Buffett's Lieutenants Continue to Impact Berkshire's Portfolio

By Greggory Warren | Senior Stock Analyst

Having had a chance to take a much closer look at the changes that were made to  Berkshire Hathaway's (BRK.A)/(BRK.B) stock holdings during the second quarter, we continue to view the equity investment portfolio at the firm as a work in progress. While Warren Buffett  has had (and continues to have) an outsized influence on the makeup of the portfolio, as time goes on we are getting more and more glimpses of just how his two lieutenants--Todd Combs and Ted Weschler--will approach their own portfolios. With Buffett noting more recently that each of these two managers will be working with a "bank" of around $4 billion each (exclusive of any gains/losses on capital that has already been put to work), which is up from $1.75 billion each at the end of last year and $2.75 billion each at the end of the first quarter, we are seeing a far greater willingness on the part of the Oracle of Omaha to hand over more and more of the investment portfolio than we would have expected this early in the transition. The fact that Buffett has also been willing to sell some of his own legacy holdings in order to fund their stock investment portfolios speaks volumes, in our view, about how much faith he has in these two managers, with him even noting in a recent interview that Combs and Weschler have "terrific talent," and that Berkshire feels "very, very, very good about where we are now versus a few years ago in terms of successor investment management."

That said, Buffett continues to hold sway over a meaningful amount of the equity portfolio--something we don't anticipate changing too significantly in the near to medium term. And this should not be surprising, given that Buffett (and his sidekick Charlie Munger) have been the driving force behind most of the larger holdings in Berkshire's investment portfolio over the last four decades. That's not to say that Lou Simpson, the now retired manager of the investment portfolio at GEICO (Berkshire's auto insurance subsidiary), did not have an influence over the years, it's just that his position sizes tended to be in the hundreds of millions, whereas Buffett's have traditionally gone well into the billions. At the time that Simpson announced his retirement in the third quarter of 2010, he was managing a total of around $4 billion in equities, accounting for 8% of Berkshire's total stock holdings at the time. This compares to the $8 billion that Combs and Weschler are currently managing, accounting for 11% of the insurer's equity holdings at the end of the second quarter of 2012. What this means is that Buffett continues to manage around 90% of the equities in Berkshire's investment portfolio. The big positive, though, from a succession perspective, is that each of Buffett's two lieutenants is now managing about 5.5% of the total equities held by Berkshire, much closer to the level that Simpson had managed over the 30 years that he was running the investment portfolio at GEICO, and higher than we would have expected given the length of time that each of these managers has been with the firm.

Berkshire Hathaway's Top 10 Stock Holdings (as of 06/30/12)

 

  Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) % of Stock Portfolio Coca-Cola (KO) 2 Wide 39.38 1.06 Low $177,647 21.0 Wlls Frgo (WFC) 4 Narrow 33.96 0.83 Medium $179,383 18.5 IBM (IBM) 3 Wide 198.29 1.03 Medium $225,781 17.5 Amrcn Exp (AXP) 3 Wide 56.08 1.04 High $63,518 11.9 P&G (PG) 3 Wide 66.73 1.04 Low $184,484 4.9 Wal-Mart (WMT) 2 Wide 74.01 1.21 Low $252,497 4.4 Kraft (KFT) 3 Narrow 40.90 0.93 Medium $72,406 3.1 US Bncrp (USB) 3 Narrow 33.02 1.00 Medium $62,281 2.9 CncPhlps (COP) 3 Narrow 57.35 1.10 Medium $69,703 2.2 DIRECTV 1 Narrow 51.91 1.37 Medium $32,473 1.9 Stock Price and Morningstar Rating data as of 08/14/12. Figures do not include foreign investments that are held abroad, such as BYD Corporation, Tesco PLC, and POSCO.

Despite a somewhat heavier bout of buying and selling activity among more than half of Berkshire's top 10 stock holdings during the second quarter, the list looks pretty much like it did at the end of last year. The one exception is the replacement of  Johnson & Johnson (JNJ), which has been a major holding in Berkshire's portfolio since the third quarter of 2006, with  DIRECTV , which was only added to the portfolio in the third quarter of last year. Berkshire sold 18.7 million shares of Johnson & Johnson during the second quarter of 2012, equivalent to 64% of the shares that the firm held at the end of the first quarter, which should have raised more than $1.2 billion (based on the average trading price for the stock during the second quarter). While we were surprised by the size of the sale, we were not surprised to see Buffett using Johnson & Johnson as a source of cash, having noted last year that he had been both buying and selling shares of the health-care firm with fairly regular frequency since the financial crisis, and that he was likely to consider the shares--along with those of  Kraft Foods (KFT) and  Procter & Gamble (PG)--as a source of cash if he needed to raise capital for other investments, especially in light of the push to build up investment stakes for Combs and Weschler.

