An Update on the Valuation of Berkshire Hathaway

Berkshire Hathaway, recently, released its earnings for the second quarter and the numbers were impressive, again driven by their insurance divisions. As I studied the data, it quickly dawned on me that BRK-A has had a remarkable run in earnings and book value growth since the Katrina trajedy.

I also heard the echos of Warren Buffett during those days foretelling exactly what has happened. BRK-A with it AAA bond ratings and its penchant for taking risks --at a price--that more risk averse firms could not or would not take, would become even stronger as a result of the Gulf-coast hurricanes.

Now our country is facing another crisis. This time self-inflicted. The big banks and pools of money in this country are backing away from much of the less-than-prime mortgage companies, and without funding, these companies are falling like dominoes.

Berkshire Hathaway owns lots of building related businesses, but the one that intrigues me is manufactured-homes giant, Clayton Homes. In that business, Buffett has a whole company that is used to dealing with credit issues in the subprime arena.

With all the big banks pulling the plug on the subprime loan business and with a company in his portfolio that has trained and experience people used to dealing with subprime issues, it is not a stretch to think that Mr. Buffett may show up on the scene somewhere in the current subprime mess. That is how he does things.

He was quoted once as saying that he likes to make investments that are like shooting fish in a barrel . . . with the water drained. Well, Mr. Oracle sir, in the subprime mortgage business, the water has left the tank. You do the picking and we'll go with you.

With the new earnings and book value data, I have updated our valuation model, as shown above on the chart. The year-ahead projected value shown in the green stripe is over $128,000 per class A share. That would translate into almost $4,200 per class B share.

As usual the model's prediction is based on my guesses about earnings and book value growth over the next year, but you can see that the fit has been pretty tight, over the last 15 years, between the model and the actual prices of BRK-A.

We own the stock in our Capital Builder Investment style.

Pepsico: The Right Thing

It has been a complete mystery to us why Pepsico has had such a flat year price wise when their earnings and dividend growth has been so outstanding. Over the past 12 months price growth
for PEP has only risen just over 5%, while earnings have grown nearly 13% and dividends have grown 18%.

We always caution clients that even though there is a tight correlation between dividend growth and price growth for many stocks, that it may take two to three years for price growth and dividend growth to come together.

In the case of PEP, however, the last twelve months seemed primed for the second-largest soft drink company in the world to be a big winner. It has been gaining market share from long-time rival Coke; it has benefited from the weak dollar; it is the leader in non-carbonated beverages, the fastest growing segment of the soft drink business; its Frito-Lay division is continuing to extend its brand; and the Quaker Oats division, which was a part of the Gatorade purchase, has been adding new products at a rapid pace.

The only reason I can see for the lacklustre performance was the retirement of Chairman Steven Reinemund. Everyone remembers that when Coke's Chairman Roberto Goizueta died in the late 1990s, the company would flounder for nearly a decade before finding a leader that the Coke army would follow.

Will the story repeat itself with Pepsico? I'm betting it won't. Pepsico is a much more decentralized company with many powerful brands contributing to the overall success of the company. Coke was much narrower in its product line and much more centralized in its management style.

Goizueta became a bigger-than-life Wall Street CEO, and the admiring-analysts drove Coke's price to the moon, even though the evidence was clear that Pepsico was catching them in many key parts of the world.

Indra Nooyi is the new CEO of Pepsico. She has had a string of successes at Pepsi, and her management style will come more into view in the years ahead, but Reinemund built a very deep bench of potential replacements should she not be able to lead the charges.

Now that the management change has been made, Wall Street appears to want to sit on it hands and wait for Ms. Nooyi to impress them. I think that will be a mistake because Pepsi's brands and deep pool of management talent will continue to propel them almost no matter who is the nominal CEO of the firm.

This may sound like I have some doubts about Ms. Nooyi. I do not. I have studied her resume, and it is impressive, but I have no idea how she will do in her new job. There are always risks in top management changes, but I think the risks are diminished when a company has the positive momentum that Pepsi has.

The Dividend Valuation Chart above shows that PEP is undervalued. Our model's best guess for the year ahead price is shown in the green striped bar at the far right. That price is nearly $80 per share, which is nearly 20% higher than the current price. You know that I can't see the future, but I would not be surprised if PEP reached $80 in the year ahead. With all of the worries about real estate, subprime loans, and the strength of the US banking system, Pepsi's worldwide presence selling a relatively inexpensive product, which has remarkable profitability just might be the "right thing."

