Client Letters June 2005

Buffett, in a private conversation at the annual meeting, indicated that he felt that Berkshire was trading below its intrinsic value, but that it was not yet sufficiently discounted for Berkshire to start buying the stock on the open market.

So what is the point at which Berkshire will start buying the stock back? While we can only guess what it is today, we do know what it was in 2000 when Buffett offered in his chairman's letter to buy the stock at $45,000 or less. The table below shows where the buy-in point would be today with the indicated assumptions about the long-term growth rate of Berkshire's intrinsic value. The table assumes a uniform growth rate, and growth in intrinsic value is, of course, never uniform. However, over time the lumpiness does tend to average out.

Keep in mind that Berkshire's intrinsic value would be a lot higher today if Buffett had been able to invest the $45 billion he has in cash in long term investments at what he considers a satisfactory rate. So while Berkshire's value may have grown at only 8% to 12% for the last five years, it is likely that it will be able to grow at a somewhat more rapid rate in a different market environment (a bear market).

Based on Growth in Intrinsic Valve of:

Year	6.80%	8.00%	10.00%	12.00%	14.00%
2000	$45,000	$45,000	$45,000	$45,000	$45,000
2001	$48,060	$48,600	$49,500	$50,400	$51,300
2002	$51,328	$52,488	$54,450	$56,448	$58,482
2003	$54,818	$56,687	$59,895	$63,222	$66,669
2004	$58,546	$61,222	$65,885	$70,808	$76,003
2005	$62,527	$66,120	$72,473	$79,305	$86,644
2nd Half	$64,653	$68,765	$76,097	$84,064	$92,709
2006	$66,779	$71,409	$79,720	$88,822	$98,774
2007	$71,320	$77,122	$87,692	$99,481	$112,602
2008	$76,170	$83,292	$96,461	$111,418	$128,366

Assuming that we can tolerate these generalizations, what does the table say? If you assume Berkshire's intrinsic value is growing at a 10% annual rate, the buy-in point at the middle of 2005 will be $76,097. If you assume 12% growth, the buy-in comes in at $84,064.

It is obvious to every one that the company can no longer sustain its historic growth rate of 23% to 24%. But even at Berkshire's present size, 10% to 12% growth does not seem to me totally unreasonable, what with the leverage it gets from its insurance float.

For a graphical representation of the data on Table One, see the chart below. The 6.8% line represents the rate of growth of per-share book value for the period since Buffett's stock purchase offer in March 2000. Buffett has been quoted as saying the Berkshire's intrinsic value has been growing much more rapidly than its book value, so we can use this line as bottom range for the growth in the buy-back price. Actually the bottom of the range must be somewhere above that line since intrinsic value has been growing faster than book value.

Last week Buffett was criticized by Patrick McGurn, senior vice president of Rockville, Maryland based Institutional Shareholder Services, which advises fund managers on governance.

"He has a very iconoclastic view of corporate governance that I don't think anyone but Warren Buffett could get away with," says McGurn. "That could come back to hurt them as people look at reinsurance practices at Berkshire."

The Board of Directors, he said "is composed exclusively of business partners and friends—including Microsoft Corp. Chairman Bill Gates..." In addition McGurn says the lack of a successor isn't a joke...

"Berkshire Hathaway is probably the riskiest company in America today because it's one heartbeat away from a substantial diminution in value," he says. There it is, that nasty Buffett premium again. This is an issue that has come up again and again in the last few years, but just how much of a Buffett premium is there in today's price? I would argue that at today's price, that premium is just about zero.

But, "The riskiest company in America?" This would be absurd even if there were a huge Buffett premium in the stock, and there is not. For a man in this guy's position, it is too bad that he never learned to read a balance sheet.

In the stock market, anything that is obvious is discounted. so as soon as something becomes well known, it is in the price of the stock, and while it's probably true that Buffett will not be around for ever, it is possible that market has already discounted his exit.