Looking more closely at the selling activity among the remaining top 10 holdings, Buffett sold another 13.7 million shares of Procter & Gamble during the second quarter, following up on the 3.5 million shares that he sold during the first quarter of 2012. When we highlighted his first-quarter sale back in May, we had noted following Berkshire's annual meeting that Buffett, in an interview with CNBC, was less than supportive of P&G's business model of selling higher-end products in a difficult economy, noting that the firm did "not have the pricing flexibility with some items that they thought they had." Year to date, Buffett has sold just over one fifth of Berkshire's shares of Procter & Gamble (with the insurer having picked up most of these shares in 2005 when P&G bought Gillette, which Buffett had first purchased shares in back in 1989). At 4.9% of the reported stock portfolio at the end of the second quarter, it remains a large position for Berkshire, but has certainly not been untouchable, as Buffett previously sold shares in the fourth quarter of 2008, the fourth quarter of 2009, and the first, second, and third quarters of 2010.

Berkshire also sold another 19.2 million shares of Kraft Foods during the second quarter, following up on the 9.0 million shares that Buffett sold during the first quarter of 2012. Since the start of the second quarter of 2011, Berkshire has sold 46.4 million shares of the packaged-food giants' common stock, equivalent to 45% of the insurer's holdings at the end of the first quarter of last year. While this is not the first time that Buffett has looked at Kraft as a source of cash, selling shares of the firm--along with shares of Procter & Gamble and Johnson & Johnson--to fund its 2010 purchase of Burlington Northern, he has been far more willing to go back to this holding in the aftermath of Kraft's purchase of Cadbury, which Buffett never truly warmed up to. With Kraft expected to complete the spin-off of its global snack business, to be named Mondelez (MDLZ), at the start of the fourth quarter, it will be interesting to see how much of Berkshire's 58.8 million share stake in Kraft is still in place at the end of the third quarter, and whether or not Buffett will be quick to shutter the slower-growth North American grocery business, to be named Kraft (KRFT), once the spin-off is completed.

The only other sales among the top 10 holdings at Berkshire involved  U.S. Bancorp (USB), with Buffett selling 3.0 million shares, and  ConocoPhillips (COP), which saw a minor sale of some 230,000 shares. As for the buying activity,  Wells Fargo (WFC) continues to be Buffett's "go to" stock, with Berkshire picking up another 16.7 million shares of the bank's common stock, for what we estimate was a purchase price of around $565 million, during the second quarter. Since the start of the second quarter of last year, Buffett has bought 68.4 million additional shares of Wells Fargo, a 20% increase in the stake over that time frame. Add that to the 52.4 million shares that Berkshire bought between the fourth quarter of 2008 and the first quarter of 2011, and Buffett has increased the insurer's stake in Wells Fargo by more than 40% in the last three and a half years. About the only other purchase that we can attribute to Buffett in the top 10 holdings was the purchase of 2.2 million additional shares of  IBM (IBM), bringing Berkshire's total stake in the technology giant to 66.6 million shares (equivalent to 17.5% of the insurer's reported stock holdings at the end of the second quarter of 2012).

Second-Quarter Purchases Made by Berkshire's Managers

 

  Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) Shares Purchased (millions) Wlls Frgo (WFC) 4 Narrow 33.96 0.83 Medium $179,383 16.7 IBM (IBM) 3 Wide 198.29 1.03 Medium $225,781 2.2 DaVita (DVA) 3 Narrow 97.87 0.98 Medium $9,402 3.3 Phllps 66 (PSX) 3 None 39.93 1.17 Very High $24,896 12.6 Bnk NY Mlln (BK) 4 Wide 22.15 0.63 High $26,060 13.1 DIRECTV 1 Narrow 51.91 1.37 Medium $32,473 5.4 Viacom 3 Narrow 49.28 0.99 Medium $25,328 5.2 Lbrty Md NA NA 98.95 - NA $11,799 2.5 Ntl Oilwell (NOV) 4 Wide 76.26 0.73 Medium $32,430 2.8 Lee Ent. (LEE) NA NA 1.33 - NA $71 3.2 Stock Price and Morningstar Rating data as of 08/14/12.

