We chatted with Mr. Loh Wei, an experienced private investor. Loh Wei is one of the most disciplined and experienced investors I know. I saw down with him to dig his brain on the favourite company among value investors; Berkshire Hathaway. Many of us might love Berkshire Hathaway, but not many is able to explain Berkshire Hathaway so elegantly as Loh Wei. I learned a great deal from him, and I know you will too.
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Disclosure: Loh Wei owns Berkshire Hathaway at the point of the recording. Stanley owns Berkshire Hathaway and Apple Inc at the point of the recording.
Stanley: Let’s go. Hey, Loh Wei, how are you?
Loh: Hey, Stanley, good to be here.
Stanley: Yes. Hey, thank you so much for being on our investing ideas. And you know, we try to talk to a wider range of investors possible in this show so that to get a different view from a different type of investors, both part-time and full-time investors. You yourself has been a full-time investor for quite some time. Why don’t you share a little bit about your own investing journey, how you got started into investing and when you first get started, how would you describe your investment start at the beginning?
Loh: So, I got started into investing in, right before uni. I was in army and I was thinking about how to be rich, how I think is possible to not work for a living. And I’ve got a good friend who introduced me to a book, he told me that, oh you know this guy invest and got 24% per annum. So I thought it was some MLM that he’s asking me to join. And so I asked him, tell me more about it. And then after a while, he gave me the book. The book is the Intelligent Investor. So that’s how I got my first book. But I didn’t understand Intelligent Investor at first.
So I started reading around the books, all the books in the Chua Chu Kang library I was in. So, I did was I started reading systematically from top right to bottom right from the Chua Chu Kang library. Every week, I’ll go through about four books and after a while, I realized that, oh, value investing is something that really talks to me and I think I know a bit of things about it. Yeah, that’s how I first got started.
And then in SMU, I did an accountancy degree, so then I’ve got the tools to now do the analysis that’s required of a value investor. And then applying the tools at what in the sense of investing my own money, it becomes a lot more fun to learn in school too. And so, I started really investing my own money from 2006 all the way into 2008-2009 into the financial crisis, out of the financial crisis and then for the past 10 years since the financial crisis. That’s how I got started.
Stanley: Let’s talk a little bit about the financial crisis. You kind of just came through. You know, you went through the financial crisis like is no big deal. But we probably started out investing around the same time. I also started around 2006. I remember the financial crisis being quite traumatic experience for me. Why don’t you talk us through as well for you, how were you feeling at the time when your stock started to crash and then how do you basically went through that crisis?
Loh: Well, maybe I can start a bit before that. 2006, 2007, when everything is going up, whatever I buy goes up, whatever I buy gets privatized also. I thought I was like really, really great investing. Some of the very good things that I bought and it immediately got privatized including things like Cerebos, the one that sells a Chicken Essence. So all these are like one beggar, two beggars within like 10 months, one year. So, I thought was really, really great investing.
So, come 2007-2008 things, that was holding started to go down a bit I think it was April and then it goes down a lot more in October and then let’s say, no, not even more. The idea of value investing is buying things that are cheap. But I realized that when I don’t know the real value of the things I own and the value declines as the market declines, I can’t do value investing well.
So, for example, one example that I like is my experience holding American Express, so I thought American Express, one of the Buffett holding, it must be very safe. One of the biggest credit card company in the world, very safe. I did my valuation, I think in early 2007 and I think the company is worth about $60-70 per share, it was selling around that amount also and then financial crisis started. Prices went down to 40-ish, I started buying. Then it went out 30-ish, I bought more. Then it went down to 18, I do not know what to do. It went down all the 10, I froze. The reason being I don’t know where the American Express will be a going concern during a financial crisis, so that’s when I realized I don’t know why I’m owning and I realized I cannot analyze financial firms clearly.
So at that time, I didn’t do much, I just watch it go down and down and down and my portfolio is all in red, is about 70% down from peak to bottom. But I was very lucky that my mom had money lying around, so I did a term loan from her, a 3-year term loan that was start to mature at the point when I start to graduate, I’ll pay her back using my salary. So with her alone, I started by industrial company, are the companies that I know very well, for example, consumer companies.
So I think at the depth of the crisis, I bought a lot of Hsu Fu Chi. Hsu Fu Chi is one of the Chinese candy company that sells candy can be called Sa Chi Ma and no matter how I analyzed, Hsu Fu Chi is worth about twice or three times the market price, so I bought a lot. I bought so much at one-third of my portfolio and one-third of my family’s portfolio was in Hsu Fu Chi. And right after the financial crisis, I think around August of 2009, Nestle privatized the whole of Hsu Fu Chi for a very nice price and a huge premium over the price I’d pay. So, then I started being very defensive in all my investment style knowing that if the financial market is not accommodating, can this company go on and that became the groundwork of my investment style.
So over the years as my ability to analyze improved, a lot of the stocks I buy are value stocks with potential catalysts. For example, potential privatization candidates, if there’s the read, that might be a rights offering this and the price and things like that where there are catalysts around. So, one example, would be Capital Mall Asia being a spinoff from Capitaland and then going nowhere for a while. But Capital Mall Asia is definitely worth more than the price that was selling at then. So I was luckily after a while, Capitaland decided to privatize Capital Mall Asia.
