A look at Berkshire's 5-star holdings.
Investment conglomerate Berkshire Hathaway BRK.B recently released its second-quarter Form-13F, which discloses the company's equity holdings as of June 30, 2007. Berkshire is one of the companies I closely follow in managing The Morningstar Ultimate Stock-Picker's Portfolio. Not only do I routinely scan the conglomerate's holdings for new ideas, but my model portfolio also has a position in Berkshire's stock.
I think most investors can learn a lot from the stock picks of Berkshire CEO Warren Buffett and his colleague Lou Simpson, given their focus on buying great businesses at good prices. While the logic behind this philosophy seems straightforward, there are really two things that set Berkshire apart from the rest of the crowd. The first is rather obvious, as the accumulated knowledge of Buffett and Simpson gives them an edge in identifying good businesses, or in the case of Berkshire's railroad purchases, businesses whose economics are slowly improving over time.
The second element that sets Berkshire apart is its time horizon, which Buffett would like to be forever, in an ideal world. In a recent video interview, hedge fund manager Mohnish Pabrai--a true Buffett devotee--refers to this concept of a time horizon advantage as a "time arbitrage." Given that the current focus in the investment world is on annual performance, and more recently even on quarterly and monthly performance, Berkshire is able to benefit by taking stakes in companies whose investment theses may take three to five years to play out. These same stocks are frequently shunned by many mutual and hedge fund managers, who often can be more short-term focused.
In managing The Ultimate Stock-Picker's Portfolio, I also believe in the benefits of a long-term time horizon, which I've stated in my core principles to be three to five years. Where the additional benefit to my model portfolio comes into play, though, is in the ability to piggyback off of Buffett and Simpson's vast sums of accumulated knowledge. Even better, by overlaying Morningstar's equity research on these same stock picks, I can determine the most attractively valued stocks in Berkshire's portfolio at any point in time. Before we get to these best ideas, though, let's recap Berkshire's most recent transactions.
Berkshire added two new names to its portfolio during the last quarter and also added to its positions in eight names. Berkshire added a stake in Bank of America BAC as well as a small position in Dow Jones DJ. The latter addition was interesting, as Buffett has said in the last couple of years that the decline in the economics of the newspaper business has made him shun these investments over time. In this case, though, News Corp's large bid for Dow Jones on May 1, and the market's doubt that the deal would eventually get done, could have prompted Berkshire to take a position in the stock, believing that Dow Jones' shareholders would eventually agree to the company being acquired, since it could have been difficult for Dow Jones to prosper as a stand-alone company.
As for Bank of America, I think it's a great business paying a large dividend, which could help potential investors earn a fairly safe double-digit total return on the stock. Not surprisingly, my colleague Ganesh Rathnam also thinks Bank of America sports a compelling valuation, and as such, I've had it on my watch list for The Ultimate-Stock Picker's Portfolio for the last few months.
Berkshire also added to its stake in Burlington Northern BNI, Johnson & Johnson JNJ, Nike NKE, Procter & Gamble PG, Sanofi-Aventis SNY, UnitedHealth Group UNH, US Bancorp USB, and Wells Fargo WFC. Of these, Johnson & Johnson, Procter & Gamble, and US Bancorp are rated 5 stars, which means our analysts think that these stocks are still cheap enough to potentially warrant a purchase. In addition, I've also included Johnson & Johnson in my model portfolio, as several other managers--including those at Berkshire--continue to believe it is a compelling idea at today's prices.
Subtractions and Deletions
Berkshire also eliminated or reduced its position in some stocks during the quarter. It fully divested itself of H&R Block HRB and Pier 1 PIR. As I've mentioned in past articles, in managing The Ultimate Stock-Picker's Portfolio, I've noticed a bit of a divergence of opinion on H&R Block; some managers have been buying this business while Berkshire has been steadily unloading it over time. At Morningstar, we have maintained our favorable opinion on H&R Block's shares, though we remain somewhat skeptical of the management team. This skepticism could be the reason for Berkshire's divesting of the business, even though it remains a cash cow whose moat is slowly being eroded over time.
It appears as though Berkshire sold Tyco spin-offs Covidien COV and Tyco Electronics TEL, given that the spin-offs took effect in mid-June, and neither of them appeared in Berkshire's June 30 filing. At Morningstar, our analysts still have a 5-star rating on each of these stocks, and as such, I've continued to hold them in my model portfolio. In addition, after accounting for the reverse-split on Tyco International's TYC shares, it appears as though Berkshire may have moderately upped its position in this name after the spin-off.
