(By Greggory Warren, CFA) When we relaunched the Ultimate Stock-Pickers concept back in April 2009, we made a point of including several insurance companies on our list of top managers because, unlike their peers in the mutual fund business, the portfolio managers at insurance companies are not impacted by investor redemptions during poor market environments. This was evident during the most recent period, as most of the fund managers on our list were in net redemption mode, with many of them building up fairly meaningful cash positions as they closed out the third quarter. Meanwhile, the four insurance companies on our Investment Manager Roster-- Berkshire Hathaway (BRK.A) / (BRK.B) , Markel (MKL), Alleghany (Y), and Fairfax Financial (FRFHF)--were net buyers during the period, taking advantage of the dislocation in the global equity markets to either add to existing stakes or put new money to work in names that were not previously held in their portfolios. With the insurers tending to be a bit more long-term oriented than fund managers, investing their portfolios according to the time horizons and payout profiles associated with the product lines underwritten by their firms, we like it when these managers are putting money to work, or selling out of positions, as these moves tend to have a bit more conviction behind them.
While some investors do pay attention to the moves that Tom Gayner makes with the stock portfolio at Markel, or the trades that Prem Watsa undertakes with the Hamblin Watsa Investment Council at Fairfax Financial, it is Warren Buffett at Berkshire Hathaway who tends to garner most of the headlines among our insurance firms each quarter, and this quarter was no different. In a bit of an early strike before the release of Berkshire's 13F filing last week, Buffett announced to the world that he had purchased 64 million shares of International Business Machines (IBM) through the first, second, third, and fourth quarters of 2011. This information was not, however, previously disclosed, as Buffett took full advantage of an obscure rule (in Section 13F of the Securities Exchange Act of 1934) that has historically allowed the Oracle of Omaha to withhold purchases or sales from his quarterly filing with the SEC until he is good and ready to disclose them. The rule, which states that "the Commission, as it determines to be necessary or appropriate in the public interest or for the protection of investors, may delay or prevent public disclosure of any such information," has typically been used by investors like Buffett to provide them with the time (and flexibility) that is sometimes necessary to build up a position in a stock. In the case of IBM, Buffett could have easily gone out to the market and dropped the $10.7 billion that Berkshire spent buying up 64 million shares of the technology giant, but a trade of that magnitude (whether conducted in a single day, or even over the course of a quarter) is bound to move the stock price, especially if someone catches wind of who is doing the buying.
Following the purchase that Buffett made during the fourth quarter, Berkshire now holds more than 5% of IBM's total shares outstanding, putting the insurer on par with the largest shareholder in the technology giant, State Street Global Advisors (which is the investment management arm of State Street Corporation (STT)). At the end of the third quarter, when Berkshire held just slightly more than 57 million shares of IBM, it was already the second-largest holding in the insurer's stock portfolio, eclipsing even Wells Fargo (WFC), which Buffett has been adding to fairly steadily since the start of 2009. What is surprising about all of this is the fact that Buffett has been adding to his Wells Fargo stake, which is currently yielding 1.9%, to help augment some of the income that was lost this year as Goldman Sachs (GS), General Electric (GE), and Swiss Re (SSREY) repaid high-yielding securities that were issued to Berkshire during the financial crisis. While IBM's current dividend yield of 1.6% is not too far off from Wells Fargo's yield, the expectation has been that the bank, which finally regained control of its dividend policy from the Federal Reserve earlier this year, would ultimately lift its quarterly dividend from today's payout of $0.12 per share to around $0.35 per share (which is where it was before Wells Fargo cut its dividend in March 2009). With IBM unlikely to match the level of dividend growth that Wells Fargo is likely to muster over the next several years, the Oracle of Omaha must believe that the potentially higher rates of growth at the technology giant (compared with a U.S. banking industry that is likely to generate lower levels of profitability than it did prior to the financial crisis) will augment the lower dividend yield.
Berkshire Hathaway's Top Stock Holdings (as of September 30, 2011)
|Star Rating||Moat Size||Current Price ($)||Price/Fair Value||Fair Value Uncertainty||Market Cap ($mil)||% of Stock Portfolio|
|Coke (KO) ||3||Wide||67.39||0.99||Low||154,827||22.9|
|IBM (IBM) ||3||Wide||185.24||1.02||Low||217,751||17.0|
|WllsFrg (WFC) ||5||Narrow||24.69||0.55||Medium||130,309||14.8|
|Am Exp (AXP) ||3||Wide||46.88||0.87||High||54,660||11.5|
|P&G (PG) ||4||Wide||63.24||0.88||Low||174,823||8.2|
|Kraft (KFT) ||3||Narrow||34.77||0.89||Medium||61,096||5.1|
|J&J (JNJ) ||4||Wide||63.85||0.83||Low||174,119||4.0|
|WalMrt (WMT) ||3||Wide||57.23||1.00||Low||198,990||3.4|
|Conoco (COP) ||4||Narrow||69.27||0.81||Low||91,589||3.1|
|US Bnc (USB) ||4||Wide||25.38||0.82||Medium||48,956||2.8|
Stock Price and Morningstar Rating data as of 11-18-11.