Another candidate I bought that was privatized because the price is just cheap by then make a lot of it will be Capital Learn. So, remember a few years ago, there was the oil crisis and my expectation is that Capital Cop as a group will want to stabilize their sources of revenue and CapitalLearn has a very good stable source of recurring income from a rental income. So, it is a potential candidate to be privatized. So I think what’s earlier about half of RNAV and I thought they will privatize it at one-time RNAV, so I’ll make like one-time my money eventually, Capital Dprivatized Capitaland, but they only privatize at 0.8 or 0.7 RNAV. So, I made a bit, but that is a very comfortable type of things to own, where you know that even if there’s a financial crisis around the corner, it won’t go bust and if there is no financial crisis, it probably will go up. If it doesn’t go bust, it doesn’t go up, it will also do okay, giving you 3-8% return. So that that’s how my style of investing has evolved along the way.
Stanley: Right. Okay, I can see that you really give a lot of thought into creating your portfolio. But I wanted to understand also during the financial crisis when you say your portfolio drop about 70+%, what give you the confidence or I guess, maybe the arrogance that you think that you can recover back the loss? Because a lot of people might at that time just freeze and then panic sell everything and say that you know, I will stay away from stock market forever and this is not something that’s not for me. How do you overcome that or is it something that never really occurs to you?
Loh: The pain of opening my brokerage account definitely occur to me where my neck would tense up, my hair would stand behind my neck before I click login, right? But I think the faith in the value investing method got me through the period. When I look back at my losses during that period of time, my inability to average down, it is due to the fact that not value investing doesn’t work, is the fact that I couldn’t tell what is the actual value or the range of value of certain companies, for example, financial companies under distress.
But for certain industrial company, certain consumer goods company, for example, Johnson & Johnson, at the depth of the financial crisis, it was selling at 7-10 times free cash flow… You look at all three segments of Johnson & Johnson, there is no way all three of them would disappear due to the financial crisis, its balance sheet is really, really solid. Then what I should you be buying, buying things I understand, buying things that will not go bust even if the financial crisis is prolonged. And even when I go look at things like Hsu Fu Chi that I mentioned just now, the confidence I get from that is during that period of time, I was watching TV, CCTV, oh, Hsu Fu Chi was he having promotions on CCTV. I asked my friends in China who are on exchange in Shanghai to go to their different supermarket. Hsu Fu Chi is selling all their candies at the entrance of all the supermarket, so that their goods are really moving.
You look at the balance sheet, they have not much debt. You look at the four brothers that run Hsu Fu Chi, they moved in to work with their workers during the financial crisis. So I cannot imagine a scenario where Hsu Fu Chi would go bust even if the financial crisis prolong and that give me the confidence to buy a lot of such safe good growing company selling a P/E of maybe 8-12 times which is not available any time since the financial crisis early.
But those giving confidence in them in the business, confidence in their balance sheet, confidence in their management and then eventually, confidence in the range of valuation that come up with that I can believe in. Yeah.
Stanley: Wow. Okay, it’s definitely very insightful. And you talked a little bit, I believe that, you know, your style of investing, I can relate to and it’s basically talking about finding a safe bet first, right, a company that will survive no matter the economic environment out there. And when we talk about value investing, of course, most of us will be inspired by Warren Buffett. And today, interestingly, you are going to talk more about his company, Berkshire Hathaway. Yes, it is a stock that many value investor will love and maybe most believers that would own them. But it is also one of the most complicated business that I have come across. Doesn’t it go against your kind of your philosophy or finding things that simple and easier to understand? Basically, how long did it take you to fully understand what Berkshire is really about?
Loh: I think it took me four years to understand what Berkshire is about. I think in 06-07 during the financial crisis, as you enter the financial crisis, what I did was I printed out every single Berkshire letter all the way to his first letter and started reading in chronological order, so I basically see how it started, how it grow, how it change over time. I honestly don’t understand most of what I’m reading during that first year.
Then in 2009, I went for the Berkshire Hathaway meeting. That’s when, even though I did not understand the stock well enough, I bought Berkshire B because I wanted attend the meeting. So I bought like I think 3K worth of Berkshire B with the little bit of brokerage account I got exchange from my past to enter Berkshire doing anything.
And during the meeting and after the meeting, I continued reading and understanding more about Berkshire. I think I gained full confidence in investing in Berkshire in 2012 and 2013 where I felt like I really understood all the different moving of Berkshire and what exactly it means to own Berkshire Hathaway. I felt it might look complicated, yes, a lot of moving parts, a lot of subsidiaries. But ultimately, I think I look at Berkshire as a machine, a machine that is so well all and so well created that it can help but compound wealth.
And once I understand the machine and how it works, the nitty-gritty part about how this particular insurance work, how the particular operating company work is not that important, it is simply a capital allocation machine that is bound compound wealth over time. And if we can buy this machine at a reasonable price, we are bound to compound our well at least the same rate as underlying return of the machine itself.
Stanley: Let’s dive down a little bit deeper when you talk about how this is a capital allocation machine. Right? So right at the top, why don’t you explain a little bit, what is Berkshire Hathaway, what are we looking at?
Loh: So, a lot of people think of Berkshire Hathaway as Warren Buffett’s company. I think the most common wrong impression of people is that they think of Berkshire Hathaway as a portfolio of equities that Buffet pick. It is actually not as simple as that. Yes, the equity portfolio is one part of Berkshire Hathaway and a very important part, but actually the most important part about Berkshire Hathaway today is its insurance business.
As an insurance company, we own Berkshire, so as the insurance company, we actually receive premiums from our customer to protect them against some future risk. So, when we collect the premium upfront, the risk event could be something 5 year, 10 years, 50 years down the road. Meanwhile, this premium that I’ve collected is available for me to invest. What do I invest in? I invest in stocks, in bonds, in cash. And for Berkshire Hathaway’s case, they invest in both equities, short-term investments, cash and also buying whole business.
