Our Picks from Berkshire's Portfolio

Investment conglomerate  Berkshire Hathaway (BRK.B) recently released its first-quarter Form 13-F, which disclosed the company's equity investments as of March 31, 2007. Berkshire's investment portfolio is run by Chairman and CEO Warren Buffett, as well as his colleague at auto insurer GEICO, Lou Simpson. Both have impressive long-term investment track records, and I think that by comparing their picks with Morningstar's 5-star stock universe, investors can potentially uncover some very attractive investment ideas. Berkshire is but one of several investment managers I closely follow while managing The Morningstar Ultimate Stock-Picker's Portfolio. To continue receiving my analysis of Berkshire's portfolio along with several other top investment managers' portfolios, please be sure to subscribe to my free e-mail alerts.

Recent Thoughts on Investing
At this year's Berkshire Hathaway annual shareholders meeting, Buffett said that when analyzing securities at Berkshire, they favor companies where they can have a very good idea of what the business will look like down the road. What's more, he said that when Berkshire looks to buy a business or stock, it wants to purchase those that have earned--and can continue to earn--high returns on capital for owners.

At Morningstar, we have a similar focus on identifying businesses with high returns on capital, and we define these types of companies--partially borrowing a phrase from Buffett--as possessing an "economic moat." You'll notice that in the table on Page 2 of this article, the bulk of Berkshire's equity positions have either a narrow or wide moat rating by Morningstar's analysts, indicating that each business has some form of competitive advantage(s). As such, we'd expect these "moaty" businesses to earn high returns on capital for owners over time.

However, simply identifying a good business is not enough for investment success. The price you pay is equally important. In his seminal book The Intelligent Investor, Buffett's mentor Ben Graham encouraged investors to buy only those stocks that are trading at substantial discounts to their intrinsic value. He coined the phrase "margin of safety" to illustrate this concept. At this year's Berkshire annual meeting, Buffett's partner, Charlie Munger, put it even more succinctly, saying "margin of safety means getting more value than you're paying."

At Morningstar, each stock star rating is based on the discount--or margin of safety--to our fair value estimate. As such, when a stock is rated 5 stars, it means that our analysts think the shares are selling at a large enough margin of safety to potentially generate attractive returns for owners over time.

Given the similarities between Morningstar's approach to analyzing businesses and Berkshire's investment philosophy, I think that when our separate analytical paths overlap on a common investment conclusion, it is a very strong indicator of an attractively priced business. Before looking at our collective best ideas, though, let's recap Berkshire's recent transactions.

New Positions and Eliminations
Through the first three months of the year, Berkshire disclosed six new positions, though it had already been building stakes in five of them for a couple of quarters. Berkshire recently disclosed positions in three railroad stocks,  Burlington Northern Santa Fe ,  Norfolk Southern (NSC), and  Union Pacific (UNP). At Berkshire's annual meeting earlier this month, Buffett said that even though railroads will never be a fantastic business, he believes that the competitive position of these firms has improved relative to truckers over the last couple of decades. What's more, he indicated that he thinks their competitive positioning could still get better over time.

Morningstar published an article last June that reached a similar conclusion about the prospects for the railroad industry. You'll notice that although we don't believe these businesses have carved out an economic moat as of yet, we were starting to see some of the same indicators of a strengthening competitive position that also came to Berkshire's attention. Even better, we had Norfolk Southern rated 5 stars last June. In the ensuing months, though--potentially while Berkshire was accumulating its position--the prices of the railroad stocks have increased, and as a result, are all now rated 3 stars (fairly valued) by Morningstar.

In its last annual report, Berkshire also disclosed a couple of international stock positions--Tesco PLC and  Posco (PKX). Because Berkshire owns the local shares of some international-based companies, and not the U.S. ADRs, it typically doesn't have to disclose its international holdings with the Securities and Exchange Commission. While we presently do not rate U.K.-based retailer Tesco, I'll note that its business is somewhat similar to another of Berkshire's large holdings,  Wal-Mart (WMT), which is rated 5 stars by Morningstar analyst Joseph Beaulieu. We do rate the ADRs of South Korean steel producer Posco, which we currently believe to be fairly valued. Finally, Berkshire disclosed a relatively small position in health insurer  WellPoint (WLP), after having disclosed a similarly sized position a few months back in fellow health insurer  United Health Group (UNH). Presently, Morningstar analyst Brandon Troegle believes that both WellPoint and United Health are fairly valued, and as such, they are both rated 3 stars.

Our analysis indicates that Berkshire didn't eliminate any of its positions during the first quarter.

Additions and Subtractions
In addition to a few new positions, Berkshire added to some of its existing holdings as well. Berkshire increased its stake in  Wells Fargo (WFC),  Johnson & Johnson (JNJ),  Iron Mountain (IRM), and  Sanofi-Aventis (SNY). The biggest additions were to Wells Fargo and J&J, the latter of which my colleague Heather Brilliant has rated 5 stars. Berkshire's additions to Iron Mountain and Sanofi-Aventis were more modest, and the two stocks are currently rated 4 stars and 3 stars, respectively, by Morningstar.

Berkshire also reduced its position in some stocks in the first quarter, selling part of its stake in  Anheuser-Busch (BUD),  Ameriprise Financial (AMP),  Western Union (WU), and  H&R Block (HRB). Further reductions in Berkshire's stake of Ameriprise were not much of a surprise, as Berkshire has been slowly selling this position since it received the shares when longtime holding  American Express (AXP) spun off the unit in September 2005.

Much more surprising, though, was the trimming of the Western Union position, which Berkshire had received when the money-transfer firm was spun out of  First Data Corporation  last year. With a bit of a different view, my colleague Brett Horn's analysis indicates that Western Union has a wide-moat business, and he currently believes that the shares are priced to offer potential investors good long-term returns. That said, he has also noted in his  Analyst Report that the current regulatory environment has the potential to be challenging for the company in the near term. As for H&R Block, Berkshire has been trimming this position over the last few quarters, potentially as a result of the firm's exposure to subprime lending in its former Option 1 subsidiary, or the firm's corporate strategy, which we've been skeptical of for some time now.

Click for our 5-star picks and more on Berkshire's holdings. >>