Buffett's Lieutenants Impact Berkshire's Most Recent Purchases

By Drew Woodbury | Stock Analyst

When we relaunched the Ultimate Stock-Picker concept 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, the portfolio managers at insurance companies tend not to be impacted by investor redemptions during weak market environments. They're also a bit more long-term oriented than most fund managers, investing their portfolios according to the time horizon and payout profiles associated with the product 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 necessary for duration matching, some insurers choose to hold a larger portion of their investment portfolios in stocks, which have historically generated superior returns over other investments when looked at in the long term.

Of the four insurance companies 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 40 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 that allow Buffett and Munger to demonstrate their investing acumen.

While the long and successful tenure of Berkshire's portfolio managers has been a competitive advantage for the firm, Berkshire is in the midst of a changing of the guards, with Lou Simpson stepping down from his position running GEICO's portfolio at the end of 2010, and both Buffett and Munger moving ever closer to that century mark. While both men are in good health and could theoretically run the investment portfolio at Berkshire for many more years, the firm started looking for upward of three to four people to oversee these investments several years ago. Buffett's first pick (announced in October 2010) was a little-known hedge fund manager named Todd Combs, who ran a fairly concentrated fund at Castle Point Capital Management dedicated almost entirely to financial services stocks.

The second investment manager picked by Buffett (and announced in September of last year), was Ted Weschler, the manager of an extremely concentrated portfolio of slightly more diverse holdings at Peninsula Capital Advisors. Weschler's hiring is notable for several reasons, the most interesting of which was the fact that he was the highest bidder on two separate occasions in a charity auction whose prize was lunch with the Oracle of Omaha. The hedge fund that he ran at Peninsula Capital followed investing methodologies similar to those preached by Buffett, and the $2 billion portfolio (at the end of June 2011) had  DIRECTV and W.R. Grace & Company as its two largest holdings (each comprising more than 25% of the total portfolio). While Buffett has not provided explicit details about the responsibilities of each of his lieutenants, we expect Weschler will manage a similar proportion of the portfolio as Combs--that is, around $2 billion-$3 billion of the more than $65 billion equity portfolio.

Berkshire Hathaway's Top Stock Holdings (as of Dec. 31, 2011)

  Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) % of Stock Portfolio Coca-Cola (KO) 3 Wide 68.69 1.00 Low $156,011 21.2 Intl Bsnss Mchns (IBM) 2 Wide 192.40 1.06 Low $226,766 17.8 Wells Fargo (WFC) 4 Narrow 30.60 0.75 Medium $161,370 16.0 American Exp (AXP) 3 Wide 52.78 0.98 High $61,303 10.8 Procter & Gamble (PG) 4 Wide 65.06 0.90 Low $179,201 7.7 Kraft (KFT) 3 Narrow 38.20 0.98 Medium $67,481 4.9 Wal-Mart (WMT) 2 Wide 62.04 1.09 Low $212,468 3.5 ConocoPhillips (COP) 4 Narrow 73.11 0.86 Low $97,071 3.2 Jhnsn & Jhnsn (JNJ) 4 Wide 64.97 0.84 Low $177,423 2.9 U.S. Bancorp (USB) 4 Narrow 29.09 0.88 Medium $55,515 2.8

Stock price and Morningstar Rating data as of 02-17-12. Figures do not include foreign investments that are held abroad, such as BYD Corporation, Tesco PLC, and POSCO.  

Turning to Berkshire's most recent 13-F filing, which details the company's holdings at the end of the fourth quarter, the first transaction of note was Buffett's purchase of another 22.3 million shares of  Wells Fargo (WFC), which brings the insurer's stake in the bank up to 383.7 million shares (worth $10.6 million at the end of the period). After touting Wells Fargo in his annual review to shareholders last year as a major holding that could see a meaningful increase in its dividend, Warren Buffett put his money where his mouth was in 2011, snatching up another 41.1 million shares of the bank last year, which increased Berkshire's position in the firm by 12%. Morningstar analyst Jim Sinegal continues to be positive on the name as well, noting that it is one of the premier financial institutions in the United States, thanks to its nationwide base of low-cost deposits and relentless focus on customer service and efficiency, not to mention its plain vanilla banking model. This narrow-moat firm continues to trade at a meaningful discount to his fair value estimate, and is likely to receive approval for further dividend increases and share repurchases by mid-2012, which would provide a positive catalyst for the stock price.

