Your thoughts and questions; My updated Berkshire Hathaway valuation; Doug Kass' favorite tech and financial stocks; I spoke to U.K. students on Monday; Survey; Hempton agrees with Ackman; The counter-arguments; The case for a market bounce

By Whitney Tilson

Friday, March 20, 2020
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1) I’m always interested in hearing what’s on the minds of my readers – and never more so than now – so I’d be grateful if you’d share your thoughts and questions by sending an e-mail to: [email protected]. Thank you!

(If you want to follow my latest thinking on the coronavirus crisis every day, simply send a blank e-mail to: [email protected])

2) I just updated my valuation model for Berkshire Hathaway (BRK-B). It’s a simple one: take investments per share and add the value of the operating businesses, calculated by placing a reasonable multiple on the company’s pretax earnings.

At the end of 2019, Berkshire had $252,000 per A share of investments and $14,464 per share of pretax earnings. To this, I applied a 12 multiple – equal to a 15 after-tax price-to-earnings (P/E) multiple, which is well below market – to arrive at a value of $174,000 per share for the operating businesses. Adding $252,000 and $174,000 yielded intrinsic value of $426,000.

But the world has changed. Berkshire’s stock portfolio has taken a beating, earnings will be lower this year (though I think they’ll hold up better than most large companies), and multiples have compressed.

So, to arrive at a new valuation, I gave the stock portfolio a 25% haircut from its year-end value (in line with the decline of the S&P 500 Index), trimmed pretax 2019 earnings by 10% (they might be lower, but I’m estimating normalized earnings), and reduced the multiple on those earnings from 12 to 10.

This results in investments of $212,000 per A share and earnings of $12,674 per share (worth $127,000 per share), resulting in intrinsic value of $339,000 per A share (or $226 per B share) – a bit more than 20% lower than my estimate a month ago. That sounds very conservative to me.

And I’m being even more conservative because I’m not factoring in the value Warren Buffett will likely create as he puts his $128 billion cash hoard to work amidst this chaos: buying back his own stock in size, buying other stocks, and negotiating deals with desperate companies.

During the global financial crisis – the last time investors panicked and the market crashed – Buffett made a fortune by quickly putting more than $50 billion to work in preferred stock with warrants (on terms only he could get) in Goldman Sachs ($5 billion), Bank of America ($5 billion in 2011), and General Electric ($3 billion)… snapping up auction rate securities ($6.5 billion)… backing Mars’ acquisition of Wrigley ($6.5 billion) and Dow Chemical’s acquisition of Rohm and Haas ($3 billion)… and buying 65.4% of Marmon ($4.5 billion).

I continue to believe Berkshire is the “No. 1 Retirement Stock in America.” It’s the perfect investment for more risk-averse investors who want a stock that is likely to modestly outperform the market, irrespective of its direction.

Importantly for all investors – and especially retirees, particularly in times like these – it’s super safe. It’s an incredible collection of high-quality businesses… it’s run by the greatest investor of all time… and it has the ultimate, Fort Knox-like balance sheet: $128 billion in cash and short-term investments, $19 billion in bonds, and roughly $200 billion in liquid, blue-chip stocks.

And Berkshire’s intrinsic value is growing at a healthy rate – rising 17% last year, 10.8% annually over the past five years, and 13.5% compounded over the past decade.

Best of all, the stock is cheap. Berkshire’s B shares closed yesterday at $174.68 – a 23% discount to their intrinsic value.

3) As for other stock ideas, I agree wholeheartedly with my friend Doug Kass of Seabreeze Partners, who wrote this morning:

Tech and financials have my attention… here’s why!

Superior investment ideas today will be an outgrowth of the successful interpretation of the change that is afoot – the lingering impact of COVID-19.

For example, we will see a nontrivial change in the usage of office space, the reduced importance of brick and mortar retail, and reduced airline travel.

By contrast, we will likely see the proliferation and acceleration of emerging trends in video conferencing, working at home, shopping [online], and in the demand for cloud services.

That is why Alphabet (GOOGL), Amazon (AMZN), and Twitter (TWTR) are among my largest individual stock holdings.

In other words, Nasdaq over S&P!

