10 Stocks to Consider from Berkshire's Latest Portfolio

By Greggory Warren, CFA | Senior Stock Analyst

When we relaunched the Ultimate Stock-Pickers concept back in April 2009, we had no idea that the market was about to take us on a very wild ride. After rising close to 30% during the last seven months of 2009, the S&P 500 Index (SPX) rose another 15% in 2010, but not without its fair share of volatility, as the European credit crisis and its potential impact on the global economic recovery weighed heavily on shares in the second and third quarters of last year. So far 2011 is looking an awful lot like 2010, with the markets rising more than 5% during the first quarter (much as they did during the first quarter 2010) before hints of trouble in Europe during the second quarter led markets downward (just as they did during the second quarter of 2010). Unlike last year, though, when the markets dropped more than 10% during May and June, only to recover over the next three months, it doesn't look like we'll see a quick recovery this time around. The potential for more than one Southern European country to default on its debt, combined with the political posturing around our own debt and deficit in the United States, has created even more uncertainty for investors--who were already growing concerned about the pace and strength of the economic recovery.

With investors pulling money out of actively managed funds in both May and June (and the pace of these redemptions accelerating in July and August), we expect many of our Ultimate Stock-Pickers to be impacted by outflows, which will likely force some selling activity among these top managers. While we saw some of this occurring in the second quarter, we expect it to increase during the third quarter given the intense see-saw action in the markets during the first couple of weeks of August. That said, we'd made it a point to include a few insurance companies in our list of top managers when we relaunched Ultimate Stock-Pickers because, unlike their peers in the mutual fund business, the portfolio managers at insurance companies are not impacted by investor redemptions during weak market environments (like we are seeing right now). 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 underwritten by their firms rather than being concerned with beating a benchmark over the near term. 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 can 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 many 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 also allow Buffett and Munger to demonstrate their investing acumen. With the retirement last year of Lou Simpson, who oversaw the portfolio at the company's GEICO auto insurance subsidiary for more than 30 years, and the hiring of Todd Combs, who ran money at his own hedge fund (Castle Point Capital Management) focused almost exclusively on financial stocks, there has been a lot more trading activity in Berkshire's portfolio over the last three calendar quarters than we have seen in a very long time.

As you may recall, Berkshire completed eliminated stakes in  Republic Services (RSG),  Iron Mountain (IRM),  CarMax (KMX),  NRG Energy (NRG), and  Home Depot (HD) during the third quarter of last year, while trimming back positions in  Procter & Gamble (PG),  Moody's (MCO),  Nike (NKE),  Fiserv (FISV),  Nalco Holding ,  Ingersoll-Rand (IR), and  Comcast . The insurer then used some of the proceeds from these sales to invest heavily in  Wells Fargo (WFC) and  Bank of New York Mellon (BK). The selling continued unabated in the fourth quarter, with Berkshire completely eliminating holdings in Nike, Fiserv,  Nestle (NSRGY), Nalco,  Lowe's (LOW),  Becton Dickinson (BDX),  Bank of America (BAC), and Comcast; directing most of the proceeds from these transactions at Wells Fargo. Aside from making a $9 billion bid for Lubrizol  during the first quarter of this year, though, Berkshire had been pretty quiet, trimming a little bit of its stake in  ConocoPhillips (COP) and building up a position in  MasterCard (MA).

The insurer did, however, note in its first-quarter 13-F filing that "confidential information has been omitted...and filed separately" with the Securities and Exchange Commission; a notation that also made its way into the firm's second-quarter filing. Buffett tends to reserve this unique arrangement he has with the SEC for situations where Berkshire is in the process of establishing a stake in a firm and does not want the disclosure of its buying activity to drive the price of the stock up before it is finished building the position. Knowing that Todd Combs had been given $2 to $3 billion to work with this year, we had assumed that he was putting money to work during the first quarter in some of his favorite companies without having to worry too much about the price of these stocks running away from him as he was in the process of building positions. That said, we were a bit surprised to see Combs merely adding to his stake in MasterCard, which now accounts for about 0.2% of Berkshire's total equity portfolio, and building up a position in retailer  Dollar General (DG), which we consider to be well outside of his comfort zone, during the second quarter.

