At the largest ever Berkshire Hathaway Annual Meeting on May 3, with approximately 40,000 stockholders in attendance, Warren Buffett and Charlie Munger rose to the occasion and were at the top of their game.  Buy good companies, let their managers run them, and invest the capital they generate has been their mantra from the outset, and it is still working.

Net income of $19 billion for Berkshire Hathaway in 2013 was an all-time record.  But net income is not a good measure of Berkshire Hathaway’s real value, whether it be the 31% increase in 2013 over the prior year or the 4% decrease in the first quarter of 2014 from the same period a year earlier (due to a drop in insurance underwriting profits which were unusually high a year earlier).

To comprehend the intrinsic or true value of Berkshire Hathaway, it is necessary to understand its three components.  First is the ownership of 68 non-insurance operating companies led by railroad BNSF and public utility Berkshire Hathaway Energy.  These operating subsidiaries now account for more than two-thirds of Berkshire’s annual net profit.

Second is Berkshire’s insurance company business and its rapidly growing $77 billion of reserve “float” invested in stocks, the largest four of which are Wells Fargo, Coca-Cola, American Express and IBM.  Profits from Berkshire’s stock portfolio are vastly understated since only dividends received by Berkshire are reported as net income, not the share in earnings these stock holdings represent nor their gain in market value.  The unrealized gain in Berkshire’s stock portfolio increased $11 billion in 2013, but none of it reported as income.

The third component is the value of future earnings which Berkshire will make from investment of its growing retained earnings.  Berkshire retains all its earnings for reinvestment with enormous stockholder approval.  Ninety-seven percent of Berkshire’s shareholders rejected a proposal that the company pay a dividend.

For the past 49 years, Berkshire has compared the book value of its shares to the S&P 500 Index.  During that period of time, Berkshire’s book value per common share has compounded at an annual gain of 19.7% compared to 9.8% for the S&P including dividends.  The recent criticism of Berkshire for the underperformance of its book value per share compared to the S&P over the last five years represents a misunderstanding of what the company is all about.  Berkshire is a value oriented investor which outperforms the S&P in years when the market is down or marginally up, underperforms the S&P when the market is unusually strong, but outperforms the S&P over the course of full business cycles.  Going back to 2007 before the Great Recession began, Berkshire’s increase in book value has outperformed the S&P.

It should be noted that Berkshire’s book value significantly understates the intrinsic value of the company.  Taking all aspects of Berkshire’s intrinsic value into account, Warren and Charlie make a strong case that Berkshire’s shares are worth much, much more.  Warren is so confident of this that Berkshire is committed to aggressively repurchase its shares if they ever fall below 120% of book value.  At just 139% of current book value today, investment in Berkshire’s stock looks very attractive.

Here are some other interesting take–aways from Berkshire’s Annual Meeting.

• Warren’s $1 million bet with New York asset manager Protégé Partners that the performance of a low cost S&P 500 Index fund would beat that of five Protégé selected hedge funds over ten years is working overwhelming in his favor.  Six years into the bet, the total return of the S&P fund is up 43.8% compared to 12.5% for the hedge funds.
• Both Warren and Charlie think that Federal Reserve Chairman Ben Bernanke did a heroic job during and after the market crash of 2008-2009, and they like what his successor, Janet Yellen, is doing now.  On a cautionary note, they point out that we are in uncharted waters with the Fed holding short term interest rates near zero and purchasing billions upon billions of US government debt securities for over five years.  Warren describes it as a movie we have not seen before and don’t know how it ends.
• Both think that the federal government should continue to provide guarantees of properly underwritten home mortgages to keep their interest rates low, but not through any form of public/private vehicle such as Fannie Mae or Freddie Mac.
• Both concur that the Canadian oil tar sands are a significant long term energy asset for the future, but neither has an opinion as to whether they are a good investment opportunity at this present time.
• Both feel that after they are no longer around, the management of Berkshire will remain excellent.  Warren has recommended a successor CEO to the board; Warren’s investment protégées Todd Combs and Ted Weschler are each managing portfolios in excess of $7 billion which are outperforming the S&P 500 Index; and Warren’s son, Howard Buffett, has been designated future non-executive chairman to preside over a future CEO change should it become necessary.

At Edgemoor Investment Advisors, Berkshire’s stock is still on our buy list, for many good reasons.