The fact is, Berkshire holds the world's largest pile of cash and the stock is very illiquid. On Friday June 3, for instance the NYSE traded 147 class A shares and 6,550 class B shares. This represents a total value of something like $30 million, at that rate Berkshire would trade something short of $2 billion dollars worth of stock in a Quarter (assuming 65 trading days in a quarter). This that means that Berkshire could buy every share of stock traded on the NYSE and basically do it out of cash flow without dipping into their $45 billion. While Friday's volume was below recent trading levels, it is not too far from the long-term tend.

So in Berkshire's case, a buyback is the real deal. Warren, if he wanted to, could have the stock trade at or above today's price until Berkshire had purchased every share outstanding (of course this would take ten years or so and the stock is not likely to stay this cheap that long). Because of Berkshire's cash and cash flowm Buffett's buy-in price is effectively an absolute floor. I doubt that there is any other company that could buy its float out of cash flow. Instead of being "one heartbeat away from a substantial diminution in value," Berkshire at today's price probably carries less risk than any other publicly traded stock. It is not necessary for Buffett to be here to initiate a buy-back as long as there is someone around who can sign checks.

At last year's annual meeting, Buffet said that while the day he dies will be a bad day for him, it will not be a bad day for shareholders. This could be just more of Warren's Omaha shtick, but I took it to mean (among other things) that the buy-back price is real and that somewhere in his desk there is an envelope that lists the price and gives instructions to his successor. The bottom line is that as the market price approaches Buffett's buy-in price, there is no Buffett premium because Berkshire will be buying stock whether Buffett is present or not. In fact, we could see a price increase at his departure due to the fact that his absence would make a buy-in more likely if the company is without Buffett to make capital allocation decisions.

So what is that buy-in point? This is something that only Warren and Charlie know, but we can guess that it is somewhere between the 6.8% and 12% lines on the above chart. We know it is above the 6.8% line because Buffett has said that intrinsic value is growing faster than book value, and we know that it is not between the 12% line and the 14% line because the stock has traded in that area several times in the last five years and there has been no offer from Berkshire to buy the stock.

Table Two indicates that the operating portion of Berkshire has been growing rapidly in the last five years. Total revenues grew at a rate of 21% per year, operating earnings at 20.8% per year, and cash flow (which I have defined for this exercise as reported earnings plus growth of the insurance float) at 17%. These figures are not that far from the numbers that Berkshire has been turning out for the last 20 years, but with 2004 revenue of $74 billion, Berkshire is simply too big to grow at anywhere near 20% in the long term future.

	1999	2004	Growth Rate
Per Share Book Value	$37,801	$55,824	6.8%
Revenues (Millions)	$24,028	$74,382	21.0%
Operating Earnings (Millions)	$2,450	$7,677	20.8%
Cash Flow (Millions)	$4,200	$9,200	17.0%

We do not know if, or at what price, Buffett will start a buy back program, but if he were to do so at a relative value close to the price he struck in 2000, in my opinion it would not be to far below the today's market price. The rates of growth shown on Table Two would lead you to believe that Berkshire's growth in intrinsic value is a lot closer to the 12% line than it is to the 6.8% line.

We have been hearing for so long about this Buffett premium and the universal assumption has always been that there will be stock decline when he leaves. I would like to suggest, just for the sake of being argumentative, the possibility of a Buffett discount and propose a scenario where the stock price will increase in his absence. It seems likely the stock is very close to the value level it reached in March of 2000. Buffett may be reluctant initiate a stock buy-back for any number of reasons. He may well believe that he will have a better use for the money in the not-too-distant future, or he may just not want to pump the stock at this particular time. Absent Buffett though, and we have a totally different set of circumstances. Take $10,000 off the Class A stock today and I think the buy-back is pretty compelling. Further, without Buffett, the buy-back threshold is likely to rise substantially simply because, what does the new guy do with all that cash? Without Buffett, the case for returning money to shareholders is much more compelling.