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Editor's note: This article has been updated since its original publication on Kiplinger.com on January 22, 2010 to reflect the latest developments in this story.
Look for a big pop in the price of Berkshire Hathaway’s newly slimmed-down shares when the stock opens for trading on January 27. The stock, which we recommended in early November after Berkshire, Warren Buffett’s holding company, announced that it would buy the 77% of Burlington Northern Santa Fe that it didn’t already own, will soon be added to Standard & Poor’s 500-stock index. Following S&P’s announcement on January 26, Berkshire’s Class B shares (symbol BRK-B) soared 8%, to $73.69, in after-hours trading.
The price of Berkshire’s B shares shrunk as a result of a 50-for-1 split that took effect on January 21. And that split is intimately connected to the Burlington deal, which is valued at $34 billion and is Berkshire’s largest ever.
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By buying Burlington, Buffett is making a major bet on the long-term health of the U.S. economy. The $100 per share that Berkshire, a crazy quilt of operating companies and a portfolio of stocks worth $57 billion, is paying appears to be a rich price. It represents a 31% premium to Burlington’s pre-announcement price and is 20 times the $5.01 per share that the railroad earned last year (Burlington announced fourth-quarter and 2009 results on January 21).
But Burlington may be worth more under Berkshire’s umbrella than as a standalone company. A railroad is a cash-intensive business, and Berkshire can use the float on premiums collected by its various insurance businesses to improve Burlington’s returns at low cost, says Larry Coats, manager of the Oak Value fund. The deal, which requires approval from Burlington shareholders and is expected to close in February, “has improved our outlook for Berkshire,” he says.
Berkshire is using its stock to pay for 40% of the acquisition costs. Buffett has long resisted splitting Berkshire’s famously high-priced shares -- the Class A shares, which did not split, closed at $110,700 in after-hours trading on January 26—but felt he had to do so now to make it easier for Burlington investors to take stock for the deal instead of cash. “I enjoy issuing shares at Berkshire about as much as I enjoy prepping for a colonoscopy,” Buffett told CNBC recently. “We gave the minimum amount of stock we can do in this. If we had to give any more stock, we wouldn’t have done the deal.” A single Class A share is now worth 1,500 B shares.
The split doesn’t change the value of anyone’s Berkshire holdings. Nor does a split affect any of the stock’s fundamental measures of value, such as its ratio of price to book value (assets minus liabilities), a key yardstick for valuing insurance companies, a major component of Buffett’s empire.
But the split makes the shares more accessible to investors who want a piece of Buffett, and has raised Berkshire’s trading volume. The higher volume is probably the main reason that S&P finally added Berkshire to the 500 index. S&P considers a stock’s liquidity, among other things, when deciding which companies to include in its indexes. Berkshire, with a stock-market value of about $170 billion, is the largest U.S. company not in the index. S&P will formally add Berkshire to the 500 after the Burlington purchase is completed, probably in early February.
Insurance, including high-profile Geico, accounts for about one-third of Berkshire’s business. Berkshire’s other units range from Diary Queen to Fruit of the Loom to The Pampered Chef. It also controls MidAmerican Energy, a collection of electrical utilities, and Marmon Group, a manufacturing conglomerate. Berkshire’s investment portfolio includes sizable stakes in Coca-Cola, Wells Fargo and Procter & Gamble. In the third quarter of 2009, Berkshire stocked up on behemoths, increasing its stakes in Wal-Mart Stores, ExxonMobil and Nestlé, the Swiss food giant.
Although valuing Berkshire is tricky because of all its moving parts, the stock does appear to be cheap, even after the lead due to the S&P announcement. The easiest gauge is the stock’s price-to-book-value ratio. The Class B shares have traded at an average of 1.5 times book value over the past five years. The shares now trade at about 1.3 times book value.
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