Berkshire Hathaway: 4 Questions and 5 Cheap Stocks

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Omaha, Nebraska, will sit in the center of the investing universe this weekend. The Morningstar senior stock analyst who covers Berkshire Hathaway will join the podcast. Plus, what Morningstar analysts think about a trio of tech titans’ stocks following earnings. And learn about four great dividend funds that could suit your portfolio. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Meta Reports Growth

Facebook and Instagram parent Meta has reported first-quarter growth. The results confirm Morningstar’s view that the company has figured out ways to make money off Reels, Meta’s rival to TikTok. It also has improved ad conversions, and that could include users clicking on an ad, watching a video, or buying something via an ad. Morningstar still expects the social-media giant to expand margins in 2024 and has raised revenue projections. Reels impressions and ad prices have improved. Cannibalization of other ads on Instagram could end by early 2024. Reels has helped increase time spent on Meta apps, and that should further increase ad demand. Meta is increasing ad-conversions despite Apple’s privacy policy changes. This reduces its dependence on data from others. Morningstar commends the firm for shifting its short-and medium-term focus toward increased efficiency, and the move will help increase capital for share buybacks and reinvesting in artificial intelligence. Morningstar has raised its estimate of Meta’s worth by nearly $20 to $278 and views its shares as undervalued.

Microsoft Delivers Strong Fiscal Third Quarter

Microsoft reported a strong fiscal third quarter with positives on both the top and bottom lines. The tech company’s revenue grew 7% year over year to almost $53 billion, topping expectations. Important areas like Azure and Microsoft 365 delivered results above Morningstar’s expectations, and the results are reinforcing the analyst’s long-term position. Management’s outlook for the June quarter is above Morningstar’s view, despite macroeconomic pressures that include the banking crisis. Morningstar continues to center growth assumptions on Azure, Microsoft 365 E5 migration, and traction with the Power Platform for long-term value creation. Investors will likely have a call option on artificial intelligence in shares of Microsoft. That said, it remains unknown if enterprise software vendors are out of the woods yet from a macro perspective. Morningstar is lifting its estimate of Microsoft’s stock’s worth from $310 to $325 per share and sees the stock as slightly undervalued.

E-Commerce and Advertising Growth Drove Amazon’s Results

E-commerce and advertising growth drove Amazon’s first-quarter results. The online retailer delivered better-than-expected revenue that rose 9% year over year. Yet, the e-commerce giant saw continued slowing revenue growth in its cloud platform known as Amazon Web Services, or AWS. Management pointed to customer optimization efforts. Microsoft is also seeing the trend, but Microsoft and Amazon expect these efforts to start easing by midyear. Morningstar is impressed that Amazon’s advertising revenue growth outpaced Meta and Alphabet. Amazon’s second-quarter outlook surpasses what Morningstar was expecting. In the long term, Morningstar still sees e-commerce, AWS, and advertising driving healthy growth for the tech company. However, the near term remains a work in progress. Macroeconomic conditions are sending mixed signals. Morningstar still estimates Amazon’s shares are worth $137 each and thinks the stock is cheap.

Southwest Airlines’ Rough Results

Southwest Airlines’ first-quarter results arrived as expected. The Dallas-based carrier reported a net loss tied to extra costs and $325 million in lost revenue due to its holiday travel meltdown. It canceled more than 16,000 flights because of system issues in late December. Management announced it will receive 70 new 737s from Boeing instead of 90 this year. Southwest has scaled back its capacity expansion plans for 2023 as a result. It’s expected to miss out on potential revenue from the loss of billions of available seat miles. Airlines use the metric to track a plane’s capacity to generate revenue. Morningstar thinks Southwest faces a problem in the short run. The costs of running an airline, like lease agreements and labor and vendor contracts, are fixed. And Southwest will have fewer revenue-generating flights, miles, and passengers to cover those costs. Morningstar has lowered Southwest’s stock worth to $54.

Berkshire Hathaway’s Annual Meeting

Berkshire Hathaway will host tens of thousands of investors this weekend. Its annual shareholder meeting is scheduled for Saturday. Investing legends Warren Buffett and Charlie Munger are expected to share their insights. Morningstar Research Services’ senior stock analyst Gregg Warren covers Berkshire Hathaway, and he’s joining Investing Insights.

