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No. of Recommendations: 36
PAINE WEBBER REPORT FEB 00

Here are some highlights from the recent PaineWebber report on Berkshire.

1. PaineWebber upgraded Berkshire Hathaway from Attractive to Buy based on valuation.
2. Berkshire is now trading at its lowest valuation relative to book value since 1983.
3. PW believes the stock is so compellingly priced that it simply overwhelms the following factors.
a. We are in a momentum market in which valuation is often considered irrelevant.
b. BRK is likely to face continued selling pressure due to money flows away from value names.
c. The upcoming quarter will probably produce weak operating earnings.
4. PW believes the stock is trading around 50% below intrinsic value.
5. An investor who buys today should reasonably expect to achieve returns of 15-35% over the next few years.

PW'S APPROACH TO FOLLOWING THE STOCK

For some reason when a stock goes up the CEO is given the credit and when it goes down the analyst is blamed. PaineWebber's approach to following Berkshire is repeated here:

“In our initiation of coverage report in January 1999, we described our approach to following the stock. We do not use a target price nor publish quarterly estimates. We repeat our rationale in full here to make clear the significance of our upgrade in the
context of the stock's valuation and near-term earnings expectations:”

“From a long-term perspective, we believe that BRK merits an Attractive rating today because it is trading at less than our view of intrinsic value. We will downgrade or upgrade the stock should it become significantly over- or undervalued versus our opinion of intrinsic value. However, we do not plan to make rating changes frequently absent a significant
change in valuation. “

“We stress that our estimate of intrinsic value has not been endorsed by anyone at Berkshire Hathaway. In fact, we hope that readers will consider our
valuation work more of a framework and “toolkit” to stimulate their own thought processes, rather than an attempt to dictate how the stock should be valued.”

“Second, we will publish annual estimates of operating earnings (excluding realized investment gains and losses) because this is a convention followed by Wall Street.”

“However, an important part of Berkshire's insurance strategy is to accept significant short-term earnings volatility in exchange for superior long-term returns. Further, major changes in asset allocation may occur at any time. These changes could have a significant impact on investment income, as potential capital appreciation is traded off against cash yield and/or operating earnings from acquired businesses.”

“Therefore, we do not consider short-term estimates of operating earnings to be significant(a three- to five-year measurement period would be more meaningful). We do not plan to focus on deviations from earnings estimates in our research. By the same token, we are not publishing quarterly estimates, as we believe that they are simply not an appropriate measure of performance for this company.”

IMPORTANT VALUATION MESSAGE:

“OUR RATING AND VALUATION METHOD IS NOT A SUBSTITUTE FOR INVESTORS THINKING FOR THEMSELVES. NEVERTHELESS, WE HOPE TO GIVE SOME INSIGHT INTO OUR OWN THINKING THAT MAY BE HELPFUL. BY UPGRADING BRK WE ARE ALIGNING OUR RATINGS WITH OUR VIEW OF THE LONG-TERM APPRECIATION POTENTIAL OF THE STOCK. FINALLY, WE WANT TO HIGHLIGHT VERY PROMINENTLY OUR EXPECTATION OF WEAK FOURTH QUARTER EARNINGS.”

SIGNIFICANT MARGIN OF SAFETY

“Berkshire last traded below the current price relative to book value in 1983, when it traded at 1.04X book value. And given the increasing prominence of its operating businesses since then, the stock merits a higher premium over book value now, so that is not an apples/apples comparison. Over this period, the stock averaged around 157% of book value. While we do not believe price/book value is the best measurement of valuation, it is a useful tool.”

1. Over the next three years PW projects BRK's price between $65,750 to $106,918 (assuming that book value compounds at rates from 0% to 20% and the market values the stock anywhere between book value and 2X book value.

2. The investor's potential return under these most likely scenarios ranges from 15.1% to 35.4% annually.

3. PW believes there is little downside risk even under a pessimistic book value growth and valuation scenario.

1999 IN REVIEW:

1. “1999 was not a great year for Berkshire. “
2. “Insurance companies are in a weak fundamental cycle, and earnings have been further depressed by results at General Re that are unfavorable compared to industry averages.”
3. “Competition is increasing in auto insurance.”
4. “Coca-Cola and Gillette's share prices are performing poorly, with the perception that their long-term franchise value has eroded. “
5. “The pace at which BRK's $30 billion of investable funds is being put to work has frustrated the market, although about 10% of this amount was used or committed in the third quarter via the purchases of equities, Mid American, and Jordan's furniture. “
6. “BRK has committed the seemingly unpardonable sin of ignoring the technology sector in its public equity investments. The fact that the bulk of BRK is now represented by operating companies, many of which have a strong Internet presences, doesn't impress anyone.”
7. “GEICO is growing its customer base and franchise value very fast.”
8. “Executive Jet is expanding rapidly.”
9. “National Indemnity has closed several sizeable transactions that generate float at attractive margins.”
10. “General Re's business model and franchise remain strong.”
11. “Finally, we do not believe that Warren Buffett's ability to allocate capital has disappeared, despite the multiples currently being placed on revenue growth of technology stocks.”

