A Bounty of Ideas from Berkshire's Portfolio

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. (If you haven't already done so, please be sure to sign up for my free e-mail alerts to get more information about Berkshire and The Ultimate Stock-Picker's Portfolio's performance.)

I think most investors, including me, 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.

New Additions
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 . 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 ,  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 . 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  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  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. In a recent interview on  American Express (AXP), my colleague Michael Kon indicated 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.

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.

Click for Page 2 and our take on Berkshire's 5-star stocks >>