AN INTRODUCTION TO VALUE INVESTING

BY WHITNEY TILSON | WTILSON@KASELEARNING.COM

AND GLENN TONGUE| GLENNT@KASELEARNING.COM

AGENDA

• Introduction and overview

• What is value investing?

• Intrinsic value and margin of safety

• Let the market be your servant, not your guide

• Three ways to beat the market

• You must have a variant perception

• Three steps to evaluating stocks

• Valuation

• Focus investing

• Case study: Berkshire Hathaway

• Case studies: Alphabet (Google) and Facebook

• Appendix: Gaining an edge and traits of successful money managers

2

INTRODUCTION AND OVERVIEW

ME• Parents were in the Peace Corps 1962-64• Grew up in Tanzania, Nicaragua, Stanford, western MA,

Boston, moved to NYC 24 years ago• Harvard ‘89• Helped Wendy Kopp start Teach for America• Two years at Boston Consulting Group (the only real job

I’ve ever had)• HBS ‘94• Worked with Prof. Michael Porter for five years as

Executive Director of The Initiative for a Competitive Inner City

• Discovered Buffett, Munger and value investing in the mid-1990s; was a classic bull market genius

• Launched my own fund with $1 million out of my bedroom on Jan. 1, 1999

• Proud father of three wonderful daughters• Celebrating my 25th anniversary next month

GLENN

• Grew up in New Jersey• Princeton• Worked in family business, Blonder-Tongue, Inc., a

manufacturer of pay television and cable television distribution equipment

• Wharton MBA• Managing Director at DLJ• President of DLJdirect• Managing Director and Head of Acquisition Finance

at UBS• Worked with Whitney for eight years• Founded Deerhaven Capital

5

LAUNCHED KASE LEARNING• My parents are both educators, I love to teach, and I’ve done a lot of teaching, writing and

mentoring over the years, so it was a natural transition

• There’s a large global market of sophisticated investors – both professionals and avid

amateurs – who want to learn and become better, many of whom want to start/grow their

own investment funds

• There’s almost nobody teaching high-level investing and fund entrepreneurship

– Continuing Legal Education (CLE) and Continuing Medical Education (CME) are major industries, but

there’s nothing comparable for investors

• My long-time partner at Kase Capital, Glenn Tongue, has rejoined me

• We seek to capture all of the lessons we learned in nearly two decades in the hedge fund

trenches, both as investors and entrepreneurs, and impart that knowledge to others so they

can stand on our shoulders and achieve even greater success

I CLOSED MY HEDGE FUNDS IN OCTOBER 2017 AND SHORTLY THEREAFTER

6

INVESTING IS A BATTLE

• The reason we call Kase Learning’s core program Lessons from the Trenches is that investing is a battle

• This long bull market combined with the rise of indexing and the increasing sophistication of supercomputers has made the job of investors and fund managers much harder

• Thus, to succeed you must be better than ever before: do even more in-depth research, do better analysis, be more patient and disciplined, etc.

• Most importantly, you have to get on a steep learning/experience curve and stay on it for a lifetime

• There are only two ways to get experience: learning from veterans (like us) or stumbling around on your own, making mistakes and getting scars on your back

• Which do you prefer?

7

REAL-WORLD EXPERIENCES & CASE STUDIES

• We are not interested in academic theories; we only teach via case studies rooted in our own real-world experiences

• There are many value investing programs and books that teach the basics: intrinsic value, margin of safety and sustainable competitive advantage; various valuation methodologies; how to do a discounted cash flow, etc.

• But understanding these topics is far from what is truly necessary to successfully navigate today’s difficult markets

• We teach dozens of lessons we learned – in many cases, the hard way – over two decades in the trenches: how to find great stocks, avoid value traps, manage a portfolio effectively, short sell, be an activist, control one’s emotions, hire the right people at the right time, make a name for yourself, raise money, communicate well with investors, and much more

8

WE FOCUS ON SUCCESSES AND MISTAKES

• During our years at Harvard and Wharton business schools, we read hundreds of

case studies and pretty much every one featured a heroic protagonist, facing a

difficult issue, but almost every time reaching the right decision and achieving

great success

– We can’t recall a single one in which the protagonist made wrong decisions and

screwed it all up

• This is not how the world works — everyone makes mistakes and suffers setbacks

• We believe that it’s just as important to teach and learn from mistakes, so we

honestly share the many we made so that others can avoid them

– “Only a fool learns from his own mistakes. The wise man learns from the mistakes of

others.” – Otto von Bismarck

9

HOW WE THINK ABOUT INVESTING

• We are value investors, so anyone looking for hot stock tips or advice on

how to get rich quick should not take our programs

• That said, we are primarily “make money” investors, so we define value

broadly

– We believe that value can be found in many places, even among growth

stocks, so we teach case studies that include Netflix, Alphabet, Facebook

and SodaStream

10

WE ALSO TEACH ENTREPRENEURSHIP

• The hedge fund industry is now very large, but at its core it’s still an

apprenticeship business: young investors learn the business from grizzled

veterans

• But what about the 99% of investors who dream of being the next Warren

Buffett or Julian Robertson, but aren’t lucky enough to land a job at an

established firm?

• How are they supposed to learn what they need to know to have a

reasonable chance of success?

11

KASE LEARNING’S THREE CORE PROGRAMS

1. A three-day Lessons from the Trenches: Value Investing Bootcamp

2. A one-day seminar on How to Launch and Build an Investment Fund

3. A one-day Advanced Seminar on Short Selling

• They can be taken individually or in any combination, though most choose to take all three

• We teach them in person over five 12-hour days (3+1+1) and also via live webinars: 15 2½-hour modules (9 for the bootcamp and 3 for each seminar) that we teach live every day from 7:00-9:30am EST

• Our next in-person seminar is in NYC the week of September 24-28

• Our next webinars are How to Launch and Build an Investment Fund (Sept. 14, 17 and 18) and an Advanced Seminar on Short Selling (Sept. 19-21); then, we’re teaching all three programs via webinar from Oct. 29-Nov. 16

12

KASE LEARNING’S CONFERENCEON SHORT SELLING ON DEC. 3• This long bull market has inflicted absolute carnage on short books, and even seasoned

veterans are throwing in the towel

• This capitulation, however, combined with the increasing level of overvaluation, complacency, hype and even fraud in our markets, spells opportunity for courageous short sellers

• On May 3rd in New York City, Kase Learning hosted the first-ever conference dedicated entirely to short selling, which featured 22 of the world’s top practitioners, including David Einhorn and Carson Block, who shared their wisdom, lessons learned, and best, actionable short ideas

• The conference was such a success that we’re hosting another one in NYC on Monday, December 3

• Contact Kase Learning for an early-bird discount

13

TESTIMONIALS

• “The greatest teacher of investing was Benjamin Graham. He was followed by Warren Buffett and Charlie

Munger. Believe me, the third person is Whitney Tilson. He’s a natural teacher.” – Chris Stavrou, Stavrou

Partners (watch the video here)

• “It was a wonderful, almost life-changing experience. In a nutshell, it felt like an intensive infusion of

wisdom and practical advice. I also really enjoyed meeting the people in the group who were, without

exception, intelligent, hard-working, open-minded and friendly.” – Gabriel Grego, Quintessential Capital

Management LLC

• “I would absolutely recommend this seminar to anyone aspiring to run their own investment management

business. What is taught in this seminar is pure gold. It’s not taught anywhere else and there aren’t that

many people in the world who really understand what it takes to raise a billion-dollar fund. I think that this

is an incredible product. It’s not really a proxy for business school or Columbia’s value investing program.

