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Adjustment to Per Share Investments Needed?


TREVNI
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I’m fully on board with the “two column” approach to value Berkshire.  That is, per share investments plus some multiple of operating earnings.

 

My question is: Should a figure for deferred taxes be deducted from the per share investments column?  My reasoning is, if Berkshire only owned investments – nothing else – would an investor pay 100% of the asset value for the investments?  Probably not, they would likely deduct deferred taxes in order to arrive at a “correct” valuation. 

 

So by this measure we’d need to adjust for the $25,117 million (page 60 of the 2015ar) deferred tax that would be paid if the investment portfolio were turned to cash.  This works out to $15,286 per A share, and would reduce the $159,794 figure shown on page 9 to $144,508.  Now, it’s relatively minor, but not insignificant, in my view. 

 

Thoughts?

 

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Per share investments exists in order to add back deferred taxes and float (and account for debt by deducting interest); it's a quickhand way to try to account for Berkshire's liabilities and get rid of the ones that historically have 0 or negative cost.

 

I personally think that adding back deferred taxes is more conservative than adding back float. the DTL really is a quasi permanent 0% interest loan, and when it comes due is completely under Berkshire's control. Berkshire has no problem monetizing investments through dividends and increased equity base over time (which allows them to underwrite more risk) without having to sell stocks.

 

Also the DTL is pretty concentrated in a few stocks and every purchase of a new stock increases the aggregate cost basis of the equity portfolio (so for example if Berkshire wanted to raise cash they could sell a loser like IBM and generate an offsetting loss to harvest gains in KO or WFC or AXP without paying a giant tax bill)*

 

The float on the other hand is of shorter duration and acts more like a "revolver" to use the word used in the letter today, with inflows (premiums) and outflows (claims) being a large % of the float in any given year. It can also yield negative surprises outside of control or prediction.

 

The DTL is a simpler, lower risk loan that is much cleaner to add back. Even the CFA folks argue for adding back a perpetual DTL to equity, so it's not like Buffett pulled that out of his ass; it's standard industry practice. Not that that makes it right, just saying that it isn't exclusive to Buffett devotees, whereas adding back float is pretty Berkshire specific and more aggressive.

 

Deferred tax liabilities that should be treated as equity in the following circumstances:

 

A company has created a deferred tax liability because it used accelerated depreciation for tax purposes and not for financial-reporting purposes. If the company expects to continue purchasing equipment indefinitely, it is unlikely that the reversal will take place, and, as such it should be considered as equity. But if the company stops growing its operations, then we can expect this deferred liability to materialize, and it should be considered a true liability.

An analyst determines that the deferred tax liability is unlikely to be realized for other reasons; the liability should then be reclassified as stockholders' equity.

 

Read more: Tax Deferred Liabilities - CFA Level 1 | Investopedia http://www.investopedia.com/exam-guide/cfa-level-1/liabilities/tax-deferred-liabilities.asp#ixzz41Q9r3B1z

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*I think, though I'm not an expert if that's how corporate taxation of equity investments held at an insurance company works, so don't quote me.

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If you go with the investments + EPS multiple of 10, looks like it is a 40% discount. Even with conservative models looks like there is 20 - 25% upside from current prices. It is a growing coupon and will grow by 6-8% in 2016.

 

Looks like some of the equity positions won't be disposed off, from page 109.

 

 

From page 109:

 

Besides, Berkshire has access to two low-cost, non-perilous sources of leverage that allow us to safely own far more assets than our equity capital alone would permit: deferred taxes and “float,” the funds of others that our insurance business holds because it receives premiums before needing to pay out losses. Both of these funding sources have grown rapidly and now total about $151 billion.

 

Better yet, this funding to date has often been cost-free. Deferred tax liabilities bear no interest. And as long as we can break even in our insurance underwriting the cost of the float developed from that operation is zero. Neither item, of course, is equity; these are real liabilities. But they are liabilities without covenants or due dates attached to them. In effect, they give us the benefit of debt – an ability to have more assets working for us – but saddle us with none of its

drawbacks.

 

Of course, there is no guarantee that we can obtain our float in the future at no cost. But we feel our chances of attaining that goal are as good as those of anyone in the insurance business. Not only have we reached the goal in the past (despite a number of important mistakes by your Chairman), our 1996 acquisition of GEICO, materially improved our prospects for

getting there in the future. In our present configuration (2015) we expect additional borrowings to be concentrated in our utilities and railroad businesses, loans that are non-recourse to Berkshire. Here, we will favor long-term, fixed-rate loans

 

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Per share investments exists in order to add back deferred taxes and float (and account for debt by deducting interest); it's a quickhand way to try to account for Berkshire's liabilities and get rid of the ones that historically have 0 or negative cost.

 

Just to add to your whole post, it’s probably not necessary to add back much in deferred taxes because the holding period is so long, which opens up many opportunities for essentially deferring the taxes indefinitely.  Just look at what happened with the Gilette stock purchase.  Gillette -> P&G -> Wholly owned Duracell - the capital gains ended up deferred indefinitely (I am not an expert but this might actually lead to a big book-value decrease—gotta ask an accountant).  The US tax code is purposefully tilted in favor of those with long holding periods, especially very long ones (though the latter is much less obvious at first).