At the end of the third quarter, Berkshire's portfolio remained relatively concentrated, with just 33 stock positions overall and its top 10 holdings accounting for around 93% of the insurer's total stock portfolio. While the addition of IBM knocked Moody's (MCO) out of Berkshire's top 10 holdings, at less than 2% of the total portfolio (equivalent to about a $900 million stake at the end of the third quarter) Moody's has always been a slightly smaller investment for Buffett in comparison to positions held in firms like Coca-Cola (KO), Wells Fargo, American Express (AXP) and Procter & Gamble (PG). That said, the Oracle of Omaha continues to be one of Moody's two largest shareholders, with Capital World Investors also holding nearly 13% of the publishing firm's total shares outstanding. With Buffett having already sold close to 20 million shares of Moody's since the start of 2009 (leaving Berkshire with slightly more than 28 million shares at the end of the third quarter), one does have to wonder if he is done selling the publisher (which continues to garner criticism in the aftermath of the financial crisis).
What we don't have to wonder about, though, is the selling that continues to take place in Berkshire's stakes in Kraft Foods (KFT) and Johnson & Johnson (JNJ). After initially purchasing more than 130 million shares of Kraft Foods in the fourth quarter of 2007, Buffett has been trimming that stake over the last year and a half, with his sale of close to 10 million shares (10% of Berkshire's Kraft stake at the end of the second quarter of 2011), reducing the insurer's stake to 90 million shares. 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.
The same could be said for Johnson & Johnson, which Buffett has been both buying and selling with fairly regular frequency over the last three years. The selling continued in the third quarter, as Berkshire unloaded another 5 million shares of the health-care giant, making the insurer a net seller of more than 24 million shares of Johnson & Johnson since the start of the fourth quarter of 2008. About the only other stock that Berkshire has been selling with regular frequency over the last three years has been ConocoPhillips (COP), the purchase of which Buffett has since admitted was a mistake (having bought shares in the energy firm at the peak of oil prices in the summer of 2008). That said, we haven't seen any meaningful sales of ConocoPhillips from Berkshire's stock portfolio since the second quarter of last year, which leads us to believe that Buffett views both Kraft Foods and Johnson & Johnson as more attractive candidates to raise cash with than the energy firm. The sales are all the more interesting since Berkshire is not necessarily a firm that is struggling to put cash together, sitting on an estimated $71 billion of "float" in its insurance operations at the end of the second quarter of 2011.
Where the cash has been going is a far less difficult question to answer, as Berkshire put money to work in 10 different names--IBM, Wells Fargo, M&T Bank (MTB), Intel (INTC), Visa (V), CVS Caremark (CVS), The DIRECTV Group (DTV), General Dynamics (GD), Dollar General (DG), and Torchmark (TMK)--during the third quarter. Of these transactions, IBM and Wells Fargo are probably the only ones that can be attributed to Buffett himself, given the size of the positions within the portfolio. While the purchase of additional shares of M&T Bank could be seen as a Buffett move, we think it could easily be something that Todd Combs had a hand in (given his propensity for financial services stocks). As for the rest of the transactions, they were definitely driven by Todd Combs, given the size of the holdings that resulted--each of which was a less than a $200 million position for Berkshire. That's not to say that Combs bought up $200 million worth of stock in each name during the third quarter--having initiated stakes in Dollar General and Torchmark in previous quarters--it's just that the total position size leaves these holdings outside of the realm of Buffett's moves (which tend to involve stakes greater than $1 billion).
Taking a much closer look at the new additions that Berkshire has made to its stock portfolio this year (most of which the insurer was buying in the most recent quarter), we've sifted through some of our own stock analysts' commentary and analysis to see if we could uncover ideas that might be worth pursuing further and have compiled our thoughts below:
International Business Machines (IBM) - 3 Star
While Buffett may have bought upward of 32 million shares of IBM in the third quarter (having initially picked up more than 4 million shares in the first quarter of 2011, and another 20 million shares in the second quarter), the stock has been fairly valued in the eyes of our analyst, Sunit Gogia, for much of the year. In his view, IBM's technological leadership, focus on the noncommodified portions of IT, strong brand, and long-term contracts make the firm a steady free-cash-flow-generating machine, which no doubt were some of the biggest attractions for Buffett. With the company focused on the higher end of computing technologies, where margins are resilient, and using its broad distribution to capture worldwide opportunities, revenue growth from higher-margin software and services has been outpacing the firm's hardware business, enabling overall margins to expand progressively over the last five years. In Gogia's view, the competitive strength of IBM's business, combined with a history of returning value to shareholders (with dividends and stock repurchases totaling more than $72 billion over the last five years), makes IBM an attractive long-term investment. With Buffett buying an additional 7 million shares during the current quarter, it is obvious that the Oracle of Omaha agrees. And while some have argued that Buffett was paying a premium for IBM, our own calculations show him to be up at least 10% on his purchases (based on the $10.7 billion cost basis figure that he revealed for his stake in the technology giant when he announced it to the world last week).