It’s more advanced and for someone farther ahead in their career. There are so many start-up, emerging

managers who have no idea how to raise money and where to start.”

14

TESTIMONIALS (2)

• “As a young analyst trying to get ahead, this was the shot in the arm I needed. I know the hedge fund world has become increasingly difficult and competitive, so I’ve been looking for any leg up I could find –and the seminar delivered, far surpassing my expectations. I was blown away by the one-on-one, personalized attention and can’t imagine a better way to learn than from Whitney’s case-based format. I left the seminar a better investor, entrepreneur and, unexpectedly, better person. Highly recommended!” – Jeremy Lichtman, SevenSaoi Capital

• “At the beginning of Whitney’s course, I didn’t know what to expect and had little idea of how to set up and market my business, but after only a few days it’s not an understatement that the seminar will make me millions of dollars and save me a great deal of trouble. Whitney laid out everything he did right in launching and growing his fund for more than a decade and then, perhaps more importantly, very honestly detailed what he did wrong. Through his connections, we also met with investors at the very top of the industry who were very generous with their time and open to all questions. Lastly, I now have 12 friends who are very bright and at a similar point in their careers who I can bounce ideas off of, a clear plan for how to market and grow the business (it’s encouraging when you hear Bill Ackman tell you he likes your plan), and most importantly I know what pitfalls to avoid.” – Angelo Martorell, Martorell Capital Partners

15

ARTICLES BY/ABOUT KASE LEARNING

• So You Want to Be a Hedge Fund Star?, Barron’s, 5/11/18– www.barrons.com/articles/so-you-want-to-be-a-hedge-fund-star-1526069114

• Want to Run a High-Flying Hedge Fund? Don’t Be a Cheapskate, WSJ, 6/26/18– www.wsj.com/articles/want-to-run-a-high-flying-hedge-fund-dont-be-a-cheapskate-1530021600

• The Last Days of Whitney Tilson’s Kase Capital, Institutional Investor, 3/20/18– www.institutionalinvestor.com/article/b17f19gwp3595r/the-last-days-of-whitney-tilson's-kase-

capital

• Whitney Tilson On The Rise And Fall Of Kase Capital, Forbes, 5/1/18 – www.forbes.com/sites/kevinharris/2018/05/01/whitney-tilson-on-the-rise-and-fall-of-kase-capital

• How My Success Led to My Fall, Yahoo Finance, 5/23/18 – https://finance.yahoo.com/news/success-led-fall-174512177.html

• The Launch Of Kase Learning And Running A Hedge Fund, Seeking Alpha interview, 5/26/18– https://seekingalpha.com/article/4177128-sa-interview-whitney-tilson-launch-kase-learning-

running-hedge-fund

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FURTHER INFORMATION

• Further information is at www.kaselearning.com or call (212) 265-4510

• Email me at WTilson@kaselearning.com if you would like to be added to my investing email list and/or have questions or comments

• Follow Kase Learning on:

17

OVERVIEW OF VALUE INVESTING

WHAT IS VALUE INVESTING?

• Attempting to buy a stock (or other

financial asset) for less than it’s worth

• Contrast with greater-fool investing

• False distinction between growth vs. value

investing

• Does not mean buying lousy businesses at

low valuation multiples

“All intelligent

investing

is value

investing.”

– CHARL IE MUNGER

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INTRINSIC VALUE

• The true value of a company or an asset based on all aspects of the business, both tangible and intangible

• It is most commonly estimated by projecting the future cash flows and then discounting them back to the present

• It is a range, not a precise number

• Intrinsic value is not the same as the current market value

• Value investors try to identify rare situations when there is a huge gap between intrinsic value and market value

20

MARGIN OF SAFETY

• Chapter 20 of The Intelligent Investor

• “ The margin of safety is always dependent on the price paid. It will be large at one price, small at some higher price, nonexistent at some still higher price.”

• The margin of safety “is available for absorbing the effect of miscalculations or worse than average luck.”

21

LET THE MARKET BE YOUR SERVANT, NOT YOUR GUIDE

• Chapter 8 of The Intelligent Investor

• “The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored.”

• The parable of Mr. Market

22

DEVELOPING A STRATEGY

THE FIRST STEP TOWARD BECOMING A SUCCESSFUL INVESTOR IS DEVELOPING A SOUND STRATEGY

• To develop a sound strategy, you have to do a careful, honest self-assessment, asking key questions:

– What am I interested in and what do I enjoy?

– What am I good at?

– What’s my edge?

• A sound strategy addresses:– What countries, industries and market caps will I focus on?

– Any short selling? If so, how much and what strategies?

– How much overall exposure in the portfolio and how concentrated will it be?

– How much trading/average holding period?

– Will I invest only in equities or across the capital structure?

24

GOOD STOCK PICKING

THREE WAYS TO BEAT THE MARKET

1) Good stock picking;

2) Good market timing; and/or

3) Leverage

• I mostly stink at market timing (though I’ve had reasonable success identifying – often too early – obviously bubbles like the internet/tech stock bubble in 1999 and the housing bubble in 2007), and leverage will eventually kill you, so I focus on good stock picking.

26

STOCK PRICES REFLECT EXPECTATIONS

• Nearly every company’s stock price reflects the consensus expectations that investors have about that company’s future– This is usually fairly easy to determine by reading a few analyst reports

• Whether a stock goes up or down over time is largely determined by whether a company’s performance exceeds or underperforms investors’ expectations

• Therefore, investment success is rooted in accurately betting against the “herd”– Sometimes this involves identifying companies encountering difficulties that

investors think are secular, but prove to be fixable (e.g., McDonalds, Best Buy, Restoration Hardware)

– Other times, it’s great companies that can maintain high rates of growth for longer than the market anticipates (e.g., Amazon, Google, Facebook)

27

VARIANT PERCEPTION

• To beat the market, all you have to do is have a

variant perception…and be right!

