Berkshire Hathaway -- New Valuation Estimate

As regular readers know, 99.9% of our research is directed toward dividend paying stocks. We follow dividends because, as it says in the masthead above, we believe they are more predictable than earnings and are an actual component of a stock's total return.

Having said this, for many years we have held Berkshire Hathaway in our Capital Builder style of management because we have found that BRK's price is highly correlated to changes in its book value and interest rates. Periodically, we update our valuation model on BRK using a multiple regression of its book value and interest rates relative to its stock price. Below is a chart of our valuation model going back 15 years. You will see that the fit is very tight and, based on the just-released data, BRK class A is selling just about at fair value of $109,500.

Using our internal estimates of the growth of BRK's book value and the changes in 10-year Treasury bond rates, we arrive at a year-end value for BRK class A of $119,800.

We think that is as good a guess as we can make, and in light of the slowing economy, we still believe BRK class A is a good hold for the year ahead.

BRK class B is 1/30 of class A, therefore its current projected year-end value is near $4,000 per share.

Our First Webcast -- Market Comments

In this our first webcast, Mike Hull and I discuss the stock market's recent run up and the prospects for its continuation. The webcast lasts about 20 minutes and covers a wide range of topics from the global economy to inflation, interest rates, Fed policy, and the areas of the stock market that we believe are most undervalued. Since this is our first shot at putting "voice" to our thoughts, please let us know what you think. You can also pick the winner of our little debate. (To start webcast, click the green play button on the player above.) gdonaldson@dcmol.com mhull@dcmol.com

Sock it to 'em Sarkozy

Nicolas Sarkozy won a bruising battle over his socialist rival Segolene Royal for the Presidency of France with 53% of the vote to 47%. This was as the polls and the betting parlors were predicting. I will limit my comments on the elections because I have written two previous pieces on the importance of the French elections to the global economy, but I would like to comment on the commentators. The main stream media in the US and abroad is essentially saying that Sarkozy's election does not mean much because the French are the French, and they have it pretty good. Nothing could be farther from the truth. France is bleeding from both ends of the financial spectrum and they know it. There is virtually no hope of landing a meaningful job for young immigrants in the country. They have become a permanent non-working class, and increasingly violent. Yet, their existence is subsidized by the wealthy, where taxes can reach as high as 72% of income. In recent years, the wealthy have been voting with their feet and moving to lower-tax countries. Sarkozy is very direct and he believes he has a mandate to get people off the dole and put them back to work. This will not likely be an easy job in a country that has large segments of the population that are anti-capitalist and rally under the banners of communists, socialists, and, yes, even anarchists. France is a colorful nation in every way, even in it politics. I am more optimistic than many and my reason is this. If the French are anything, they are proud. Indeed, they are the originators of the products that epitomize fine living: perfume, wine, design, architecture, cooking, etc,. Increasingly, these products and services are beyond the budget of the average French citizen, and there is a growing recognition that the bon vivant lifestyle that the French brought to the world is now slipping from their grasp. Sarkozy will have a very difficult time in putting France back to work, but he is said to be a very tough minded person, and I believe he will bring increasingly seen by the French as a man who can help them reclaim their glory. Recently, we bought our first French company, Axa, one of the world's largest insurance companies. We see two or three other French companies that we like, and if we can get them at our price, we will add them as well. Blessings,

Slowing Economy, Rising Stock Prices, Part 2

Greg Donaldson and Mike Hull write:

In our October 27, 2006, blog we wrote that while the economy would likely continue to slow, US and international blue chip stocks would likely continue to rally. The following is a quote from that piece:

"Markets seldom feel right because we human beings have a habit of projecting today's headlines onto tomorrows stock performance. Remember, the stock market is not a democracy. Prices move in the direction that big money pushes it. Fortunately, big money is normally rational and understands economic cycles and the power of the Fed to slow and speed up the economy.

Big money has a problem. The places where it has been treated well over the past few years are all rolling over. Treasury bonds yield are under 5% in most of the major industrialized nations of the world. Bonds simply are not competition to stocks. Real Estate and commodities are no longer competing effectively for investors against stocks because they are now in downtrends.

Blue Chip stocks, alone, stand out as a value now that bonds, real estate, and commodities have become over owned and over valued. Finally, blue chip stocks are in an uptrend. This positive momentum is a rarity in today's world's financial markets. As long as earnings growth holds near 10%, stocks will continue their strong advance."