The “Fasten Your Seatbelts” public announcement that the Berkshire Hathaway Annual Meeting was about to begin in Omaha’s packed convention center this past Saturday was like a plane steward’s admonition before a perfectly smooth flight.  It’s difficult to imagine how anything could be going better for Berkshire Hathaway.

Warren Buffett reported that his company’s operating earnings during the first three months of 2013, $4.9 billion, 51% above the first three months of 2012, were the highest for any quarter ever reported.  Berkshire’s four major industry operating sectors all performed well including their largest components:  insurance companies Berkshire Hathaway Insurance Groups and GEICO; regulated companies BNSF (railroad) and MidAmerica (public utility); manufacturing/service/retailing companies Marmon (150 different businesses); and financial companies Clayton Homes (manufactured housing/finance) and CORT (leasing).

But Berkshire’s operating company earnings were only part of the story.  In addition to its $4.9 billion of reported net income was another $5.5 billion of net appreciation of investments representing the increase in book value of Berkshire’s fixed income and equity marketable securities in its investment portfolio.  The largest of these investments were Wells Fargo, Coca-Cola, IBM and American Express aggregating $52 billion at year-end 2012.

On the acquisition front, Buffet is still looking for a couple of “elephants” to purchase with readily available proceeds from Berkshire’s $48 billion in short term Treasuries.  He expressed his satisfaction with Berkshire’s $12 billion investment in Heinz during the first quarter, and he believes that there are other good large investment opportunities to pursue for the benefit of Berkshire shareholders in the future.

Finally in terms of valuation, there is the unrecorded intrinsic value of Berkshire’s operating subsidiaries.  Buffett used the example of GEICO’s first quarter insurance underwriting operations to explain.  Based on its first quarter new insurance policies, GEICO is positioned to write $1 billion of new US auto insurance in 2013 out of $1.5 billion industry-wide.  The intrinsic value of GEICO’s growing insurance business is worth far more than the company’s book value carried on Berkshire’s financial statements, and the same is true for most of Berkshire’s other operating businesses.

Buffett said that Berkshire will acquire its own stock whenever its market value falls below 120% of book value (currently at 140%).  Don’t hold your breath.  The market has responded positively to all the good news from Berkshire Hathaway, and it is now the fifth largest company in total market value after Apple, Exxon Mobil, Microsoft and Google.

As always in recent years, questions were raised about what happens to Berkshire after Buffett is no longer around, and a particular question was raised about the future role of Buffett’s son, Howard.  Warren explained that his recommendation for Berkshire’s future Chief Executive Officer and Chief Investment Officer(s) were confidential, but well known to Berkshire’s Board of Directors.  However, as assurance that Berkshire continue to operate the same, he has recommended to his Board of Directors that after his departure, his son Howard become the non-paid, non-executive Chairman of the Board.  As a Berkshire director and major shareholder, Howard is immersed in Berkshire’s principles and culture.  He would assure that Berkshire’s management would either continue successfully on the same path as before, or if not, request the board make appropriate management changes.

While questions about Berkshire were answered confidently and completely, questions about the ultimate impact of the Federal Reserve Bank’s quantitative easing were not.  Both Buffett and his longtime investment partner, Charlie Munger, agreed that the Fed, led by Chairman Ben Bernanke, responded correctly to the financial market crisis of 2008 and subsequent slow economic recovery, but neither could offer an opinion of its aftermath results.  Munger simply said, “I don’t know,” and Buffett agreed, comparing it to an interesting movie where you don’t know the ending. However, Buffett did comment that that the Fed’s quantitative easing has the potential to be very inflationary and that “bonds are a terrible buy right now,” with which we at Edgemoor concur.  He said that the Fed’s balance sheet, which has swollen to $3.4 trillion, is in unchartered territory, and he observed that when the market gets the signal that the Fed is going to stop purchasing $85 billion of mortgage backed securities per month, it could be a “shot heard around the world.”

Be that as it may, it is this author’s opinion that Berkshire Hathaway’s stock is a good value in today’s market.

Once again, Berkshire Hathaway’s Annual Meeting was a showcase for the best of corporate America featuring the guru of value investing, 81-year-old Warren Buffett, and his long-time partner and alter ego, 88-year-old Charlie Munger.  Five hours of answering questions from shareholders, financial analysts, and journalists, and they didn’t miss a beat.