Berkshire also continued trimming its Ameriprise AMP position. My colleage Michael Kon recently said that the firm's decision to spin off this unit was prudent given Ameriprise's lackluster prospects. What's more, my colleague Alan Rambaldini has it rated 3 stars, indicating that the business is fairly valued.PAGEBREAK
Berkshire also significantly reduced its stake in money-transfer firm Western Union WU. At Morningstar, my colleague Brett Horn continues to maintain his favorable opinion on the shares, though he notes that the regulatory risks to the firm could have serious consequences.
I will also note that Berkshire's second-quarter Form 13-F did not show that the firm still has stakes in Norfolk Southern NSC or Union Pacific UNP. It would surprise me if Berkshire had already completely sold these names, given Buffett's comments about the improving economics of the railroad business earlier this year, as well as Berkshire's hefty stake in Burlington Northern. It could be possible that Berkshire is still accumulating a position in both Norfolk Southern and Union Pacific, and regulators have potentially allowed the conglomerate to omit the disclosure during this accumulation phase.
Berkshire's 5-Star Stocks
Currently, our analysts at Morningstar believe that 12 of Berkshire's stocks are attractively valued enough to earn our 5-star rating as of Aug. 15. Even better, I've also included three of these stocks in The Ultimate Stock-Picker's Portfolio, as several other like-minded investors also share my views on American Express AXP, Wal-Mart WMT, and Johnson & Johnson JNJ. Without further ado, here are the 12 best ideas from Berkshire's portfolio based on Morningstar's rating for stocks:
My colleague Michael Kon recently wrote about Amex, "American Express has a fantastic business model and is poised for continued success. We think the firm's late 2005 spin-off of its advisory unit, Ameriprise Financial AMP, has allowed Amex's flagship card-related business to really shine in 2006, and we expect a very bright future."
Ganesh Rathnam recently commented on B of A's BAC latest acquisition, "We are thrilled with Bank of America's proposed purchase of LaSalle bank. We believe LaSalle will be worth a lot more under the B of A umbrella than its $21 billion purchase price. B of A expects to close the acquisition in the fourth quarter, and we estimate it will take as long as a year for the bank to bring LaSalle's sky-high expense ratio in line with its own. Nonetheless, we remain confident that B of A will accomplish that goal, now that it is a veteran integrator of large acquisitions. We believe the market is offering a tremendous discount for the shares of this giant."
Morningstar analyst Brady Lemos recently remarked on Home Depot's HD second-quarter earnings, "Home Depot reported second-quarter results that were in line with our estimates, and we are maintaining our fair value estimate. As expected, sales at the home-improvement retailer were hurt by the slowing domestic housing market; same-store sales fell 5% in the period. We think the housing market will remain challenging through 2007 and into 2008, yet we are comfortable with our long-term revenue growth and profitability assumptions. In our opinion, Home Depot is well positioned to emerge from this cyclical downturn as a more dominant force in the home-improvement market."
Like Home Depot, Lemos believes competitor Lowe's LOW is attractively valued as well, recently commenting, "While housing market worries could pressure sales over the next few quarters, we like Lowe's long-term prospects and expect the retailer to continue to gain share of the fragmented home-improvement market. We believe Lowe's can leverage its industry-leading customer service, shopper-friendly stores, and proven business model to profitably expand domestically and abroad."
Heather Brilliant recently said about Johnson & Johnson, "J&J is unique among pharmaceutical firms in that more than half of its revenue comes from other areas, namely medical devices and consumer health-care products. We expect these businesses will grow faster than the firm's pharmaceutical division in the coming years, and will therefore increase as a proportion of J&J's revenues and profits. Businesses, such as orthopedic device maker DePuy and minimally invasive surgery division Ethicon Endo-Surgery, continue to develop innovative products and lead their respective markets."
My colleague Michael Corty recently commented on the perceived risk in his 5-star call on Moody's MCO, saying, "We think that Moody's (and other credit-rating firms) will continue to face 'headline risk' due to losses suffered in the subprime mortgage market. It's likely that Moody's will face litigation from parties claiming damages related to its rating actions, in particular, the company's ratings on residential-mortgage-backed securities and related credit derivative products. Moody's has been downgrading its ratings on certain RMBS and CDO issuances, and we think it's likely that additional downgrades will continue as its initial ratings are proving to be too optimistic. It's our understanding that the firm's rating methodology did not correctly anticipate the impact of a decline in residential housing prices."