With around 9,500 stores in 35 states, Dollar General is the largest dollar store chain in the country. The retailer offers low-income consumers a variety of consumable items as well as home, apparel, and seasonal products that are priced below $10. Acquired by Kohlberg Kravis Roberts (KKR) near the height of the private-equity boom in early 2007, Dollar General was brought public again in late 2009 with plenty of debt on its books. The firm is not alone in its pursuit of low-income consumers either, facing off with other dollar store chains like  Family Dollar , as well as mass merchants like  Wal-Mart (WMT). With no economic moat, a stock that has traded above our fair value estimate for quite some time, and an intensely competitive environment for consumer sales (especially at the lower end of the market), we're not sure that Dollar General was the best place for Combs to be putting capital to work. Having spent much of our last article looking for stocks that Combs might be buying--names like  U.S. Bancorp (USB),  Western Union (WU),  JPMorgan Chase (JPM), and  Charles Schwab (SCHW)--we have to admit that Dollar General was nowhere near the universe of stocks that we considered.

As for the other transactions that Berkshire reported for the second quarter, we have to assume it was Buffett behind the sale of 5.8 million shares of  Kraft Foods (KFT). Never completely warming to the Cadbury acquisition, and with the stock up more than 10% through the first two quarters of 2011, Buffett may have decided to take some money off the table. It's worth noting that this isn't the first time that Buffett sold Kraft shares, selling more than 31 million shares over the first and second quarter of 2010. At the end of the second quarter, Berkshire still held close to 100 million shares of Kraft, with the recent sales taking place before Kraft's announcement that it was splitting itself into two separate companies. After the packaged foods giant announced its restructuring plans, Buffett went on the record to note that he expects to stay invested in Kraft longer term. As for the other major portfolio transaction during the second quarter, which also has Buffett written all over it, Berkshire purchased 9.7 million shares of Wells Fargo, with the insurer increasing its stake in the bank by more than 10% in the last year.

Looking at the two other changes in the portfolio--the elimination of 5.7 million shares of Wesco Financial and the addition of 2.1 million shares of Verisk Analytics (VRSK)--both need to be taken with a grain of salt. Berkshire already owned 80.1% of Wesco Financial, the insurance firm run by Charlie Munger, and agreed earlier this year to pick up the remaining noncontrolling interests that it did not already own. Verisk, meanwhile, is a technology firm that provides insurance companies with data and software that they need to run their business. Prior to its initial public offering in October 2009, Verisk had been funded by a number of large insurance companies--including Berkshire--that received shares in the company as it went public. With restrictions placed on the Class B shares the insurers received as part of the IPO, Berkshire has held approximately 7.1 million shares of Verisk's Class B common stock since that time. With half of these shares automatically converting to Class A common stock in early April, we expect it was the conversion (and subsequent sale of some of the shares) rather than an outright purchase of Verisk that was responsible for the change in Berkshire's 13-F filing. We expect to see even more shares pop up during the fourth quarter of 2011, as the remaining Class B shares convert to Class A common stock in early October.

While Buffett's portfolio remains relatively concentrated, with just 27 stock positions overall (and its top 10 holdings accounting for around 95% of the total stock portfolio), there are more than a handful of names trading at prices that our analysts consider attractive right now:

 Wells Fargo (WFC)
Wells Fargo continues to get a lot of attention from Buffet, with Berkshire adding more than 32 million shares to its stake over the last four calendar quarters. In his annual letter to shareholders, Buffett noted that he expected an increased dividend at Wells Fargo this year to help make up for some of the income it would lose as  Goldman Sachs (GS),  General Electric  (GE), and Swiss Re (SSREY) all repaid their obligations to Berkshire. Our analysts continue to view Wells Fargo as one of the clear winners of the financial crisis. Besides gaining a nationwide footprint, the firm has used its package-based sales approach and its concentration on getting every customer's deposit account to achieve stable, higher-than-average net interest margins, which has directly contributed to enviable returns on equity. While they expect future asset growth to be significantly lower than historical rates, Wells Fargo's returns should still be the envy of the industry.