So, having this insurance business that generate this premium, Buffet call it float, it’s not the most valuable part about Berkshire Hathaway. Because float essentially, a liability, but a liability that not only, you don’t have to pay off immediately, no one can call any upfront so about the financial safety part. Wat more is if you manage to do right, underwriting profit on your float, the underwriting profit of the float is essentially a negative interest cost. So you make money not only by borrowing from a customer, you also make money by investing it, you make money through underwriting profitably. So, this is two sources of wealth that comes from insurance business.
In terms of the moving parts, we can look at Berkshire Hathaway as an insurance business, a group of non-insurance business and tons of cash and this super big marketable securities portfolio and that is the three or four moving parts of Berkshire Hathaway. And once you understand these four moving parts, actually, Berkshire Hathaway is pretty simple to understand even though it took me almost a decade, 6-10 years. Yeah.
Stanley: Yeah. You describe some of the moving parts of Berkshire, the different parts of Berkshire itself and why it makes it such a beautiful money-making machine. But when you look at it, yes, you say the great thing about Berkshire is because it has this insurance business but if that’s the case, why do you think that other insurance company has not been able to emulate Berkshire and have a similar success of Berkshire?
Loh: So, I think one part of Berkshire success is Buffet’s ability to allow all his insurance companies to not write policies when the prices are bad. So, now imagine you have a room full of employees, the rates are bad, insurance business basically is a commodities business. Individual companies cannot dictate the rates. When the rates are bad, the only sound way to underwrite profitably is to don’t underwrite. But if you have a company full of employees, you got the boss, Stanley, would you allowed time to just sit around and just drink coffee all day?
Stanley: Probably not.
Loh: Yeah. So, you would ask them to do something. Right? And if their job is to underwrite policies, then they will start going out and underwrite policies. Right? So why Buffett is quite unique in the sense that he told his managers that if you need pay them to go play golf, pay them to go play golf and not to underwrite new policies when the rates are bad. To have that one mindset through and through again is actually very hard, because most companies crave actions. And Berkshire Hathaway is one of the only business I’ve seen where inaction is always greater strength, so the only strike when the rates are good. They only buy companies when things are cheap. And most time, they wait, they sit around, not doing much. Yeah, like [inaudible 18:44] very, very hard to emulate.
Stanley: Almost very Zen like.
Stanley: Yeah. Why don’t we go into more details of each of the part that you talked about? You talked about its non-insurance control business, let’s dive into that first. What are some of the main non-insurance control businesses?
Loh: So, some of the main non-insurance control business, the biggest two is actually BNSF, which is a railway company. I think it is the largest railway company in the United States, so it has the largest railway network. It moves goods around, tons and tons of goods. The second biggest company in Berkshire Hathaway’s non-insurance control business is the energy business, Berkshire Hathaway Energy. Berkshire Hathaway Energy owns and distribute and create energy for a large part of Mid-America. So Mid to West America is mostly supplied, a lot of energy supplied by Berkshire Hathaway Energy. Within Berkshire Hathaway Energy, you have your home services of America, which is their home brokerage company.
So, other than that, there is still a lot of industrial companies like Precision Castpart and Marmon Group, ISCAR, these are all industrial companies that has very niche business. So, all of them are very high return on capital for the other companies. For BNSF and Berkshire Hathaway Energy, these are two regulated business so they do not an insane amount of return on capital. They earn enough. But one of the great thing about Berkshire Hathaway is that for BNSF and Berkshire Hathaway Energy, they absorbs a lot of capital to make more money. So, this absorption of capital can be a place where Berkshire Hathaway puts their insurance flow into so that it owns enough written on the float. So, it absorbs the excess liquidity from Berkshire Hathaway’s insurance business.
And the other thing is both BNSF and Berkshire Energy is a very capital-intensive business. Especially for Berkshire Hathaway Energy, there is a lot of renewable energy that they are doing. When you do renewable energy in the States, you get tax credit for doing green stuff. So, the tax credit from Berkshire Hathaway Energy for any other utility firm, if it’s not on the Berkshire Hathaway will be useless because you’re going to be paying tax for the next 10 years, 20 years, 30 years. And for Berkshire, because there’s so much profit going on at other part of business, this tax credit can be used absorb other part of business. So, this Berkshire Hathaway Energy itself simply by the fact that is owned by Berkshire Hathaway becomes a lot more efficient because the tax credit can be utilized immediately.
Stanley: Right. So, let me get this straight. Berkshire Hathaway Energy, basically, when they say that they’re going to build, say, wind farm, they’re one of the largest wind farm in Midwest. So, when they build a wind farm, they will they will have tax credit on their capex?
Stanley: And then they can transfer this tax credit to other part of Berkshire Hathaway or it must stay with…
Loh: Apparently so.
Stanley: Okay, that’s very interesting. Is it the same for BNSF as well?
Loh: So, BNSF, they don’t get this additional tax credit. But BNSF, due to simply timing issue of accounting versus tax accounting, you will see that BNSF because when you are spending a lot of your capex upfront, your tax depreciation rate could be, so for example, you’d appreciate your railway in tax life over three years. But the real way has a thirty-year useful life. So, because you depreciate at a tax level faster than at the accounting level, you have this different tax liability that appears. So this different tax liability is a liability on Berkshire Hathaway’s consolidated balance sheet, but you do not need to pay taxes for a long while. So that is another way where tax benefit are moved around.
Stanley: Okay. In the sense, doesn’t it means that, you know, we can expect in the future when Berkshire try and make full all acquisition, it will be towards more and more capital intensive businesses so that?
