The Berkshire Hathaway Portfolio

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I regularly review the stock holdings of Berkshire Hathaway BRK.B, the investment conglomerate run by Warren Buffett, one of the all-time great investors. It should also be noted that some of Berkshire's stocks are selected by Lou Simpson, who has run the equity portfolio at Berkshire's wholly owned auto insurer, Geico, for the past 25 years. As Buffett laid out in Berkshire's 2004 annual report, Simpson's investment record is impressive in its own right, having outpaced the S&P 500 by an average of almost 7% per year. As such, I'll gladly learn from either.

Each quarter, Berkshire files form 13-F, which discloses its consolidated equity investments, with the SEC. Berkshire's latest 13-F disclosed 39 stock positions as of Sept. 30. Berkshire also owns some foreign investments, but the firm doesn't have to disclose these because it owns the local shares, not the U.S. ADRs. As such, I've excluded them from this analysis.

Recent Commentary
At Berkshire Hathaway's annual meeting in May, Buffett said that if he were starting his investment partnership over again, he would invest in securities around the world and focus on smaller companies. To illustrate this, he used the experience of his relatively recent investments in Korea, stating that since companies with strong balance sheets were trading at a meager 3 times earnings, he would have been almost 100% invested in Korea. What's more, he said he wouldn't expect all of his small investments to pay off, but would only need a few to pay off very big. While this commentary is very instructive for most of us, you won't necessarily see Berkshire making these types of small-company investments anymore.

The reason for this is that Berkshire is so big now--it has more than $40 billion in cash on its balance sheet--that it is difficult for the firm to invest in stocks with relatively small market capitalizations. In addition, given their small size, these investments would have a negligible impact on Berkshire's results. As such, Berkshire tends to make investments in larger companies, where it can deploy enough cash to move the needle on its own intrinsic value. And Buffett has a fairly conservative outlook on Berkshire's current stock investments, stating in last year's annual report that he believed the share prices of Berkshire's stock portfolio might only double in about 10 years' time.

Now you're probably thinking: Great, if Buffett himself thinks Berkshire's equity investments will only be slower growers, why should I be interested in them? Well, in my view, the ability to buy a fractional ownership interest in some great businesses at attractive prices with limited downside is still a very good proposition, especially when compared to the average investor's current opportunities. In fact, investors who might be able to safely double their portfolios in 10 years' time--a 7.17% potential compound annual return--will still probably beat the returns of the majority of investors and quite possibly the S&P 500. While the S&P 500 has appreciated in the last few years, it is still now only within shouting distance of the level it reached during 1999-2000, and even worse, my colleagues at Morningstar collectively believe that the S&P 500 is modestly overvalued entering 2007.

New Investments and Additions
As of Sept. 30--Berkshire's most recent filings with the SEC--the conglomerate didn't add any new positions compared to its June 30 report, but it did receive shares in Western Union WU which was spun off from longtime holding First Data FDC. Berkshire also increased its stake in five of its existing holdings: Iron Mountain IRM, Lowe's LOW, Nike NKE, and USG USG.

I think the most intriguing of these is Western Union, which dominates the lucrative money transfer market. My colleague Mark Weber has long held Western Union to be the most undervalued part of First Data's overall business, and he believes that the spin-off now allows potential investors to participate in the economics of this outstanding franchise at a very attractive price. In fact, Weber estimates Western Union's fair value to be $32 per share, about a 45% upside to the firm's current share price.

It should also be noted that Berkshire boosted its stake in USG, a manufacturer of gypsum wallboards, which emerged from asbestos-related bankruptcy last June. Berkshire has owned USG since 2001, and more recently backed a rights offering from the company in mid-2006. Given Buffett's experience with asbestos liabilities via Berkshire's insurance operations, as well as his acquisition of the formerly asbestos burdened John Mansfield, I'm cautiously optimistic about Berkshire's stake in USG as well. I will note, however, that as of this writing Morningstar does not have a rating on USG shares.PAGEBREAK

Eliminations and Reductions
Even though Berkshire is typically a buy and hold investor--especially when it comes to making wholly owned acquisitions--it does from time to time trim or outright sell some of the positions in its equity portfolio. In the quarter that ended Sept. 30, Berkshire modestly trimmed its position in beer maker Anheuser Busch BUD, sold some of its holdings in tax adviser H&R Block HRB, continued to divest its stake in financial services distributor Ameriprise Financial AMP, and appears to have sold a significant chunk of its shares in mass-market retailer Target TGT.