• The former is easy; the latter is hard

• “The hardest thing over the years has been having the courage to go against the dominant wisdom of the time, to have a view that is at variance with the present consensus and bet that view. The hard part is that an investor must measure himself not by his own perceptions of his performance but by the objective measure of the market. The market has its own reality. In an immediate, emotional sense, the market is always right. So if you take a variant point of view, you will always be bombarded for some period of time by the conventional wisdom as expressed by the market.” – Michael Steinhardt

• “It’s much warmer inside the herd.” – Jean-Marie Eveillard

“If you just do

what other

people do,

you will get the

results other

people get.”

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– BILL MILLER

A THREE-STEP PROCESSFOR EVALUATING STOCKS

THREE STEPS TO EVALUATING STOCKS

Step 1: Circle of competence

• Do we understand this company and its industry deeply?

• Can we make reasonable projections about the company’s future?

Keep it simple. Good investment ideas can usually be explained in 30 seconds.

CIRCLE OF COMPETENCE

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THREE STEPS TO EVALUATING STOCKS

Step 2: Company and industry evaluation• Often involves company visit, management and customer interviews.• Is this a good business?

• Does it have sustainable competitive advantages?• High returns on capital? • Solid, steady growth? • Healthy balance sheet?• Strong free cash flow?

• Is this a good industry? • Are the trends favorable? • What are the competitive dynamics?

• Look for an informational edge, often via proprietary sources or scuttlebutt research

COMPANY AND INDUSTRY EVALUATION

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THREE STEPS TO EVALUATING STOCKS

Step 3: Evaluation of management

• Are they good operators?

• Are they good capital allocators?

• Are they trustworthy and shareholder friendly?

EVALUATION OF MANAGEMENT

32

THE FINAL CRITICAL STEP: VALUATION

• Is the stock really, really cheap?

• Are you “trembling with greed”?

• Is there a huge margin of safety?

33

FOCUS INVESTING

• When you get an easy pitch, swing hard• Owning two stocks eliminates 46% of non-market risk of just owning one

stock• Four stocks eliminates 72% of the risk• Eight stocks eliminates 81% of the risk• 16 stocks eliminates 93% of the risk• 32 stocks eliminates 96% of the risk• 500 stocks eliminates 99% of the risk

• Buffett’s 20-punches analogy• Sizing shorts and options

34

THOUGHTS ON VALUATION (1)Discounted Cash Flow

• Present value of a 10-year Treasury note

• Same analysis for a stock or bond

• Focus 90% of your attention here

Public Company Comps

• Make sure comps are valid

• Make sure entire sector isn’t misvalued

Acquisition Comps

• What multiples are acquirers (other companies or LBO firms) paying for similar companies?

• Strategic vs. financial buyers

35

THOUGHTS ON VALUATION (2)Historical Comps

• What multiples has this company traded at in the past?

• Has the business changed?

• Careful to exclude bubble periods

Sum of the Parts

• Often useful to break business down into its parts and value each part separately

Rules of Thumb

• Pay no more than 10x trailing earnings (normalized) for a fair business and no more than 20x trailing earnings for even the greatest business

• Paychex, Google, eBay

36

APPENDIX:GAINING AND EDGE AND TRAITS OF

SUCCESSFUL MONEY MANAGERS

GAINING AN EDGE (1)THERE ARE MANY WAYS IN WHICH A STOCK PICKER MIGHT TRY TO GAIN AN EDGE TO BEAT THE MARKET:

1. Size

– Small funds can invest in the nooks and crannies of the market, in which there are more inefficiencies

– Example: SPAC warrants

2. Time arbitrage

– “Time arbitrage just means exploiting the fact that most investors – institutional, individual, mutual funds or hedge funds – tend to have very short-term time horizons, have rapid turnover or are trying to exploit very short-term anomalies in the market. So the market looks extremely efficient in the short run. In an environment with massive short-term data overload and with people concerned about minute-to-minute performance, the inefficiencies are likely to be looking out beyond, say, 12 months.” – Bill Miller

3. Concentration

– Invest in fewer, highest-conviction ideas – which works great when you’re right, but can kill you when you’re wrong

– Example: Loading up on Berkshire at the right times

38

GAINING AN EDGE (2)4. Analytical

– Take the same information as everyone else and analyze it better; just be smarter

5. Informational

– Gather better information (legally of course!) to inform better decisions

– Examples: shorting the housing crisis; McDonald’s; and CKE Restaurants

6. Experience

– Investing is an experienced-based business, so those with more (relevant) experience can make better decisions

7. Emotional

– “Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ…Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” -- Warren Buffett

8. Relationships

– Building a network of other smart investors to share ideas and information

• Example: MBIA

– Getting to know certain CEOs and investing behind them

• Example: HHC

39

TRAITS OF SUCCESSFUL MONEY MANAGERS

The Right Approach 1) Think about investing as the purchasing of companies, rather than the trading of stocks.2) Ignore the market, other than to take advantage of its occasional mistakes.

• “Basically, price fluctuations have only one significant meaning for the true investor. They provide him an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times, he will do better if he forgets about the stock market.” – Ben Graham

3) Only buy a stock when it is on sale.• “To distill the secret of sound investment into three words, we venture the motto, MARGIN

OF SAFETY.” – Ben Graham

4) Focus first on avoiding losses, and only then think about potential gains.• “We look for businesses that in general aren’t going to be susceptible to very much change. It

means we miss a lot of very big winners but it also means we have very few big losers.... We’re perfectly willing to trade away a big payoff for a certain payoff.” – Warren Buffett

THE RIGHT APPROACH (1)

40

TRAITS OF SUCCESSFUL MONEY MANAGERS

The Right Approach

5) Invest only when the odds are highly favorable -- and then invest heavily.

6) Do not focus on predicting macroeconomic factors.• “I spend about 15 minutes a year on economic analysis. The way you lose money in the

stock market is to start off with an economic picture. I also spend 15 minutes a year on where the stock market is going.” – Peter Lynch

7) Be flexible! It makes little sense to limit investments to a particular industry or type of stock (large-cap growth, mid-cap value, etc.).

8) Shun consensus decision-making.• “My idea of a group decision is looking in a mirror.” – Buffett

THE RIGHT APPROACH (2)

41

TRAITS OF SUCCESSFUL MONEY MANAGERS

The Right PersonMost successful investors have the following characteristics:1) They are businesspeople, and understand how industries work and companies

compete.• “I am a better investor because I am a businessman, and a better businessman because I am an

investor.” – Buffett

2) They have a lot of intellectual horsepower.• However, “investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ” –

Buffett

3) They are good with numbers -- though advanced math is irrelevant -- and are able to seize on the most important nuggets of information in a sea of data.