Loh: I feel that has been the way since mid or early 2000 and that is the reality where Berkshire is so big. It needs to buy things that absorb cash, instead of just throw up cash, because the insurance business is already throwing up so much cash. See’s Candy doesn’t need cash at all, you only need cash for a few months in the year and for the rest of the year, throwing out cash. But you can grow See’s Candy fast, but you can grow a railway company by laying more tracks, doing more capital expenditure fast. And the incremental return on the type of expenditure base of over interview Buffett and Munger has is between 8-12%. 8-12% return on incremental capital on a regulated business seems to me a pretty good return on your capital, yeah, plus you can borrow. Yeah, so then the rate might be even slightly higher than that.
Stanley: Right. So basically, they are just trying to use it almost like fixed deposit for their [crosstalk 24:37]
Loh: A fixed deposit that gives you a 10% return, I think that’s pretty good.
Stanley: Yes. Okay, fascinating. And let’s move on to their second big block of value which is coming from their collection of equity, right. And then this is the part where most people think of Berkshire when they are looking at the company. Berkshire has predominantly been very focused on investing away from tech, but we can see in the recent few years, but Buffett himself has been buying Apple and previously, he has a failed attempt in buying IBM, his investment. So, how is the collection of equity looking at now and how should investors be looking at this basket of stocks right now?
Loh: So as of 31st December 2019, that basket of equities is of about $248 billion. The cost of this basket of equities is $110 billion. So, they have like $148 billion worth of unrealized capital gain on this.
So, if you look at this group of equities, a lot of them, Buffet do not think of them as pieces of paper that you treat. He typically look at this companies as partial ownership in other businesses. And from that point of view, which is why in a recency NBC interview, he told Becky that, Buffett told Becky that the largest subsidiary of Berkshire Hathaway is actually Apple. Biggest Apple on paper is well like 73 billion, right. So is actually, the largest subsidiary of Berkshire Hathaway. So, even though he own 5.7% of Apple, he looks at it as a subsidiary, even if they own only say, 0.6% of Visa, while Visa is still our subsidiary, in the sense, 0.6%.
So, the real rate for our investor to look at this group of equities is to go through this idea of look through earning. From accounting point of view, earnings are only recognized when it is paid out in dividends. And with the recent tax gap changes in US accounting, even and realize gain or losses are booked through your P&L. By the way, Buffet looks like this would be if imagine if you own 5% of Apple, 5% of total Apple earnings regardless of whether it is realized as dividend or retain earning as within earning above 5% of Berkshire’s earning. So which is why in this years annual report, you’ll see that Buffet actually break down the retain earning portion of all his big investment.
And what I would do as investor, I would remove away the unrealized skin that is booked through the gap earning, but add back the retained earning portion that Berkshire actually owned is entitled to, but it’s not distributed as dividend. That’s how I would say I would look at this group of equities as a group of companies that is retaining earning and working for Buffet without him working for them and that’s how I would look at all my investments. So in that way, Buffet is my employee… You know, I own just a little bit of Berkshire Hathaway.
Interviewer: Yeah. I think just from the way he described this collection of equities in his, I know like this and also how he constantly talk about owning them as a part ownership of a business really show us how Buffet really things about stock investment. Right?
Interviewer: But he has been talking about this for almost 50 years of how he invest, why do you think it is a concept that is so hard for general investor to grasp? And although, we hear this over and over again, but in the stock market even among value investors, right, like I still at least meet many investors that doesn’t think in this way. Right? They would still be fearful when they stock prices drop. They will still feel very smart when their stock price rally regardless of whether that is due to just multiple expansion or the company is really earning more. So, in your own opinion, why do you think this concept is so hard to grasp and to really emulate compared to what Buffett is talking about?
Loh: I think the main reason is it sounds too simple. There is no real arithmetic and complex equations behind it. Essentially, it requires the person who is a portfolio manager to think and behave like a businessman. And I just feel that most portfolio managers don’t want to put in the effort of businessmen to understand their businesses as well as the businessmen would.
So, imagine if you are a small owner of a coffee shop, I bet that you would be looking around your estate for any new competitors coming up. If people are having a new promotion, you’ll be eager to follow and try and see how to upbeat your competitor as a business owner. But a lot of people who invest in stocks still see them only as pieces of paper that quotation that goes up and down. The concept of business ownership through investing, I think that’s not naturally attract investors. First, is boring, then it’s a lot of hard work. And if you can think like a businessman, there is a very high chance that you would be very rich just by running a business, without not running a portfolio.
So, then you see there’s this there’s a tension between the talent pool. If you are that good at business analysis and running business, then you should be a businessman to be very, very rich. If you are good at analyzing, but you can take action and don’t really know what’s economics of your business, you might as a portfolio manager. And this portfolio manager, if he does not eat his own cooking, could just be a closeted indexer and that is actually very comfortable and it pays well and makes you look good in front of your investors. You tweak your balance a bit and if it goes really wrong, you say oh, the stock market did not do well this year. You go all the way out, swing into cash, swing back into stock, buy only one is cheap, I think it’s quite hard to grow [inaudible 31:27]. It’s not very marketable. This concept is not very marketable as a public investor.So, I think that’s why value investing will still work because it’s hot and there is natural things that block people from behaving that way.
Stanley: Yeah. Yeah. That’s fascinating insight. In my own experience, what I found is many of the business owners that I know, they might not make very good investors as well, because many business owners they are very action-oriented. And in stock investing, sometimes, you know like you said doing nothing might be the best thing.
Loh: Yes. Yes.
Stanley: And to a businessman, that is very hard to grasp because they constantly need to have some action. That’s something I found. And if that’s the case, real very good businessman is already focusing on doing business and more excited in running business. And people who are more theory-based might prefer investing, but they might not be very good investors. In your opinion, which are the subset of people that’s ideal to be an investor and be successful in it?