Real Estate and Mortgage Woes Do Not Mean a Recession is Inevitable

Yesterday American Home Mortgage, a specialized mortgage company, lost 90% of its value, when its lenders refused to advance the company more funds to meet its reserve requirements and lending demands. When the news was announced, the Dow Jones was higher by over 100 points, after the news hit, the market immediately turned lower and finished down over 100 points, wiping out hundreds of billions of stock market value.

The question that everyone is asking is how much more bad news are we likely to get from the mortgage and real estate businesses, and do their problems have the potential to endanger the banking systems and the economy?

Here’s my short answer. From what I read, American Home Mortgage’s –AHM -- biggest problem was that their banks pulled the plug on them because of the falling values of AHM’s underlying collateral, so it was not necessarily a case of them being swallowed up in sea of bad loans.

The big banks and investment banks in the US, in an effort to protect their own assets, have begun to cut off additional loans to all but prime mortgage credits. This will likely lead to more headlines for specialized mortgage lenders who are forced into bankruptcy because of being cut off by their lenders. So the answer to the first part of the question is the mortgage mess will be with us for a while, yet.

Having said this, I do not believe the odds are very high that the problems of the subprime and specialized mortgage lenders will cause severe damage to the major banks in this country or to our overall economy. My reason for saying this is that the banks in this country entered the year 2007 in as a good a financial position as they have been in 20 years. The best way to look at this is to compare the cumulative financial condition of the major banks at the beginning of 2007 with their condition when they entered the last period of financial stress, which was in the late 1980s—to early 1990s, resulting from the S&L debacle and a severe pull back in corporate profitability.

The table shows that there is little comparison between the financial position of the major banks today and that of 1989.

Today the banks’ equity capital as a % of assets is 60% higher than it was in 1989; non-accrual loans (loans on which the bank is not receiving

payment), at 0.5% of total loans are only about 20% of what they were in 1989; the banks’ current loan loss reserves (money that is set aside to cover potential losses) is 274% of their actual loan losses, compared to 1989, when loan loss reserves were only fractionally higher than actual losses at 102.5%. Finally, At the beginning of 2007, actual loan losses were only 2.3% of equity capital compared to an 11.2% rate in 1989.

The bottom line is the banking system is strong, and I believe it can withstand the current real estate and mortgage problems very well.

The stock market is retreating because of fears that the banking system will be threatened by the current mortgage mess, which will result in a recession for the whole economy.

The best argument against that line of thinking is the aforementioned strength of the banks, but beyond that is recent US economic data. US Gross Domestic Product was just reported to have grown 3.4% (annualized) in the second quarter and the US unemployment rate has remained steady at only 4.5% of the workforce. Remember these data occurred simultaneous with the bad news in real estate and mortgage lending. Finally, if a recession were imminent, the Federal Reserve would have an obligation to start cutting rates.

As I mentioned in my last blog, I listened to the quarterly earnings reports of three of the biggest banks in the country. None of the three reported big jumps in loan charge offs, or greatly increased their loan loss reserves. And, to remind you, two of the three increased their dividends more than we were predicting.

Gyrating markets are not much fun for most people, and they always raise the question: “What are these stock worth, anyway?” If all you are only looking at prices, you might decide that stocks aren’t worth very much, but when you look at companies from the perspective of the cash dividend they are paying and the dividend's rate of growth over the long-term, another picture becomes clear. Many companies are veritable cash flow machines and will be worth more in 10 years than you can imagine.

Cash dividends are real money and determining the value of companies that have long histories of raising their dividends is much easier than it is for companies who must be valued on earnings alone.

As I have said in these blogs before (see my series on The Rising Dividend Story on the side bar)[from the beginning], it was during the severe market correction of October 1987 that our Rising Dividend investment style was born. I knew those dark days would pass because I was convinced the selloff was not fundamentally driven, but I did not know what to buy, and so I sat on the sidelines and let one of the best buying opportunities in the history of the capital markets go by. Now 20 years later, we have a few pretty good valuation tools, and they are signaling that some truly wonderful companies are being put on sale (some of which we already own). I don’t think we need to be in a big hurry, but there are a few that I have been trying to buy for a long time. I’ll be discussing some of those companies in the days and weeks ahead.