Management succession was again a major topic of discussion, but in spite of Buffett’s recent announcement of prostate cancer, the topic did not seem to be the same level of concern as previously.  Buffett said that he “feels good,” he does not require hospitalization, he is undergoing very successful treatment, and he expects to live many more productive years.  Berkshire’s board has designated a CEO successor who was described at the meeting as an existing Berkshire executive immersed in the company’s value investment culture.  As with Buffett, the new CEO would also be Chief Risk Officer who will continue to avoid excess leverage and insurance risk.  Could it be Ajit Jain who has been with Berkshire since the 1980s and is in charge of Berkshire’s own highly successful reinsurance business?  If so, we would applaud his choice.  Buffett praised Jain’s ability to create value and manage risk.

Future designated Co-Chief Investment Officers Todd Combs and Ted Weschler were reported to be performing well with assets under their management increased by $1 billion to $2.75 billion each.  Emphasis was also placed on the quality of Berkshire’s outstanding subsidiary CEOs, who run their companies independently.

Concern about the US economy was much less than that expressed in annual meetings of the last few years.  US banks were described as now being “in fine shape” with most of their “abnormal losses taken,” their capital “buttressed,” and their liquidity “built.”  The Federal Reserve and Treasury Department were given high marks for their actions which benefitted the banks’ recovery.  Problems still needing to be addressed include the ongoing excessive US government fiscal deficits and the high US unemployment rate.  Buffett said that the deficit could be contained by reducing expenditures to 21% of GDP and increasing revenues to 19% for a 2% differential as opposed to the current 8.5%.  Munger estimated the future US long-term real economic growth rate (above inflation) at 1% annually, which would increase the income of each succeeding generation by 25%, although income distribution between the wealthy and the poor could pose a problem.

Less confidence was expressed for Europe.  The European Central Bank’s support of the European banking system by providing one trillion euros of liquidity has kept the European banks in business, but successful resolution of the 17 member European Union’s sovereign debt crisis will be difficult to achieve politically.

Most of the annual meeting was spent discussing Berkshire’s operating subsidiaries and their future.  Buffett considers Berkshire’s stock significantly undervalued, and so do we. Historically, Berkshire Hathaway has traded in the range of 1.5–1.7 times book value, which we think more accurately reflects its true value.  Buffett renewed last year’s pledge that the company would repurchase its shares should their price fall to 110% of book value and further said Berkshire would be willing to purchase “tens of billions of dollars” of Berkshire stock at that level.   On the subject of dividends, Buffett believes that he can reinvest earnings for greater value to shareholders, so there will be no dividends forthcoming from Berkshire.

Buffett said that Berkshire’s major operating subsidiaries are performing extremely well.  GEICO’s share of the automobile insurance market has increased from 2% in the 1990s to 10% today, and he projects continued growth in underwriting profits and reserves available for investment.  As a regulated electric utility, MidAmerican Energy has significant opportunity for profitable additional investment.  So does railroad Burlington Northern Santa Fe, whose transport of one ton for 500 miles requires only one gallon of diesel fuel.  While MidAmerican and Burlington Northern are in capital intensive industries, Berkshire is “happy with their 12% return on equity” for new investment.  Altogether, Berkshire owns 79 operating companies plus many investments in publically held enterprises, the five largest of which are The Coca-Cola Company, International Business Machines Corp., Wells Fargo & Company, American Express Company, and The Procter & Gamble Company.

In response to a question, here’s a list of investment don’ts from Buffett and Munger:

• Stay away from companies you don’t understand and can’t forecast long term;
• Avoid highly priced stocks and look for those selling at less than intrinsic value;
• Stay away from initial public offerings (seller has too great a timing advantage);
• Avoid big disasters.

Sounds simple, but the trick is to execute like Warren Buffett.

As those who have followed our investing approach know, preferred stocks have been mainstays of our income portfolios for many years.  In today’s environment of low interest rates, including a yield of 2% on the 10-Year Treasury, the much higher yields offered by preferred stocks are particularly attractive.

Fidelity recently published a detailed review of the benefits and risks of investing in preferreds.  Click here to read the article and learn more about these securities.

For more on our approach to income investing, click here.