Finally, in The Great Decession of 2007-09 the banks were the problem – they were leveraged over 35-1, had concentrated and risky portfolios, had irresponsible managements, and distributed financial weapons of mass destruction with gusto.

Today, banks will be part of the solution of resuscitating domestic economic growth. With excess capital, extremely low leverage ratios (10-15:1), diversified loan portfolios, the best management teams (in history), generational low valuations, and with interest rates likely to rise in the years ahead – when combined with the stock price degradation over the last two months – the reward vs. risk is remarkably attractive now.

JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C), Goldman Sachs (GS), and Wells Fargo (WFC) are my favorite names.

4) On Monday afternoon, I spoke via webinar for 38 minutes to Coventry University (in the U.K.) students who are members of the Investment Society. You can watch it here.

After introducing myself, I talked about the coronavirus crisis, what happened in China, why I think the U.S. and Europe will be able to control its spread in the near future, and why therefore I feel that it’s a great time to invest. I then answered some questions, and concluded with some life advice on developing good habits and becoming a learning machine.

5) If you didn’t have a chance to fill out the brief two-question survey I included in yesterday’s e-mail about how bad you think the coronavirus crisis will get in the U.S. (as measured by total cases and deaths by the end of this month, the end of May, and the end of the year), I’d be grateful if you’d take 30 seconds to fill it out – you can do so here. Thank you! I’ll share the responses later next week.

6) Australian fund manager John Hempton of Bronte Capital is no fan (to say the least) of Pershing Square’s Bill Ackman, but he’s in agreement with him on taking the strongest possible measures to stop the spread of the coronavirus. Here’s what he posted on his blog yesterday: Coronavirus – getting angry. Excerpt:

The right policy is not “herd immunity” or even “flattening the curve”. The right policy is to try to eliminate as many cases as possible and to strictly control and test to keep cases to a bare minimum for maybe 18 months while a vaccine is produced.

The alternative is literally millions of people dying completely unnecessarily.

What is required is a very sharp lockdown to get Ro well below one – and put the virus into exponential decay.

When the numbers are low enough – say six weeks – you let the quarantine off – but with Asian style monitoring. Everyone has their temperature measured regularly. Quarantine is rigid and enforced. You hand your phone over if you are infected and your travel routes and your contacts are bureaucratically reconstructed (as is done in Singapore). And we get through.

And in a while the scientists save us with a vaccine.

The economic costs will be much lower. Indeed life in three months will be approximately normal.

The social costs will be much lower.

Every crisis has its underlying source. And you want to throw as much resources (and then some) close to the source. Everything else is peripheral.

The last crisis was a monetary crisis and it had a monetary solution.

This is a virus crisis and it has a virology solution.

Asian Governments are not inherently superior to ours – but they have done a much better job of it than ours. The end death toll in China (probably much higher than stated) will wind up much smaller than the Western death tolls. I do not understand our idiocy.

John

PS. Longtime followers of this blog will know that I have rarely publicly agreed with Bill Ackman. I do here. This minimizes economic and social [costs] of the virus. I am not sure the stock market bounces hard with a rational policy, only that it minimizes the damage.

I regard the current course of English speaking democracies (other than New Zealand) as mass murder by the political elite. I think history will regard it that way too.

7) Not everyone is in agreement with Hempton and Ackman, however. Richard Epstein isn’t an epidemiologist – he’s a legal scholar at Stanford’s Hoover Institution – but he nevertheless makes the best case I’ve heard for why the coronavirus isn’t going to be anywhere near as bad as many fear. Coronavirus Perspective. Excerpt:

From this available data, it seems more probable than not that the total number of cases world-wide will peak out at well under 1 million, with the total number of deaths at under 50,000 (up about eightfold). In the United States, if the total death toll increases at about the same rate, the current 67 deaths should translate into about 500 deaths at the end…

Much of the current analysis does not explain how and why rates of infection and death will spike, so I think that it is important to offer a dissenting voice. In what follows, I look first at the trends in the American data, and then, building on my conclusions there, I construct a theoretical framework to evaluate the evolution of the coronavirus in other places.

Based on the data, I believe that the current dire models radically overestimate the ultimate death toll. There are three reasons for this.

