closed Monday at $134.17.

The threshold of 1.2 times book is now around $186,600 per share and that level generally rises each quarter because the company's quarterly run rate of earnings is around $3,000 per class A share. Many investors consider a level of 1.2 times book to be an effective floor on the stock because Berkshire has ample ability to repurchase stock given its huge cash holding, which stood at $61 billion at the end of 2015. That cash level likely did decline to about $39 billion following the early-year purchase of Precision Castparts.

Berkshire is willing to eagerly buy stock at 1.2 times book because what Buffett considers the company's intrinsic value “far exceeds” book value and intrinsic value also comfortably exceeds 1.2 times book, Buffett wrote in the shareholder letter.

During the current quarter, Berkshire's core operating profits are likely to be partly offset by declines in the value of its equity portfolio, which totaled $112 billion at year-end. Wells Fargo (WFC), American Express (AXP) and IBM (IBM), three of Berkshire's Big Four equity investments, are in the red so far this year. The other member of that quartet, Coca-Cola (KO), is about flat. Kraft Heinz (KHC) is the fifth large equity holding but isn't counted with the others because of arcane accounting rules.

Looking ahead, Berkshire's book value could hit $167,000 by year-end 2016, based on an estimate by Nomura analyst Cliff Gallant. That estimate times 1.2 is about $200,000, or roughly the current stock price. Gallant wrote today in a client note that the current valuation “presents an attractive opportunity to invest in Berkshire.” He has a Buy rating and a target price of $235,000 per class A share.

Berkshire's book value, meanwhile, is understated because accounting rules require that the company carry its big stake in Kraft Heinz at a below-market value. That stake is worth about $25 billion, but is carried for only about $16.6 billion. The difference is about $8 billion or about $3,000 a share after taxes, we estimate.

The company's operating profits of $2,843 per share in the latest quarter amounted to a mild disappointment, although Buffett deemphasises short-term results. Gallant did cut his 2016 and 2017 estimates to $11,795 and $12,482 from $12,481 and $13,111, reflecting weakness at Burlington Northern railroad and manufacturing businesses. Berkshire is facing headwinds from a weakening energy and industrial sector, including coal shipments at its railroad.

Barron's wrote a favorable cover story on Berkshire last year when the stock traded for about $213,000.

Over time, it's not unreasonable to expect Berkshire to expand its book value by close to 10 per cent annually reflecting operating profits and some investment gains. That could support a similar gain in the share price – not a bad return in what could remain a low-rate, low-return investment world.

With Buffett now 85, there's succession risk, but that appears to be at least partly factored into the share price given the modest premium to book value. Buffett offered no fresh information about his potential successor in the letter. Our favored candidate to succeed Buffett is Berkshire Hathaway Energy chairman Greg Abel.

* This report originally appeared in Barron's and is republished with permission.