There are many plausible explanations for this strong showing. One of the most obvious is Berkshire’s relative lack of tech exposure. Although Berkshire’s largest position is Apple (AAPL), the rest of its portfolio has little tech. That fact alone can account for some of this year’s outperformance, as the NASDAQ-100 is currently lagging the S&P 500 for the year.
After peaking in November of last year, US tech went into a bear market. The NASDAQ peaked at 16.057; since then it has fallen to 12,795-a 20.3% decline. In the meantime, traditional “value” sectors have fared decently well. bank stocks are down only 8.5% year-to-date, while energy stocks are up for the year. Utilities are also doing comparatively well.
Berkshire Hathaway has significant exposure to the outperforming sectors mentioned above. Its second largest holding after Apple is Bank of America (BAC). It has a collection of energy and utility subsidiaries. Just recently, it disclosed a position in the energy firm Western Petroleum (OXY). Although Apple was 48% of Berkshire’s portfolio as of the most recent disclosure, most of the rest resides squarely in the value realm. This is a desirable characteristic for a portfolio in 2022. With interest rates rising, investors are much more skeptical of growth stories this year than last year. The higher the “risk-free rate,” the lower the present value of a growing cash flow. So, value is comparatively more attractive than growth today.
All of this bodes extremely well for Berkshire Hathaway. Its portfolio consists of diversified holdings, mostly in value sectors, and the one big tech play it has on its books is among the more “mature” tech stocks out there-definitely not one of the speculative plays that’s giving the NASDAQ grievance this year. So there is reason to think that Berkshire will continue outperforming for a good while longer. Perhaps, for the remainder of the year.
Now at this point, you might say “sure, Berkshire is pretty well suited to today’s market conditions, but pure-play energy stocks are doing even better. Why should I buy Berkshire when I could go long energy stocks and make even more money that way?”
I don’t necessarily disagree. Energy stocks could well beat Berkshire this year. But keep in mind what happened to tech investors. If you go chasing alpha in the energy sector without regard to price, you could end up just like they did. Berkshire Hathaway stock gives you some energy exposure, in a fairly diversified package. Furthermore, you know that the company’s managers aren’t overpaying for their energy bets, because they adhere to a value philosophy that counsels respect for the margin of safety. For this reason, Berkshire could be considered a form of “disaster insurance” that provides a portfolio with a level of safety that even indexing can’t match, making it an ideal investment for uncertain times.
Margin of Safety – a Staple of Buffett’s Investing Philosophy
In order to understand how Berkshire Hathaway can function as “disaster insurance” in a portfolio, it helps to understand a staple value investing concept:
Margin of safety.
A stock’s margin of safety is its discount to its intrinsic value. This discount provides a safety buffer against market volatility because a stock’s price should at least equal what its assets and earnings are worth, given enough time.
Let’s say you have a stock that costs $1. The underlying company owns $10 per share in assets, $8 per share in debt at 1% interest, and EBIT equaling $0.8 per year. We’ve got enough earnings here to cover the interest expense but no more than that, so we can think of this stock simply in terms of the value of its assets. $10 minus $8 is $2. The stock costs $1. So if you could buy this company outright, you’d be able to double your money by selling off all the assets and retiring all the debt. That’s a margin of safety.
In the real world, things are often more complicated than this. Notably, as a small time shareholder, you don’t have enough influence to simply liquidate a company for salvage value. As a passive shareholder buying the stock described above, you may find that the company’s earnings dry up and management loses the ability to pay the debt. In that scenario, the value of the assets would likely decrease. But in principle, if an investor consistently buys stocks with the “margin of safety” principle in mind, they will enjoy positive returns over time. Were the stock market to not recognize the company’s intrinsic value, shareholders could lobby management to pass value to them in other ways; say, through dividend increases.
Even more importantly, portfolios built according to the margin of safety principle avoid the biggest investing mistake of all:
Participating in bubbles.
Because a value investor consistently buys stocks with a margin of safety, they will by definition avoid overvalued stocks. They may own a stock that becomes overvalued later, but they will never buy a stock after overvaluation sets in. The margin of safety puts a floor on their potential return-assuming the strategy is executed perfectly. As an individual investor, you may attempt to make some value investments only to find out later that your intrinsic value calculations were imperfect. That could lead to poor returns. Fortunately, you can buy Berkshire Hathaway and enjoy the portfolio management skills of an investment team that has grown book value at 20% CAGR over 57 years.
