One of the biggest stories on Wall Street last week was the news Bill Ackman (Trades, Portfolio) decided to invest $660 million of his investors' money at Pershing Square into Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B).
Ackman has studied the Oracle of Omaha and his investment strategy for decades. He has also often attended the Berkshire Hathaway annual meeting, frequently asking questions about investing and Buffett's view on the market.
So in many ways, it makes sense that this well-known activist investor would invest alongside his mentor.
While the guru has carved out a reputation for himself as a very successful activist investor, this is not an activist position. Instead, it is a traditional value investment. Ackman believes Berkshire is undervalued, and he's put his money where his mouth is.
An undervalued turnaround?
Ackman's analysis of Berkshire, which was published in Pershing's half-year report last week, gives us some insight into his way of thinking. The investor presents his valuation model for the business (which I will cover later) and also details why he believes Berkshire has reached a turning point in its history.
Key to Ackman's thesis is the elevation of two of Berkshire's best managers, Ajit Jain and Greg Abel, to key positions in the company last year. Writing in Pershing's letter, Ackman said these two managers "have a track record of improving operations under their purview" and he expects "this new management structure will empower them to enhance the operational performance of Berkshire's businesses that have underperformed their peers."
Berkshire is generally considered to be one of the best-managed businesses in the Fortune 500, so Ackman's comments here do bring a new argument to the table. In the letter, he went on to say:
"For example, Burlington Northern's current operating profit margins are nearly 500 basis points below the average of its North American peers, and nearly 800 basis points below that of its best-in-class peer despite BNSF's industry-leading scale. In Berkshire's insurance subsidiaries, GEICO's loss ratio is more than 800 basis points higher, and its underwriting profit margin about 400 basis points lower, than its closest competitor, Progressive Corp., and General Re's expense ratio offers the potential for significant improvement based on our due diligence."
Ackman's letter reports that when you combine this potential for operational improvement with the conglomerate's fortress balance sheet, market-leading position in many markets and reputation across the insurance industry and Wall Street for being a successful steward of capital, Berkshire looks like a no-brainer growth investment.
His analysis shows Berkshire is trading at less than 12 times earnings net of cash:
"Net of its excess cash, Berkshire currently trades at less than 12 times our estimate of earnings per share over the next year. Given the company's strong competitive position, solid future growth prospects, large degree of excess cash and superlative track record of value creation, we believe that Berkshire should be valued at a large premium to its current valuation. Moreover, we believe an investor's downside is limited due to the company's fortress balance sheet, highly diversified business portfolio, and significant earnings contribution from recession-resistant businesses such as insurance and regulated utilities."
Berkshire after Buffett
One of the biggest debates in the value community for some years now has been what will happen to Berkshire after Buffett.
Ackman's analysis seems to suggest he believes Berkshire will not only continue to grow after its current CEO and chairman departs, but will thrive under the management of Jain and Abel.
Ackman also says the market doesn't really understand this potential because analysts are spending too much time focusing on Berkshire's track record as an investor and investment vehicle, rather than as an operating business.
Looking at Ackman's analysis, it is easy to reach the conclusion Berkshire will be able to compound investors' capital at an attractive rate of return for many years to come, even without Buffett at the helm.
Disclosure: The author owns shares of Berkshire Hathaway.
Read more here:
- Bill Ackman Buys Berkshire, Says Investors Are Undervaluing the Business
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- Bank of America Was Warren Buffett's Favorite Stock Last Quarter
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This article first appeared on GuruFocus.
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