 

Another option that could happen under new management, would be directly spinning off the shares.  The individual owners would become liable for the capital gains, but at least under current rules, this would be a significant savings.  In addition, any individual can still keep holding, and eventually could pass on the stock at a stepped-up basis to their heirs, essentially tax-free (up to the estate exclusion).  That’s without even getting into trusts and stuff like that.

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Of course I know I'm splitting hairs here, and that if it's that close you shouldn't base a decision on it.  My valuation has large enough a margin of safety that it doesn't matter, I just wanted to do the exercise.

 

Let's say you had a one investment company (Hold Co.) that held only Coca Cola stock.  It has a market value of $1,000 on the asset side (the Coke stock) and on the liability side of the balance sheet it was funded by $250 of deferred taxes and $750 of equity.  What is it worth?  Even if Hold Co. planned to hold onto it forever would you pay the full $1,000?  Probably not.  Now, if you were a long-time shareholder of Hold Co. and had built up a large deferred tax position of your own the economics would change.  Your calculus would be different because in liquidating you'd have to pay the tax.

 

So what I'm really saying is that at the Berkshire level the full per share investment figure is rational.  I think it's also rational for a new buyer of Berkshire to discount that figure by the deferred tax liability that would be owned if Berkshire liquidated (which I do not expect to happen). 

 

I've spent some time thinking about deferred taxes in the past, and in relation to Berkshire and specifically Berkshire's investment in Coke.  You might enjoy them.  See here: http://www.meadcm.com/memos

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Guest longinvestor

Of course I know I'm splitting hairs here, and that if it's that close you shouldn't base a decision on it.  My valuation has large enough a margin of safety that it doesn't matter, I just wanted to do the exercise.

 

Let's say you had a one investment company (Hold Co.) that held only Coca Cola stock.  It has a market value of $1,000 on the asset side (the Coke stock) and on the liability side of the balance sheet it was funded by $250 of deferred taxes and $750 of equity.  What is it worth?  Even if Hold Co. planned to hold onto it forever would you pay the full $1,000?  Probably not.  Now, if you were a long-time shareholder of Hold Co. and had built up a large deferred tax position of your own the economics would change.  Your calculus would be different because in liquidating you'd have to pay the tax.

 

So what I'm really saying is that at the Berkshire level the full per share investment figure is rational.  I think it's also rational for a new buyer of Berkshire to discount that figure by the deferred tax liability that would be owned if Berkshire liquidated (which I do not expect to happen). 

 

I've spent some time thinking about deferred taxes in the past, and in relation to Berkshire and specifically Berkshire's investment in Coke.  You might enjoy them.  See here: http://www.meadcm.com/memos

Nice letter, thanks for posting. I do have an investment that has doubled and as you point out, have to consider the cost of switching. Sitting on one's rear side is good, ha.

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Of course I know I'm splitting hairs here, and that if it's that close you shouldn't base a decision on it.  My valuation has large enough a margin of safety that it doesn't matter, I just wanted to do the exercise.

 

Let's say you had a one investment company (Hold Co.) that held only Coca Cola stock.  It has a market value of $1,000 on the asset side (the Coke stock) and on the liability side of the balance sheet it was funded by $250 of deferred taxes and $750 of equity.  What is it worth?  Even if Hold Co. planned to hold onto it forever would you pay the full $1,000?  Probably not.  Now, if you were a long-time shareholder of Hold Co. and had built up a large deferred tax position of your own the economics would change.  Your calculus would be different because in liquidating you'd have to pay the tax.

 

So what I'm really saying is that at the Berkshire level the full per share investment figure is rational.  I think it's also rational for a new buyer of Berkshire to discount that figure by the deferred tax liability that would be owned if Berkshire liquidated (which I do not expect to happen). 

 

I've spent some time thinking about deferred taxes in the past, and in relation to Berkshire and specifically Berkshire's investment in Coke.  You might enjoy them.  See here: http://www.meadcm.com/memos

 

it's clear to me you understand the rationale behind "investments / share", the power of tax deferral, etc.

 

I disagree with you in that I don't think it is "rational to discount that figure by the DTL".  because the DTL is so concentrated in a few investments that are not going to be touched and because the cash to be reinvested elsewhere keeps pouring into Berkshire.

 

In your hypothetical, where a holdco only owns 1 stock, then I agree with discounting by a DTL, because in order to invest elsewhere, the tax must be realized. I think this dynamic is seen in the real world with closed end funds that have existed for a while or conglomerates concentrated in a highly appreciated stock (like Yahoo!). T

 

The deferred tax liability in Yahoo's case creates a friction in terms of capital allocation and the market slaps a big discount on it (I personally think in that particular instance the discount is too high and they'll find some way to work around it but some discount is warranted.

 

In Berkshire's case, the embedded gains don't prevent optimal capital allocation and the investments w/ a big DTL are able to be monetized through divvy's. Going back to YHOO/BABA, the embedded gains arguably do prevent optimal capital allocation, distract management from the core business, and cause all kinds of problems that prevent the market from giving full credit to YHOO for its BABA shares.