Loh: I think it would be a very, very, very small percent of people who are naturally born with that. I think in terms of understanding value investing, understanding that investing is most intelligent when it is most businesslike and then to even know that when you’re running a business, sometimes inaction is also a good action, but very few businessmen does that. Once we are very honest with ourselves that not many of us are wired and trained to good investors, I think the natural conclusion would be either we index and have a very sound as an education policy and I think was to do very well in the very long run, very long run. Or we find a few people that you think can do very well. Could be fund managers. Could be Berkshire Hathaway. Could be people you trust, like maybe Stanley. And for know what they do, because you know that I’m not possibly, maybe I’m not the one wired to do this well.
And I always go back to the Intelligent Investor where Benjamin Graham split up investors into aggressive investors and conservative investors, defensive investors. I think few of us should be the enterprising investor that go out there to try to beat the market. It takes a lot of effort to beat the market and most of us would fail. But it takes very little effort and very, very high chance, almost certainty that we can beat the market, be… And just having the market return is good enough for us to retire in a very comfortable way. Why not just do that?
So, I totally agree with the idea that most of us should be doing indexing. Or if we think we can beat the market, either we find the right people to back or to follow or we know that we can really do it, then we have to do a lot of work just to get a little bit of incremental return and then see what this was all about to do the do it full-time. Yeah.
Stanley: Okay. We digress. Let’s go back to Berkshire. We talked about the first two major part of Berkshire, which is its non-insurance business and also is equity holdings. Now, there are some smaller portions such as the business ownership with other parties. This is not big part of Berkshire, but it’s a quite a new approach that Berkshire is trying out. Why don’t you share a little bit about that, what’s that about?
Loh: So, I think the first big business ownership other party started in the financial crisis. There is another company, I’m not sure familiar with, people call it a mini-Berkshire called the Leucadia lifestyle. Leucadia is a mini-Berkshire Hathaway, a conglomerate. During the financial crisis, they launched this business and they get 50% funding from Berkshire Hathaway. Leucadia does all the work, Berkshire put in the money and they share the profit and that company is called Berkcadia.
Yeah, so now Berkshire owns 50% Berkcadia and Leucadia owns 50% Berkcadia.
Loh: Yeah to our smaller companies, one, electrical transmission company and pilot testing company. So, these three forms the joint ownership with other parties, plus a very big chunk is actually Kraft Heinz. So, Kraft Heinz comes about when Berkshire initially bought a partial ownership in Heinz and then 3G Capital came about to borrow money from Berkshire and combine Kraft and Heinz together into Kraft Heinz. And Berkshire now owns a portion of Kraft Heinz. But because they control Kraft Heinz, so they cannot account for it as a publicly listed company, they account for it in equity accounting.
So, for example, I think most of us knows that Kraft Heinz did not do well over the past many years. And one thing is to do with the general move away from branded products and also Kraft Heinz having its own operational issue. So, for example, if you look at the split of the value of this group of companies, Kraft Heinz listed about 12 billion on their balance sheet, but in the market value is about 10.5 billion. The other three jointly owned companies combined together about 0.7 billion in operating income. If I place a fifteen times P, then this group of businesses, three business would be worth about 10 billion. Combined this two, this is just 20 billion worth of investments or the value of Berkshire Hathaway.
If we compare this briefly with the collection of equities that is worth about $277 billion, you realize that it’s actually really not a very important part of the valuation of Berkshire Hathaway.
Stanley: Okay. Okay. Fair enough. It’s still good to understand this part of Berkshire, but of course at the moment is not a very big business for them. Another big part of their business of course is their insurance business. But before that, Berkshire is famous to have in having a very strong balance sheet and they constantly talk about that they have enough capital reserve in case of any Black Swan event so that they can pay out for their insurance. Why don’t you talk a little bit about that, how did they manage to maintain this cash buffer, now what are you doing with this cash buffer and why is it so important for Berkshire?
Loh: So, I think in terms of paying for catastrophe, Buffett has stated in the 2008 letter that… in 2008, they have about 112 billion, in 2009, they have 127 billion. But in 2008, the 112 billion, only 20 billion is kept aside for emergency, he called it ‘external calamities’. Which means that the other 90 billion is available for him to buy anything he wants.
So, this 90 billion is now currently invested at very, very low interest rate return so the low interest rate environment that we are in right now is bad for Berkshire in a few ways. Firstly, they earn very little on the cash balance, there’s this apparent. But the real issue comes when the low interest rate causes a lot of people to issue cheap debt that financed a lot of private equity firms purchase of good companies or decent companies at very high multiples. These are the same company that might be sold to Berkshire, say, 15 times PE will now prefer to sell to this private equity firm at say, 25 times PE which Buffet is not willing to pay out for.
So if interest rate stays low, private equity firms has a lot of liquidity. Buffet or Berkshire is not able deploys capital to buy good businesses at a fair price. Which gives them there are other alternative which is to buy, like what we say just now, to buy equities in the open market which is one of things he did was to buy Apple a few years back.
The other thing is to allow this money to be redeployed into the capital intensive business to earn decent return on incremental capital. And the last thing would be for each individual subsidiaries to do this thing they call Booked on Acquisition: to buy company says either in the same level, their supplier or their customer and they form a bigger company. So these are the only three sources of cash that can be used which is to buy companies whole, buy individual stocks, to do more capital expenditure and within capital expenditure, the other way is for the individual companies to do both on acquisition, to grow their stability of their business or to grow their business through acquisition. So that’s the only four uses of cash.
And Berkshire has been criticized again for not deploying their cash. I am personally quite comfortable having the cash not being deployed. Because if I owned 100% of Berkshire is my portfolio if I do that, I feel very comfortable a large portion of my portfolio is essentially balanced, because that makes up about 20% of my total value of Berkshire Hathaway. Yeah. So, I’m happy for Buffet to do that as education for me for free.