Table and data from BCAresearch.com and FDIC

Viewing the Market Selloff from the Perspective of a Dividend Investor

By Greg Donaldson and Mike Hull Yesterday's 300 point loss in the Dow is not the end of the stock market nor the demise of our clients' assets. Every time the stock prices fall like water out of a boot, everyone throws their hands in the air and tries to shield themselves from the pieces of sky that surely must be falling. The sky is not falling, and neither will every bank in America collapse in the face of the housing debacle. Stock prices will gyrate and the media will pontificate on all the things that are wrong, but that is their way -- to fan the fires, so they can sell more kindling. We listened to three earnings calls this week: Wachovia, Wells Fargo, and Bank of America. These are three of the largest banks in the county, and all are deeply involved in the mortgage market. None of these companies said they were seeing big increases in their non-performing credits, and none said that they were experiencing big defaults in their loan portfolios. Two of the companies, Wells Fargo and Bank of America, signaled their confidence in the future by hiking their dividends, 11% and 14% respectively. How can these companies raise their dividends in the face of all this bad news and falling stock prices? Two answers: 1) These companies have strong balance sheets and their earnings are good. They are confident that they will come through this challenging mortgage market just as strong, if not stronger, than they are today. 2) They know that stock prices have nothing to do with their fundamental businesses. We love dividends because they ignore what is going on today. They reflect, in large part, the track record of the company paying them, and they give us wonderful insight into what their leaders believe about the future. This week Bank of America raised its dividend 14%, to $2.56. That means that an investor buying BAC today could expect to receive a yield of 5.4% in dividends over the next twelve months. And, we're betting BAC will raise that dividend by at least 7% per year year over the next decade. At that rate of growth, BAC's dividend in 10 years would rise to $5.12 per share. That would mean that based on today's price of $47 per share, in 10 years, BAC would be offering a yield on today's cost of 10.8% ($5.12/$47). Now let's compare that to a riskless 10-year US Treasury bond. Today the yield on a 10-year T-bond is 4.8%. BAC's current dividend yield of 5.4% is higher, but let's face it T-bonds have no risk, so based on yield alone we would not choose BAC over the T-bond. However, when we factor in the dividend growth of only 7%, which is much less than their dividend growth over the past decade, BAC offers a much better potential total rate of return over the coming decade. We would be much more worried about the economy if the major banks were not in such good financial shape. All three of the banks we mentioned earlier have at least a AA rating, as reported by Bloomberg. These are solid outfits run by seasoned managers. These companies, like so many of our other "Rising Dividend" companies, are attractive just from their dividends alone. However, when you add in the their prospects for future dividend growth, they are tough to beat by pure growth investments. Pure growth investing requires that an investor buy right and sell right because the timing of these two actions determines the entire rate of return. That is why the stock market is correcting right now. For traders, when the markets start to fall like they have this week, they must sell out fast or risk losing all of their gains. With dividend investing, our rate of return is much more a function of the cash flows that we receive while we "own" the stock. Thus, from the perspective of we dividend investors, if we are happy with the dividend growth and financial strength of a company we own, a big selloff in stocks is an opportunity to add to our positions and look for other solid, dividend-paying companies that the market is "putting on sale." The panic of the day will scare the traders and they will do what they always do-- run -- and this correction in the market may last a while longer. In the end, however, cooler heads will do their homework and conclude that many stocks are too cheap, and that the mortgage mess in this country will pass, like all the crises before it.

Dividends Talk: Bank of America -- Wow!

Ok, I have been on a 30-day Wells Fargo watch and today's 10.7% increase was much better than I had expected. No sooner had I started to figure out why the hike was as generous as it was when one of our readers announced that Bank of America had hiked its dividend 14%. BAC's 14% hike has the effect of nearly striking me dumb(almost) : either they are complete idiots and a hike of such magnitude is equivalent to paying people to be their friends, or it is an honest signal on their part that their business is getting better, since last year's hike during the the 'good real estate days' was only 12%. I'll say it, so you won't have to: "So, Bank of America, et al, what about this nasty real estate balloon that is crashing against the jagged rocks; don't you see that you are going to lose a lot of money over the next couple of years as you foreclose on all those houses overlooking the Pacific ocean, or the Atlantic ocean, or the Gulf of Mexico. Doesn't that thought make you want to hold on to your precious cash. Aren't you worried that global warming will make West Virginia the new Florida (I'm just kidding here) and all of your so-called Sunbelt loans, shall we say, become 'Wetbelt loans?' Your 14% dividend hike is an insult to the intelligence of the New York Times. They say that banks are in trouble, and that investors should look at China, because it is the new California (I am kidding here, too). May I say in the nicest possible terms, 'Are you nuts?' Do you realize that your dividend yield in tomorrow's New York Times, Wall Street Journal, and Evansville Courier and Press will show 5.34%? That does not compute. You mean that your business is good enough to pay people more than they can earn from a 30-year US Treasury bond and throw in what ever growth you have over the next 30 years for free? You can't fool me. The New York Times is a bastion of capitalism, and if they say banks are in trouble, you are in trouble whether you know it or not. Of course, its interesting that the New York Times did not announce to the world that they were in trouble, too; that readers were abandoning them for the Internet and graffiti on subway walls. I don't remember them saying that they had bought a newspaper in China at the time that you bought a bank there. Maybe, just maybe they are the fools, not you. Maybe, just maybe, your dividend hike is an honest to goodness sharing of your blessings with your shareholders. Naw, surely not that. No one does something for nothing anymore."