While not a top 10 holding, we also think that Buffett was the primary force behind the purchase of Lee Enterprises (LEE), a regional newspaper firm based in Davenport, Iowa, which was first disclosed in an amended 13-F filing in June. As for the non-Buffett moves made during the second quarter, we saw Berkshire pick up another 5.4 million shares of DIRECTV, which at $1.4 billion at the end of the second quarter made it Berkshire's 10th largest stock holding, even though it accounted for just 2% of the insurer's reported $74.3 billion stock portfolio. We continue to ascribe this position, as well as  DaVita (DVA), which increased in size by 3.3 million shares, and Liberty Media , where Berkshire picked up picked up another 2.5 million shares, to Ted Weschler, as these three firms were top-five holdings in his fund at Peninsula Capital Advisors. We also believe that Weschler has been behind Berkshire's growing stake in  Viacom , which fits in nicely with his bent toward media and communications names, with the manager picking up 1.6 million shares of the global media firm in the first quarter, and another 6.8 million shares in the second quarter of this year.

Meanwhile, we think that the ramping up of Berkshire's position in  Bank of New York Mellon (BK), which increased in size by another 13.1 million shares (after a 3.8 million share increase in the first quarter), was the work of Todd Combs. We also think that he was the one likely behind the purchase of 2.8 million shares of  National Oilwell Varco (NOV), which was Berkshire's only new-money purchase during the second quarter. And as a tangent to that, we feel that he might have been involved in the purchase of 12.6 million additional shares of  Phillips 66 (PSX), which was spun off from ConocoPhillips at the end of April. With ConocoPhillips distributing one share of Phillips 66 common stock for every two shares of ConocoPhillips common stock held, Berkshire should have ended up with 14.5 million shares of Phillips 66 common stock (based on 29.1 million shares of ConocoPhillips held at the end of the first quarter), But the company reported a stake of 27.2 million shares. While Buffett did disclose in an interview last month that Berkshire had bought additional shares of the spun-off entity, we still feel that the push into energy names is coming from Combs' part of the portfolio.

Second-Quarter Eliminations Made by Berkshire's Managers

 

  Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) Shares Eliminated (millions) J&J (JNJ) 4 Wide 68.64 0.89 Low $189,741 -18.7 P&G (PG) 3 Wide 66.73 1.04 Low $184,484 -13.7 Kraft (KFT) 3 Narrow 40.90 0.93 Medium $72,406 -19.2 Intel (INTC) 3 Wide 26.48 0.91 Medium $131,437 -7.7 U.S. Bncrp (USB) 3 Narrow 33.02 1.00 Medium $62,281 -3.0 Visa (V) 3 Wide 129.89 1.11 High $106,651 -0.8 UPS (UPS) 3 Wide 76.18 0.95 Medium $73,043 -1.2 CVS (CVS) 3 Narrow 44.12 0.96 Medium $55,403 -1.8 Gnrl Elctrc (GE) 4 Wide 20.94 0.84 Medium $220,576 -2.8 Ingrll-Rand (IR) 3 None 44.71 1.06 Very High $13,684 -0.6 Verisk (VRSK) 1 Wide 49.02 1.53 Medium $8,178 -0.4 Dollar Gnrl (DG) UR None 52.31 - Medium $17,308 -0.3 CncPhlps (COP) 3 Narrow 57.35 1.1 Medium $69,703 -0.2 Stock Price and Morningstar Rating data as of 08/14/12.

Looking more closely at the non-Buffett-related selling activity in the portfolio, Berkshire sold off its remaining stake in  Intel (INTC), a position that it had only started to build in the third quarter of last year. While we've always ascribed this stake more to Combs than Weschler, the rapid manner in which it was built up and ultimately discarded represents a bit of a sea change for investors who have followed Berkshire for a number of years. While the shares did appreciate considerably off of the depths they reached during the third-quarter decline, most Buffett watchers have grown accustomed to Berkshire holding positions for years, if not decades, in spite of market movements. Given this transaction, as well as some of the selling we saw in  Visa (V),  CVS Caremark (CVS), and  Dollar General (DG), all of which were purchased by Combs in the last year and a half, we believe that the future will see a lot more buying and selling activity at Berkshire, given the willingness of both of Buffett's lieutenants to move in and out of names in relatively short order.

As for the remaining sales activity in Berkshire's portfolio, the positions in  General Electric (GE),  United Parcel Service (UPS), and  Ingersoll-Rand (IR), were all holdovers from the Lou Simpson era, most of which have been whittled down to raise capital for Combs and Weschler to put to work in their own investment portfolios. With Ingersoll-Rand, it looks more like a trade didn't clear at the end of the quarter more than anything else, given that Berkshire recorded 20,400 shares in its 13-F filing, with the position tucked in right at the end of all of the other holdings (which are represented in alphabetical order). As for  Verisk Analytics (VRSK), a technology firm originally funded by Berkshire and other insurance companies to provide them with data and software that they ultimately need to run their business, and which first popped up in the portfolio in the second quarter of last year as part of mandatory conversion of privately held to publicly held shares, we expect Berkshire to continue to view this holding as a source of cash.

Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble and Kraft Foods. 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.