Billionaires



August 18, 2019,   9:36 AM

Billionaire Bill Ackman Explains Why He Invested 11% Of His Fund In Berkshire Hathaway

Antoine Gara

FULL BIO

warren buffet

Hedge fund billionaire Bill Ackman of Pershing Square Capital Management is riding high after a multiyear stretch of trouble.

A publicly traded vehicle that houses the vast majority of his fund’s assets is up 48% net of fees as of August 13, about triple the return of the S&P 500 Index. Big turnaround investments in Chipotle Mexican Grill and Starbucks are trouncing the market in 2019, as is his return to familiar holdings like Hilton Worldwide and even a highly speculative bet to back mortgage giants Fannie Mae and Freddie Mac, both of which remain in government conservatorship.

The last time Ackman was doing this well was 2014, a year where he posted net returns of nearly 40% but then promptly plowed billions into the controversial drugmaker Valeant Pharmaceuticals and lost virtually all of his money. The move ushered in a three-year stretch where Pershing Square badly underperformed the market and shed billions of dollars in investor assets. Due to redemptions during this troubled time, most of the firm’s assets now come from an Amsterdam-traded vehicle called Pershing Square Holdings and not traditional hedge fund structures. With his fund recovering and even beginning to thrive anew, Ackman seems to be turning a new page.

This week, Pershing Square disclosed it had exited two large investments, Automatic Data Processing and United Technologies, and plowed the proceeds into Berkshire Hathaway, the insurance and investing conglomerate headed by Warren Buffett and Charlie Munger. As opposed to Valeant, Berkshire has long been considered a defensive stock with low leverage, and it is managed by trustworthy operators.

Berkshire Hathaway owns high cash balances and has a tendency to do well in bad markets as Buffett and Munger, icons in American business, deploy funds at rock-bottom prices. Berkshire’s cash pile hit a record $122 billion in the second quarter. With markets now falling, it’s hard to not see new investment opportunities on the horizon.

The move by Ackman into Berkshire signals he’s decided against swinging for the fences after a new run of success. It also continues a trend of putting his investment money in familiar holdings in the wake of Valeant, such as restaurants, hoteliers, and financial software and data providers. Since his days in business school, Ackman’s been a student of Berkshire, attending its annual shareholder meeting in Omaha well over a dozen times. As with Restaurant Brands, the owner of Burger King, Popeye’s Louisiana Kitchen and Tim Horton’s, sometimes Pershing Square and Berkshire holdings have overlapped. But Valeant was an investment where they diverged greatly. Buffett and Munger excoriated its price-gouging model and opaque finances. Now Ackman's buying their stock.

Here’s how he explained the investment in a semiannual filing released on Thursday:

My interest in Berkshire began decades ago when I began following the company in 1988. I have attended the substantial majority of shareholder meetings since the early 1990s and followed the company and Warren Buffett—Berkshire’s Chairman, CEO and controlling shareholder—extremely closely since that time. Yet, funds I have managed have owned Berkshire only once for a brief period in late 1999 and 2000.

The catalyst for our current investment in Berkshire is our view that the company is currently trading at one of the widest discounts to its intrinsic value in many years, at a time when we expect the operating performance of its subsidiaries to improve as a result of certain managerial and organizational changes at the company. While Mr. Buffett has long been one of most high-profile and closely followed investors in the world, we believe that Berkshire Hathaway’s undervaluation is partially explained by the fact that it is one of the least followed and misunderstood mega-cap companies.

Berkshire is often described in the media as akin to an investment fund, leaving many with the impression that Berkshire’s shareholder returns are dependent on Warren Buffett’s extraordinary stock-picking ability. While this depiction of Berkshire was a better reflection of its reality in its earlier years, it no longer reflects the company’s current reality. Today, Berkshire is a $500 billion market cap holding company with about half of its value residing in its insurance subsidiaries, and the balance in controlling stakes in highly diversified operating companies. Mr. Buffett has clearly designed the company to succeed decades after he is no longer running the company. As a result, we believe that Berkshire should continue to generate high returns for shareholders from the current stock price even if the investment returns from the company’s large cash holdings and marketable securities portfolio are similar to that of the broad market indices.

Berkshire’s primary asset is the world’s largest insurance business, which we estimate represents nearly half of Berkshire’s intrinsic value. In its primary insurance segment, Berkshire focuses on the reinsurance and auto insurance segments. In reinsurance, Berkshire’s strong competitive advantages are derived from its enormous capital base, efficient underwriting (a quick yes or no), ineffable trustworthiness, and its focus on long-term economics rather than short-term accounting profits, all of which allows the company to often be the only insurer capable of and willing to insure extremely large and/or unusual, bespoke insurance policies.

We believe that Berkshire’s reinsurance business, operating primarily through National Indemnity and General Re, is uniquely positioned to serve its clients’ needs to protect against the increasing frequency and growing severity of catastrophic losses. In auto insurance, Berkshire subsidiary GEICO operates a low-cost direct sales model which provides car owners with lower prices than competitors that rely on a traditional agent-based sales approach. GEICO’s low cost, high quality service model has enabled it to consistently gain market share for decades.

The enduring competitive advantages of Berkshire’s insurance businesses have allowed it to consistently grow its float (the net premiums received held on Berkshire’s balance sheet that will be used to pay for expected losses in the often distant future) at a higher rate and a lower cost than its peers. While Mr. Buffett is best known as a great investor, he should perhaps also be considered the world’s greatest insurance company architect and CEO because the returns Berkshire has achieved on investment would not be nearly as good without the material benefits it has realized by financing these investments with low- cost insurance float.