Gregg, you served on the panel at Berkshire Hathaway’s annual meetings for several years. Can you briefly talk about that?

Gregg Warren: The panel was an interesting addition that Berkshire brought in. They actually started about 15 years ago. They brought in a journalist panel in ‘09 with three journalists, and then they brought in the analyst panel, the first one, in 2012. And the idea behind that was Buffett felt that shareholders weren’t asking enough company-specific questions, things that would allow them to talk about what was going on with the firm, the operations, what their expectations were. Granted, they were asking a lot of questions about macro events and other things, which he loves to talk about, but he really wanted to showcase a lot of things with Berkshire. So, he figured bringing in some journalists, bringing in some analysts, would help keep the meeting focused on a lot of Berkshire-specific things.

We were fortunate enough to be on the panel for six years up until the final year in 2019, but they decided—COVID interrupted everything, but even before that, they had decided to move away from the analyst panel because there was a lot of feedback from shareholders wanting to see Ajit Jain and Greg Abel up on stage with Warren and Charlie because these are the guys heading the two big pieces of the business right now, and Greg is the heir apparent. So they really wanted to get some interjection from them during the course of the meetings. And unfortunately the analyst panel was the sacrifice that was made.

But it is interesting because COVID interrupted things so much that they ended up actually eliminating the journalist panel as well. And now it’s basically Becky Quick fielding questions from outside of Berkshire, from shareholders, and then feeding those in and then shareholders asking questions as well. During the time we were on the panel, we thought it was a good addition. We as the analysts and the journalists were only allowed to have six questions during the course of the meeting. And we would try to really hone in on either company-specific issues, like what’s going on with Geico or what’s going on with Burlington Northern, or capital allocation decisions. I think we really spent a lot of time the last few years that we were doing the panel trying to get Buffett to give us firmer decisions or at least understandings about dividend, share purchases, and other capital allocation decisions.

Questions for Warren Buffett and Charlie Munger

Hampton: So what are you listening for at this weekend’s meeting?

Warren: It’s always interesting. I mean, at a higher level when we look at Berkshire, we see it as a big decentralized operation, and that has both opportunities and problems associated with it. So when we’re looking at the business, we’re trying to understand where the operating businesses are, what the key competitive pressures are right now, and then also looking at capital allocation decisions. Because Berkshire’s had this problem the past 10, 15 years where they continually have a lot of cash build up on the balance sheet. It’s a great problem to have, but for the years that interest rates were near zero, it really wasn’t helping drive returns for the business. As we look forward to this year’s meeting, it’s a couple of standby questions that continue to come up. One is on Geico; they’re really struggling relative to Progressive, which we feel is probably the best comparable for them.

The auto insurance industry overall has been a mess post COVID, just up and down. And right now with all the inflationary costs on auto parts and car replacements, it’s just been tough for a lot of operators to run the business profitably. Now, Geico is profitable right now, but they’re running far behind Progressive, and we kind of want some explanation about that, how the business is doing since Todd Combs came on board, and whether or not telematics, which they’ve apparently adopted, is making any meaningful impact on underwriting. Same sort of issue at Burlington Northern. They have one tough near-competitor in Union Pacific, and they’ve opted out of adopting precision scheduled railroading, which everybody else has adopted. And it’s really put them behind the eight ball from a profitability perspective. The margin gap between them and Union Pacific has gone from about 300 basis points to 700 the last five years. So it’s a troubling thing for us. And we’d like more answers about what they’re doing, why this gap has gotten this wide, and whether or not they’re going to adopt the scheduling strategy overall.

And then when we look at capital allocation, it is always, “Where’s cash? How much is it building up? What kind of share repurchase activity are you doing? Where do you have expectations about capital over the long run?” So a lot of good areas for us to focus on overall. Every year we actually put out a piece looking at 10 questions we would ask if we were at the meeting this year. And that piece should be coming out this week.

Munger Issues Warning About Commerical Property Loans

Hampton: All right. This week, the second-biggest bank failure in U.S. history happened, and we were watching it, Charlie Munger was watching this unfold. First Republic Bank collapsed. JP Morgan Chase bought it. And Charlie Munger, he issued a warning about commercial property loans in a Financial Times article. What are your thoughts about his comments?