How Berkshire’s Strategy Avoids Bubbles
As we have seen, Berkshire Hathaway has grown its portfolio at 20% CAGR over 57 years-20.1% CAGR, to be precise. That’s one of the best investment track records of all time. But it’s not necessarily one that outperforms every year.
Until recently, Warren Buffett and Charlie Munger had been thought to have lost their touch. Berkshire was underperforming the S&P 500 for several years, up until early 2021. There was no shortage of think pieces circulating about how value investing was outdated, how Buffett had lost his touch, and so on.
It was in February 2021 that things began to change.
That month, the Ark Innovation ETF (ARKK) hit a high of $156. After hitting that high, it began a downtrend that lasted all year long. That was due to a selloff in growth stocks that began around that time. For a while, mega-cap tech was unaffected. Goal in November, the NASDAQ Composite hit a high of 16,057, and proceeded to fall from there. Eventually, the entire index entered a bear market.
It was in this period when the ARKK and the NASDAQ were declining that Berkshire was beginning to outperform yet again. For 2021, BRK.B pink 27%, beating the S&P 500 in the same period. The outperformance continued into early 2022, when Berkshire rose 6% compared to substantial negative returns in the S&P 500 and NASDAQ.
Why did Berkshire outperform?
Obviously, the fact that its earnings beat expectations was a big part of it. That goes without saying. Still, it leaves open the question of why Berkshire’s earnings have been so good. Or put differently, why its investments have worked out so well.
In large part, it appears that simply avoiding bubbles is a big part of why Berkshire’s portfolio is doing so well. If you look at the Ark Innovation ETF, a lot of its holdings were soaring up until February of 2021. People were touting the fund’s 150% one-year return. But when the bubble in innovator stocks popped, ARKK went on to drop 69%. Not only did the people who bought the top lose money, most people who bought in 2020 lost money as well.
It was exactly the opposite for Berkshire. BRK.B mostly avoided the family of growth stocks that crashed 90% or more last year. It had some tech exposure in the form of Apple, but that’s not down a whole lot. Why isn’t it down as much? Because it has a margin of safety. A complete analysis of Apple stock is beyond the scope of this article, but suffice it to say, it has:
So, there is theoretically some stock price at which Apple would be selling for less than it’s worth. There are countless stocks that can’t be said about. Any stock with negative earnings is worth $0 if historical results continue indefinitely-it requires a catalyst to kick in before a discounted cash flow analysis can even be done on it. Sometimes, such speculative bets work out. But when these kinds of stocks get very expensive, they, as a family, tend to fall quite dramatically. In the 2000-2002 dotcom crash, several went bankrupt and were delisted. Berkshire holdings like Apple don’t face this problem. So, Berkshire tends to outperform during “shake out” periods when companies go broke.
We can conclude this article with a brief review of Berkshire’s financials-its most recent earnings, its balance sheet, and its valuation.
Berkshire’s most recent quarter beat analyst expectations on both the top and bottom line. In it, the company delivered:
$4,904 in GAAP earnings per share (beat by about $653).
$71.8 billion in revenue, up 11.5% (beat by $28 billion).
$7.3 billion in operating income, up 45% (beat by $1 billion).
Both the top line and two separate earnings metrics beat by large percentages. It was a strong showing.
The long-term averages are strong too. According to Seeking Alpha Quant, Berkshire has produced five year CAGR growth of 5% in revenue, 26% in EBIT, and 52% in free cash flow. Terrific growth, especially for such a large company.
Berkshire’s balance sheet is excellent. Some key metrics include:
$958 billion in total assets.
$146 billion in cash and equivalents.
$105 billion in long-term debt.
$443 billion in total liabilities.
$514 billion in shareholder equity.
That gives us a healthy debt-to-equity ratio of 0.2, which indicates a very healthy balance sheet.
Given the combination of strong growth, strong profitability and financial soundness Berkshire has, you would think that it would come with a premium price tag. But in fact, it trades at just 8 times GAAP earnings, 2.6 times sales, and 1.4 book value. The stock is only trading at 40% more than the value of its assets, net of debt! Overall, it is a solid value play, just like the stocks it invests in.
So, when we look at Berkshire’s earnings, balance sheet and valuation, it becomes evident that it’s a worthy buy in 2022. Sure, there are value plays you could buy that may rise more than Berkshire-energy stocks, for example. But you never know when a bubble will break out in any of those stocks and you’ll lose money buying something overpriced. With Berkshire, you get a good collection of value stocks and businesses that were hand picked by the best value investor of all time. There’s always the risk that Buffett’s successor won’t perform as well as he has, but that’s a risk I’m personally willing to take. Berkshire’s portfolio has stood the test of time.