Stanley: You talk about the different way that Berkshire can allocate their capital, but one thing that has been missing in Berkshire has always been private equity or VC, right, venture capital. Why do you think that Berkshire has always stayed away from this two asset class, given that you know, their capital doesn’t need to be use and can be deployed for a very, very long term and in that sense wouldn’t private equity or venture capital be almost a perfect type of asset that they venture into?
Loh: I would argue that Berkshire Hathaway is one of the best private equity firm in the world. But they use private money to buy equity of other business without a lot of leverage. So this is actually the essence of private equity, just simply money that’s not public. Right? But in terms of private equity as a business, I don’t think they want to get into it, because I think private equity as a business is mostly a fee business, fee generating business and it is not about buying good companies. Whereas VC is very different. VC, you are trying to buy say, 10 companies with 2 that do very well, 5 that that’s okay and 3 that go bust. And that is definitely not Berkshire thinking and model from the outset.
So, I think VC not being part of the business is quite natural and they have been doing a whole acquisition of business and holding them for the longest time since the takeover of Berkshire Hathaway by Warren Buffett. Yeah.
Stanley: Yeah. Okay, fair enough. Let’s dive in more detail into the main business, which is the insurance business. Why is their insurance business so special apart from you say that they have very strong underwriting discipline, right? But just looking at the way that they have grown their insurance has been quite fantastic compared to a lot of other insurance company in the same field, how has Berkshire really been able to achieve that?
Loh: Berkshire has been able to achieve in growth in this, I will just call it float, mostly through a few areas. One is through its original businesses like Geico earning market share from people buying more car insurance. Those are pretty easy to understand. The other type of insurance that they actually sell is this thing called Reinsurance. Basically, Berkshire Hathaway is the insurance company of insurance company.
So, imagine a classic case would be asbestos liabilities. So, imagine another insurance company having sold this sort of health insurance to their customers and this payout could be done in the next 30 years, 50 years where we don’t know what is the final payout of this group of people who are going to claim. But a lesser company may not have the cash flow or the financial strength to have enough reserve to last till then.
So, what they do is they will package all these liabilities together and will pass it to Berkshire Hathaway for cash up front… I’m sorry. Berkshire Hathaway would take cash from them upfront to say that okay, in the next 30 years, should this, this thing happen, I will pay up for you. So, now the great thing is Berkshire Hathaway got cash from their insuree and they do have to pay out this cash for a long time. Even Berkshire’s ability to underwrite very well, they also make money from the people who pass them these liabilities. For the people who pass on this liabilities, they are happy, because now their balance sheet is freed up to write more insurance and the regulators are happy because they say that, oh, who ensured your insurance contract? Berkshire Hathaway. Berkshire Hathaway has such a good credit rating, sure, go on and write more contracts. So that’s how reinsurance work.
So, it is really Berkshire leveraging its financial strength to, I will also export but to get very good rates from other companies which has lesser financial strength. So, that’s one of the major way they grew. They grow through reinsurance contract, they grow through underwriting more within the same market space and the last thing is very often, Berkshire Hathaway’s insurance subsidiaries will do their own Bolt-on [inaudible 46:47] acquisition. When they do their own Bolt-on [inaudible 46:50] acquisition, they will buy companies that is similar to what they are doing and have the same culture of underwriting profitably. It could be old owner who wants to retire. It could be someone who wants to combine efforts with Berkshire. It is rarely the case where they buy the portfolio and they liquidated. They actually just buy the company, let it run as it is which to me sounds like private equity again. Yeah.
But so, they are not trying to squeeze more, say, synergies out of any acquisition, but just to buy good companies at decent price and the seller is happy because they can continue to do what they [inaudible 47:29] And Berkshire is happy because they have a new stream of income, new flow and yet don’t have to have more management work to be done. So, there’s a win-win for them all.
Stanley: You are almost describing like the perfect business. Right? And from the way you explain it, it is quite straightforward and it’s not very difficult to understand. But what is the core competitive advantage of Berkshire. Why are they one of the only ones that is able to create such a machine so perfectly while others may try and copy but has not really done as well?
Loh: I feel that it has to do with what Munger calls Deserve way of Trust. He says that this is one of the highest form of human evolution, where a person that is both to be trusted is being trusted by the person trusting him. So, everyone deserves that trust within that framework.
And in this sense, general lease manager, Ajit Jain, Buffet always the jokes that if Munger, Ajit and Buffet falls into the water and they all can’t swim and you have to save one person, save Ajit. That’s what Buffet says. And yeah, you have someone like Ajit who can earn definite a lot more outside Berkshire Hathaway, choosing the same Berkshire Hathaway. Then the question is why? And I would say, it’s the culture. The culture that is very risk aware and who want the top.
The culture where there is no big committee breathing down your neck, I don’t think very telling the people like people to breathe down their neck. A lot of listed companies have to do quarterly reporting, annual reporting. We have analysts who do not know your business well breathing down your neck. We have fund managers breathing down your neck. You spend your time not doing your job, but to make sure these people are happy. Whereas if you’re at Berkshire Hathaway, you only have one boss who know your business inside out and only ask of you is to underwrite profitably. I would love to work for him if I’m insurance guy.
And now can you imagine any other listed company that can recreate this easily, the sense of trust, the sense of ownership, the sense of liberty when you work for this conglomerate, but yet you have your own independence? All you have to do is send cash up and he will help you invest. So no, it absorbs you of need to the having an investment committee to meet 4 times a year, 8 times a year. You have Berkshire Hathaway investing on your behalf.