About the only other transactions we can ascribe to Buffett--that is, purchases and sales of holdings that are greater than $200 million in size (a benchmark that the Oracle of Omaha put out in the past to differentiate the trades he and Charlie Munger were making from those initiated by Lou Simpson for the GEICO portfolio)--were the purchase of 6.6 million additional shares of  IBM (IBM) (which we already knew about last quarter), as well as the sale of 8.4 million shares of  Johnson & Johnson (JNJ) and 2.7 million shares of  Kraft Foods (KFT). Berkshire has many reasons to sell securities, but this quarter's sales may simply reflect the firm's desire to free cash for Weschler and Combs to invest. While Buffett has insisted time and time again that Berkshire is invested in Kraft for the long haul, he seems to be looking at it more as a source of cash than anything else of late. After initially purchasing more than 130 million shares of Kraft in the fourth quarter of 2007, Buffett has been trimming that stake over the last two years, with his most recent sale bringing Berkshire's stake down to 87 million shares. Johnson & Johnson is another long-term holding that Buffett has been both buying and selling with fairly regular frequency over the last three years. The insurer's most recent sale further reduces Berkshire's stake in the health-care giant to 29 million shares (from a peak of 43 million in the second quarter of 2010, but basically in line with its holding at the end of the fourth quarter of 2008).

Ted Weschler's Top Stock Holdings at Peninsula Capital (as of June 30, 2011)

  Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) % of Stock Portfolio DIRECTV 2 Narrow 45.45 1.20 Medium $32,069 26.0 W.R. Grace NA NA 56.00 - NA $4,134 25.1 DaVita (DVA) 3 Narrow 86.14 1.00 Medium $8,054 19.0 Liberty Media NA NA 87.28 - NA $7,112 11.8 Valassis Comm NA NA 26.02 - NA $1,165 7.7 Cogent Comm (CCOI) NA NA 18.35 - NA $841 3.5 Cincinnati Bell 3 Narrow 3.86 1.10 High $756 3.4 WSFS Fin (WSFS) NA NA 40.52 - NA $349 3.0 FiberTower NA NA 0.20 - NA $10 0.4

Stock price and Morningstar Rating data as of 02-17-12.

While the purchase of another 16.1 million shares of DIRECTV might have looked like a Buffett move, given that the size of the stock position was worth more than $870 million at the end of the fourth quarter, it is more likely a purchase from one (or both) of Berkshire's two new hires. DIRECTV was among Weschler's largest holdings in his Peninsula Capital fund at the end of the second quarter of 2011 (the last full reporting period before Weschler started to liquidate the fund), and as his hiring wasn't announced until mid-September, we have to assume that the third quarter purchase of 4.2 million shares was the work of Todd Combs. Looking at the rest of Weschler's holdings at the end of the June quarter, it looks like he was also the driving force behind Berkshire's new money purchases of 2.7 million shares of  DaVita (DVA) and 1.7 million shares of Liberty Media , with both stocks being top five holdings in his fund.

What's interesting to note, though, is the absence of W.R. Grace from the fourth-quarter transactions in Berkshire's portfolio, given that it was Weschler's second-largest holding at the end of the second quarter of 2011. While W.R. Grace holds some sentimental value for Weschler, who started his career with the conglomerate and bought more than 5% of the company's stock after it filed for bankruptcy protection more than a decade ago, it may not be liquid enough (at this point) to be purchased for the portfolio. The same could also be said for the remaining five holdings in Weschler's nine-stock portfolio, with the largest market capitalization just above the $1.1 billion mark (and the lowest at a measly $10 million).

While Morningstar analysts do not cover most of the stocks that were held by Weschler in his fund at Peninsula Capital, they do have a take on two of his largest holdings--DIRECTV and DaVita. Our analyst Mike Hodel believes that DIRECTV's scale advantages and the low cost of each incremental customer gives it an advantage over its peers. In contrast to some of the recent market entrants, the firm can add new customers at a relatively modest capital expense, allowing it to meet demand fairly easily. Furthermore, in many rural areas, customers don't have an option for fixed-line pay-television service, leaving DIRECTV as one of the only choices. At current prices, though, the stock is not all that attractive from a valuation perspective, trading at more than a 20% premium to our fair value estimate of $38 per share. With the prospect of slower growth and compressed margins in the near-to-medium term, it becomes all that more important for investors to have an adequate margin of safety built in before looking at the shares.

With regard to DaVita, which is a leading provider of dialysis services for patients with chronic kidney failure in the United States, our analysts believe that the firm continues to sport a narrow economic moat. The pure-play dialysis firm has the second-leading market position in services, which is essentially an oligopoly with market leader  Fresenius (FMS). Our analysts believe that while both firms have dug narrow economic moats in this business, there's not much separating them in terms of market share and returns on invested capital. They note that in recent quarters DaVita has been stealing market share from Fresenius in the post-bundling U.S. reimbursement environment, believing that DaVita's position as a key endorser home-based service provider (where patients self-administer the therapy) may be a reason for some of that share shift. Furthermore, DaVita's contract with Amgen for its anemia drug Epogen has been extended through 2018. With several alternative drugs potentially coming to market, our analysts suspect that DaVita was able to obtain a significant discount on the drug, which may contribute to expanding future cash flows even as it deals with the new bundled payment system.