4) They are simultaneously confident and humble.• The former comes easily to most people in the business; it’s the latter that presents the problem…• Buffett is a great role model

THE RIGHT PERSON (1)

42

TRAITS OF SUCCESSFUL MONEY MANAGERS

The Right Person

5) They are independent, and neither take comfort in standing with the crowd nor derive pride from standing alone.

6) They are patient.• “Long-term greedy” – Buffett

• “If you find shares that are low in price, they don’t suddenly go up. Our average holding period is five years.” – John Templeton

7) They make decisions based on analysis, not emotion.

8) They love what they do.• “I’m the luckiest guy in the world in terms of what I do for a living” and “I wouldn’t trade my

job for any job” and “I feel like tap dancing all the time.” – Buffett

THE RIGHT PERSON (2)

43

CASE STUDY:BERKSHIRE HATHAWAY

THE BASICS• Stock price (9/12/18): $322,910 ($215 for B shares)

• Shares outstanding: 1.64 million

• Market cap: $530 billion

• Total assets, equity, revenue and float (Q2 ‘18): $712B, $362B, $241B and $116B, respectively

• Book value per share (Q2 '18): $217,677

• P/B: 1.48x

• Berkshire Hathaway today is the 9th largest company in the world (and 3rd largest in the U.S.) by revenues

At today’s price, we’re not pounding the table on the stock, but if you want to sleep well at night and have a very good chance of beating the S&P over time, especially if the market does poorly, then Berkshire is a great addition to a conservative portfolio.

HISTORY

• Berkshire Hathaway today does not resemble the company that Buffett bought into during the 1960s

• It was a leading New England-based textile company, with investment appeal as a classic Ben Graham-style "net-net"

• Buffett took control of Berkshire on May 10, 1965

• At that time, the company had a market value of about $18 million and shareholder's equity of about $22 million

THE BERKSHIRE HATHAWAY EMPIRE TODAYLargest Stakes in Public Companies ($B)

Notes: Share count as of 12/31/17 13-F plus 75M AAPL; Stock prices as of 5/4/18.

Company Shares Price Value

Apple 241.7 $183.83 $44,434

Wells Fargo 482.5 $52.41 $25,290

Bank of America 700.0 $29.30 $20,510

Kraft Heinz 325.4 $58.01 $18,879

Coca-Cola 400.0 $42.36 $16,944

American Express 151.6 $98.35 $14,911

Phillips 66 74.6 $115.61 $8,623

U.S. Bancorp 103.9 $50.34 $5,228

Moody’s 24.7 $166.31 $4,103

Bank of NY 53.3 $54.49 $2,905

Delta Airlines 53.1 $52.34 $2,780

Goldman Sachs 11.4 $234.94 $2,676

Southwest Airlines 47.7 $52.78 $2,515

Charter Comm 6.8 $276.07 $1,874

General Motors 44.5 $36.71 $1,635

BYD 225.0 $6.45 $1,451

Others $24,294

TOTAL $199,052

THE BERKSHIRE HATHAWAY EMPIRE TODAY (2)

Source: UBS analyst report, 3/28/16.

Revenues (2015)

BERKSHIRE’S NON-INVESTMENT INCOME HAS SOARED OVER TIME

-$5

$0

$5

$10

$15

$20

$25

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Investment

Insurance

Non-Insurance

($B)

Note: Insurance losses in 2017 were primarily due to “several significant catastrophe loss events occurring during the year including

hurricanes Harvey, Irma and Maria, an earthquake in Mexico, a cyclone in Australia and wildfires in California” and an increase in

“ultimate claim liability estimates related to the…aggregate excess-of-loss retroactive reinsurance agreement with AIG.”

BERKSHIRE’S FLOAT HAS GROWN ENORMOUSLY

$0

$20

$40

$60

$80

$100

$120

$140

($B)

GenRe acquisition

Equitas deal

AIG deal

BERKSHIRE’S Q2 EARNINGS WERE EXTRAORDINARY

• Net earnings per share almost tripled from $4.3 billion to $12.0 billion.

• These headline numbers were impacted by a number of items, the most important of which was a new accounting rule that

requires changes in the value of equity holdings, both realized and unrealized, to be shown in the income statement

(previously the income statement only reflected realized gains). In addition, Berkshire is a major beneficiary of the lower

corporate tax rate for U.S. corporations (its tax rate fell from 29% in Q2 ‘17 to 20% in Q2 ’18).

• But even excluding these two items, Berkshire’s pretax operating earnings soared 67% (!) from $4.1 billion to $6.9 billion. The

standout was the insurance group, led by GEICO, where pretax income jumped more than 5x from $119 million to $673

million. Overall, insurance underwriting profits were $1.2 billion vs. -$24 million in Q2 ’17.

• Investment income was up almost 8%, increasing to a run-rate of over $5 billion annually, and the pretax profit of all other

operating businesses, the largest of which are manufacturing and BNSF, grew 9%.

• Other items of note:

– Float grew by $2 billion year to date to $116 billion.

– Book value per share grew to $217,677 per share, up 3% year to date.

– No shares were bought back under the repurchase program, but subsequent to quarter end, Buffett said he’d bought some back.

– Cash and investments per share were virtually unchanged from the end of 2017.

DESPITE BEING VERY CONSERVATIVELY POSITIONED, THE STOCK HAS KEPT PACE WITH THIS LONG BULL MARKET

-$15

-$10

-$5

$0

$5

$10

$15

$20

$25

$30

$35

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Acquisitions

Net Stock Purchases

BUFFETT, COMBS & WESCHLER WERE PUTTING CASH TO WORK AT A HEALTHY CLIP UNTIL 2017

• High valuations are keeping Buffett, Combs and Weschler on the sidelines these days• But markets have a way of presenting big opportunities on short notice

– Junk bonds in 2002, chaos in 2008– Buffett has reduced the average maturity of Berkshire’s bond portfolio so he

can act quickly

Burlington Northern($26.5B for 77.5% BRK didn’t own;

$16B in cash, balance in stock)

Heinz ($12.3,

$3.0, and $5.3B

in 2013-15)

Lubrizol ($8.7B)

BofA ($5B) &

IBM ($10.9B)

PCP

($33B)

ISCAR ($4B for 80%)

& PacifiCorp ($5.1B)

VALUING BERKSHIRE"Over the years we've…attempt[ed] to increase our marketable investments in wonderful businesses, while simultaneously trying to buy similar businesses in their entirety." – 1995 Annual Letter"In our last two annual reports, we furnished you a table that Charlie and I believe is central to estimating Berkshire's intrinsic value. In the updated version of that table, which follows, we trace our two key components of value. The first column lists our per-share ownership of investments (including cash and equivalents) and the second column shows our per-share earnings from Berkshire's operating businesses before taxes and purchase-accounting adjustments, but after all interest and corporate expenses. The second column excludes all dividends, interest and capital gains that we realized from the investments presented in the first column." – 1997 Annual Letter

"In effect, the columns show what Berkshire would look like were it split into two parts, with one entity holding our investments and the other operating all of our businesses and bearing all corporate costs." – 1997 Annual Letter

BUFFETT'S COMMENTS ON BERKSHIRE'S VALUATION LEAD TO AN IMPLIED HISTORICAL MULTIPLIER OF ~12X

• 1996 Annual Letter: "Today's price/value relationship is both much different from what it was a year ago and, as Charlie and I see it,

more appropriate."

