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(JASON REED)
(JASON REED)

TheStreet.com

Why you should buy into Buffett's Berkshire Add to ...

Insurance operations are the second big pillar of the Berkshire business, and as we have seen in the past two weeks, will continue to be a major driver for Berkshire shareholders. Berkshire Hathaway announced last week that it bought the biggest book of insurance business ever, from Swiss Re, for $1.3-billion. What's more, Reuters recently reported that Berkshire has also increased its stake in Munich Re to $1-billion, or a 3 per cent stake in the world's biggest reinsurer.

Larry Coates, manager of the Oak Value Fund, which has Berkshire Hathaway as its largest holding, says the insurance business is ultimately a spread opportunity. The spread exists between the cost of underwriting insurance at a low cost of capital -- with the Swiss Re transaction, Mr. Buffett estimates $50-billion in premium income over the next several decades -- and being able to reinvest those profits. This spread has always been one of the key drivers of return for Berkshire.

Mr. Coates estimates that the Berkshire spread opportunity is between 50 to 150 basis points. For example, if Berkshire has 100 basis points in underwriting profits and can reinvest those profits at a 6% rate of return, it results in a 700 basis point spread.

"We've done analysis that shows that every 100 basis point change in the spread incrementally increases the value of Berkshire's A share by $10,000," he said.

The final pillar of the Berkshire portfolio is its wholly owned operating subsidiaries, among which Burlington Northern is about to become the newest addition.

These Berkshire Hathaway operating subsidiaries run the gamut across stocks tied very tightly to Buffett's "all-in wager" on the U.S. economy. Housing, through Clayton Homes, and related stocks in the home furniture and carpet business, such as Shaw Industries.

This portion of the Berkshire portfolio is the one most sensitive to the cyclical nature of the economy. In addition to the focus on the housing market, Berkshire owns several jewelry companies. Anyone who has wandered into a Tiffany's in the past few years and watched the flocks of salespeople descending on one customer buying a gold pen knows how sensitive these stocks are to economic peaks and valleys.

Thus, the cyclical stocks in the Berkshire Hathaway portfolio are a good place to look at what the company's biggest backers think is its most unique trait in the current market: its undervaluation.

Undervalued

Granted, when it comes to discussing the Oracle of Omaha, Berkshire Hathaway shareholders often seem about as independently minded as the proverbial Jonestown Kool-Aid drinkers, but these days they are talking about some hefty discounts built into Berkshire shares as a result of its recent underperformance.

It is not uncommon for long-time private investors to estimate the current Berkshire Hathaway valuation as 30 per cent to 35 per cent below fair value. Mr. Buffett himself said last week on television that he thought the shares were the cheapest they had ever been, on a price-to-book ratio.

"There is more potential recovery in those operating subsidiaries than the market currently thinks," said Bill Bergman, an analyst at Morningstar. Mr. Bergman believes fair value on Berkshire Hathaway's B shares is $88.

Jerome Bruni, a longtime private investor in Berkshire, says that Berkshire is selling at about 10x economic earnings, and for a company with its strength and outlook, that is cheap. He thinks that a conservative estimate values Berkshire Hathaway shares at least 25 per cent higher.

Paul Lountzis, of Lountzis Asset Management, another longtime private investor in Berkshire, says the discount is 30 per cent to 35 per cent now.

Oak Value Fund's Mr. Coates said: "You can certainly say that Berkshire is undervalued by 30 per cent or 40 per cent. That undervaluation adds an attractive margin of safety at this point in the market cycle."

Time to Buy

Still, there are several reasons to believe that the hefty claims about Berkshire's current undervaluation are not just the delirium of the Berkshire Kool-Aid drinkers.

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