Berkshire Hathaway Shakes Up Its Stock Portfolio

By Greggory Warren, CFA | Senior Stock Analyst

When we relaunched Ultimate Stock-Pickers last year, 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, the portfolio managers at insurance companies are not impacted by investor redemptions during poor market environments. They also tend to be a bit more long-term oriented than fund managers, investing their portfolios according to the time horizons and payout profiles associated with the product lines underwritten by their firms. While fixed income tends to dominate the investment portfolios of most insurance companies, 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, in these portfolios.

Of the four insurance companies in our Investment Manager Roster-- Berkshire Hathaway (BRK.A) / (BRK.B),  Markel (MKL),  Alleghany , and Fairfax Financial (FRFHF)--Berkshire Hathaway is probably the best known, owing to the legendary 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 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. We'd be remiss, though, if we didn't mention the contribution made by Lou Simpson, who has overseen the investment portfolio at GEICO, Berkshire's auto insurance subsidiary, for more than thirty years. While Simpson has operated with relative autonomy, his management style has not been all that different from Buffett's--researching the companies he invests in extensively, taking large positions in firms he considers attractively valued, and running a fairly concentrated portfolio.

Changing of the Guard at Berkshire
Two big changes at Berkshire this year, though, could lead to some meaningful changes in the stock portfolio. First and foremost, Lou Simpson is retiring at the end of 2010. While Lou, at 74, is younger than either Buffett or Munger, both of whom are octogenarians, he has decided to end what has been a spectacular career running money at GEICO. While the portfolio he works with at the auto insurer is relatively small compared to Berkshire's total investment portfolio, which includes close to $50 billion in equities, around $40 billion in fixed income, and another $25 billion in other investments, many of the stock trades we see pop up every quarter in Berkshire's 13-F filing are more Lou's doing than they are Buffett's or Munger's. With the insurer's investment holdings commingled, it can be difficult to discern who is buying or selling in any given period, but Buffett has noted over the years that he is more likely to be the one buying if the trade is worth more $1 billion, while purchases smaller than that are more likely to be Lou's doing.

With Lou departing, and both Buffett and Munger well past retirement age, Berkshire has started taking the steps necessary to install a successor to Buffett once he does retire. Over the past five years, the firm has laid the groundwork of its succession planning process, hinting that Berkshire would ultimately have one person handling the operating side of the business, and upwards of three to four people handling the investments. Berkshire's announcement late last month that it had selected Todd Combs, a little-known hedge fund manager, to handle a "significant portion" of the firm's investment portfolio are signs to us that the process is moving forward. At just 39 years of age, though, Combs is relatively young and, while his investment performance at Castle Point Capital Management has been commendable, his track record only goes back a few years. He has also been focused almost exclusively on financial services stocks, which, while significant contributors to Berkshire's overall portfolio (at more than 40% of the equity portfolio at the end of the third quarter), are just one part of a broader portfolio of stock holdings and operating businesses.

While both Buffett and Munger (who had introduced Combs to Buffett) have faith in the young man, it appears that faith only goes so far, with Buffett noting recently that Combs would initially be running around $2-$3 billion of Berkshire's nearly $50 billion stock portfolio as part of an extended trial. We wouldn't be surprised if Buffett, who continues to act as chairman, chief executive and chief investment officer, finds it difficult to step completely away from the last aspect of his job description. While the possibility still exists for Berkshire to hire two or three more investment managers to help with the firm's portfolio, we'd be surprised if anything happened in the near term (given that it has taken Buffett and the board nearly five years to get to where they are today).

Berkshire Hathaway's Top 10 Stock Holdings (as of 09/30/10)