• 1997 Annual Letter: "Berkshire's intrinsic value grew at nearly the same pace as book value" (book +34.1%)

• 1998 Annual Letter: "Though Berkshire's intrinsic value grew very substantially in 1998, the gain fell well short of the 48.3%

recorded for book value." (Assume a 15-20% increase in intrinsic value.)

• 1999 Annual Letter: "A repurchase of, say, 2% of a company's shares at a 25% discount from per-share intrinsic value...We will not

repurchase shares unless we believe Berkshire stock is selling well below intrinsic value, conservatively calculated...Recently, when

the A shares fell below $45,000, we considered making repurchases."

Pre-tax EPS

Excluding All Year-End

Investments Income From Stock Intrinsic Implied

Year Per Share Investments Price Value Multiplier

1996 $28,500 $421 $34,100 $34,100 13

1997 $38,043 $718 $46,000 $46,000 11

1998 $47,647 $474 $70,000 $54,000 13

1999 $47,339 -$458 $56,100 $60,000

BERKSHIRE’S EARNINGS AND INVESTMENTS PER SHARE HAVE STEADILY RISEN

Note: We subtract insurance earnings, but then add back a conservative estimate of normalized earnings from Berkshire's insurance businesses: half of the $2 billion of average annual profit over the 14 years prior to 2017, equal to $608/share.

-$2,000

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Investments Per Share (left axis)

Pre-tax EPS (right axis)

BERKSHIRE’S INTRINSIC VALUE: 2001-2017

1. In every annual letter through 2015, Buffett disclosed both pre-tax earnings as well as cash and investments per share.” Since then, we estimate them.2. We subtract insurance earnings, but then add back a conservative estimate of normalized earnings from Berkshire's insurance businesses: half of the $2 billion of average annual profit over the 14 years prior to 2017,

equal to $608/share.3. Historically we believe Buffett used a 12x multiple, but given compressed multiples during the downturn, we used 8x in 2008-2010 , 10x from 2011-2016, and 11x in 2017 (due to the benefits of the tax reform bill

passed at the end of 2017).

Pre-tax EPS

Cash and Excluding All Subsequent

Investments Income From Intrinsic Value Year Stock

Year End Per Share Investments Per Share Price Range

2001 $47,460 -$1,289 $64,000 $59,600-$78,500

2002 $52,507 $1,479 $70,255 $60,600-$84,700

2003 $62,273 $2,912 $97,217 $81,000-$95,700

2004 $66,967 $3,003 $103,003 $78,800-$92,000

2005 $74,129 $3,600 $117,329 $85,700-$114,200

2006 $80,636 $5,300 $144,236 $107,200-$151,650

2007 $90,343 $5,600 $157,543 $84,000-$147,000

2008 $75,912 $5,727 $121,728 $70,050-$108,100

2009 $91,091 $3,571 $119,659 $97,205-$128,730

2010 $94,730 $7,200 $152,330 $98,952-$131,463

2011 $98,366 $8,036 $178,725 $114,500-$134,060

2012 $113,786 $9,124 $205,027 $139,610-$178,275

2013 $129,253 $10,013 $229,381 $163,038-$229,374

2014 $140,123 $11,260 $252,720 $192,200-$224,880

2015 $159,794 $12,060 $280,396 $189,640-$249,711

2016 $168,099 $12,322 $291,323 $240,280-$299,360

2017 $201,317 $12,903 $343,253 ?

1 2 3

Though book value only rose 2.8% in the first half of 2018, we estimate that intrinsic value has likely risen ~6% as of mid-September, so let’s call it $365,000

BERKSHIRE IS TRADING 12% BELOWITS INTRINSIC VALUE

* Investments per share plus 12x pre-tax earnings per share through 2007, then an 8x multiple from 2008-2010, a 10x

multiple from 2011-2016, and an 11x multiple in 2017.

Intrinsic value*

1996 1998 2000 2002 2004 2008 2010 2012 2014 20162006

$50k

$0

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2017

12-MONTH INVESTMENT RETURN

• Current intrinsic value: $365,000/share

• Plus 6% annual growth of intrinsic value of the business

• Plus ~$10,000/share cash build over next 12 months

• Equals intrinsic value in one year of $397,000

• 23% above today's price

CATALYSTS

• Continued earnings growth of operating businesses

• Likelihood of meaningful acquisitions

• New stock investments

• Additional cash build

• Share repurchases (especially now that Buffett has abandoned the 1.2x book value limit and has repurchased stock above 1.4x)

RISKS: WHO WILL REPLACE BUFFETT?• When Buffett is no longer running Berkshire, his job will be split into two parts: one CEO, who has

not been named (likely Greg Abel and/or Ajit Jain, both of whom were just added to Berkshire’s board), and a small number of CIOs (Chief Investment Officers)– A CEO successor (and two backups) have been identified, but not publicly named– Two CIOs have been named already, Todd Combs and Ted Weschler, both of whom are excellent investors

• Nevertheless, Buffett is irreplaceable and it will be a significant loss when he no longer runs Berkshire for a number of reasons:– There is no investor with Buffett's experience, wisdom and track record, so his successors' decisions

regarding the purchases of both stocks and entire businesses might not be as good– Most of the 80+ managers of Berkshire's operating subsidiaries are wealthy and don't need to work, but

nevertheless work extremely hard and almost never leave thanks to Buffett's "halo" and superb managerial skills. Will this remain the case under his successors?