EARNINGS:

1. PW does not expect fourth quarter earnings to be good.
2. PW is upgrading the stock based on valuation and PW's expectations that BRK will outperform the market significantly over a reasonable time horizon of 12 months or more – preferably several
years.
3. PW projects 'that Berkshire is likely to have cash operating earnings of $982 and GAAP earnings of $670 per share. In 2000, we expect cash earnings of $1,335 per share and GAAP operating earnings of $1,025 per share.'

INTRINSIC VALUE:

Using the float method of valuation BRK's intrinsic value is currently approximately $75,000 (per a share) and $2500 (Per B share).

Note: This estimate is approximately 17.5% or $16,000 lower per A share than the valuation in PW's first report. The only significant difference in PW's assumptions is the use of the current 30-year treasury rate. The decline in value reflects the higher rate of discounting earnings in the current environment, and change in relatively attractiveness of those earnings versus risk free interest rates. This same dynamic affects the entire market, although not all stocks have been equally impacted, with financials particularly hard-hit.

SHARE REPURCHASES:

As already noted a share repurchase program would need to be publicly announced. And this very announcement would create wild short-term swings in the stock price, not serving the best interest of long-term shareholders.

PW comments regarding share repurchases:

1. PW does not believe that Berkshire would ever buy back stock in order to signal that it is undervalued or improve the market price.
2. Although a repurchase is possible, even if Mr. Buffett thought the stock was materially undervalued, PW believes that he would not buy back unless the stock was more undervalued than other investment opportunities, which would generate future cash flows for him to invest.
3. PW believes Mr. Buffett would not buy back stock unless he thought the prospects of finding other attractive investments would be poor, not just currently, but for some time to come.
4. PW believes that buying back stock right now would be problematic given that 1999 results are pending release. As a matter of principal we believe Berkshire would not initiate a buyback during a period when shareholders are awaiting information on BRK's operating and financial results and outlook.
5. Finally, returning capital conflicts with the fact that Berkshire is in the capital allocation business. Why would you return capital to shareholders if you are the "Ft. Knox" of capital, the ultimate risk-taker and liquidity provider of last resort for others?

GENERAL RE:

“Some investors, especially those not used to the leveraged and cyclical nature of the insurance industry, believe that the General Re acquisition is a failure. Without defending the underwriting results General Re is currently reporting, which are indefensible, it's important to remember that insurers are in the volatility business, and the impact of inadequate pricing and underwriting have a magnified effect over short time periods compared to other industries.”

“Restoring former levels of price adequacy through more disciplined underwriting,which will likely lead to reduced premium writings, should improve the results
significantly over several quarters. General Re is quite capable of doing this and market scuttlebutt suggests it is already happening.”

“Nevertheless, we expect the fourth quarter to extend the underwriting loss trend and most likely, to be worse than the third quarter, for several reasons:

1. “Berkshire Hathaway made it plain in the third quarter 10-Q that General Re's woes relate partly to inadequately priced current year business. Even with perfect execution of a re-underwriting program, a correction would not appear in results immediately. Further, we are aware of several specific outsized losses that are likely to appear in the fourth quarter.”
2. “Cologne Re, General Re's German subsidiary, is known to have expanded its business in France in recent years. Therefore, we assume that Cologne Re was caught by the French holiday week storms, and will produce some noticeable losses. Because we don't know Cologne Re's retrocessional program, it is possible that a fair amount of this loss may have been passed along to other reinsurers. But we still expect to see some impact on General Re's overall results.”
3. “Again this quarter The St. Paul Companies ceded a large loss -- $149 million, more than last quarter – to its aggregate stop-loss reinsurance programs. General Re underwrote one of these two programs and, in fact, the previous St. Paul cession was responsible for a large portion of General Re's third quarter underwriting loss.”

GEICO:

“In the short term, GEICO's earnings are likely to decline further, and in fact, underwriting losses are likely as the company “invests” in new customers. These losses should be accompanied by sustained growth in contrast to sharply curtailed growth by other auto insurers. Further, the industry as a whole is likely to experience underwriting losses in auto insurance at an unacceptable level.”

“Ultimately, this should trigger consolidation, capital withdrawal, and even more customer turnover as weaker carriers withdraw from the line. When profitability returns to more normal levels, GEICO's market share should be much larger relative to other carriers. In addition, the scale that is being built should create a sustainable advantage in keeping loss costs low and maintaining competitive pricing.”

OTHER RISK FACTORS:
“Loss reserves, inflation, auto insurance regulatory environment, catastrophe losses,
dependence on key personnel, General Re merger integration, management succession,
equity market, capital markets convergence.”

REPORT COMMENTS:

Hope this helps. This material has been reprinted here by permission.

I highly recommend this report. Remember it should be used as a tool to make up your own mind about your investment.

The bottom line is if you know the value of what you are investing in you know to hold and when to buy more at fire sale prices. Mr. Market is the friend of the Berkshire shareholder that reads, calculates intrinsic value, understands what he/she owns, buys more during times of under valuation, and thinks for themselves.
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