Why We Own Berkshire

A friend who is a rocket scientist (literally) at NASA once asked a simple question that most value investors would consider blasphemy: "So what's the big deal about Warren Buffett, anyway?" But it's a fair question, and it's worth answering.

The longtime Berkshire Hathaway chairman's mystique starts with his track record. With a net worth of $62 billion (and counting) by Forbes's reckoning, Buffett is the wealthiest person on earth, a position he achieved by producing perhaps the greatest long-term investing record in history. Thus, any investor who fails to learn as much as possible about how he achieved this success is, to use a favorite word of Buffett's partner, Charlie Munger, "bonkers."

There is a certain purity to the way Buffett has built his fortune. No exploitation of the masses, no monopolies, no giant inheritance. Simply by buying stocks, and later companies, over more than 50 years, he's turned his paperboy earnings into a fortune. Markets ruthlessly separate winners from losers, and no one has won bigger than Buffett -- ever. That's a big deal.

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A real mensch

But Buffett's appeal goes far beyond the fact that he's rich. Roger Lowenstein wrote in his biography of Buffett that his "character and career unfolded as a sort of public tutorial on investing and on American business." His willingness to share of himself and his knowledge gives his followers the impression that we know him and that he's speaking to us directly as he conducts this "tutorial." Is there another public figure -- a movie star, a politician, a CEO -- of whom we can say the same? Not that we can think of.

The way Buffett communicates -- with charm, clarity and wit -- also draws us to him. Others may have comparable insight, but he articulates it in a way we remember and quote endlessly. His description of competitive advantage as a "moat" is one example, as is this response to a student who planned to take a high-paying job before pursuing a more fulfilling career: "That's like saving up sex for old age." He even offers personal advice on how to be a better person: "You should think about what you like in other people and admire about them. Then ask yourself which of these traits are ones you physically or mentally can't have. The answer is none."

So what are the core elements of Buffett's ongoing investing tutorial? While it's impossible to reduce decades of investment wisdom to a few bullet points, here are a few of his investing tenets we try to abide by:

1. A share of stock is a share of a business. Lost at times in the breathless tracking of daily highs and lows is the fact that the value of a company's shares is ultimately tied to the free cash flow it can generate over time. That means you should put considerable emphasis on researching a company's strengths and weaknesses, the competitive dynamics of its industry, and how likely it is that in ten years its business will not be truly different than it is today.

2. Stick to what you know. Buffett often speaks of the importance of staying within your circle of competence when investing. "They don't give bonus points for difficulty," he says, so if you don't understand how a company makes money, go elsewhere.

3. Ignore the "cheery consensus." Independent thinking is not just helpful in becoming a successful investor, it's required. Conventional wisdom is already built into a stock's price, so if you find yourself agreeing with it, your upside will be limited. Or, as Buffett puts it: "You pay a very high price for a cheery consensus."

4. Value can mean many things. By his own admission, early in his career Buffett focused much more on quantitative measures of a stock's cheapness -- a low price-earnings or price-to-book-value ratio, for example. Over time (and with the prodding of partner Munger), he also recognized the tremendous value inherent in a company's ability to generate sustainable growth -- insight that helped lead him to the likes of American Express, Coca-Cola and Gillette.

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5. Doing nothing is okay. The scourge of many investors is the temptation, regardless of the market environment, to constantly tinker with their portfolios. On the buy side, Buffett advises to wait only for the "fat pitches" and ignore the rest. Sell a stock only when the market's optimism is clearly excessive. Buffett counsels: "Returns decrease as motion increases."

6. Never stop learning. What's both fascinating and challenging about investing is that the changing nature of business and finance means you can never have it all figured out. Those who stop learning get passed by. We'd argue that never succumbing to hubris and constantly challenging himself to learn new things are primary reasons Buffett has stayed at the top of his game so long.

Why we own Berkshire

The most direct way to benefit from Buffett's wisdom, of course, is to invest in shares of Berkshire Hathaway (symbol BRK-A) -- and the good news is that we think they're on sale.

For every stock we buy, we seek safe, cheap companies with growth potential, and Berkshire fits the bill. It has one of the few triple-A credit ratings in the world and is flush with more than $60 billion in cash and bonds. It has exemplary corporate governance and is overseen by perhaps the world's greatest allocator of capital. It is one of the fastest-growing large companies in the U.S., with the earnings of Berkshire's operating businesses having grown at an annualized rate of 23% over the past 15 years. We estimate that the stock trades at roughly a 20% discount to Berkshire's intrinsic value.

So how does one value such a large and complex company, which has more than 75 wholly owned subsidiaries? Our preferred approach is straightforward -- the same one we apply to valuing most businesses, in fact. We simply determine the worth of the company's investments (cash, stock and bonds) and then add the value of the oper-ating businesses. Given the entire portfolio's size and complexity, we defer to the year-end value Berkshire itself put on its investments in its 2007 annual report -- $90,343 per Class A share. While markets have gyrated since then and the company has paid out $4.5 billion for a large stake in Marmon Holdings, we don't believe these factors have changed Berkshire's intrinsic value materially.

The key, then, to valuing Berkshire is to estimate the value of its operating businesses, which run the gamut from Dairy Queen to Shaw Industries to Geico. These businesses, including profits from Berkshire's insurance subsidiaries, earned more than $6,000 per share before taxes in both 2006 and 2007. But because both of these were benign years for catastrophic insurance claims, a more reasonable estimate for 2008 pretax earnings is $5,500 to $5,700 per share.

Putting it together

The last variable is what multiple to place on these earnings. Given that Berkshire's operating businesses have shown remarkably consistent, rapid growth and range in quality from very good to some of the best in the world, we think a pretax multiple of 12 -- equivalent to a P/E of roughly 18 -- is reasonable.

Now the math is simple: multiply $5,500 to $5,700 by 12 and you get $66,000 to $68,400. Add the $90,343 of investments and you come up with an intrinsic-value estimate of $156,000 to $159,000 per share -- about 22% more than the mid-June price of about $129,400. (If you don't have that kind of spare cash lying around, you could instead buy Berkshire's Class B shares, each of which is worth one-thirtieth of an A share. The math is identical.) Our valuation includes no "Buffett premium," which we believe is substantial. It is simply the value of the businesses today.

It's beyond our circle of competence to handicap the date when Buffett may leave Berkshire, or the tangible impact on the company when he does. We have great confidence that the winning culture he has created will endure, and that the planning of his succession has been done with the same level of care and intelligence he's applied to everything he does.

As evidenced by his recent whirlwind trip to Europe to drum up potential acquisitions, it's clear that Buffett remains quite firmly at the helm. We're thrilled to continue along on the ride.

Columnists Whitney Tilson and John Heins co-edit ValueInvestor Insight and SuperInvestor Insight. Mutual funds or hedge funds co-managed by Tilson own shares in Berkshire Hathaway.