Stock Price and Morningstar Rating data as of 11-19-10

Looking at Berkshire's stock portfolio at the end of the third quarter, the insurer had close to $50 billion under management, spread out over 33 different equity positions. The portfolio remains concentrated among the top ten stock holdings, which accounted for more than 90% of the total value of Berkshire's stock holdings at the end of the third quarter. This continues to have a big influence on the insurer's sector allocations, with top ten holdings  Wells Fargo (WFC),  American Express (AXP), Wesco Financial , and  U.S. Bancorp (USB) lifting financials to more than 40% of the total portfolio. Meanwhile, large stakes in  Coca-Cola (KO),  Procter & Gamble (PG), and  Kraft Foods (KFT) have made consumer goods just as big of a sector bet for Berkshire. For some perspective, the insurer's next largest sector allocations are in health care (6%)--with holdings in  Johnson & Johnson (JNJ),  Becton Dickinson (BDX),  Sanofi-Aventis (SNY), and  GlaxoSmithKline (GSK)--and consumer services (5%)--through stakes in  Wal-Mart (WMT),  Costco (COST), and  Lowe's (LOW). [These figures do not include foreign investments that are held abroad, such as BYD Corporation, Tesco PLC, and  POSCO  (PKX).]

Trading during the third quarter was a bit more active than we normally see from Berkshire, as the insurer completely eliminated stakes it had previously held in  Republic Services (RSG),  Iron Mountain (IRM),  CarMax (KMX),  NRG Energy (NRG), and  Home Depot (HD). Of these, Republic Services was a relatively recent addition to the portfolio, having been added in the third quarter of 2009. Berkshire also trimmed back positions in Procter & Gamble,  Moody's (MCO),  Nike (NKE),  Fiserv (FISV),  Nalco Holding ,  Ingersoll-Rand (IR), and  Comcast  during the period. It should be noted, though, that with these trades Berkshire has nearly eliminated its holdings in both Ingersoll-Rand and Comcast. We estimate that these sales collectively generated more than $1.5 billion in proceeds for Berkshire (based on average closing prices for these stocks over the course of the third quarter).

Putting Berkshire's Sale Proceeds to Work
The insurer used more than $500 million of the cash derived from these sales to make additions to existing stakes in Wells Fargo and Johnson & Johnson, as well as to make a new money purchase of shares in  Bank of New York Mellon (BK). While the latter name remains a favorite of Morningstar analyst Michael Kon, who believes that the bank benefits from its unmatched market share in the global custody business, especially with demand for third-party custody and fund administration services on the rise, the stock is trading at about a 10% premium to his Consider Buy price. The same could not be said of Johnson & Johnson, which is trading much closer to its Consider Buy price. Morningstar analyst Damien Conover attributes some of the more recent weakness in the stock to the firm's poorer-than-expected third-quarter results, which were impacted by product recalls and lower-than-expected sales in its consumer and device divisions. While he thinks it could take several quarters for Johnson & Johnson to get back on track, Damien still believes that Johnson & Johnson stands alone as a leader across the major health-care industries. It should also be noted that Berkshire was buying Johnson & Johnson when the stock was trading between $57 and $61 per share.

As for Wells Fargo, which Berkshire committed another $400 million to during the third quarter, the retail bank remains a favorite of Morningstar analyst Jaime Peters, who believes that it will be one of the clear winners to come 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 Wells Fargo to continue to achieve a stable, and higher-than-average, net interest margin going forward. She also believes that if regulators give the green light to healthy banks that are looking to pay higher dividends that Wells Fargo could be one of the first domestic banks to announce a hefty dividend increases sometime in early 2011. With the stock trading just below her Consider Buy price, it is definitely an idea worth pursuing further.

As for the other 5-star stocks in Berkshire's portfolio--Lowe's, Becton Dickinson, and  General Electric (GE)--they are all smaller holdings, with the insurer having less than $150 million invested in each name. Of these three, Lowe's is the most attractively priced (relative to our fair value estimate), with General Electric not too far behind it. The problem with these two names, though, is that they are highly sensitive to the economic recovery, which continues to be on life support. It's also interesting that Berkshire completely blew out its position in Home Depot, while retaining its holdings in Lowe's, as they are both home improvement retailers facing an extremely difficult sales environment, with neither really gaining the upper hand on the other. That said, shares of both firms really tanked during the second quarter, with Home Depot seeing a much stronger recovery in its stock price during the more recent period, which could explain why it was sold.