The apparent decision to jettison shares in Target is surprising, given that Berkshire had recently released that it built a position of 5.5 million shares of the retailer through June 30. Berkshire's Sept. 30 filing indicates that the conglomerate now only owns 745,000 shares. An analysis of Target's stock price history indicates that if Berkshire did in fact reduce its position in Target, it would likely have done so at a price at least equal to, if not below, the price at which it had accumulated the position. Given that Berkshire still has sizable positions in relatively similar retailers like Wal-Mart WMT and Home Depot HD, it seems odd that Berkshire would do an about-face on Target. It should be noted, though, that the SEC allows Berkshire to delay filing its holdings on some stocks while it is still accumulating a position. For example, this is how the conglomerate has disclosed its growing stake in Johnson & Johnson JNJ. Thus, it's still possible that Berkshire has maintained a position in Target, with the disclosure being somewhat delayed. Giving further credence to this hypothesis is my colleague Joseph Beaulieu's $65 per share fair value estimate for the retailer, which indicates that at Morningstar we still believe that the shares are moderately undervalued.

Less surprising than Target, however, was the continued liquidation of the Ameriprise shares, which Berkshire had acquired when longtime holding American Express AXP spun off the unit in mid-2005. My colleague Dafina Dunmore believes that it will be difficult for Ameriprise to generate above-average returns on capital due to a difficult regulatory climate and intensifying competition. Given this outlook and the fact that Dunmore believes the shares are fairly valued right now, I suspect that Berkshire will continue to divest itself of Ameriprise over time.

5-Star Stocks
As of Jan. 8, only four of Berkshire's stocks boasted 5-star Morningstar Ratings for stocks, which itself is an interesting commentary on overall stock market valuations. That said, our analysts still believe that the shares of United Parcel Service UPS, Wal-Mart, the aforementioned Western Union, and White Mountains Insurance WTM are currently offering investors the potential to earn attractive long-term returns.

More interesting still is that even with the recent runup in the share price, Berkshire's stock still has a 5-star rating, with a fair value estimate of $4,550 per class B share. In my view, an investment in Berkshire would have a dual benefit--it gives investors exposure to all of the companies in Berkshire's equity portfolio as well as to the conglomerate's substantial private holdings.

The Complete Holdings
Here's the complete list of Berkshire's equity portfolio, ranked from the largest position to the smallest. I continue to note that despite having 39 names in the portfolio, Berkshire's holdings are very concentrated. The top 10 stocks account for more than 80% of the portfolio: American Express, Anheuser-Busch, Coca-Cola KO, Conoco Phillips COP, Johnson & Johnson, Moody's MCO, Procter & Gamble PG, Washington Post WPO, Wells Fargo WFC, and Wesco WSC.

The list below includes each company's economic moat--Morningstar's assessment of the firm's competitive advantages--as well as the current Morningstar Rating for stocks, which is based on the difference between the stock's current price and our fair value estimate.

The Berkshire Hathaway Portfolio
Stock	Morningstar Rating	Moat Rating	% of Holdings
Coca-Cola KO		Wide	17.69%
American Express AXP		Wide	16.83%
Wells Fargo WFC		Wide	13.66%
Procter & Gamble PG		Wide	12.27%
Moody's MCO		Wide	6.21%
Wesco Financial WSC		Narrow	4.93%
Anheuser Busch BUD		Wide	3.43%
Johnson & Johnson JNJ		Wide	3.16%
Washington Post WPO		Wide	2.52%
ConocoPhillips COP		Narrow	2.11%
Wal-Mart WMT		Wide	1.95%
Ameriprise AMP		None	1.79%
White Mountains WTM		Narrow	1.69%
M&T Bank MTB		Narrow	1.59%
USG Corporation USG	Not Rated	Not Rated	1.56%
American Standard ASD		Narrow	0.92%
Comcast CMCSA		Wide	0.81%
Nike NKE		Narrow	0.69%
Tyco TYC		Narrow	0.55%
General Electric GE		Wide	0.54%
Costco COST		Narrow	0.52%
Iron Mountain IRM		Wide	0.51%
SunTrust Banks STI		Wide	0.49%
H&R Block HRB		Wide	0.47%
First Data FDC		Wide	0.45%
Lowe's LOW		Wide	0.39%
Gannett GCI		Narrow	0.39%
Western Union WU		Wide	0.38%
Torchmark TMK		Narrow	0.35%
Home Depot HD		Wide	0.30%
United Parcel Service UPS		Wide	0.20%
Petrochina PTR		Narrow	0.14%
Outback Steakhouse OSI		None	0.11%
Servicemaster SVM		Narrow	0.09%
Target TGT		Narrow	0.08%
Sealed Air SEE		Narrow	0.07%
Pier 1 Imports PIR		None	0.05%
Sanofi Aventis SNY		Wide	0.04%
Comdisco Holding CDCO	Not Rated	Not Rated	0.04%
Holdings as of 09-30-06 Morningstar data as of 01-08-07

Justin Fuller, CFA, is a stock analyst with Morningstar. He has a position in the following securities mentioned above: HD HD HD TYC GE PG USG WU.