So, I think all these are very unique things that is only in Berkshire. And which is one thing I like about Berkshire Hathaway, is that I think these are cultures and culture is a thing that is not on their balance sheet, it is not there but you know it’s there. It’s the way things are done and how people behave and think. And over time, this culture attribute alone value. It create internal controls and it create value ‘addedness’ for your shareholder in a super long run, but culture takes decades and decades to build.
And I believe the Berkshire Hathaway today already have that culture of being risk aware of not overpaying, of not breathing down telling that managers neck and that will outlast Warren Buffett, a human being which makes Berkshire Hathaway a good long-term investment over, say the next 30 years till then [inaudible 51:08]
Stanley: I might want to challenge you on that [crosstalk 51:12] right, oh no premise saying that the culture might surpass Buffett in his lifetime. Because a lot of what you talk about say if you are a talented manager and you want to work for Buffett, yeah, because he has created this company with this culture, he’s still and up that I want to work for him because I’m working for Warren Buffett. Right?
And let’s talk about the succession planning and what would happen to Berkshire in the future when Buffett and Munger is both out of the picture. Because Berkshire has always been created with this culture, but at the top seats Buffett, he’s almost like the Emperor, right of Berkshire, benevolent Emperor nonetheless. Right? But whenever the Emperor leave, then there is a power vacuum and people tendency would still, even if they are not, they might be subconsciously aware of this, but they would want someone to fill their void. There will be a power struggle. Yeah, we seen it now in Malaysia as well, in Malaysia politics, right? The Emperor has not passed away, but they already have a power struggle within.
So, wouldn’t that also happen in Berkshire, even though today he say that I’m going to pass the CEO position to say, Ajit, okay or whoever it might be. But the people down the line, they are there to work for Berkshire not to work for Ajit, right because they’re there to work for Buffett, wouldn’t that create tension and break down the culture?
Loh: I would agree with our previous slip of tongue saying that they are there to work for Berkshire. For example, if I’m a talented manager, I would say that I want to work at a place where I get to do my work and I got to do my work does not mean I get to work for Buffett. I get to work for a place where it doesn’t breathe down my neck. And as long as that side of the bargain holds, I think talented manager would stay.
If there is a power vacuum, I don’t think there will be a power vacuum. Because if you think of it, Buffett over the past 5 to 8 years has done something quite unimaginable. At the operating site, you have Ajit doing all the insurance, you have Greg Abel doing all the non-insurance business, you have Ted and Todd running the portfolio. Ted and Todd also sit on many subsidiary BOTS that requires capital allocation decision. So, these four of them, this is a big four. And yet at the same time, their chairmanship will be passed to Howard Buffet, Buffet son. I am not familiar with Howard Buffett. I’m not sure how he will behave or what part of the culture thing does he’d bring.
But the most amazing thing is look at Berkshire Hathaway’s board. Berkshire Hathaway’s board is filled with directors who have a large part of their network in Berkshire Hathaway. Where does Buffett’s stock goes to after his death? It goes to Bill and Melinda Gates Foundation. Essentially Bill and Melinda Gates Foundation indirectly controlled the largest part of Berkshire stock in the future, at least in the next 10 to 15 to 20 years. Who benefit the most if Berkshire Hathaway continued be a good company over the long run? The end beneficiaries of Bill and Melinda Gates Foundation. Who is one of directors on Berkshire Hathaway board? Bill Gates.
So, if all this pieces in in place, I think he has created quite an amazing check and balance where even if Buffet’s [inaudible 55:10] now, to protect the beneficiaries of the future, I’m very sure the board will keep buffered up. And that is my belief in Berkshire Hathaway. This structure of shareholder who is also a lead director is perfect alignment of interests, which is very rare. But in corporate governance, we call it non-independent director. No idea why. But if I’m a director who is sitting there and my beneficiaries are going to benefit from the growth of Berkshire Hathaway, I will do my utmost to protect my assets, which is what Buffet has been doing his whole life. 99% of his net worth is in Berkshire Hathaway.
Stanley: Okay. Okay. Fascinating talk. Before we end, why don’t you share a little bit about how eating evaluation for this company, how do you actually value up this collection of company and assortment of stocks within Berkshire?
Loh: So, in my valuation of Berkshire Hathaway, I followed his 2018 valuation method. He cautioned us not to be too caught up in the nitty-gritty details on Berkshire Hathaway. He told us that there’s actually just five groves in this forest and don’t lose the forest for the trees. The trees would be understanding BNSF, understanding Berkshire Hathaway Energy to very minute details to understand every single moving parts of Berkshire Hathaway…
No, he said that all you have to do is understand that we have five groves and if five grows work in tandem, so the first one is the non-insurance control business that we talked about at first. The non-insurance control business makes about $17 billion last year. It has about depreciation of 10 billion. I assume a zero growth capex, which means that this business doesn’t grow at all in the future and apply 15 times P which is, I think current SMVP is whether 25…
Stanley: We have to check on that, but should it be in the 20s.
Loh: Of this, right? So… that 15 times P assuming a zero growth business and this would bring me to about $221 billion both of non-insurance control business. The collection of equities as at 31st December, 2019 is worth 248 billion. If we sell all this today, we have to incur a federal tax rate of 21%. So I minus this $29 of 248 and I’m ending with $211, thereabout. Yeah. So 200 billion over dollars in collection of equities and then thinks we have business ownership with other parties that we talk about Kraft, Berkcadia and the other two companies and just so I said it was $20 billion, that’s about 3% of my total valuation.