With more than $1 billion in cash proceeds from Berkshire's sales during the third quarter not being reinvested, we have to wonder if Buffett is building up cash for Combs to work with once he joins the firm in the first quarter of next year. If that's the case, we could see more sales as Berkshire looks to raise additional capital, with Ingersoll-Rand and Comcast likely to be the next holdings eliminated from the portfolio (given the significant sales that already took place in the third quarter). While we expect Combs to be given free license to trade within the portfolio, much as Lou Simpson has over the years, we don't believe that he will be as active as he was in his own fund (which held more than 80 different securities, concentrated in total holdings of less than 30 stocks in any given quarter, over the nearly three years that he was running it). That said, we were curious to see what kind of names he has been holding and whether or not any of them could fit into Berkshire's portfolio from the get go.

Todd Combs's Top Holdings at Castle Point (as of 09/30/10)

Stock Price and Morningstar Rating data as of 11-19-10

Looking at the holdings at Castle Point Capital Management at the end of the third quarter, there were only two names that Berkshire and Combs held in common--US Bancorp and Wells Fargo (although it should be noted that Combs held an equity stake in  Goldman Sachs (GS), which Berkshire is also invested in via 50,000 shares of the firm's preferred stock and warrants to purchase 43 million shares of its common stock). With so little overlap between the two portfolios, one could assume that Combs's holdings at the end of the third quarter would serve as a potential shopping list for the investment manager once he starts his stint at Berkshire. If that's the case, then the handful of 4- and 5-star stocks currently in his portfolio (that aren't Wells Fargo) could end up making their way into Berkshire's holdings. Sifting through our analysts' current thinking on the three names that we found in the portfolio's total holdings that fit that bill, we came away with the following conclusions:

 Western Union (WU)  
Our analyst Brett Horn believes that Western Union is the clear leader in an industry where size confers significant advantages. With a network of over 375,000 agents worldwide, and a marked cost advantage over its rivals, he believes that Western Union is well-positioned to come out on the back end of the global economic downturn in a stronger operating position than its peers. Horn notes that most money transfers are typically sent by immigrants working in more developed economies to cover necessary living expenses of relatives they've left behind in their home country. While he admits that the U.S.-to-Mexico corridor gets the most attention, those transfers actually account for less than 7% of Western Union's total revenue. He sees the company continuing to achieve strong growth in underpenetrated Asian markets, and while he doesn't foresee a quick rebound in Western Union's more developed markets, which have struggled with slow economic growth and high rates of unemployment, he believes that the current market valuation implies that we will never again see solid growth in the money transfer industry--a scenario which he finds overly pessimistic.

 J.P. Morgan Chase (JPM)  
Morningstar analyst Jaime Peters believes that J.P. Morgan's discipline and strong balance sheet created an opportunity for the bank to take advantage of the credit crisis rather than become a victim of it. A combination of savvy acquisitions (Bear Stearns and Washington Mutual) that filled in holes in its investment bank and retail operations, along with the bank's ability to attract new customers (given the firm's solid reputation and conservative balance sheet), increased J.P. Morgan's per-share earnings power. That said, she remains cautious about the opportunities the firm has in the long run. Peters believes that much of J.P. Morgan's success is attributable to well-known CEO Jamie Dimon and his tight grip on the risks that the company takes on as a whole, which could unravel should Dimon either retire or leave. She also sees the firm grappling with a grab bag of operations that may lack the profit potential of its more focused peers. If J.P. Morgan can continually hit its goals, though, which will require discipline and a close eye on risk, Peters thinks the stock could be a winner for investors.

 Charles Schwab (SCHW)  
Our analyst Michael Wong believes that Charles Schwab's earnings bottomed in the first quarter of 2010. Arguably the most well-known provider of retail brokerage services in the United States, the company made its mark early among self-directed investors by pioneering the discount brokerage model and establishing an online presence. Over the years, the company has expanded its model to include independent advisors and institutional services. Earnings have been under pressure lately due to an abnormally low interest rate environment. When interest rates begin to rise, Charles Schwab's revenue and earnings should recover. In the meantime, the firm continues to generate revenue from its trading operations, as well as from its asset management arm. As a leading distributor of mutual funds and as a gatherer of client assets, the company's asset management revenue should experience steady growth, while trading revenue likely rebased after the introduction of reduced equity commission fees and subdued trading volumes from relatively low market volatility.

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Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble, Kraft Foods, Johnson & Johnson, Becton Dickinson, and Western Union.