Why Would an Ultimate Stock-Picker Dump Berkshire?

By Brett Horn | Associate Director of Equity Research

As you may recall from one of our recent articles, we avoid including managers in our list of Ultimate Stock-Pickers who are too diffuse in their equity portfolio holdings, because closet indexers tend to give very few signals that investors can exploit for their accounts. Holding 1% or less of your portfolio in any given stock doesn't display much conviction, as too little is at stake. As such, we like fund managers such as the team running  Fairholme (FAIRX) who are not only willing to make bigger bets but have been able to generate strong historical performance as well. Making concentrated bets is not without controversy, though, and Fairholme has created plenty of that over the last couple of years as it sold what had been a very large stake in  Berkshire Hathaway (BRK.A) (BRK.B) and built up a similarly large position in  Pfizer (PFE). In this article, we'll take a much deeper look at each of these moves and see whether or not investors should consider following Fairholme's lead.

Fairholme Bets Big on Pfizer
Over much of the past year and a half, Fairholme has built up a very concentrated stake in Pfizer. At the end of February of this year, the position accounted for 16% of the fund's total portfolio. Now that's conviction. While it looks to be part of a larger health-care play that Fairholme's lead manager, Bruce Berkowitz, discussed with us in a recent video report, nobody invests this much in a single stock without a strong feeling that the upside dramatically outweighs the downside. So what has Berkowitz so excited about Pfizer's prospects? In his own words (from a March 30, 2009 conference call):

"[A] AAA-quality balance sheet [and] a company producing vital products and services greatly appeals to me. And I think [it is] a company that is somewhat misunderstood. So I think our edge is...informational arbitrage in that I believe the company is being undervalued."

This begs the questions why was Pfizer misunderstood by the market, and how did Berkowitz come to believe it was undervalued? Again, in his own words (from a conference call on Oct. 15, 2008):

"I don't think most people in the United States realize that there is a difference between a generic drug, and [branded] drugs. And Pfizer, I think, is going to become a giant in [the branded] area. There are also new executives. Kindler, we like a lot.... He's really cutting the fat out of the organization, going more--much more towards the venture capital model, whereby, instead of having people internally coming up with new miracle drugs, he's waiting for young vibrant companies and universities to do it. And then Pfizer is one of few places they will go to get the cash they need and the distribution system."

Getting to Know Pfizer Better
This all sounds pretty good, but there's always the possibility that it is Berkowitz who misunderstands the company and not the market. To get more information, we spoke with our analyst, Damien Conover, who covers the company. He believes Pfizer's size gives it a substantial scale advantage and puts a wide moat around its business. Drug development is as much about plate appearances as batting average, in his view, and Pfizer has ample resources to support the development of new drugs. He does, however, see some bumps in the road ahead and notes that the expected loss of exclusivity on Lipitor can't be ignored. Lipitor makes up 25% of total sales and carries higher-than-average gross margins. That said, the company's pending acquisition of  Wyeth  should help insulate Pfizer somewhat from this issue, as after the merger Lipitor will represent only 13% of the total sales of the combined firms. Overall, Damien thinks Pfizer is a high-quality company that is trading at an extremely attractive price and agrees with Berkowitz that the market is overlooking the potential for significant cost reductions. His fair value estimate is $26 per share and the stock is currently rated 5 stars.

So we agree with Berkowitz that Pfizer is an attractive play. It was attractive enough in Berkowitz's opinion, in fact, to put 16% of Fairholme's investment portfolio into the stock. The fund did, however, build up the majority of its stake in Pfizer over the first, second, and third quarters of 2008, which meant that Berkowitz was actually too early into the stock. Fairholme finished building its current stake by the end of November 2008, when the stock was trading between $14 and $18 per share; although most of the shares appear to have been purchased at significantly higher prices throughout 2008. While Pfizer has bounced back a bit with the recent market rally, it has spent the last month trading in the $14-$15 range.

Fairholme Blows Out Berkshire
As interesting as Fairholme's high-conviction bet on Pfizer is, it wasn't the first move the fund has made that has crossed our radar. In November 2007, Fairholme's stake in Berkshire Hathaway accounted for almost 20% of the fund's total portfolio, and yet by November 2008 it was completely gone. Fairholme effectively went from high conviction to no confidence in a proverbial heartbeat. For some insight into what the thinking was behind the decision to eliminate Berkshire from his holdings, let's look at Berkowitz's comments (from an Oct. 15, 2008, conference call):

"We have tremendous respect for Warren Buffett but we have to listen to the man who believes that he's going to do a couple of points better than the S&P 500 and given [Berkshire's] size, I would not disagree with that comment. He also has companies that are subject to the same problems that today's economy are presenting [and] significant contracts on puts on the S&P. I mean Berkshire Hathaway traditionally has suffered with most companies during difficult period[s]. But in the past, it has gone up much faster than the S&P during a turnaround. So we felt that given our size we should still have the ability to do better than a couple of points [over] the S&P [and] it was time to dramatically lighten the load."