 U.S. Bancorp (USB)
Accounting for 3.4% of Berkshire's $52 billion stock portfolio at the end of the second quarter, the insurer's holdings in U.S. Bancorp have not changed all that much since the first quarter of 2009. Our analysts note that during the recent credit crisis, U.S. Bancorp never had a single quarter where it lost money. While returns on common equity did dip as low as 8.4% in 2009, they recovered to 12.8% in 2010, and are likely on their way back to 17%-18% levels. Having actually ramped up its capital investment during the crisis--improving its technology and buying multiple banks, trust businesses, processing portfolios, and credit card portfolios--U.S. Bancorp grew rather than shrank in the past couple of years. Our analysts believe that the bank's fundamental earnings power will emerge in 2011, reaching its post-crisis capital levels by the end of the year and leaving room for a large ramp up in share buybacks and dividends in 2012.

 ConocoPhillips (COP)
Buffett has acknowledged (on several occasions) that the timing of Berkshire's initial purchase in ConocoPhillips, when oil and gas prices were near their peak in 2008, was a major mistake and has been selling down what was at one time an 84.0 million share stake in the energy firm ever since. Having initiated his last major sale of the stock during the second quarter of 2010, it looks like Buffett is content to hold the remaining 29.1 million shares left in Berkshire's portfolio. Morningstar analyst Allen Good feels that ConocoPhillips made significant progress last year executing its returns improvement plans by divesting $15 billion worth of assets, including its stake in Lukoil, and repurchasing $4 billion worth of stock. Despite the positive response by investors to these initiatives, management recently announced plans to spin off the downstream assets. While still short on details, the spin-off planned for the first half of 2012 brings some uncertainty to the shares. In the meantime though, an increased asset divestiture program and about $1 billion in share repurchases per month, which (along with higher oil prices and improved refining margins) should add support to the company's stock price over the near term.

 Procter & Gamble (PG)
A legacy holding from Berkshire's investment in Gillette, which P&G acquired in 2005, Buffett had actually added to the stake prior to the collapse of the credit and equity markets, but has since trimmed the stake down to its current 76.8 million shares (compared to 105.8 million at the end of the second quarter of 2008). That said, P&G remains a cornerstone of Berkshire's equity portfolio, accounting for 9.3% of total stock holdings and yielding 3.4% at today's prices. Our analyst Lauren DeSanto believes that P&G has been getting little credit as a safe-haven stock over the last two years, but feels that this could change, as markets have turned more volatile. While a run-up in commodity and energy costs has impacted margins over the last year, DeSanto believes that the firm's geographic reach and brand mix have given P&G a sufficiently diverse toolkit to help it navigate the ups and downs of the ongoing economic recovery. She also notes that over the last three years, P&G has generated $35 billion in free cash flow and has effectively returned this value to shareholders in the form of dividends and share repurchases.

 American Express (AXP)
American Express is another cornerstone of the Berkshire equity portfolio, accounting for 15.0% of total stock holdings at the end of the second quarter. Buffett has not made any meaningful changes in its stake in American Express since before the financial crisis, which was a sound move, as the stock has risen more than 300% in value since the markets bottomed in March 2009 (even after taking into account the recent sell-off in the markets). While not currently trading below our analyst Michael Kon's consider buy price, he feels that it is worth keeping an eye on (especially as markets continue to trend lower). Kon notes that while  Visa (V) and MasterCard are global giants that dominate the global payment industry, American Express' closed-loop credit card network has enough scale to garner a wide economic moat. In order to grow, the firm has opened up its network to issuers and merchant acquirers. With this strategy, American Express is attempting to expand its distribution platform and steal market share from Visa and MasterCard. While investors typically think of American Express as a network first and a credit card lender second, Kon believes the firm's underwriting practices before the most recent cycle, and the losses incurred thereafter, should alert investors to the importance of taking a much closer look at American Express' loan book before pulling the trigger.

 Johnson & Johnson (JNJ)
Much like Procter & Gamble, J&J was a source of cash for Berkshire following the collapse of the credit and equity markets. Buffett started rebuilding that stake almost immediately, though, with Berkshire holding 42.6 million shares at the end of the second quarter. Trading much closer to our analyst Damien Conover's consider buy price, J&J reported second-quarter results that slightly exceeded his expectations due to better-than-expected top-line growth. Having largely passed the major patent cliff facing the rest of the drug industry, with the loss of patent protection on its antipsychotic Risperdal and neuroscience drug Topamax, J&J is in a much better position than many of its peers. With new potential blockbusters hitting the pipeline and a revitalized device segment (aided by the acquisition of the fast-growing orthopedic company Synthes), Conover sees both the drug and device segments at J&J poised for strong growth, which he feels should help offset any of the issues the firm faces in its consumer division.

