Four Stocks that Buffett and Combs Could Be Buying

By Greggory Warren, CFA | Senior Stock Analyst

Aside from making a $9 billion bid for Lubrizol ,  Berkshire Hathaway's   first-quarter trading activity was markedly different from what The Morningstar Ultimate Stock-Pickers Team saw from the insurer back in the third and fourth quarters of last year. As you may recall, Berkshire completely eliminated stakes in  Republic Services ,  Iron Mountain ,  CarMax ,  NRG Energy , and  Home Depot  during the third quarter, while trimming back positions in  Procter & Gamble ,  Moody's ,  Nike ,  Fiserv ,  Nalco Holding ,  Ingersoll-Rand , and  Comcast ; they used some of the proceeds from these sales to invest heavily in  Wells Fargo  and  Bank of New York Mellon . The selling continued in the fourth quarter, with Berkshire eliminating holdings in Nike, Fiserv,  Nestle , Nalco,  Lowe's ,  Becton Dickinson ,  Bank of America , and Comcast.

While Berkshire put some of the money from these fourth quarter sales into Wells Fargo, we also noted that the insurer was building up a $2 billion to $3 billion cash stake that incoming portfolio manager Todd Combs could work with once he started overseeing investments this year. Much of the selling that took place during the second half of last year was directed at many of the smaller positions in Berkshire's stock portfolio, which Warren Buffett has traditionally ascribed to Lou Simpson, who had overseen the investment portfolio at the company's GEICO auto insurance subsidiary for more than thirty years. With Simpson retiring at the end of last year and Buffett looking to raise capital for Combs to work with, these holdings became expendable. That's not to say that the smaller positions that remain in the portfolio are sacrosanct, especially after there was just one stock sale during the first quarter of 2011, but the decision to sell (or buy more) may not come as readily as it did for the holdings that were sold in the third and fourth quarters of last year.

Thus, the future of smaller holdings (less than $200 million) in names like  USG ,  Torchmark ,  Sanofi-Aventis ,  United Parcel Service ,  GlaxoSmithKline ,  ExxonMobil , Ingersoll-Rand, and  Gannett  is likely to remain in flux until Buffett and Combs (as well as any other portfolio managers that come on board during the next couple of years) figure out where they want to weight the portfolio in the longer term. As it stands now, the majority of Berkshire's $53.6 billion stock portfolio is dedicated to the consumer defensive (46% of total stock holdings) and financial services (40%) sectors. It should be noted, though, that large stakes in top-five holdings  Coca-Cola , Wells Fargo,  American Express , Procter & Gamble, and  Kraft Foods , which collectively account for close to three quarters of Berkshire's total stock holdings, are responsible for such a heavy weighting in these two sectors. With it highly unlikely that Buffett will exit any of these top-five positions in the near term and Combs' expertise running the way of financial services, we don't expect the weighting to change too much in the near term. In fact, even if Combs had put $2 billion into  MasterCard  during the first quarter, as opposed to the $50-some million that he put into the name, it would have lifted financial services to 42% of the total stock portfolio (while reducing the weighting of the consumer defensive sector to 44%).

Berkshire Hathaway's Top 10 Stock Holdings (as of 03/31/11)

Stock Price and Morningstar Rating Data as of 05-20-11

As is the case in most periods, Berkshire's equity portfolio remains concentrated among its top 10 holdings, which accounted for more than 93% of the total dollar value of its stock holdings at the end of the first quarter. The only trading activity in these names was an 8,000 share reduction in Berkshire's stake in  ConocoPhillips . As you may recall, Buffett has acknowledged (on several occasions) that the timing of Berkshire's initial purchase in the firm in 2008, when oil and gas prices were near their peak, was a major mistake, and has been selling down the position ever since. Having sold close to 55 million shares between the fourth quarter of 2008 and the second quarter of 2010, we had assumed that Buffett was done selling. So, we were a bit surprised to not only see Berkshire's stake in ConocoPhillips decline during the first quarter, but to see it go down by just 8,000 shares (relative to a stake that is greater than 29 million shares overall). While we could make the case that this was the start of a complete unwinding of the stake and that Berkshire's notation in its 13-F that "confidential information has been omitted...and filed separately" with the SEC could be related to this transaction (given that Berkshire held around 2% of ConocoPhillips total shares outstanding at the end of the first quarter of 2011), we think it is unlikely.