Since we wrote that piece, stocks, as measured by the Dow Jones Industrials, have risen nearly 12%, including dividends, (an annualized return of over 20%) while the US economy has slowed to under 2% real growth.

And here's the answer to the question we are asked most often: Yes, stocks have room to go higher and the path of least resistance is up for the same reasons we explained in our October 2006 piece -- stocks are still cheap and they have no competition from other forms of investment. In addition, with economic growth having slowed and inflation cooling, the Fed is poised to begin lowering rates sometime in 2007.


The chart below shows our most recent update of our proprietary Dow Jones 30 Dividend Valuation Model.


As you recall, the Dividend Valuation Model is a single formula that is constructed from the associations between dividends, interest rates and prices. You might think of the green bars as the values predicted by the normalized relationship among the data points. The actual prices are shown as a blue line.

It is important to keep in mind that every green bar on the chart, which goes back 25 years, is produced by the same formula. By comparing the green bars, which we call "value steps," and the actual prices, it is clear to see that the fit is very tight.

The key areas to note on the chart are the late 1990s, when the value steps clearly showed that prices were overvalued, and the DJ 30's turn in 2002, which occurred almost precisely on the predicted "value step."

Since 2002, the chart shows that, even though actual stock prices have risen sharply, they have remained consistently in undervalued territory. The model currently predicts that fair value is near 14,100. That would be our best guess of where the market runs out of value, and where we would become less bullish about blue chip stocks.

Finally, the recent run up in stocks has been met with fear and not greed, as is the usual case in run ups. Everyone is now talking about pullbacks and the old adage of,"sell in May and go away." We have found that when USA Today or your local newspaper starts telling you to "sell in May and go away," that it might not be a bad idea to "buy in May have a nice payday by Labor Day." Granted its not as catchy as the original adage, but we suspect it will be more profitable approach this year.

Blessings,

Why the French Elections Matter

From an economic perpective, France matters because the European Union (EU) matters and the EU matters because it now totals 495 million people in 27 countries and has an economy larger than that of the US. The European Union is fast becoming a power in the world's economic order. Yet, while it has mass and some clout, because it comprises 27 different countries spread over thousands of miles and many languages, it does not have a unified political or economic structure that has been able to drive the big ideas in the world. France is not one of the largest members of the Union, but it has a prominence in the EU that gives it a cachet far greater than its size. France's prestige and importance come from three things:

1. It was an originator and charter member of the EU 2. France has long promoted the "third way" or middle ground between the US and its foes around the world. 3. France is a squeeky wheel in terms of its culture, language and desire for a position of power on the world stage. While France has authentic prominence and a clear desire to lead the EU, it's leadership has been thwarted because it has lagged most of the other nations in the EU economically. I described the reason for that last time: a lack of faith in the free and flexible markets for commerce and labor. Many observers now believe that the economic malaise in France has reached the proportions that the French people are willing to give up some of their state-sponsored security blanket for the greater economic growth and employment gains that they see bubbling up in countries that are following a more free market approach. If France moves politically and economically to the right, by electing pro-business Nicolas Sarkozy over socialist Segolene Royal, the entire economic world will be the winner, and Sarkozy will assume almost an immediate leadership role in the EU, and consequently the world.

France and much of Europe has tremendous untapped growth potential that is likely to blossom if Sarkozy can lower taxes on entrepreneurs and deconstruct France's maze of job-stifling limits on employers' hiring and firing flexibilities.

Over the past decade, the EU has grown at only about half of the rate of the US, England, Canada, and Australia, where more pro-business policies are in place. With a pro-growth President in France leading the way and offering the proper incentives, the EU could increase its rate of growth by nearly a third.

Finally, as country after country in the EU has adopted more business friendly policies, we have shifted more funds into companies in the region. We now hold between 15% and 20% of our equity assets in European companies.

If Sarkozy wins, we believe the opportunities for continued stock appreciation from companies in the region are greatly enhanced.

Below is the most recent Intrade.com betting line on a Sarkozy win in the election. It has risen from near 70% last week to near 80% today. Bettors are not necessarily voters, but these betting lines have been remarkably accurate in recent years.

I'll keep you posted on the outcome.