 Moody's (MCO)
While Buffett has trimmed down his stake in Moody's (from 48.0 million share before the financial crisis to 28.4 million shares at the end of the second quarter), it is still a top 10 holding at Berkshire. While not currently trading below our analyst Michael Corty's consider buy price, he feels that investors are likely to assign a lower relative valuation multiple to the stock than they have historically, given their concerns about future regulatory changes for the credit rating business. Despite the heightened regulatory scrutiny, Corty notes that Moody's still has a large market share in the credit rating business and generates high profit margins with very little capital investment required. While he admits that the credit rating agencies are one of many entities that deserve blame for the excesses that occurred in the public debt markets, he notes that when handicapping potential regulatory changes, investors should remember that sometimes what should happen is different than what is most likely to occur, especially as government entities tend to maintain the status quo without an easy substitute for the current system. The possibility of fundamental regulatory and market changes can't be ignored, though, and the firm's long-standing wide economic moat has taken a hit.

 Kraft Foods (KFT)
As we noted, Buffett was a seller of Kraft shares in the most recent period, reducing Berkshire's stake to 99.5 million shares (or 6.7% of the insurer's stock portfolio at the end of the second quarter), but expects to be a long-term holder of the packaged foods giant. Much like Buffett, our analyst Erin Lash was quite skeptical of Kraft's acquisition of Cadbury when it was announced 18 months ago, and she sees the firm's announcement of its spin-off of Cadbury/Nabisco from the core grocery operations as vindication of her view. While Lash believes the move to break up the firm is a value-enhancer, Kraft's shares are not trading at a large enough discount to her fair value estimate to recommend purchasing the shares. That said, she sees the global snack business potentially garnering an EBITDA multiple of 13 times (in line with the multiple that Kraft paid for the Cadbury business), with the North American grocery business seeing an EBITDA multiple of 8 times (due to a slower growth profile, albeit with respectable margins), which is reflected in her current fair value estimate.

 Wal-Mart (WMT)
At 4.0% of Berkshire's total stock portfolio, Wal-Mart is another top 10 holding for the insurer. Buffett's decision to double his stake in the retailer during the third quarter of 2009 may not have been the best move, though, given that the firm's shares have been relatively flat since the market bottomed in March 2009. Our analyst Michael Keara thinks that this situation is unlikely to change in the near term, believing that the stock will at best remain range-bound, buoyed by buybacks until the company begins to stem its recent market share losses. Keara notes that for the first time ever, Wal-Mart is actually losing domestic sales to competitors. He believes the retail price leader defending its market share, not massive share repurchases, is the only thing that will move shares materially higher. With the stock trading around 15% higher than his consider buy price, Keara suggests that investors not only wait for a better price, but for signs that Wal-Mart is serious about defending its market share before looking seriously at the company's shares.

 M&T Bank (MTB)
While not a top 10 holding, Berkshire holds a $470 million investment in M&T Bank. Morningstar analyst Jim Sinegal believes the management team at M&T Bank has proven its mettle through recessions that have decimated many of its peers. In his view, the bank's conservative underwriting standards and substantial core earnings power should enable it to continue improving its performance at a faster pace than its competitors. Sinegal does note, however, that the bank's merits are no secret to market participants, with the shares continuing to trade above his consider buy price. That said, he feels these high-quality bank shares would be an acceptable, if not exceptional, long-term investment when purchased at a reasonable price, with M&T Bank offering an attractive quarterly dividend in the meantime, having avoided a cut to its payout during the financial crisis.

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Disclosure: Greggory Warren own shares in the following securities mentioned above: Procter & Gamble, Becton Dickinson, Kraft Foods, and Western Union. It should also be noted that Morningstar's Institutional Equity Research Service offers research and analyst access to institutional asset managers. Through this service, Morningstar may have a business relationship with fund companies discussed in this report. Our business relationships in no way influence the funds or stocks discussed here.