Todd Combs' Top Stock Holdings at Castle Point (as of Sept. 30, 2010)

  Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) % of Stock Portfolio U.S. Bancorp (USB) 4 Narrow 29.09 0.88 Medium $55,515 9.1 MasterCard (MA) 3 Wide 393.99 1.00 High $50,011 7.1 Renaissance Re (RNR) 3 None 73.18 1.03 High $3,790 6.3 Chubb Corp 3 Narrow 69.07 1.03 Medium $19,206 6.0 Western Union (WU) 5 Wide 17.85 0.62 Medium $11,052 6.0 Starwood Hotels 3 Narrow 55.05 1.10 Very High $10,753 5.9 PennyMac (PMT) NA NA 18.01 - NA $502 5.7 State Street (STT) 4 Wide 39.82 0.80 High $19,587 5.6 Progressive (PGR) 3 Narrow 21.53 1.03 Medium $13,362 5.3 Annaly Cap Mgmt (NLY) NA NA 16.62 - NA $16,118 5.2

Stock Price and Morningstar Rating data as of 02-17-12. Does not include short positions at Castle Point Capital Management.

As for the remaining transactions, which we assume were handled by Combs, Berkshire picked up another 573,000 shares of  Visa (V) to go with the 2.3 million shares he'd picked up with new money during the third quarter. Combs also purchased another 1.4 million shares of  CVS Caremark (CVS) during the fourth quarter, adding to the 5.7 million-share stake he had initiated in the previous period. The same sort of activity occurred with  General Dynamics (GD) and  Intel (INTC), both of which were also new-money purchases during the third quarter. In the case of General Dynamics, Combs added 813,000 shares to a 3.1 million-share stake. With Intel, it was the addition of 2.2 million shares that brought Berkshire's stake in the semiconductor firm to 11.5 million shares at the end of the fourth quarter. We also assume Combs sold the remaining 422,000 shares of  ExxonMobil (XOM), which was originally purchased in the third quarter of 2009 and was never a meaningful holding at Berkshire.

Buffett Pans Bonds and Gold, Sticks With Stocks
While not directly related to Berkshire's release of its 13-F holdings, the Oracle of Omaha did cause a bit of a stir this month when he released an excerpt from his upcoming annual letter to Berkshire shareholders in Fortune magazine. While the main arguments expressed in the article have been heard by Buffett followers many times in the past, the underlying mood seems to indicate that he is in a buying mood, which may give hints about his plans for future purchases. Buffett devotes a decent portion of the piece to his feelings on gold, spurred on by the increase in popularity of the asset class among some investors. In general, he echoed statements he made at last year's annual meeting about gold being an unproductive asset, and that its value is only determined by the price that the next buyer is willing to pay for it.

Since gold is not used, in his view, for any industrial or production purposes, about the only thing you can do is look at it, or, as he mentions specifically, "fondle it." Buffett also makes allusions to the fact that gold may be experiencing a bubble, and that "bubbles blown large enough inevitably pop." But gold was not alone in receiving the Oracle of Omaha's derision, as he also panned currency-based investments, namely money market funds, bonds, mortgages, bank deposits, and other similar instruments. In particular, he noted that "bonds promoted as offering risk-free returns are now priced to deliver return-free risk," a quote that he ascribed to Shelby Cullom Davis, a leading financial advisor to governors and presidents, whose son founded Davis Advisors in the late 1960s.

For people concerned about inflation, which was another common theme in the piece, Buffett recommends that investors focus on companies that do not require much capital reinvestment in order to maintain pricing power during inflationary periods. In general, we agree with him, holding a similar view here at Morningstar that investors should consider moaty stocks first, which tend to have the type of pricing power that Buffett mentions. In particular, he mentions IBM and  Coca-Cola (KO), whose securities are held in Berkshire's investment portfolio, as well as See's Candy, a company that is fully owned by the insurer, as examples of firms that benefit from some form of pricing power. The conclusions of the Fortune article are nearly the same as the "Buy American" op-ed that Buffett penned for the New York Times during the financial crisis.

While his investment strategy does not change much with the times, as Buffett has always believed in looking for high-quality companies trading at discounts to their underlying value, he notes that his first choice would be to own these type of firms in their entirety. He is not, however, not adverse to ownership "by way of holding sizable amounts of marketable stocks." That said, there was little in the article that would help investors to discern where he might be looking to buy next, but we could look specifically to companies that require little capital reinvestment as likely targets. If the world is truly on the brink of a more inflationary period, it is left to be seen, though, whether or not Buffett would pass up more capital-heavy businesses--like MidAmerican and Burlington Northern--in favor of lower capital companies, or find value in both.

Disclosure: Drew Woodbury holds positions in the following securities mentioned above: Wells Fargo. 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.