Warren: Yeah, I mean, he’s onto something in some sense, and again, this is not a Berkshire-related issue. They’re not going to have any problems. They don’t really have a whole lot of situations where they fronted money for commercial property development or anything like that. I think this is more than just a bank problem. I look at it as a bank problem, a debt market problem, but also a private capital problem. If we look back over the past 10 years, money’s been relatively easy. Interest rates were near zero, and there was a lot of money flooding into private capital funds as well. A lot of deals were done on the real estate side with the expectation being that rates were going to be lower longer. And if we look at one subset of that commercial market, which is office properties, you know as well as I do not everybody’s back in the office, a lot of office leases have been terminated, so rents are falling below where debt payments are now or where they’re expected to be over time.

And if we look back just over the past year, we’ve seen situations where the investors have basically defaulted on their debt because either A) they couldn’t get the debtholders to renegotiate terms, [B] they were running variable-rate debt, which escalated significantly last year with rates going up 500 basis points, or [C] they just weren’t collecting enough in rent to really cover what was there.

So we’re likely to see more of that activity as we move forward, but I think that’s still a problem that’s going to be spread out a little bit more. I mean, the banks are probably about as in good a shape as they ever have been. The financial crisis really taught a lot of lessons and really sort of minimized the amount of risk they were willing to take. And if you look back at that decade period we just came through, for loans that weren’t being made by the banks, it was private capital that was stepping in and picking up the slack. So when I say that pain’s going to be felt across the board, it’s a little bit of everybody getting it there.

And I was actually just talking to our bank analyst about this, too. Most of the commercial real estate loans is really centered in a lot of the smaller banks. And then when we look at the banks that did fail here, honestly, these were not lending problems. Signature Bank, Silicon Valley Bank, First Republic, all of them failed because they mismanaged their deposit base relative to their investment book. So they had a lot of long-dated maturity holdings in their investment book, and when the depositors started asking for their money back, they kept taking huge losses in order to meet those needs. It was more of a mismanagement problem on their part as opposed to poor lending decisions.

Banking Crisis Help From Buffett, Munger?

Hampton: In the past, Berkshire has come in to help troubled banks before. Do you see Munger and Buffett doing something during this banking crisis?

Warren: I think based on the comments Munger made in the FT article, I don’t see it happening. I never say never. I mean, if there were any sort of support coming in, it would probably be again to the money center banks like they did in the financial crisis. They backstopped Goldman Sachs, they backstopped Bank of America, but that comes at a price. They asked for preferred securities or preferred stock at a high coupon rate. I think it was 10% or 11% for Goldman, and I think it was 9% for Bank of America, so a pretty steep coupon on that. And then they also got warrants to buy common stock. From that perspective, it is a pricey thing to get the Warren Buffett seal of approval for those banks.

When I look at the smaller, more regional banks, it’s tough to see. A lot of those would be more outright takeovers. And if we look at Berkshire historically, I can’t see them owning another bank. They did own one in the early 1980s. They owned about 97% of it. It was called Illinois National Bank. Really good regional bank, very profitable, but the regulators changed their opinion about who could own banks that weren’t within financial services, that weren’t banking companies, and forced Berkshire basically to sell it—or keep holding it and become a bank holding company. And Buffett was like, “Well, we already have so many regulators looking at our books from the state side on the insurance business. I don’t want the federal regulators, the banking regulators, looking at our books as well and maybe even putting restrictions on what we can do from an investment perspective.” So they actually sold off that stake. Now they’ve held banks since, but there’s always been historically about a 10% threshold. You couldn’t earn more than 10% of a bank if you were a nonbank entity. That’s recently moved up to around 15%-ish. Still some gray area on that. We’re not sure exactly where that number is. The regulators weren’t really clear about where they’re going to stop people from buying stakes. Buffett currently owns about 13% of Bank of America, and I think that’s where he’s going to stay. I think he’s concerned if he pushes it any further then either he is got to sell off positions or accept the regulators’ request that they become a bank holding company.

Investing Lesson From Investing Legends

Hampton: All right. The Federal Reserve staff is predicting a mild recession later this year. Warren Buffett, he’s in his 90s. He has seen his fair share of recessions. What has he done during past recessions, and what can investors learn from him?

