Berkshire Hathaway Whittles Portfolio Down Further

By Drew Woodbury | Stock Analyst

When we relaunched Ultimate Stock-Pickers nearly two years ago, we made a point of including a few insurance companies in our list of top managers because, unlike their peers in the mutual fund business, portfolio managers at insurance companies are not impacted by investor redemptions during weak market environments. They also tend to be a bit more long-term oriented than fund managers, investing their portfolios according to the time horizon and payout profiles associated with the products lines that are underwritten by their firms. While fixed income tends to dominate the average insurance company's investment portfolio, as the asset class provides a steady stream of cash flows and (in most markets) less risk than equities, there is always room for stock holdings, which provide the potential for capital appreciation.

Of the four insurance firms in our Investment Management Roster-- Berkshire Hathaway (BRK.A) / (BRK.B),  Markel (MKL),  Alleghany  and  Fairfax Financial (FRFHF)-- Berkshire is probably the best known, owing to the cult-like status that Warren Buffett and Charlie Munger have with investors. Buffett has been involved in Berkshire's investment portfolio for more than forty years, while Munger has been contributing to investment decisions at the firm for nearly as long. This type of longevity is rare among asset managers, and speaks to the success that Berkshire has had finding investments that not only meet the needs of its business, but which allow Buffett and Munger to demonstrate their investing acumen. Having two well-regarded investment managers would be a boon for any firm, but Berkshire was fortunate enough to have a third successful stock picker in Lou Simpson, who oversaw the portfolio at the company's GEICO auto insurance subsidiary for more than thirty years.

Simpson Retirement Drives Selling Activity
While Simpson operated with relative autonomy, his management style was not all that different from Buffett's. He researched the companies he invested in extensively, took large positions in firms he considered attractively valued, and ran a fairly concentrated portfolio. The best way to differentiate Buffett's stock picks in Berkshire's quarterly holdings from those made by Simpson was the size of the position. Buffett has noted in the past that Simpson's investments usually ran in the $200-$300 million range, whereas Buffett's own stock picks were significantly larger in size. With Lou Simpson retiring at the end of 2010, many of these smaller holdings in Berkshire's stock portfolio were being unwound. During the third quarter of last year, the insurer completely eliminated stakes in  Republic Services (RSG),  Iron Mountain (IRM),  CarMax (KMX),  NRG Energy (NRG), and  Home Depot (HD), all of which we assume (based on their position sizes) were Simpson-directed holdings. The insurer also trimmed back positions in  Procter & Gamble (PG),  Moody's (MCO),  Nike (NKE),  Fiserv (FISV),  Nalco Holding ,  Ingersoll-Rand (IR), and  Comcast  during the period.

The selling continued in the fourth quarter, as Berkshire completely blew out stakes in Nike, Fiserv,  Nestle (NSRGY), Nalco,  Lowe's (LOW),  Becton Dickinson (BDX),  Bank of America (BAC), and Comcast. Given their position sizes and past commentary from Warren Buffett (who acknowledged that the Bank of America stake was not his) we can generally assume that these were also initiated by Simpson, and were being unwound prior to his retirement. This left Berkshire with 25 stock holdings at the end of the fourth quarter, with the top ten positions accounting for around 94% of the total portfolio. These top ten holdings have been relatively unchanged over the last four calendar quarters, with Berkshire making adjustments to only a handful of the names. It should be noted, though, that Wesco Financial  will likely fall off the list this year as Berkshire acquires the remaining 20% of Wesco's outstanding shares it does not already own--a move that would move  Washington Post (WPO) up into the top ten holdings.

Berkshire Hathaway's Top Stock Holdings (as of 12/31/10)

Stock price and Morningstar rating data as of 2-18-2011.

After trimming back its stake in  ConocoPhillips (COP) during the first and second quarter of last year (following up on sales in five straight calendar quarters starting in the fourth quarter of 2008), Berkshire made no further sales in the energy firm during the latter half of 2010. The insurer also sold a significant chunk of its stake in  Kraft Foods (KFT) during the first quarter of last year, and trimmed its holdings in Procter & Gamble during the first three quarters of 2010. After selling more than three million shares of  Johnson & Johnson (JNJ) in the first quarter, Berkshire bought more than 17 million shares of the health care giant during the second quarter of last year, and another million in the third quarter. The only other holding that the insurer was adding to aggressively during 2010 was  Wells Fargo (WFC), with Berkshire adding more than 16 million shares during the third quarter, and another 6 million during the fourth quarter.

The retail bank remains a favorite of Morningstar analyst Jaime Peters, who believes that it will be one of the clear winners coming out of the financial crisis. She notes that the firm's purchase of Wachovia, which finally gave it a national footprint, as well as its package-based sales approach and concentration on getting every customer's deposit account, should allow the bank to continue to achieve a stable, and higher-than-average, net interest margin going forward. Jaime also believes that if regulators give the green light to healthy banks that are looking to pay higher dividends, Wells Fargo could be one of the first domestic banks to announce a hefty dividend increase sometime this year. Although the stock has recently rallied more than 40% off of the lows seen in both July and October of last year, Jaime feels that investors can still use pullbacks in the stock price as opportunities to build positions in the name.

