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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is an investor, corporate adviser and former hedge fund manager
Equity markets are at highs, especially in the US, for many good reasons. US corporate earnings are strong despite the current sluggish consumer confidence and the muted housing market. Stocks have also been aided by the infectious optimism on AI.
Yet beneath the market’s placid surface, things are not fully stable. The ratio of stock volatility to overall market volatility is unusually high. Bond yields have risen on concerns about inflation and the scale of the US federal deficit. Unease is also brewing over the returns being earned on the very substantial investment needed to develop AI.
It is precisely in environments such as this that investors seek out hedges in case conditions take a turn for the worse. One traditional haven — government bonds — is not straightforward as they have to contend with large public debt.
There is still gold and, of course, one could just sell assets, overlooking the inconvenience of capital gains tax, to hide in cash. But the latter is a notoriously difficult strategy to execute and it is often, impolitely, described as a “mug’s game”. History teaches that “time in” the market invariably triumphs “timing the market” for the majority of us.
So what is another asset that offers a potential hedge and arguably an active one too? What asset can simultaneously provide some exposure to the compounding power of global economic growth and, by the way, not appear expensive? This article should not be construed as investment advice but from where I sit, Berkshire Hathaway — the financial citadel built by Warren Buffett and the late Charlie Munger — is one such hedge.
Admittedly, Berkshire has underperformed the total return on the S&P 500 index over the past two to three years by more than 20 per cent. This lag is largely self-inflicted: management has amassed a staggering cash pile, representing roughly a third of its own market capitalisation, leaving it underinvested.
That said, the recent second-quarter results demonstrated strong performance from its core operations. Profits rose 20 per cent in the quarter and within its non-insurance operations, operating margins increased by two full percentage points. The conglomerate has virtually no direct, large-scale exposure to the AI build-out (other than its $36bn stake in Alphabet).
Some investors might hold concerns about generational transition. Buffett has ceded day-to-day operational control as he heads into his late nineties.
Yet these concerns overlook the sum-of-the-parts valuation of its assets. Notably, its energy network distributes 15 per cent of all natural gas consumed in the US. Its rail franchise carries 28 per cent of all rail freight. Its insurance operations are a strong number three in the industry. If one then strips away the market value of its publicly listed equities (less capital gains tax) and factors in its surplus cash of about $365bn, the residual private assets trade on a prospective price-earnings multiple of about 14 times. For context, this compares with 20 times for the S&P 500.
If you look at the book value of its assets, Berkshire trades at 1.4 times on my calculations. And if you strip away its listed assets and its net cash, its price-to-book ratio is about two times compared with the broader market at more than 5.5 times. If the group were to trade closer to the sum of its parts, this would imply upside, I believe, of 10 to 20 per cent.
Some will observe that its return on equity is unimpressive at 9 to 10 per cent, suggesting it is a mature business. But this calculus is suppressed by the fact that each year Berkshire “marks to market” the value of its public assets (cash invested in Treasuries and its listed holdings). Unlike most corporates that benchmark against an old historical book cost for their assets, its RoE is fresh and not inflated.
Then there is the “active” hedge feature embedded in Berkshire’s corporate DNA. Over the years many of the very best deals have come to it during moments of stress because it has the firepower and the culture to react swiftly.
Should a broad financial dislocation materialise, then Berkshire’s low correlation with the general market trend should cushion the initial drawdown. If things were to then worsen, then Berkshire is well positioned to deploy its mountain of dry powder into quality assets at attractive entry points.
In effect, this liberates investors from the impossible task of timing the market, leaving the heavy lifting to Greg Abel and his team, with the Sage of Omaha keeping watch from a distance.