For more than the last decade, Berkshire has grown its float at an 8% compounded annual growth rate while achieving a negative 2% average cost of float due to its profitable insurance underwriting, while incurring an underwriting loss in only one out of the last 15 years. These are extraordinary results particularly when compared with the substantial majority of insurance companies which lose money in their insurance operations and are only profitable after including investment returns. Furthermore, we believe that Berkshire’s cost of float will remain stable or even decline as its fastest growing insurance businesses (GEICO and BH Primary) have a lower cost of float than the company’s overall average.

Since the end of 2007, we estimate that Berkshire has averaged a nearly 7% annual rate of return on its insurance investment portfolio while holding an average of 20% of its portfolio in cash. Berkshire has been able to produce investment returns that significantly exceed its insurance company peers as the combination of the company’s long-duration float and significant shareholders’ equity allow it to invest the substantial majority of its insurance assets in publicly traded equities, while its peers are limited to invest primarily in fixed-income securities. We believe these structural competitive advantages of Berkshire’s insurance business are enduring and will likely further expand.

Berkshire also owns a collection of high-quality, non-insurance businesses, which include market-leading industrial businesses, the largest of which are the Burlington Northern Santa Fe railroad and Precision Castparts, an aerospace metal parts manufacturer. While Berkshire’s non-insurance portfolio is comprised of highly diversified businesses that have been acquired during the last 50 or so years, we estimate that the portfolio derives more than 50% of its earnings from its largest three businesses: Burlington Northern (>30%), Precision Castparts (~10%), and regulated utilities (~10%).

Burlington Northern is North America’s largest railroad which benefits from strong barriers to entry, industry-leading scale, and long-term secular growth due to rail’s cost advantages over trucking in moving freight over long distances.

Precision Castparts has a strong competitive position in complex metal parts and components manufacturing due to the stringent regulatory requirements in the aerospace industry, and an excellent future growth outlook due to a nearly decade- long backlog of aircraft deliveries that are required to support the world’s growing travel needs.

Berkshire’s regulated utilities business primarily consists of a handful of well-managed, highly efficient energy utilities that earn a reasonable return on equity while satisfying their customers’ and regulators’ desire for low energy prices. Berkshire’s regulated utilities business is relatively insulated from economic downturns due to the essential nature of the service it provides, which has allowed it to steadily grow its earnings during all phases of the economic cycle.

While we have utilized a number of different approaches to our valuation of Berkshire, we believe it is perhaps easiest to understand the company’s attractive valuation by estimating Berkshire’s underlying economic earnings power, and comparing the company’s price-earnings multiple to other businesses of similar quality and earnings growth rate. Using this approach, we believe that Berkshire currently trades at only 14 times our estimate of next 12 months’ economic earnings per share (excluding the amortization of acquired intangibles), assuming a normalized rate of return of 7% on its insurance investment portfolio. While generating a 7% return on such a large amount of investment assets is not a given—particularly in an extraordinarily low-rate environment—we believe that Berkshire’s ability to invest the substantial majority of its insurance assets in equity and equity-like instruments and hold them for the long term makes this a reasonable assumption. Based on these assumptions, we believe that Berkshire’s valuation is extremely low compared to businesses of similar quality and growth characteristics.

Berkshire’s current earnings are also meaningfully understated in the currently low interest rate environment as the company is earning a minimal return on its approximately $100 billion of excess cash which is invested in short dated, risk free assets.

Net of its excess cash, Berkshire currently trades at less than 12 times our estimate of earnings per share over the next year. Given the company’s strong competitive position, solid future growth prospects, large degree of excess cash and superlative track record of value creation, we believe that Berkshire should be valued at a large premium to its current valuation. Moreover, we believe an investor’s downside is limited due to the company’s fortress balance sheet, highly diversified business portfolio, and significant earnings contribution from recession-resistant businesses such as insurance and regulated utilities.

Furthermore, we expect that certain recent positive developments will highlight and enhance the per-share value of Berkshire’s business over the next several years. First, we believe that it is likely that management will intelligently deploy some of its $100 billion of excess cash into value-enhancing large-scale business acquisitions and/or a greater than historical amounts of share repurchases. We believe that this can be achieved because Mr. Buffett has built a deep bench of managerial and investment talent and a durable culture of character and performance.

Second, Berkshire created a new managerial structure in 2018 to elevate two long-time managers, Ajit Jain and Greg Abel who now directly oversee the insurance and non-insurance businesses. Both managers have a track record of improving operations under their purview. We expect this new management structure will empower them to enhance the operational performance of Berkshire’s businesses that have underperformed their peers. For example, Burlington Northern’s current operating profit margins are nearly 500 basis points below the average of its North American peers, and nearly 800 basis points below that of its best-in-class peer despite BNSF’s industry-leading scale. In Berkshire’s insurance subsidiaries, GEICO’s loss ratio is more than 800 basis points higher, and its underwriting profit margin about 400 basis points lower, than its closest competitor, Progressive Corp., and General Re’s expense ratio offers the potential for significant improvement based on our due diligence.

We expect that Berkshire’s enviable competitive advantages and the positive underlying growth trends in most of its businesses will allow the company to sustainably grow its earnings at a high-single digit rate without any operational improvement at its larger businesses, and without including the benefit of the productive deployment of excess capital.

If Berkshire can improve its operations and intelligently deploy a substantial portion of its excess capital over time, we estimate that the company’s earnings per share should grow at a mid-teens’ compounded annual rate over the intermediate term. In light of the company’s currently depressed valuation, understated near-term earnings, and the potential for significant future earnings per share growth, we believe that Berkshire’s share price is likely to increase substantially over the coming years.



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