Buffett tends to reserve his unique arrangement with the SEC for situations in which Berkshire is in the process of establishing a stake in a firm and does not want the disclosure of its buying activity to drive up the stock's price before it has finished building its position. While there has been some speculation that this could involve the large multinational firm that Berkshire was pursuing in the first quarter, we think that is less likely, given that Buffett tends to either buy publicly traded firms outright or, in cases when Berkshire does have a stake, build a position in the firm well in advance of a takeout of the firm.

We also don't think that this has anything to do with Lubrizol, a company Berkshire agreed to acquire in March for $9 billion, which is expected to close in the third quarter of this year. We also think this involves neither  Goldman Sachs  nor  General Electric , both in which Berkshire holds warrants as part of the financing arrangements Buffett made with these two firms during the financial crisis.

That said, we do think that with Goldman and Swiss Re , another recipient of financial aid from Berkshire, repaying more than $8 billion combined to the insurer so far this year, Buffett has more than $44 billion in cash to work with right now. While the Lubrizol deal and Todd Combs' $2 billion to $3 billion starter fund will reduce that cash down to $32 billion, Berkshire will also recoup more than $3 billion from General Electric before the end of the year, leaving Buffett with a cash stake equivalent to what he had on hand at the beginning of 2011.

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

While it would be interesting to speculate about what Buffett may have been buying during the first quarter, we're doubtful that it was the Oracle of Omaha's trading activity that necessitated the special dispensation from the SEC. We think it is far more likely that Todd Combs was looking to build up stakes in some of his favorite companies without having to worry too much about the price of these stocks running away from him while in the process of building positions. With that in mind, we looked back at Combs' stock portfolio prior to his closing down of Castle Point Capital Management at the end of last year to see if we could glean any insight into what he might be purchasing today. In addition to the 10 names mentioned above (which accounted for two thirds of his total stock portfolio), Combs had another 14 equity positions (two of which were warrants) outstanding at the end of the third quarter of 2010.

Looking over these holdings, we feel there are a few names that we can probably eliminate. First and foremost, we don't see Berkshire building up a stake in Renaissance Re , given that it already has heavy exposure to the reinsurance market through subsidiaries General Re and Berkshire Hathaway Reinsurance. We're also doubtful that Combs would look to build up a stake in  Progressive , given Berkshire's ownership of GEICO, which is the third-largest auto insurer in the United States and a direct competitor to Progressive. While one could argue that other insurance holdings like  Chubb ,  Genworth Financial , and Global Indemnity  don't suffer too much from an overlap with Berkshire's own operations, we just don't see them making their way into the company's investment portfolio, especially since Berkshire already has a small stake in Torchmark.

We also don't believe that Combs has been buying Goldman Sachs or Wells Fargo, both of which were smaller holdings in his hedge fund. Berkshire currently holds warrants, which expire in 2013, to buy $5 billion worth of Goldman common stock for $115 per share, making a purchase of the shares (which have traded between $135 and $165 per share since the start of the year) in the open market far less attractive. As for Wells Fargo, Berkshire already has a sizable stake in the bank, and Buffett made rather substantial additions to the insurer's holdings back in the third and fourth quarters of last year (when the stock was trading in the mid-$20s), so we don't believe that Combs was interested in making it one of his first purchases.