He raises some valid points, and with hindsight, his decision to sell Berkshire was extremely prescient, given the lackluster performance of its shares since Fairholme first started selling the position in the first quarter of 2008. Berkshire has grown over the years into a conglomerate with its fingers in many different pies, so we'd agree with Berkowitz that it is hard for a company of Berkshire's size to outlap the growth of the overall economy. And while Berkshire's financial strength is largely intact, in our view, the company has not been completely immune from the financial crisis or economic slowdown. We do think, however, that concerns over the market puts that the company has written were largely overblown due to the long-dated nature of those options, as we discussed in a recent note. It should also be noted that the marks on those put options have reversed somewhat in recent months.

Berkshire Is Now Attractively Priced
But at this point, we think investors would do well to give Berkshire a much deeper look, as one important thing has happened since Fairholme started selling its stake: The stock has gotten significantly cheaper. At this point, Berkshire's shares trade at about 1.3 times book equity value, compared with the 1.5 to 2.0 times range the stock has traded at over the last 10 years. And we wouldn't discount Buffett's ability to create value going forward. Our analyst Bill Bergman, who covers Berkshire, notes that the company came into the crisis with a lot of cash and that Buffett used that position to secure investments in quality companies such as  General Electric (GE) and  Goldman Sachs (GS) on what have proved to be very attractive terms.

While Buffett has also made some investment mistakes over the past year or so, such as being too early into  ConocoPhillips (COP) or riding his financial stock holdings all the way down, we wouldn't turn away the opportunity to invest alongside him at what looks to be one of the most attractive valuations for Berkshire's shares in recent memory. Berkshire's financial strength gives the company incremental pricing power and flexibility in its insurance operations, which Berman believes is an advantage that will reap dividends in today's uncertain environment.

Seven High-Conviction Ultimate Stock-Pickers' Stocks
	Star Rating	Fair Value Uncertainty	Moat Rating	Current Price ($)	Price/ Fair Value	No. of Fund Owners
Johnson & Johnson (JNJ)		Low	Wide	55.66	0.70	15
Wal-Mart Stores, Inc. (WMT)		Low	Wide	50.06	0.83	15
Microsoft Corporation (MSFT)		Low	Wide	22.55	0.65	13
Procter & Gamble Company (PG)		Low	Wide	52.08	0.68	12
Wells Fargo Company (WFC)		High	Narrow	24.91	0.83	12
Berkshire Hathaway Inc. (BRK.B)		Medium	Wide	2,925.00	0.73	11
ConocoPhillips (COP)		Medium	Narrow	45.76	0.57	11
Coca-Cola Company (KO)		Low	Wide	48.41	0.57	9
Pfizer Inc. (PFE)		Medium	Wide	14.05	0.54	8
Burlington Northern Santa Fe		Medium	Narrow	75.35	0.91	6
Data as of 07-16-09. Fund ownership data as of funds' most recent filings.

As you can see from the top holdings of our Ultimate Stock-Pickers during the most recent period, it would appear that Fairholme's conviction in Pfizer over Berkshire is not so widely held. Of the 26 managers in our Investment Manager Roster, 11 hold Berkshire while only eight have positions in Pfizer. Two managers actually hold both names, but one of them,  Fairfax Financial (FFH), has actually made a much larger bet on Pfizer than it has on Berkshire. What is truly interesting, though, is that the managers holding Berkshire tend to hold it with far more conviction than those holding Pfizer, with the median position size for Berkshire being 4.3% of the portfolios in which it is held versus 2.6% for Pfizer.

Only time will tell whether or not Fairholme, and the other managers holding Pfizer, do better than those that have placed their bets on Berkshire, but it is at least interesting to see some divergence of opinion among our top managers. We'd encourage investors, however, to take a much deeper look at both of these 5-star stocks, which are highly regarded by our analysts and continue to trade at attractive prices for portfolios focused on the long term.

Disclosure: Brett Horn does not own shares in any of the companies mentioned above. An immediate family member of Brett Horn is employed by a Berkshire subsidiary.