First, they underestimate the rate of adaptive responses, which should slow down the replication rate. Second, the models seem to assume that the vulnerability of infection for the older population – from 70 upward – gives some clue as to the rate of spread over the general population, when it does not. Third, the models rest on a tacit but questionable assumption that the strength of the virus will remain constant throughout this period, when in fact its potency should be expected to decline over time, in part because of temperature increases.

8) Along the same lines, Victor Davis Hanson – also of the Hoover Institution – calls for a more measured response: Some Coronavirus Humility. Excerpt:

With new draconian measures of containment, we are entering the realm of cost-benefit analyses, given that for every drastic action there is an equally radical reaction – calibrated by everything from physical and mental health issues to economic, financial, security, legal, and political upheavals. Whether we like it or not, the current sweeping measures to curb the virus come at a huge cost – and the tab isn’t just financial or economic, as is sometimes alleged, by both advocates and critics of quarantines, cancellations, and radical social distancing. It involves health issues as well.

If the country goes into a serious recession or even depression; if trillions of dollars more of investment and liquidity continue to be wiped out while businesses crash and jobs are lost; if millions of unemployed cut back on their scheduled health care; if they increase their use of drugs, alcohol, or tobacco, and get less exercise and suffer depression holed up in their homes or must borrow or scramble to find daycare for their school-age children; if they even contemplate suicide – then the human toll spikes in concrete terms of life and death. In the long term, arming ourselves against the virus could be as serious as the virus itself, though to suggest that in these dark days of plague is heresy…

Issuing dramatic warnings can be as much about life-and-death decisions as not issuing them. Not going to work for those under 65 can pose as much a collective societal risk as going, and panic may be as deadly for a country of 330 million as infection is for those not in high-risk groups – and all such suppositions can change by the time this essay is read.

Humility, not certainty – much less accusation and panic – should be the order of the day.

9) Value Investors Club is my favorite site, by far, for stock ideas and discussion. I know the founders well, I was one of the first members nearly two decades ago, and I have been telling all of my friends and readers ever since that they should apply and become a member. It’s highly selective – a major reason why the ideas and discussion are so good – but even if you’re just a guest, you can still get a lot of value. Here’s a 2018 Barron’s article about it: Even Wall Street Pros Have a Tough Time Getting Into This Club.

Nearly all of the ideas posted on the site are for individual stocks, but occasionally someone posts a market call, as one member did earlier this week, making the case for a turnaround in the S&P 500. I’m reprinting it here, with permission from the site:

[I] want to make the case for [a market bounce].

The first question is how did we all miss this? I think the answer is quite simple: most of us are trained to think Chinese data is fake, so we heavily discount all information out of China – so hearing that China was quarantining tens of millions of people fell on deaf ears. Everyone also assumed the government would act with some basic competence (bad assumption), and they let the problem spiral to the level requiring massive intervention to stave off the extreme bear case (will discuss this more later).

To recap, where are we today is in the sharpest economic decline ever seen in US history – never before has the economy dropped off so sharply, so suddenly. I think this is akin to a consumer confidence crisis – it’s essentially the consumer version of the 2008 financial crisis. Many service, leisure, travel, and other consumption businesses are seeing an unheard of drop-off in business – OpenTable data suggests down 50% for some restaurants, others are reporting drops of 90% or more. Data shared on Twitter recently suggests the largest uptick in layoffs since 9/11 – and likely to get worse. I would [liken] what we are experiencing to a National 9/11. It seems likely we see a similar amount of deaths in the U.S. until this hopefully gets under control (I don’t say that lightly and pray for a better outcome, but as investors we have to go with the data).

Watching how Trump has handled this crisis has been pretty confounding and frustrating – but there are a number of reasons to be positive:

1. Thanks to the clever state vs. national separation design (thank you Founders!) – governors and local governments have wide latitude to institute draconian quarantine-like measures to help stem the spread. This has been put into place in every major area of the US – see the move by NY/CT/NJ today.