 

Because Berkshire has many other ways of raising cash (either by sitting on its ass and watching the ~$4B of investment income come in or by owning a bunch of operating businesses or by raising debt on very favorable terms or by writing insurance), there aren't any real issues or suboptimal decision making being caused by the DTL. I mean taxes may have prevented Buffett from selling KO when it traded at 50X or whatever, but that's water under the bridge and happened like 15 years ago.

 

So I don't see the "rational" reason for applying a discount. But that's what makes a market.

 

From your memos, you clearly understand all the mechanics at play and are free to discount what you wish to and not discount what you don't wish to. I personally still have a hard time adding back the float or capitalizing underwriting income. That to me is more aggressive than DTL. But that's been debated without end for a while other threads. People will have different valuation techniques and come up with different prices that they are willing to own/buy at.

 

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So to summarize, your argument is basically:

 

1. They made suboptimal decisions in the past as a result of deferred tax liability, such as not selling Coke when it was grossly overvalued. But I'll ignore that and assume that it'll never cause them to make sub-optimal decisions. Umm, again.

 

2. Though they've sold long-held positions in the past, such as Fannie Mae, I'll assume that they'll never sell these long-held positions and realize the tax liability, but just keep getting dividends.

 

3. Therefore it's rational for me not to discount the value of Berkshire based on DTL.

 

I don't think Berkshire should be discounted by the full DTL, but as far as I'm concerned, saying that a Berkshire with billions in DTL, and Berkshire with no DTL that is otherwise identical should be worth the same amount is really irrational.

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well i'd obviously rather the DTL not exist ($100 KO w/ no liability is better than $100 KO w/ the DTL), so, as you point out, that is an inconsistency.

 

But I don't think it really matters in the grand scheme of the $30B of cash being deployed / year and the value creation occurring. The DTL does not prevent the constant refreshing of the business mix, the excellent growth in operating earnings, etc.

 

My argument has more to do with the fact that the DTL does not inhibit the cash generation and earnings growth, which is what will drive the stock. When Berkshire was more of an insurance co / investment operation, I would care more about the frictions created by the DTL in terms of constantly allocating capital to the best risk / reward.

 

Clearly, as Buffett himself has admitted, mistakes were made and the tax tail may have wagged the investment dog. But Berkshire looks a lot different now.

 

I think you are saying the full discount is not correct and to ignore it is not correct. While I agree with you, I think the "correct" approach is MUCH closer to ignoring it than counting it in full.

 

Also, it's obviously an important component of valuation, but at today's market cap of $325B, the $30 odd billion DTL related to appreciated stock will result in a valuation difference that is, at maximum, 9% of the current stock price. So if you think 50% of the DTL is the "correct" accounting of it and I think 0%, then we'll come up with a 4.5% difference in current valuation and it won't really affect either of our growth/earnings expectations so looking out several years it really becomes not material. Not trying to be dismissive of the discussion, just putting it in context. 

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Thanks for the great discussion.  There's something else which occurred to me, which is in favor of the "ignore it" group.  As many have pointed out, the DTL are largely in a few "permanent" investments.  If GEICO were still only partially owned, and the rest traded in the open market, there'd be a huge DTL associated with it.  If Berkshire were to ever sell GEICO it'd have a huge gain and so in effect there is a large "off balance sheet" DTL already.  If the investments truly are permanent holdings then yes, the monetization is through dividends.  What's that I hear, the ghost of John Burr Williams..."A cow for her milk, a chicken for her eggs, and a stock, by heck, for her dividends."

 

P.S.  Any feedback (+ or -) on my memos is always appreciated.  Thanks!

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But I don't think it really matters in the grand scheme of the $30B of cash being deployed / year and the value creation occurring. The DTL does not prevent the constant refreshing of the business mix, the excellent growth in operating earnings, etc.

 

Fair point, and really what matters the most for this investment.

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Buffett on CNBC:

 

We'll sell a stock for one of two reasons, if we need-- if we need the money to buy something that we like even better. Now that's not easily-- that's almost never a case at Berkshire, because the money keeps coming in. So-- that wasn't the case 20 or 30 or 40 years ago. But it's not the case now. And that-- now we'll only sell something basically if we think the-- the company is not worth what it's selling for.

 

Not to beat a dead horse, but this is why I don't apply the DTL to the stock holdings w/ big gains. They have no need to sell and I own Berkshire primarily for its earnings power (though I do obviously pay attention to Price /my estimate of NAV and base sizing decisions on that). The DTL does not hurt the earnings power of the stocks (which in the case of KO where he hasn't bought/sold in 22 years is simply a growing dividend).

 

That's not the only "correct" way to view things.

 

As Richard points out an equity portfolio without a DTL is better than one with one, ceteris paribus. So why would you ever not require some discount to the portfolio of stocks with a DTL.

 

 

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thepupil,

 

I think you make a good point.  In addition, they seem to be doing a good job of swapping public securities for operating businesses. 

 

John Malone and Greg Maffei have done this same thing at Liberty to avoid paying taxes. 

 

Just another way of thinking about it.

 

 

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