– Buffett's relationships and reputation are unrivaled so he is sometimes offered deals and terms that are not offered to any other investor – and might not be offered to his successors

– Being offered investment opportunities (especially on terms/prices not available to anyone else) also applies to buying companies outright. There's a high degree of prestige in selling one's business to Buffett (above and beyond the advantages of selling to Berkshire). For example, the owners of Iscar could surely have gotten a higher price had they taken the business public or sold it to an LBO firm

AREN'T WE CONCERNED ABOUT THE UNCERTAINTY OF BERKSHIRE AFTER BUFFETT?Answer: Not really, for three primary reasons:1. Buffett isn't going anywhere anytime soon. We think it's at least 75% likely that Buffett

will be running Berkshire for five more years• Buffett turned 88 on Aug. 30th, 2018, is in excellent health, and loves his job• There are no signs that he is slowing down mentally – in fact, he appears to be getting better with age

• A life expectancy calculator (http://calculator.livingto100.com) shows that Buffett is likely to live to age 94 – and we'd bet on the over

2. The stock is undervalued based on our estimate of intrinsic value, which does not include any Buffett premium• We simply take investments/share and add the value of the operating businesses, based on a

conservative multiple of their normalized earnings• The value of the cash and bonds won't change, and Wells Fargo, Kraft Heinz, Coke, American

Express, Burlington Northern, GEICO, etc. will continue to generate robust earnings even after Buffett is no longer running Berkshire

3. Buffett has built a powerful culture that is likely to endure

WHY DOESN'T BUFFETT IDENTIFY HIS SUCCESSOR NOW?We agree with Buffett's decision not to name his successor for three reasons: 1. It would place enormous pressure and expectations on this person, which is

unnecessary and counterproductive; 2. It might be demotivating for the candidates who were not chosen; and 3. Who knows what will happen between now and the time that a successor

takes over (which could be more than a decade)? – Maybe the current designee falls ill, leaves Berkshire, performs poorly, or makes a

terrible mistake (e.g., David Sokol)– Or what if another candidate (perhaps one of the two backup successors today)

performs incredibly well, or Berkshire acquires a business with a fantastic CEO, and Buffett and the board decide that another candidate is better?

– By not naming Buffett’s successor now, Buffett and the board will be able to switch their choice without the second-guessing and media circus that would occur if the successor had been named

THE REAL BUFFETT RISK

• Buffett is often asked (as are we): "What would happen to the company (and stock) if you got hit by a bus (i.e., die suddenly)?"– If it happened tomorrow, our best guess is that the stock would fall 15% (which might give

Berkshire the opportunity to buy back a lot of stock)– But this isn't likely. Not to be morbid, but most people don't die suddenly from something like

an accident or heart attack, but rather die slowly: their bodies (and sometimes minds) gradually deteriorate

– A far greater risk to Berkshire shareholders is that Buffett begins to lose it mentally and starts making bad investment decisions, but doesn't recognize it (or refuses to acknowledge it because he loves his work so much) and the board won't "take away the keys", perhaps rationalizing that a diminished Buffett is still better than anyone else

– Buffett is aware of this risk and has instructed Berkshire's board members, both publicly and privately, that their most important job is to "take away the keys" if they see him losing it

– We trust that both Buffett and the board will act rationally, but also view it as our job to independently observe and evaluate Buffett to make sure we're comfortable that he's still at the top of his game. Today, we think he's never been better

BERKSHIRE'S CULTURE IS POWERFUL AND UNIQUE: “A SEAMLESS WEB OF DESERVED TRUST”• Berkshire operates via extreme decentralization: though it is one of the largest businesses in the

world with approximately 377,000 employees, only 26 of them are at headquarters in Omaha– There is no general counsel or human resources department

• "By the standards of the rest of the world, we overtrust. So far it has worked very well for us. Some would see it as weakness." – Charlie Munger, 5/14

• "A lot of people think if you just had more process and more compliance — checks and double-checks and so forth — you could create a better result in the world. Well, Berkshire has had practically no process. We had hardly any internal auditing until they forced it on us. We just try to operate in a seamless web of deserved trust and be careful whom we trust." – Munger, 5/07

• "We will have a problem of some sort at some time…300,000 people are not all going to behave properly all the time." – Warren Buffett, 5/14

• "Behavioral scientists and psychologists have long contended that 'trust' is, to some degree, one of the most powerful forces within organizations. Mr. Munger and Mr. Buffett argue that with the right basic controls, finding trustworthy managers and giving them an enormous amount of leeway creates more value than if they are forced to constantly look over their shoulders at human resources departments and lawyers monitoring their every move." – NY Times, 5/5/14

WE THINK BERKSHIRE AFTER BUFFETT WILL BE LIKE APPLE AFTER JOBS• The most comparable example of a business that, like Berkshire, is closely associated

with its legendary founder and CEO is Apple– As Steve Jobs' health began to fail, he assumed fewer day-to-day responsibilities, passing them to top

lieutenants– Jobs resigned as CEO on Aug. 24, 2011 and died exactly six weeks later– Apple's stock declined less than 1% on the first trading days after both his retirement and death, and

has more than quadrupled since then as this chart shows:

OTHER RISKS

• The single biggest risk is that as Berkshire gets larger and Buffett gets older, investors value the stock at a lower and lower multiple of earnings and book value, such that even if intrinsic value continues to grow, the stock goes nowhere for an extended period

• A recession impacts Berkshire's earnings and stock portfolio materially

• A very large investment goes awry

• A major super-cat event costs Berkshire many billions

CONCLUSION: BERKSHIRE HAS EVERYTHING WE LOOK FOR IN A STOCK: IT’S SAFE, CHEAP AND GROWING AT A HEALTHY RATE

• Extremely safe: Berkshire's huge hoard of liquid assets, the quality and diversity of its businesses, the fact that much of its earnings (primarily insurance) aren't tied to the economic cycle, and the conservative way in which it's managed all protect Berkshire's intrinsic value, while the share repurchase program provides downside protection to the stock

• Upside: trading 12% below intrinsic value (without giving any credit to immense optionality), with 23% upside over the next year

• Growing: Intrinsic value is growing at roughly 6-8% annually

APPENDIX

EARNINGS BY YEAREarnings before taxes* 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Insurance Group:

GEICO 970 1,221 1,314 1,113 916 649 1,117 576 680 1,127 1,159 460 462 -310

General Re 3 -334 526 555 342 477 452 144 355 283 277 132 190 -685

Berkshire Reinsurance Group 417 -1,069 1,658 1,427 1,222 250 176 -714 304 1,294 606 421 822 -2,963

Berkshire H. Primary Group 161 235 340 279 210 84 268 242 286 385 626 824 657 719

Investment Income 2,824 3,480 4,316 4,758 4,896 5,459 5,145 4,725 4,454 4,713 4,357 4,550 4,482 4,902

Total Insurance Oper. Inc. 4,375 3,533 8,154 8,132 7,586 6,919 7,158 4,973 6,079 7,802 7,025 6,387 6,613 1,663

Non-Insurance Businesses:**

Burlington Northern Santa Fe 3,611 4,741 5,377 5,928 6,169 6,775 5,693 6,328

Berkshire Hathaway Energy 466 485 1,476 1,774 2,963 1,528 1,539 1,659 1,644 1,806 2,711 2,851 2,973 2,584