Ronnie,Maggie, and . . . . . . Sarko

The French go to the poles in the first of two rounds of voting for a new President this Sunday. The stakes could not be higher for this fading member of "old Europe." The twelve candidates running in the first leg of the voting, who represent everything from communists to Joan of Arc, will be pared down to a short list who will then face off again in two weeks. There are three candidates who are leading in the poles, Socialist Segolene Royal, Francois Bayrou, the centrist, and Nicolas Sarkozy, the conservative. There are more twists in this election than we would have in the US in five elections, but I want to comment on the eventual winner, who I believe will be Sarkozy(nickname Sarko). He is speaking Reaganesque, and the average Frenchman, no matter what they think of the US or Sarkozy, for that matter, knows that he is telling them the truth -- they live in a failed economy. French economic growth is among the weakest in Europe and less than a third of that of the US; unemployment is near 8.5%, almost twice that of the US and England, and their brightest and wealthiest citizens are leaving the country for lower taxes in Belgium and around the world. In an interview with the "New Yorker," Sarkozy said the following: " “In this country, work isn’t encouraged, it has no value. We’re in a crisis that comes from a very false idea of solidarity—the idea that you have to give as much to the person who doesn’t work as to the one who does. The élites have been wrong about this for decades. They have betrayed the idea of equality and given us egalitarianism.” I[ the "New Yorker" author speaking] brought up the grim projects across the ring roads of every French city—hundreds of neighborhoods where young people are so disaffected and angry that the police are reluctant to enter, and where Sarkozy himself is largely unwelcome to campaign. “The voters there aren’t scared of me,” he said. “They are the ones who ask me to do something. Why else am I in first place in the polls? I have been interior minister for five years. I am efficient. I get things done. I say this in my campaign: the risk isn’t change, the risk is to refuse change.” Sarkozy is saying exactly what Ronald Reagan and Margaret Thatcher said in the 1980s: that too many people are riding on the wagon and too few are pulling the wagon. France, absolutely, must give incentives for people to get off the government dole and disincentives for them to stay on it. Sarkozy is the only major candidate who remotely understands economics. He is the last best hope for France. If he loses, France, as we know it, may become nothing more than a kind of Disneyland of Europe -- beautiful old buildings, immaculately cared for, with lots of visitors, but everybody goes home at night. If the bettors can be believed, Sarkozy has a commanding lead. The chart below shows that at the online betting site, Intrade.com, he is favored by nearly 70% of the betting crowd. For the entire world's sake, let's hope they are correct. The French may be finally coming to terms with the abject falsehood of Leon Trotsky's assertion that capitalism would die under a workers' revolt. It is ironic that there now appears to be a "non-workers" revolt underway in France that will drive a stake in the heart of Leon, Karl Marx, and Frederick Engels.

US Bank's 80% Pledge -- A New, Old Idea.

US Bank (USB), the big Minneapolis based bank, has a continuing pledge, which they reiterate periodically, to return to their shareholders 80% of their earnings in either dividend increases or share buybacks. I know of no other company that has this specific a pledge. REITs, of course, by law must pay out 90% of their earnings, but USB is unique, as far as I know, in communicating a commitment to shareholders that even my elderly mother sitting in a small town in Indiana can understand. Pledges like USB's were common place in the early days of stock trading in the US when early traders on Wall Street gathered under the buttonwood tree. They had none of today's ever lengthening list of rules and regulations. Yet, somehow they made deals and bought and sold securities based on the "word" of the men who ran corporations in those days. Those were the days of "a man's word is his bond." Today things have changed. Now its "A man's bond is his contract, unless he or she can find the loop holes." I personally believe that salt-of-the-earth Americans are near a tipping point in their level of trust for corporate America and Wall Street. The images of both have been sullied by the incessant news of broken promises and broken laws by the people we have hired to run "our" companies. In company after company "fast and loose" is not a bad word; it is a way of life. The attitude seems to be: "D__n the shareholders. "Whose company do they think this is, anyway?" US Bank with their Midwestern mindset must be hearing the same things we are, and they are responding the way plain talking Minnesotans and Hoosiers do, by eliminating as much "maybe" from their conversation with their shareholders as possible. I think USB's 80% pledge will catch on with other companies trying to distance themselves from the bad actors. USB is a AA rated company that is currently yielding 4.7%, and over the last 5 years, they have raised their dividend by an average of 15% per year. We have been buying USB in our Income Builder style of management.