Monday, June 23, 2008

Post Mortem: Berkshire Acquires Gen Re, 1998. Part 2

What Berkshire gave up when it traded its shares for Gen Re's:

Let's just look at some numbers. Here is the historical balance sheet at the time of the merger, with all entries shown in dollars per Class A share rather then dollars.*

A couple of numbers stand out: The equity portfolio of $33,402 per share and the $9,957 deferred tax liability. One of the main motivations for Buffett's buy and hold strategy is the almost $10k per share in deferred taxes from unrealized gains on the equity portfolio. However, the downside is that the large cap stocks in the portfolio are very richly valued in June of 1998. Here are the major holdings as of 12/1998:

And here is the portfolio at 12/2008:

In order to avoid doing a lot of heavy lifting, I would just point out that Coca-Cola, American Express (3 for 1 split), and The Washington Post account for a hefty chunk of the portfolio and haven't done anything for the last decade (except pay modest dividends).

However you want to value BRK at June 1998, it is hard to argue (especially in retrospect) that paying any premium over book value for a large cap investment portfolio doesn't make much sense. Therefore, the price to book ratio of 2.7 ($80,400 price, $29,621 book) didn't make a lot of sense. If you assume that the stock portfolio made up 50% of Berkshire's value and assign it a value of 1xmarket price, then the price book ratio on the remaining half would be 5.4!

The bottom line is that there is no way that BRK couldn't be considered richly valued at the $80,400 price used to calculate the conversion ratio in the Gen Re merger. The two points here are that Buffett sold high, and in coming to this conclusion, it's easy to get a feel for the value added by the shifts in the investment portfolio facilitated by this deal, from richly priced stocks to bonds and cash.

*This balance sheet differs from the actual pro forma balance sheet in omitting the 'adjustments' column which primarily adds $12 billion in goodwill. Omitting goodwill from the deal more accurately reflects the economics of the combined company.

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