Warren: Yeah, I mean, the interesting thing about that, and it’s unfortunately an answer most people don’t want to hear, is basically nothing. I mean, Berkshire historically has been run on a completely decentralized basis. So when it comes to making decisions about the businesses, that’s all pushed down to the managers. They know what’s best for their businesses. They know how to navigate periods of either higher interest rates or inflation, and he trusts them to work with that. Now, his job historically, him and Charlie, has been to take all the excess capital that’s generated by these businesses and try and find lucrative opportunities to put money to work, which means market dislocations like we saw last year, where the equity markets, credit markets sold off, or you’re likely to see during a recession. That creates opportunities.

So for him, he likes to see that. He likes to be able to go shopping and see if there’s anything that he can pick up while the market overreacts to poor economic conditions or, like last year, to poor market conditions. So I would say that the key lesson there is, and I think Charlie hinted a little bit about this in the FT column last week, is you’re just waiting for that fat pitch to come along, waiting for that good opportunity to come along. In fact, I think Charlie noted that he’s made most of his personal fortune owning just four different companies. From that perspective, it’s learning their lessons about being patient and waiting for the opportunity that comes along, and then when it does, just seizing it.

Berkshire Hathaway Stocks: Class A and Class B

Hampton: All right. Let’s shift our discussion to Berkshire Hathaway stocks. It offers two types, Class A and Class B. What are the similarities, and what are the differences?

Warren: The A shares are definitely the higher price shares. They come with 10,000 more voting rights than the Class B. It’s always hard to explain that. It’s like the Class B shares are 1/10,000 of the voting rights of the A shares, but they’re 1/1,500 of the economic value. And that’s really the difference. The B shares do have voting rights; it’s just significantly smaller than the A shares, and Buffett owns a large chunk of the A shares overall, so it keeps his interest aligned with the voting interest of Berkshire overall. When we look at the two share classes, historically, they tend to trade as if though the B shares are worth 1/1,500. So if we look at our fair value estimate right now, the Class A shares, we have a $550,000 per share value on that; for the B shares, it’s 370, and that’s just 1/1,500 of the A shares. And the past five, 10 years, it’s been around that level. I mean, the premium is maybe 0.1%, 0.2% of the Class A shares over the Class B. But what’s been interesting this year, especially since October, is that premium’s been around 1% if not more. There’s been a couple of times, especially in the last month, where it’s been actually 2%. And Buffett historically has told shareholders, “Hey, if the Class A shares are trading up more than a 1% premium to the B shares, buy the B shares,” because the expectation is eventually that gap will narrow back to where it should be.

And for most of us, we really can’t afford the A shares. I mean, buying them in large numbers is just not going to happen. So when we can get a discount on the B shares, it’s worth taking a look at. Now that said, I mean right now the B shares are trading about a 12% discount to our fair value. It’s interesting. It’s definitely piqued our interest, and we recommend people looking at it. We’d be happy to see the discount closer to 20 before really aggressively buying the shares, but there’s no reason to step back from it here. I mean, it still offers a good value.

Hampton: All right. So our audience can check morningstar.com and see that percentage hopefully drop to 20% and know that you’re excited about that. [laughter]

Undervalued Berkshire Hathaway Stocks

Hampton: So what are a few stocks in Berkshire’s portfolio that Morningstar considers undervalued?

Warren: It is interesting because I was actually just looking at that yesterday. There aren’t a whole lot of deep values right now. A lot of names are trading at or above fair value, surprisingly. But again, our fair value estimates have come down, too, during the past year as analysts have reacted to the market conditions but also the economic conditions. But if we look at the top 20 holdings, which are about 90% of the overall portfolio, we did find five names that stood out. Two of them, not surprisingly, are banks. Bank of America, I think, is trading at about a 25% discount to fair value right now. Citigroup is about a 40%. Bank of America’s arguably the better-run bank. It is a wide-moat firm, but our analyst feels there’s a greater risk/return trade-off for Citigroup right now. He actually has it as a Best Idea relative to B of A right now. But again, a 25% discount on a wide-moat firm is nothing to cough at.

