Warren_Buffett_2011-06-29_1752-300x261When investors and traders look at Berkshire Hathaway (BRK.A), they always focus on the stocks owned by Warren Buffett’s conglomerate rather than the businesses owned and operated by Berkshire. Then they look at the share price — $118,000 for the “A” shares. Then they make a third mistake —  that of not owning Berkshire. Berkshire’s operating companies are currently being valued at two and half times earnings — that is not a misprint. And there are ways to reduce that $118,000 to $55.

Why Berkshire, why now?

Warren Buffett’s buyback plans

The stock has been stuck for a while but the company has not. Berkshire is often seen as a holding company and investors look at the stocks held by Berkshire. Besides being an operating company with many subsidiaries from Burlington Northern railroad to See’s Candies, the company functions as a mutual fund owning shares in a number of companies. Right now, investors are overlooking the very strong profits and cash flows from the enterprises owned and run by Berkshire. The stocks held by Berkshire represent 85% of the earnings of the company. That means the owned-and-operated companies are valued at only 15% of the share price or about $12.20 of a “B” share. These companies contribute $5.40 a share in earnings and that means these companies are being valued at 2.5 times earnings!

There is also a floor price under the stock. Buffett believes the stock is very cheap. He has indicated and analysts believe he would begin buying back shares at around $110,000 for the A shares, which translates into roughly $75 for the B shares. And he has a lot of money to spend. Based on comments on how much cash he wants the company to keep, Buffett could spend up to $40 billion or 20% of the current market cap buying back shares. A very strong floor for the stock.

Look at LEAPs for Berkshire Hathaway

Think about LEAPs. If you believe, as I do, the stock is at or near a bottom, they are a great way to invest. I prefer LEAPs at least midway between zero and the current stock price and with very little extra premium built into the price. In this case, I suggest you look at the BRKB January 2013 $55 LEAPs. You pay $26 for them or about one extra dollar in premium for the convenience of reducing your capital requirements by $25 a share. If the stock goes to $100, you will have a gain of $20 or 77% rather than the 25% gain you would have if you owned the stock.

LEAPs can also be used to sell calls. Yes, you can sell calls against the LEAP, reducing your net cost of capital to get into the position. That is a discussion for another day.

Bottom line: Berkshire Hathaway, the A shares, the B shares, the company, all are wildly undervalued. Some day investors will see the gap between the share price and the underlying value of the internally owned and operated companies and the stock will move. LEAPs are an efficient way to trade that move.



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