Morningstar analyst Lauren DeSanto recently said about Procter & Gamble's PG brands, "P&G has an unparalleled skill with brands. It has 22 brands that realize more than $1 billion in annual sales and another 16 brands that rack up more than $500 million per year. The firm's brand equities are so strong that P&G is often the price leader in its categories with brands that hit a value-added, slightly aspirational, premium-priced, sweet spot with consumers. There are competitors that challenge P&G in specific categories, particularly Colgate-Palmolive CL in toothpaste and L'Oreal LRLCY in beauty care, but no other company can hold a candle to the firm's entire product portfolio. More importantly, P&G possesses an amazing ability to reinvent its brands, whether resuscitating Olay, repositioning Old Spice, or boosting Tide by combining it with Downy."PAGEBREAK
Heather Brilliant wrote about Sanofi-Aventis' SNY business, "Sanofi is the product of many mergers, most recently that of French drug powerhouses Sanofi-Synthelabo and Aventis. The firm boasts an enviable product portfolio of drugs that are leaders in their respective markets, including Lovenox for preventing blood clots, sleep aid Ambien, and oncology drugs Eloxatin and Taxotere. Sanofi has also established itself as one of the largest providers of vaccines, a business that has experienced tremendous growth in recent years."
My colleague Ryan Lentell is encouraged by US Bancorp's USB willingness to return capital to shareholders, recently writing, "We admire management's goal of returning at least 80% of earnings to shareholders annually, achieving 10% long-term earnings per share growth, and maintaining returns on equity above 20%. We think these significant self-imposed hurdles are shareholder-friendly, and achieving them should create shareholder value. In our opinion, the firm's efficient and diversified franchise is the key to its consistently strong financial results. Today, almost 50% of US Bancorp's revenue is non-interest-related, reducing its interest rate sensitivity."
Morningstar analyst Parrish Glover recently wrote about USG's USG business, "Even with the strength of USG's brands and distribution, the business remains highly cyclical, with revenue closely tied to booms and busts in commercial, industrial, or residential construction. USG is able to obtain price premiums on wallboard during hot periods, but it must scale prices back when building slows. However, while price volatility leads to choppiness in short-term results, return on invested capital over the long run has averaged 15%, well in excess of the company's cost of capital."
Joseph Beaulieu provided his most recent take on Wal-Mart after its second-quarter earnings release: "Wal-Mart Stores' second-quarter results showed that the company is struggling with slowing spending from its core customers and with its apparel merchandising. We've adjusted our revenue and margin estimates to reflect expectations for a weaker second half of the year and a weaker 2008, but this doesn't have a significant impact on our fair value estimate. However, if same-store sales turn negative over a couple of quarters, we think the deleveraging of fixed costs would result in a significant margin decline, and we'd be likely to cut our fair value estimate."
I continue to believe Berkshire's 80% owned subsidiary Wesco Financial WSC remains a compelling bargain, recently writing, "Berkshire Hathaway's 80%-owned subsidiary, Wesco Financial, recently reported first-quarter results that were somewhat consistent with our expectations. We're sticking with our fair value estimate. Wesco's results were driven by higher investment income, which climbed by more than 16% from the prior-year period, thanks to higher short-term interest rates. Wesco's insurance operations also showed better-than-forecasted results, though we note that the third quarter is typically the heaviest for insurance claims, so we're sticking with our extant assumptions for these businesses. So far this year Wesco's book value per share is up only around 2%, to $344 per share as of June 30. We don't foresee any huge jumps in book value, at least until management can begin to deploy some of Wesco's growing cash hoard--which now approximates $1.27 billion--into new investments."
Despite regulatory risks, Morningstar analyst Brett Horn continues to have a favorable view on Western Union WU, commenting in his latest Analyst Report, "Western Union's second-quarter results were about on par with our expectations, so we are maintaining our fair value estimate. Revenue grew 8%, with tough conditions in the U.S.-Mexico corridor continuing to weigh on the company's results. The operating margin fell from 29% to 27%, but this was largely due to incremental costs associated with operating as a stand-alone entity. The immigration debate and the slowdown in the construction industry are still creating softness in the U.S.-Mexico corridor. Through pricing decreases, Western Union was able to achieve 5% transaction growth along this corridor. However, revenue still dropped 7%. Offsetting this decline was solid growth in money transfers to other countries, which increased 20%. While short-term trends have made for a difficult operating environment, we take some comfort from Western Union's solid cash-flow generation. The company produced almost $500 million in operating cash flow in the first half of 2007 and expects to generate $1 billion for the year."
The Full Portfolio
Justin Fuller is a stock analyst with Morningstar.