If we look down the list, Kraft Heinz has been a long-standing holding for Berkshire. It’s trading at around a 25% discount as well. They just reported earnings today. I saw Erin’s note—and a pretty good quarter. I mean, inflation’s definitely helping them here, but it has some troubles just like a lot of other firms working in the consumer packaged good space right now. But it’s a 4% dividend yield, and she thinks that that’s a name that should really be in people’s shopping list right now.

And then the last two names, we got Paramount Global, which is trading at about a 45% discount, if I remember right. That’s a company that our analyst really likes. It’s a Best Idea as well. And it’s one that he sees really benefiting from livestreaming over time. And then the last name that fits this mold of deeply undervalued would be General Motors. It’s trading at about a 50% discount to our fair value estimate right now. Most of the other auto manufacturers, it’s been a tough slog post-COVID. I mean, there was a huge semiconductor issue problem for a number of years there, which really gunked up the supply chain. Everybody’s just working their way through that. His expectation is that GM has so far outperformed expectations on recovering from that. He feels that’s going to continue even if we have a recession in the near term.

So, five good solid names there across a broad spectrum of industries. So interesting looking at right now. I mean, the biggest holding for Berkshire is still Apple, but that’s trading at a premium to our fair relative estimate right now, so it’s hard to make a recommendation on that right now.

Hampton: All right. So, the recap, Bank of America, Kraft Heinz, Paramount Global, General Motors …

Warren: Citigroup.

Hampton: Citigroup. All right, Gregg. Thank you for your time and your insights today.

Warren: Thanks for having me.

4 Great Dividend Funds

Hampton: Adding dividend investments to your portfolio could provide a steady stream of income. Morningstar Research Services’ director of manager research Russ Kinnel is spotlighting four great dividend funds.

Russel Kinnel: A good dividend fund can deliver income, appreciation, and even defensiveness if you find the right one. There are two main dividend strategies: growth and yield. Dividend growth strategies sacrifice some short-term yield to find companies with potential to raise dividends over time. That requires a healthy balance sheet and good growth prospects. Dividend yield strategies go straight for the yield but still look for companies with good fundamentals. I’ve got two picks from each camp.

For dividend growth, I’m a fan of T. Rowe Price Dividend Growth PRDGX, which we recently upgraded to Gold. Tom Huber is a steady hand, seeking out companies with strong cash flow and competitive advantages. He builds a diversified portfolio that tends to shine when things are darkest. In 2022, the fund’s 10% loss was about 900 basis points less than the market thanks to a strong emphasis on quality and balance sheets.

Passive is also a good way to go here. Vanguard Dividend Appreciation Index VDADX tracks an index that looks for companies raising dividends but eliminates the 10% highest yielders because those are higher risk. This Gold-rated fund charges just 8 basis points, and it’s available both in open-end and ETF formats.

For dividend yield, let’s stay with a passive Vanguard approach and discuss Vanguard International High Dividend Yield VIHAX. The fund paid out a yield of more than 4% the past 12 months by taking the higher-yielding half of foreign equities and then market-cap weighting them. It’s a simple, cheap, and effective way to invest.

Silver-rated Fidelity Equity-Income FEQIX is a good choice among actively managed equity-income funds. Ramona Persaud is a cautious value investor who has guided the fund to steady results. She looks for solid cash flow companies that pay dividends. And though most of her picks are typical equity-income names, she will dabble in growth names like Apple AAPL to boost return potential.

Hampton: Thanks, Russ. Subscribe to Morningstar’s YouTube channel to see new videos from our team. You can hear market trends and analyst insights from Morningstar on your Alexa device. Say, “Play Morningstar.” Thanks to craft editor and cinematographer David Ettinger and senior video producer Jake VanKersen. And thank you for tuning into “Investing Insights.” I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

Read about topics from this episode.

Meta Earnings: Reels Monetization Becoming a Reality While Network Effect Remains Intact

Microsoft Earnings: All-Around Strength, Including Azure, Demonstrates Resiliency

Amazon Earnings: E-Commerce and Advertising Drive Good Quarter While AWS Decelerates Further

Southwest Airlines Earnings: Pivots Some Capacity and Takes Unit Cost Hit, Most of It Is Temporary

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