Based on our previous assumptions about position size, there are another ten holdings-- Torchmark (TMK),  General Electric (GE),  Sanofi-Aventis (SNY),  United Parcel Service (UPS),  GlaxoSmithKline (GSK),  Bank of New York Mellon (BK),  ExxonMobil (XOM),  Ingersoll-Rand (IR),  Gannett (GCI), and Comdisco --that could continue to be whittled away as we move through 2011, especially if they were positions that were established and actively monitored by Lou Simpson. If we had to choose the next stock to be eliminated from the portfolio, it would probably be Ingersoll-Rand, where Berkshire held close to 8 million shares at the end of the third quarter of 2009 before trimming it down to less than 1 million shares at the end of the third quarter of last year. Less likely candidates might prove to be Sanofi-Aventis, where Berkshire added marginally to its holdings in the second quarter of 2010, and Bank of New York, which the insurer just established a stake in during the third quarter of last year. That said, Berkshire did trim that stake somewhat in the fourth quarter, and the stock was not part of Todd Combs's portfolio when he accepted the investment manager position at the firm last October.

Raising Cash for Todd Combs's Extended Trial
Looking at the thirteen stocks that Berkshire has eliminated since the start of the third quarter, we continue believe these sales were not a reflection of any sort of fundamental problem with the firms that were seeing selling activity, but rather a clearing of the decks by the insurer in preparation for Lou Simpson's retirement, and Todd Combs's coming on board to manage a portion of the Berkshire's portfolio. Warren Buffett recently noted that Combs would initially be running around $2-$3 billion of Berkshire's total stock portfolio as part of an extended trial, so we expect much of the cash that was raised (and not put to work in other names) will be used to help fund that effort. Based on our estimates, the insurer generated more than $1 billion (net of purchases) from its fourth-quarter sales, and another $500 million during the third quarter.

Along with the cash that Berkshire has been raising through stock sales, the insurer has also started to see some of the capital it had extended to other firms during the financial crisis come back onto its books. With  Swiss Re  recently repaying the 12% convertible preferred shares it had issued to Berkshire in March 2009, the insurer not only received the 3 billion Swiss Franc (equivalent to $3.1 billion) in principal, but an additional 20% (or $600 million) for early repayment, as well as more than $800 million in interest payments over the life of the loan. Berkshire could also see  Goldman Sachs (GS) repay its 10% cumulative perpetual preferred stock this year (if allowed to do so by the Federal Reserve), which would bring another $5 billion back into the coffers. We've also heard rumors that Wrigley has been working aggressively to repay the 11.45% loan used by Mars to purchase the gum manufacturer in 2008, which would put another $4 billion back into Berkshire's hands.

The repayment of these instruments will not only increase the cash that Berkshire has on its books, but will have a detrimental impact on the firm's investment income, and leave it in the undesirable position of having to reinvest the proceeds in less lucrative offerings in the near term. This, in our view, will only put even more pressure on Todd Combs to impress. While both Buffett and Munger (who had introduced Combs to Buffett) have faith in the young man, we expect that they will have him on a fairly short leash (evidenced by the $2-$3 billion limit placed on the fund he'll have to work with as part of his extended trial with the firm), and will continue to make the larger capital allocation decisions (like what to do with the more than $10 billion of proceeds that could come in over the next couple of years from the "early" repayment of capital that was provided to Swiss Re, Goldman, Wrigley and others during the financial crisis).

As for Combs himself, while we're not exactly sure how he will manage his slice of the investment portfolio, we would not be surprised to see him continue to invest in financials. His own hedge fund was focused exclusively on the sector, and we expect he will continue to concentrate on this part of the market while at Berkshire, where Buffett has never shied away from running a concentrated portfolio, and has historically held a large allocation in financials (with the insurer's eight financial names accounting for 43% of the stock portfolio at the end of 2010). While Combs was probably not involved in Berkshire's decision to add more than 22 million additional shares of Wells Fargo during the third and fourth quarters of last year, he did have a small holding in the bank in his own fund prior to shutting it down last year. It is also interesting to note that Combs largest position at Castle Point was in  US Bancorp (USB), which remains a top ten holding for Berkshire.

All that said, there was relatively little overlap between Combs's holdings and Berkshire's at the end of the third quarter of 2010, which means that we could see a lot of new names entering the portfolio this year. Of the stocks that Combs held that Morningstar actively covers,  Western Union (WU),  JP Morgan Chase (JPM), and Wells Fargo stand out as being the most attractively priced right now. In the end, though, we expect any investments that Combs makes at Berkshire will likely be on the margin, as the insurer's largest and longest-held positions will likely be considered untouchable for any manager, at least as long as Buffett is still involved in capital allocation and investment decisions.

Disclosure: Drew Woodbury owns bullish derivatives in the following companies mentioned above: Bank of America and Wells Fargo.