Heavier Trading Activity Continues at Berkshire

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 third 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. And while Buffet did make a point during the third quarter of noting that these two managers would be working with a "bank" of about $4 billion each (exclusive of any gains/losses on capital that has already been put to work)--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 think that this amount could rise even higher in the near term, given the level of selling activity we continue to see in some of the larger legacy positions in the portfolio. This willingness on Buffett's part to sell some of his own legacy holdings in order to fund the investment portfolios being run by his two lieutenants speaks volumes, in our view, about how much faith he has in Weschler and Combs, both of whom have been actively managing money for Berkshire for less than two years.

That said, Buffett continues to hold sway over a meaningful amount of the firm's equity portfolio, and we don't believe that will change much in the near- to medium-term. This should not be surprising to those who have followed Berkshire over the years, given that Buffett (and his sidekick Charlie Munger) have been the driving force behind most of the larger holdings in the firm'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; 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 about $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 will be managing on a combined basis, with the two men holding sway over 11% of the insurer's equity holdings at the end of the third quarter of 2012. This means that Buffett continues to manage about 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 two managers has been with the firm.

Berkshire Hathaway's Top 10 Stock Holdings (as of 09/30/12)

Even with the heavier bouts of buying and selling activity we've seen this year in Berkshire's equity portfolio, the list of top 10 stock holdings looks pretty much like it did at the end of 2011, with the one notable exception being  Johnson & Johnson (JNJ), which has been supplanted by  DirecTV  due to a combination of major sales of shares of the health-care firm and meaningful purchases of the satellite television provider.

We would also note that Kraft Foods, which Berkshire sold once again during the third quarter, is on the brink of falling off the list, and likely will not make the top 10 holdings next quarter, given the early October split-up of the firm into  Kraft Foods Group , which retained its grocery operations, and  Mondelez International (MDLZ), which held on to the firm's global snack food operations. While Berkshire has been selling shares of Kraft Foods fairly regularly over the last two years, eliminating another 28.4 million shares (equal to 48% of its stake) during the third quarter, it still held 30.4 million shares at the end of the period (worth more than $1.2 billion in total). Between the split, and our belief that Berkshire will keep looking at Kraft (and its successor firms) as sources of cash, we're doubtful that it will remain a top 10 holding at the end of the year.

Looking more closely at the selling activity among the remaining top 10 holdings, Buffett sold another 6.8 million shares of  Procter & Gamble (PG) during the third quarter, following up on sales of 13.6 million and 3.5 million shares during the second and first quarters of 2012, respectively. As a result, Buffett has now sold more than 30% of the holdings in Procter & Gamble since the start of the year (a stake that is comprised primarily of shares that Berkshire received in 2005 when Procter & Gamble bought Gillette--a holding that Buffett had originally established in 1989). At 4.9% of the reported stock portfolio at the end of the third quarter, it still 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. We continue to view it as a source of cash for Buffett as he looks to free up capital longer-term for his two lieutenants.

The only other sales among the top 10 holdings at Berkshire involved  U.S. Bancorp (USB), with Buffett selling 4.7 million shares, and  ConocoPhillips (COP), which also saw a sale of 4.7 million shares. As for the buying activity,  Wells Fargo (WFC) continues to be Buffett's "go to" stock, with Berkshire picking up another 11.5 million shares of the bank's common stock, for what we estimate was a purchase price of about $390 million, during the third quarter.

Since the start of the second quarter of last year, Buffett has bought 79.9 million additional shares of Wells Fargo, a more than 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 45% since the end of the fourth quarter of 2008.

About the only other transactions that we can attribute to Buffett in the top 10 holdings was the purchase of 870,000 additional shares of  International Business Machines (IBM), bringing Berkshire's total stake in the technology giant to 67.5 million shares (equivalent to 18.6% of the insurer's reported stock holdings at the end of the third quarter of 2012).

Third-Quarter Purchases Made by Berkshire's Managers

As for the non-Buffett purchases made during the third quarter, we saw Berkshire not only pick up additional shares of  General Motors (GM),  National Oilwell Varco  (NOV),  DaVita HealthCare Partners (DVA), DirecTV,  Viacom , and  Bank of New York Mellon (BK), but also make new-money purchases of  Deere (DE),  Precision Castparts , Wabco Holdings , and Media General . We continue to attribute holdings in DirecTV, DaVita, and Viacom to Ted Weschler, given that these were top five holdings at Peninsula Capital Advisors prior to his joining Berkshire late last year. It is also interesting to note that Weschler has more than $1 billion invested in both DirecTV (at $1.5 billion or 2.1% of Berkshire's total equity portfolio) and DaVita (at $1.0 billion or 1.4% of the portfolio), which has been a rarity for managers not named Warren Buffett at the firm over the years.

We also ascribe the new money purchase of Media General stock to Weschler, given his penchant for media stocks, as well as the fact that he was instrumental in Berkshire's tossing of a lifeline to the struggling media firm during the second quarter. Besides offering financing to Media General, which was struggling with a heavy debt load, Berkshire agreed to acquire 63 newspapers from the firm for $142 million, and picked up 4.6 million warrants that gave it the right to purchase a 19.9% stake in Media General. From what we can tell, those warrants were exercised during the third quarter.