The total cash that they own, cash equivalent like T-Bills is about 128 billion. And then the last part where Buffet in 2008 did not give a clear figure of how to value this business, so what I do is seem quite simple. I look at the current level of float, which is $129 billion, I assume that this flow constantly decline over the next maybe 30, 40, 50 years, so they don’t write any new business, is a dying business. And yet at the same time, they earn, their combined ratio is saying 98.5%. Which means that for every $100 of underwriting, they will make $1.50. Over the next 30 years, the present value of this stream of underwriting profit would be 14 billion. But mind you, for the past 10, 20, 30, 40 years, Berkshires float has been growing and growing and growing. My assumption here is, is going to decline at 3% year after year after year after year. Yeah. So, this is about $14 billion.
If you sum all this up, you get to a total valuation of about 600 over billion dollar. Per share value is about $229 and the value per share is about $270 thereabout. The last I checked a few nights ago is about $239 sold on the MIRC. So you are buying this company that is very safe at a 15% discount to value. Yeah.
So, the underlying value of Berkshire Hathaway should grow at between 8 to 10% per annum of the longer period. You are buying it a 15% discount. So I think you should be able to get 8 to 12% over the long run while sleeping very, very well. Yeah. Is it going to be the best stock to own? No. Is it going to be the high flyer? No. Is it the worst next 10 years? Definitely not. Is it going to be S&P over 10 years? I think by a small margin, yes. Is it going to be S&P over the 10 years by a small margin at lower volatility? I think yes. So, that’s my main thesis of holding Berkshire Hathaway. It’s a very comfortable thing to own. It’s not going to make you super rich. I know going to be [inaudible 01:00:33] artists that you have to look for a surging. Yeah.
But doesn’t something very comfortable. And I think if someone wants us exposure, you want to own a group of very stable companies, Berkshire Hathaway I think is a very good choice. Yeah.
Stanley: Okay. When I think during one of their Berkshire annual meeting, Buffet actually have this 10-year bet with a fund manager, right, if you remember. That even if this fund manager bet 10 funds of funds and Buffet basically say that regardless of whatever funds you choose, the S&P 500 were most likely outperform those funds, those basket of funds. And after 10 years, he was proven right. Right? The S&P was so much high-end return over the funds of funds.
And similarly, in the case of Berkshire stock itself and when we compare it with to the past 10 years of S&P returns, the S&P 500 has actually outperform Berkshire as a stock. Right?
Stanley: And you’ll also mentioned that the non-insurance business, Berkshire has reached a point where it’s not no longer looking for super high growth and super high return businesses, but just stable businesses that will give him reasonable return there’s more than what he needs to pay out in the float. So in that sense, hasn’t Berkshire really reached a point where it might be just better if we just buy S&P 500 given that S&P 500 now is still predominantly very focused on a lot of the tech sector stock, which are growing, you know, upwards of 20% a year still, whereas Berkshire, the only tech stock that they have is Apple, which is one of the slowest growing tech stock in the whole nest [inaudible 01:02:34]. So, what’s your view on that, why choose Berkshire?
Loh: My view is that the underperformance can be explained by investors preference. Now is 2020, since 2010, it is just right after the financial crisis. Right after the financial crisis, it is not the safe big companies that grow well. It is the riskiest part of your Russell 2000 that grow very well, the riskiest part. And then as capital rotate into other stocks, it is your tech stock that’s very well, tech stock that may or may not be earning any profit or cash flow, but tech stock that can earn people’s imagination.
Berkshire Hathaway as a company has underperformed stock indexes over a period of time for many periods in the past. Most apparently would be the dot-com bubble period. Are we in the dot-com bubble? Buffet say, we are not in the bubble territory anyway. But the underperformance can be explained by people do not want to own something as boring as this and want to own something exciting. If enough people want to own something exciting, the exciting thing becomes more exciting. And then the question is am I confident in 10 years time for example, in 10 years time, am I confident that S&P will be a lot higher or a lot lower than today? I will say, if higher a bit higher. But by what percentage? I don’t know the reason is not that I think earning will go down, but I’m not sure if PE on apply on my earnings will compress.
So if P goes from say 25 to 15, I lose about almost 1/3 of my capital in terms of P contraction, which means that going forward for the next 10 years, if P goes on 25 to 15, my earnings has to grow very more than 30% for me to even get a decent return. So, I cannot predict why is the next 10 years return on my S&P 500 index.
For Berkshire Hathaway, you can see where the sources of growth are going to come from and it’s going to be about 6 to 10% or 8 to 12% thereabout. You are not paying extra today for Buffett, you are not paying extra for growth. In all my valuation, I assume that this is a company that’s dying. As though it doesn’t die right, my valuation is overly undervalue. Since you are buying something safe growing and you are not going to pay anything for growth, any growth is free gift, then I’m quite confident of getting my 8% to 12% from Berkshire Hathaway compared to say maybe 5% to 25% from S&P 500. So from the perspective of me liking to sleep very well at night, I was to prefer to own Berkshire Hathaway over S&P 500 over the next say, 10 years. Yeah.
Stanley: There’s no way of catching you out on your thesis. Okay, extremely fascinating talk and is always interesting to talk to you Loh. Thank you so much for agreeing to come on our show and I’m sure that our audience will love your ideas on the full detailed description of what Berkshire Hathaway is really is and why it can survive beyond Buffett. Once again, this is Loh Wei, thank you very much.
Stanley Lim has spent the last decade in the investment industry. Over the course of his career, he has kick-started a few businesses, worked in the family office industry and most recently in the investment advisory industry. He has been a writer and analyst for The Motley Fool Singapore from 2013 to 2017. He has written close to 2000 articles online, on investment education and market analysis. He is the co-writer of the investment book: “Value Investing In Asia”, published in 2018. Stanley is currently the chief editor of Value Invest Asia.