Dividends Talk: Wells Fargo, Good Very Good

For those of you who have been on the Wells Fargo dividend watch for the last 30 days, the oracle has spoken, and the news is good, very good. Although, the headlines tomorrow will be filled with tales of the woes of subprime loans, mortgage defaults, and the Dow's 200 point fall, there is good news in Mudville. Wells Fargo, which is as deep into the mortgage business as any bank in America, and thus, not only sees the data but lives in it, has raised their dividend by 10.7%. In my previous blogs on this subject, I said anything above a 9% hike would be a signal that WFC believes that a bottom for the mortgage mess is in sight, but more importantly, that they are gaining market share and will come out of this real estate bubble stronger than they went in. That is a remarkable thought in itself, since WFC is already one of the highest rated firms in the US. There will be those who argue with me that this 10.7% hike is not connected to their forward view of their business prospects , but that it is a payback for the past year. That is bunk. Last year, with earnings running in the mid-double digits, they raised their dividend only 7.6%. I said in an earlier blog that that soft hike was one of the reasons that we concluded that the housing slump was going to be longer and deeper than was generally thought at the time. Our thinking then was, if WFC was a bit bearish on their future prospects, that was news because they have had such a great record over the past two decades at gauging the business climate. It is important to note that WFC is not a pure mortgage bank. They now cover the financial spectrum of financial services, so this solid dividend hike is not a pure reflection of the mortgage business. Having said that, their mortgage busines is so big that if they were bearish on this part of their business, it would have resulted in a smaller dividend hike. I'm convinced of that. Bank of America and Wachovia are due to announce their dividend hikes in the coming months. With WFC having put the pressure on them, with this double-digit increase it will be interesting to see the sizes of those companies' dividend hikes. Dividends talk you know. You just have to listen.

Real Estate, the Banks, and the Ugly Brush

In our investment policy meeting this morning the question was raised, what are the leading indicators of a bottoming in the real estate mess. Almost in unison, we all agreed that the best leading indicator of real estate in these bad times is the same leading indicator in the good times, the banks. However you look at it, the banks are the biggest players in the mortgage market. They have the relationships with the homeowners, and they are the primary sellers of mortgage products to the average consumer. What is not well known, is that most banks then sell off their mortgage originations to Fannie Mae and Freddic Mac, the quasi-governemental agencies, thus minimizing their potential losses. As a result of the almost incredible financial shenanigans practiced by Fannie Mae and Freddie Mac in recent years regulators have forced both firms to limit their rates of growth. This has opened the doors for big banks across the country to become more active in the mortgage holding business, as opposed to just the mortgage origination business. Wells Fargo, Bank of America, Wachovia, as well as Washington Mutual and Countrywide Credit have stepped into the gap left by Fannie and Freddie. As a reminder, this is the "traditional"(good credit with down payment) mortgage loan business, not the subprime loan busniess(nothing from nothing). Even though most of these firms have continued to report fairly good earnings, with few alarming upticks in loan losses, investors are painting all of them with an ugly brush. The clear message is that investors believe that the subprime woes will spill over into the traditional mortage business and, at the least, surely these companies got greedy and have a slab of loans they wish they didn't. We are believe that the majority of these firms were able to say no the real estate sirens who were claiming that no price was too high to pay for "that house down the street." They are all survivors, and they must have been aware of how anxious all the private pools of money were to take on these risks. We are betting most of these firms stepped aside and let the greater fools ply their trade, without holding on to too much foolish merchandise themselves. Remember Wells Fargo -- WFC -- is due to report their dividend increase within the next few days. Our call is this: 1. A 5%-7% hike would be a negative sign that would mean that no end is in sight for the real estate troubles.

2. A 7%-9% hike would indicate that the real estate business is wounded, but the bottom is in sight.

3. A hike above 9% would mean that the bottom in real estate is not only in sight, but WFC is taking market share.

We will have an analysis of WFC's decision after their announcement. We will also run a number of banks through our Dividend Valuation Models over the next few weeks and share the results.