This leaves us with a handful of firms--excluding MasterCard (in which Combs built a stake during the first quarter and, as such, would be unlikely to ask for special dispensation from the SEC)--in which Combs has shown interest and that are not only covered by our analysts, but are trading at enough of a discount to their fair value estimates to consider further investigation:

 U.S.Bancorp 
Besides being Combs' largest holding at the end of the third quarter of last year, U.S. Bancorp is already a top-10 holding at Berkshire. While we're doubtful that Combs used up his starter fund to make a meaningful addition to U.S. Bancorp, we do believe that he could have impressed on Buffett the need to increase the position size during the first quarter before the bank received permission from the Federal Reserve to raise its dividend. As our bank analyst Jaime Peters noted in a previous article, U.S. Bancorp has been one of the most vocal banks about wanting to raise its dividend payout during this time of stress. While the bank raised its quarterly dividend less than the $0.15-$0.20 range that Peters was looking for once it has received permission to do so from the Federal Reserve, she thinks that U.S. Bancorp could raise its dividend again later this year, which feeds into our thoughts that Berkshire may be increasing the stake it already has in the firm. With its dividend currently yielding more than what Berkshire is earning on Wells Fargo, it would make sense for Buffett to increase the stake in order to offset some of the income Berkshire will be losing this year as a result of repayments from Swiss Re, Goldman and General Electric.

 Western Union 
Combs made Western Union (at a little more than 6% of his total stock holdings) a top-five holding in his fund, and with the stock trading at a meaningful discount to our fair value estimate, it is a name worth looking at. Our analyst Brett Horn believes that Western Union's business model is very attractive. The company uses outside agents to collect and disburse cash around the globe, eliminating the need to maintain a retail footprint. As such, the business requires little in the way of capital investment. He also notes that as the largest player (by a wide margin) in what is a very scalable industry, Western Union is extremely profitable. While not unaffected by the global downturn, Horn believes that the money transfer industry has been resilient due to the fact that most money transfers are typically sent to cover the living expenses of relatives residing in other countries. He sees growth continuing to trend back to more normalized levels, with the first quarter showing signs that Western Union continues to shake off some of the headwinds it faced during the recession, as average principal amount per transaction increased for the first time in two years. Horn still believes that the long term dynamics behind immigrant population growth (low population growth in wealthy countries and large disparities in GDP per capita between rich and poor countries) are firmly in place, which should allow Western Union to continue to reap the benefits of its position in the market.

 JPMorgan Chase 
While not a top-10 holding, JPMorgan Chase was the 11th largest stock position at Castle Point (making up a little more than 5% of the fund's total stock holdings). As you may recall form our last article, the bank was a high conviction purchase for three of our top managers during the most recent period and remains one of Morningstar analyst Jaime Peters' top picks. While there weren't many financial services executives that came out of the financial crisis with an improved reputation, JP Morgan's CEO Jamie Dimon may be the highest profile member of this rather exclusive club. Peters believes that the company's success is largely due to Dimon's tight grip on the risks the company takes as a whole, as well as his insistence on having a fortress balance sheet. This, in her view, allowed the bank to operate from a position of relative strength during the crisis. That said, Peters feels that Dimon now faces a whole new set of hurdles as JP Morgan attempts to navigate what has become a more challenging regulatory environment, especially the Basel III standards (set to start phasing in during January 2013), which will force banks to hold more capital and, ultimately, crimp profitability. The fact that JP Morgan's current market price equates to a price/book multiple of only 1.1 times suggests to us that the market believes the company will have difficulty achieving excess returns given these new requirements. In Peters' mind, that's selling Dimon a bit short, as she continues to believe that JP Morgan can achieve a 13% return on equity in the long run.

 Charles Schwab (SCHW)
Right in line behind JPMorgan Chase was Schwab, which accounted for close to 5% of Todd Combs' stock portfolio at the end of the third quarter of last year. While not quite as cheap as Western Union and JPMorgan Chase on a price/fair value basis, the shares have pushed down close to $17 twice since the start of the year. Morningstar analyst Michael Wong notes that Schwab is arguably the best-known provider of retail brokerage services in the United States, with the company making its mark early among self-directed investors through the advent of the discount brokerage model, as well as the early establishment of an online presence. The company has also expanded its model to include independent advisors and institutional services over the years, helping to diversify its revenue stream. Wong believes that Schwab's earnings, which he feels likely bottomed in the first quarter of 2010, continue to be pressured by the impact that historically low interest rates are having on fees collected from its money market funds. While the company has been able to offset some of this through increased trading revenue and growth in assets under management overall, Wong expects Schwab's earnings growth to be slower than it has been in the past--that is, until interest rates start going up--which should help to accelerate earnings growth longer term.

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