McLane Company 228 217 229 232 276 344 369 370 403 486 435 502 431 299

Manufacturing 436 733 686 813 992 3,911 4,205 4,811 4,893 6,211 6,861

Service & Retailing 1,787 1,921 3,297 3,279 3,014 1,028 3,092 3,675 1,272 1,469 1,546 1,720 1,820 2,083

Finance and financial products 584 822 1,157 1,006 771 653 689 774 1,393 1,564 1,839 2,086 2,130 2,058

Total Non-Insur. Oper. Inc. 3,065 3,445 6,159 6,727 7,757 4,239 10,113 12,211 14,000 15,458 17,511 18,827 19,258 20,213

Total Operating Income 7,440 6,978 14,313 14,859 15,343 11,158 17,271 17,184 20,079 23,260 24,536 25,214 25,871 21,876

Note: In 2017, Berkshire consolidated General Re and Berkshire Reinsurance Group, so the breakdown is estimated based on the prior year’s split.* In 2010, Berkshire changed this table from "Earnings before income taxes, noncontrolling interests and equity method earnings" to "Earnings before income taxes".** Non-insurance businesses were recategorized in 2014, so figures prior to 2012 are not comparable.

BERKSHIRE’S SHARE REPURCHASE PROGRAM (1)

• On September 26, 2011, Berkshire announced the first formal share repurchase program in Berkshire's history, and only the second time Buffett has ever offered to buy back stock

• It's unusual in three ways:1. There's no time limit2. There's no dollar cap3. Buffett set a price: "…no higher than a 10% premium over the then-current book value of the

shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount…"

• In December 2012, Berkshire increased the limit to 1.2x book and announced that it had repurchased $1.2 billion in one transaction

• In July 2018, Berkshire announced a new repurchase program whereby there’s no limit to the buybacks so long as the company's consolidated cash balance stays above $20 billion and the valuation of the stock is less than intrinsic value in the eyes of Buffett and Munger

BERKSHIRE’S SHARE REPURCHASE PROGRAM (2)

• Buffett said in an interview that he bought back some stock subsequent to the end of Q2, which is a major development since the stock was trading above 1.4x book value

• It confirms that Buffett shares our belief that Berkshire stock remains undervalued– He wouldn't be buying it back at a 40% premium to book value if he thought its intrinsic value was, say, 50%

above book

• Buffett has put a new (albeit soft) floor on the stock: he appears eager to buy back a lot of stock –and he has plenty of dry powder to do so:– Berkshire has $103 billion of cash (excluding railroads, utilities, energy, finance and financial products), plus

another $19 billion in bonds (nearly all of which are short-term, cash equivalents), which totals $122 billion, meaning he has over $100 billion to deploy

– On top of this, the company is generating well over $20 billion in free cash flow per year – in other words, the better part of ~$2 billion is pouring into Omaha every month

• It's unlikely, however, that Buffett would repurchase anything close to this amount, as some of the cash and bonds are held at various insurance subsidiaries, plus Buffett likely wants to keep plenty of dry powder to make acquisitions and investments

– In summary, Buffett could easily buy back $75 billion of stock and still have plenty of dry powder for other investments

DON’T OVERLOOK MUNGER –HE IS A GENIUS IN HIS OWN RIGHT (1)Favorite Mungerisms

• The more hard lessons you can learn vicariously, instead of from your own terrible experiences, the better off you will be…So the game is to keep learning.

• What is elementary, worldly wisdom? Well, the first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form. You've got to have models in your head. And you've got to array your experience – both vicarious and direct – on this latticework of models.

• Most people are trained in one model and try to solve all problems in one way. You know the old saying: To the man with a hammer, the world looks like a nail. This is a dumb way of handling problems.

• Our experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. If you took our top 15 decisions out, we’d have a pretty average record.

• As Jesse Livermore said, “The big money is not in the buying and selling…but in the waiting.”

• There’s always been a market for people who pretend to know the future. Listening to today’s forecasters is just as crazy as when the king hired the guy to look at the sheep guts.

• All I want to know is where I’m going to die, so I’ll never go there.

DON’T OVERLOOK MUNGER –HE IS A GENIUS IN HIS OWN RIGHT (2)Favorite Mungerisms (continued)• No wise pilot, no matter how great his talent and experience, fails to use his checklist.• In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the

time – none, zero.• We have never given a damn whether any quarter’s earnings were up or down. We prefer profits to losses,

obviously, but we’re not willing to manipulate in any way just to make some quarter look a little better.• To say accounting for derivatives in America is a sewer is an insult to sewage.• We think there should be a huge area between what you’re willing to do and what you can do without

significant risk of suffering criminal penalty or causing losses. We believe you shouldn’t go anywhere near that line.

• Our approach has worked for us. Look at the fun we, our managers, and our shareholders are having. More people should copy us. It’s not difficult, but it looks difficult because it’s unconventional.

• If you rise in life, you have to behave in a certain way. You can go to a strip club if you’re a beer-swilling sand shoveler, but if you’re the Bishop of Boston, you shouldn’t go.

• Spend each day trying to be a little wiser than you were when you woke up. Discharge your duties faithfully and well. Step by step you get ahead, but not necessarily in fast spurts. But you build discipline by preparing for fast spurts. Slug it out one inch at a time, day by day. At the end of the day, if you live long enough, most people get what they deserve.

DON’T OVERLOOK MUNGER –HE IS A GENIUS IN HIS OWN RIGHT (3)• To learn more about/from Munger, I highly recommend two books:

1) Poor Charlie’s Almanack (I wrote Chapter 3 and provided many of the transcripts)

2) Seeking Wisdom: From Darwin to Munger

CASE STUDY:ALPHABET (GOOGLE)

THE BASICS

• Stock price (9/12/18 close): $1,171 (GOOGL)

• Market cap: $823 billion

• Cash & STI: $102 billion ($147/share)

• Debt: $4 billion

• Enterprise value: $725 billion

• 2018 est. EPS and P/E: $48.05, 24.4x

Q2 ‘18 EARNINGS WERE EXCEPTIONAL

• Revenue up 26% (23% constant currency)

• Operating cash flow up 37%

• Aggregate paid clicks up 58%

GOOGLE WAS MY WORST CALL EVER

• In a column published on The Motley Fool website on July 30, 2004 entitled The Tech Stock Opportunity, I wrote:

Just as Google came out of nowhere to unseat Yahoo! as the leading search engine, so might another company do this to Google. I admire Google and what it has accomplished --and I'm a happy user -- but I am quite certain that there is only a fairly shallow, narrow moat around its business.