As for the other purchases that were made during the quarter, we think that the ramping up of Berkshire's position in Bank of New York Mellon, which increased in size by another 900,000 shares (after a 13.1 million share purchase during the second quarter and a 3.8 million share increase during the first quarter), was the work of Todd Combs, given his penchant for financial-services stocks during his time at Castle Point Capital Management. That said, Combs has branched out some with his investments since joining Berkshire, taking stakes in consumer defensive firms--like  CVS Caremark  (CVS) and  Dollar General (DG)--and more cyclical industrials--like General Motors and  General Dynamics (GD)--based on our reading of the ongoing changes in Berkshire's portfolio. Given that he eliminated both CVS Caremark and Dollar General from the portfolio during the third quarter, owing to meaningful increases in the value of both stocks since Combs first bought them, we believe that he funneled the proceeds from those sales, as well as the elimination of 25% of his position in  Visa (V), into the new-money purchases of Deere, Precision Castparts, and Wabco.

We also think that Combs was behind the purchase of 1.3 million additional shares of National Oilwell Varco, which Berkshire had initiated a stake in during the second quarter of 2012. This was also one of just two names (the other being General Motors) on the list of purchases that our analysts continue to feel are trading with a wide enough margin of safety to recommend buying them at today's prices. Looking more closely at the firm, our analyst Stephen Ellis feels that as the dominant rig equipment supplier, National Oilwell Varco remains at the center of the rush by oil and gas companies to develop large offshore discoveries. After years of underinvestment by drillers, he believes that the drilling industry badly needs retooled and upgraded rigs to economically drill far more complex and deeper wells, and given that National Oilwell Varco has spent decades consolidating the rig equipment industry, it is the best and only source of rig equipment for many of the largest offshore drillers. At $70 per share, the stock trades at about 6 times our analyst's 2013 EBITDA estimate and 10 times his forward EPS estimate. Ellis' current fair value estimate of $105 per share implies a forward 2013 EV/EBITDA multiple of 9 times and a P/E multiple of 15 on 2013 earnings.

Regarding General Motors--which Berkshire started buying in the first quarter of 2012, with the insurer now holding 15 million shares in the auto manufacturer--Morningstar analyst David Whiston feels that the firm has emerged from the 2009 government bailout in much better shape, with the company now putting out car models that are of the best quality and design. He also notes that, with GM already being a leader in truck models, having a fully competitive lineup (combined with a much smaller cost base) should allow it to print money once vehicle demand recovers. While he expects government ownership stakes to act as an overhang on the stock for some time, with investors seemingly worried that shares could be dumped on the market at any time by either the U.S. or Canadian governments, he views them as short-term issues that will be resolved. Whiston feels that patient GM shareholders ultimately will be rewarded, and believes that the stock, currently trading at a 50% discount to his $48 fair value estimate, is a bargain at today's prices. He does, however, note that his fair value uncertainty for the shares is high to account for the wide possibilities in GM's fair value, given its high degree of operating leverage.

Third-Quarter Eliminations Made by Berkshire's Managers

Looking more closely at the sales that were initiated during the quarter, we already highlighted Kraft, which continues to be a source of cash for Berkshire. The same could be said for Johnson & Johnson, which Berkshire has been selling fairly regularly over the last year. We've always considered this to be a Buffett holding, with the Oracle of Omaha eliminating another 9.8 million shares (equivalent to 95% of the shares that Berkshire held at the end of the second quarter of 2012) during the third quarter. At this point, the company holds less than 500,000 shares of the health-care firm, and we would not be surprised to see the position completely eliminated before the end of the year (given that it now represents one of the smallest stock holdings in Berkshire's portfolio).

While not as drastic as the Johnson & Johnson sales, the insurer did sell another 4.7 million shares of ConocoPhillips, which Buffett has been whittling down ever since he bought it at the height of the energy price runup in mid-2008. It was also interesting to see Buffett reducing Berkshire's exposure to U.S. Bancorp, which has not seen any meaningful trading activity since the financial crisis. That said, we don't expect it or ConocoPhillips to be major sources of cash for Berkshire going forward, believing that Johnson & Johnson, Procter & Gamble, and Kraft (through its successor firms) will continue to fill that role for the foreseeable future.

While not quite what we would consider to be a legacy position, it was interesting to see Berkshire sell about two thirds of its stake in Lee Enterprises (LEE), given that the insurer had really only started to build a position in the firm this year. While some of this could be due to the fact that Berkshire had increased its exposure to newspapers overall through its deal with Media General, it should also be noted that the stock has doubled since the start of the year, partly because Berkshire was taking a stake in the firm, so this could be a move to book some gains. That said, moves like that tend to be pursued more by Combs than Weschler, which runs contrary to our belief that media-related stocks are in Weschler's realm more than they are Combs, so it is anybody's guess as to who was truly behind this trade.

We are, however, more confident that Combs was behind the sales of CVS Caremark, Dollar General, and Visa, all of which were built up during his initial employment at the firm. Combs completely eliminated the first two stocks from the portfolio, with CVS up 25% in the year leading up to the start of the third quarter, and Dollar General up more than 60%, leaving him with a decent enough gain to book. Combs also took advantage of the 45% runup in Visa's stock price from the end of the second quarter of 2011 to the end of June 2012 to eliminate about one fourth of his stake in the firm. As we noted above, the proceeds from these transactions were likely funneled into Berkshire's new-money purchases of Deere, Precision Castparts, and Wabco.

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 (or completely eliminated) in order to raise capital for Combs and Weschler to put to work in their own investment portfolios. That said, it should be noted that Berkshire does still hold warrants to buy General Electric shares at $22.25 a share any time before October 2013 (as part of the lifeline it extended to the conglomerate during the financial crisis), so the sales we've seen of late may not represent the final chapters in Berkshire's holdings in the firm.

We expect Berkshire to continue to use  Verisk Analytics (VRSK) as a source of cash. This technology firm was originally funded by Berkshire and other insurance companies to provide them with data and software that they ultimately need to run their business. It first popped up in the portfolio in the second quarter of last year as part of a mandatory conversion of privately held to publicly held shares.

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