2. Trump, despite initially being in denial – has finally accepted the gravity of the problem. The more the market goes down, the more it forces him to act. Today I saw arguably the first ever maturity Trump has shown – he said the market will take care of itself and he just has to fix the corona issues. He seems to be finally heeding the calls of scientific / medical advisers, and it seems very likely Trump will enact additional extreme measures to help contain the spread. Watch the news coverage from today – even CNN, which hates Trump, admitted he had a dramatic shift in tone. Today he started taking the crisis seriously – very late, sure, and maybe he’s a terrible president – but nonetheless with massive action. It’s not too late to save this one.

3. The U.S. has the best innovation engine and research universities in the world. We will build more tests, faster tests, innovate on treatment and containment options, etc.

4. We are benefitting from the knowledge and learnings of China and Italy with regard to treatment and containment, so it’s likely that the case fatality rate and virality can be contained somewhat vs. current base rate estimates as we are essentially gen 2 of treatment / containment.

5. The federal government will do the biggest bazooka ever seen – they have no choice because if they don’t, half of businesses will be bankrupt – with clever actions like the Fed backing corporate debt / loans, providing needed cash assistance to workers/consumers, saving our critical transportation / lodging industries, etc. The government can prevent a depressionary spiral before it happens. The underlying economy is sound, we just need the crisis to abate and to kickstart spending again.

6. This is essentially a national consumer solvency issue. If everyone agrees to let everyone stay afloat, there will be no run on the banks per se (e.g., if your landlord agrees to give you a pass, your local grocer gives you a break). If Americans band together, we can avoid catastrophe here.

7. To paraphrase Buffett, for 244 years betting on America has been a wise bet. I expect that to continue.

Now that we’ve discussed the reasons for optimism, let’s discuss how to know when things will turn:

1. Over the next 1-2 weeks, I think the panic selling will likely continue. The main variable to track is the second derivative of cases, the growth rate. As long as this is constant or roughly constant, the selling will not abate – it doesn’t matter what the Fed or anyone else does.

I believe the epicenter of the crisis will be on the East Coast and LA most likely, and think the numbers coming out of NYC in particular will be particularly frightening.

2. The other major issues is the load on the healthcare system. If you do some quick math, many states like NY could become overwhelmed with patients needing serious care – that’s holding the facilities constant. We can fix this by aggressively building temporary facilities and importing / manufacturing additional medical devices – we are blessed with tons of vacant retail tombstones that can be repurposed into testing and treatment facilities, etc.

3. The key will be to watch when this turns. Right now the limiting factor on the number of reported cases is the ability to test and confirm them. As the massive efforts underway to contain the spread start to work, the second derivative of cases will start to turn – I expect this to coincide with around the bottom of the market.

Where can I be wrong? I think the only way this analysis proves wrong is essentially an end-of-world type scenario – which would certainly be unfortunate, but if it plays out I doubt stocks long or short will matter much.

Also, this is the crux of why I think the second derivative of reported cases starting to go down will lead to markets bottoming: the market right now is ascribing a nonzero chance to the extreme bear case of the world ending – because, sadly, it is a legitimate possibility right now given how negligent our government has been – but the more aggressive action we take, the more the market can discount this case asymptotically to zero.

If you told me three months ago that Trump was ordering a national quarantine, I’d guess markets would be down who knows how many points – but now I think the market would easily rally [5% to 10%] on that news, similar to when TARP was approved. Also, the coronavirus has already shut down the economy anyway, so quarantining now has essentially no economic cost. Our marginal cost is now zero and there would likely be almost no public opposition, given that almost everyone now appreciates the severity of the problem. Celebrities coming face to face with the virus and all sports being cancelled have done wonders to raise public awareness. The obstacle has become the way in many ways…

Best regards,

Whitney

Whitney Tilson

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About Whitney Tilson

Prior to creating Empire Financial Research, Whitney Tilson founded and ran Kase Capital Management, which managed three value-oriented hedge funds and two mutual funds. Starting out of his bedroom with only $1 million, Tilson grew assets under management to nearly $200 million.

Tilson graduated magna cum laude from Harvard College with a bachelor’s degree in government in 1989. After college, he helped Wendy Kopp launch Teach for America and then spent two years as a consultant at the Boston Consulting Group. He earned his MBA from Harvard Business School in 1994, where he graduated in the top 5% of his class and was named a Baker Scholar.

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