Think about it. What are the odds that it is the leading search engine in five years (much less 20)? 50/50 at best, I suspect, and I'd wager that odds are at least 90% that its profit margins and growth rate will be materially lower five years from now. Yet investors appear ready to value this company at as much as $36 billion, nearly 200 times trailing earnings! Google with the same market cap of McDonald's (a stock I own)?! HA! I believe that it is virtually certain that Google's stock will be highly disappointing to investors foolish enough to participate in its overhyped offering -- you can hold me to that.

WHAT DID I MISS?

• Google is in enormous, rapidly growing markets

• It has expanded from desktop search into many other areas: Gmail, mobile search, Chrome, app store, YouTube, Google maps, Android, etc.

• I was completely wrong that Google has “only a fairly shallow, narrow moat around its business”; in fact, Google has a very powerful virtuous cycle at work, that leads to a huge moat:

Large User Base

Large Advertiser

Base

Better Monetiz-

ation

Most R&D

Dollars

Best Product

High Barriers to Entry

• Network Effects

• Economies of Scale

• Winner-Take-All

REVENUE GROWTH HAS BEEN REMARKABLEUP 35x SINCE 2004

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REVENUE GROWTH IS ACCELERATINGThis is truly remarkable for a company this large (revenue run-rate of $125+ billion)

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MARGINS ARE HIGH AND STABLE

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EARNINGS GROWTH HAS BEEN PHENOMENAL

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THE STOCK HAS BEEN A HUGE WINNER

ALPHABET IS ONE OF THE GREATEST BUSINESSES ON EARTH• It dominates its sectors globally, is growing rapidly, has enormous, sustainable competitive

advantages in the form of brands, habits, and network effects, and has a low-capital-intensive, high-margin business model that generates gobs of free cash flow

• It has seven products with more than one billion monthly average users: Search, Android, Maps, Chrome, YouTube, Google Play and Gmail

• Google Search has 90% share of search in most countries, Android has ~90% share of smartphones globally (vs. 5% in 2010), and YouTube serves ~20% (and growing) of all video consumed on the internet

• Alphabet currently captures 14-15% of global advertising spending• 100% of the incremental ad spending in the world is going to Alphabet and Facebook• There is plenty of room for growth:

– Enormous trend of advertising moving from traditional media to online– Only ~12% of U.S. commerce is online today– Smartphone penetration is only ~32% globally

YOUTUBE HAS ENORMOUS POTENTIAL• The world’s second-most visited website (after Google.com), 80% outside of the U.S.

• Video appears to be at an inflection point, and Alphabet has arguably the most valuable video platform in the world, as users watch 1.3 billion hours/day (5 billion videos/day) and upload 300 hours of video every minute

• The average mobile viewing session lasts more than 40 minutes, up with more than 50% year-over-year

• Video is currently ~15% of Alphabet gross advertising revenue, growing at twice Alphabet’s overall rate

• Opportunity to increase monetization, as YouTube serves ~20% of the web’s videos, yet only ~10% of the web’s video ads

• In the U.S. YouTube currently monetizes at 60-70% the level of TV despite significantly better targeting

• Annual revenue/user is slightly below Twitter despite having nearly 3x time spent/user

• If Alphabet spun off YouTube, how would the market value it?

– How it’s currently valued within Alphabet: $17 billion (est. $12 billion in revenue * ~4% net margin * 24x) = $12/share

– How it could be valued: $190 billion (assuming 40 cents/hour viewed, half of what cable companies are valued at) = $270/share (source: Bill Nygren, VII, 5/17)

“OTHER BETS” DEPRESS REPORTED PROFITABILITY

• Alphabet’s “Other Bets” segment includes Waymo (autonomous vehicles), Nest (thermostats), Verily (life sciences & healthcare), Access, Calico, CapitalG, GV, and X

• In 2017, Other Bets generated revenues of $1.2 billion (up 49% YOY) and operating losses of $3.4 billion (down 6% YOY; down 19% in Q1 ‘18)

• Alphabet’s operating income in 2017 was $26.1 billion, so excluding Other Bets, it would have been $29.5 billion or 13% higher

• Alphabet has invested ~$25/share into Other Bets; a conservative estimate is that this could be worth ~$50/share or 4% of Alphabet’s value

BUT WHAT ABOUT VALUATION?

• It’s hard to argue that Alphabet is misunderstood, with 40 analysts following the company

• But the stock looks reasonably valued, at 24x 2018 EPS estimates

• This multiple isn’t crazy in light of the quality and growth prospects of Alphabet’s core businesses

• They’re even less crazy if you adjust for various factors:

– If you subtract net cash ($141/share) and the value of Other Bets ($50/share), and add $2.7 billion ($3.89/share) to net income for after-tax losses on Other Bets, Alphabet is trading below 20x 2018 earnings estimates – not far above the average for the S&P 500, for a company that is vastly superior to the average large U.S. corporation

– If you think YouTube adds $255/share of extra value, the P/E drops below 15x

• If revenues continue to grow at ~20% annually and margins and multiples remain steady, then the stock will also grow at ~20% annually

• If you asked me to name 10 stocks that I think are most likely to outperform the S&P 500 over the next five and ten years, Alphabet would be on the list (after Berkshire Hathaway and Howard Hughes, to be sure), so I’ve made a bit of room for it in my portfolio

CASE STUDY:FACEBOOK

THE BASICS

• Stock price (9/12/18 close): $162.01

• Market cap: $479 billion

• Cash & STI: $42 billion ($15/share)

• Debt: $0

• Enterprise value: $437 billion

• 2018 est. EPS and P/E: $7.18, 22.6x

• 2019 est. EPS and P/E: $8.34, 19.4x

Q2 ‘18 EARNINGS WERE EXCEPTIONAL

• Revenue up 42%

• EPS up 32%

• Monthly active users at 2.2 billion (!), up 11% YOY

– 2/3 are daily active users (1.47 billion)

– Massive potential to further monetize users, as Average Revenue Per User is $25.91 in the U.S. and only $8.76 in Europe, $2.62 in Asia/Pacific, and $1.91 in the rest of the world

• However, guidance was weak and the stock tumbled

REVENUE GROWTH IS ASTRONOMICAL

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THE STOCK HAS BEEN A MONSTER, BUT IS DOWN 26% FROM ITS JANUARY HIGHS

THE STOCK IS TRADING AT ITS LOWEST MULTIPLES EVER

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SUMMARY

• Despite all of the bad press this year, revenue growth was still 42%

• It appears unlikely that regulators will take action that meaningfully crimps growth or margins– In fact, certain proposed regulations, ironically, might further entrench Facebook

(and Google)

• There is massive potential to further monetize users

• The stock is trading at it lowest valuation multiples ever

• While the valuation doesn’t appear low based on traditional metrics, if Facebook can continue to grow at anything close to its historical rates, the stock is a huge bargain today

FACEBOOK HAS VAST OPPORTUNITY TO MONETIZE FOREIGN USERS