Intel (INTC) - 3 Star
Although it is highly unlikely that Buffett would ever buy shares of Microsoft (MSFT), given his close relationship with Bill Gates, which would potentially raise questions about "inside information or something" if Buffett were to own the stock personally or buy it on Berkshire's behalf, he is apparently not adverse to following some of Gates' advice when it comes to investing in technology (even if it took him some 20 years to act on it). As the story goes, when Buffett and Gates first met in the summer of 1991, the software tycoon told the Oracle of Omaha to buy Intel and Microsoft in response to Buffett's question about the future of IBM. While we have ascribed the purchase of Intel to Todd Combs, given its smaller size (9 million shares valued at $200 million at the end of the third quarter), Buffett had to have some input into this decision, as technology is as far outside of Combs' core competency (which is financial services stocks) as it is his own. Perhaps both men were impressed by Intel's positioning as the largest semiconductor firm in the world, with a dominant position in the PC microprocessor market. Morningstar analyst Andy Ng believes that the firm's greatest asset is its technological prowess in semiconductor manufacturing, an attribute that should allow it to continue to thrive even in a maturing market for PCs. Much like with IBM, which is still around 20 years after Gates and Buffett had their first encounter, Berkshire is buying into the future growth of one of the established leaders in the technology industry, which, while hardly cutting edge, is a big step forward for a man who for years has avoided the sector because, in his view, it was too difficult to predict which technology firms would actually prosper in the long run.
Visa (V) - 3 Star
Despite holding a rather substantial stake in American Express (which at close to $7 billion accounted for more than 11% of Berkshire's total stock holdings at the end of the third quarter), the insurer has been picking up shares in both MasterCard (MA) and Visa this year. Both holdings can be traced back to Todd Combs, who had invested heavily in MasterCard in his own portfolio at Castle Point Capital Management. While Combs started building his stake in MasterCard during the first quarter of 2011, it looks like he went all in with Visa in the third quarter, picking up slightly more than 2 million shares (which were worth around $200 million at the end of the third quarter). While our analyst, Michael Kon, believes that the shares are fairly valued right now, he notes that Visa operates the world's largest credit and debit card networks in terms of cards outstanding and purchase volume, and that with few direct competitors, the firm has unmatched scale in this market and a wide economic moat. No doubt it was this positioning in the marketplace along with the growth that is expected to come from electronic payments longer term that got Combs interested in the stock in the first place.
CVS Caremark (CVS) - 3 Star
Picking up more than 5 million shares of CVS Caremark (which were worth around $190 million at the end of the third quarter), Todd Combs is making a decent-sized bet on a firm whose outlook, in the opinion of our analyst, Matthew Coffina, seems to fundamentally shift every few weeks. In his view, CVS Caremark could provide a model for the future of integrated health care, or it could provide a model for why companies should stick to the core businesses that they know best and avoid disruptive and expensive acquisitions. Much like Combs' purchase of Dollar General (which we talk about in further detail below), this purchase seems to be completely foreign to his own core competency, which has revolved around financial services names. In the current environment, we thought that we would be more likely to see Combs buying stakes in beaten-down financials that once graced his own portfolio--like Western Union (WU), JPMorgan Chase (JPM), Charles Schwab (SCHW), and Goldman Sachs--rather than throwing money at CVS Caremark and Dollar General, neither of which are all that attractively priced on a price/fair value basis.
The DirecTV Group (DTV) - 2 Star
Much like with Intel, Visa, and CVS Caremark, Todd Combs threw a nearly full position weighting behind The DirecTV Group during the third quarter, buying up more than 4 million shares (which were worth around $180 million at the end of September). While the shares of DirecTV did take a tumble during the third quarter, they never traded at a level where Morningstar analyst Michael Hodel would have felt comfortable recommending them. While the firm has had some success over the last couple of years generating growth in excess of the industry overall, he continues to believe that DirecTV will face tough challenges over the next several years, as the pay-television industry matures and turns increasingly more competitive. Hodel feels that the ability to combine phone with high-speed Internet access and television service gives cable a major weapon in its fight with satellite providers like DirecTV, and he also notes that the phone companies are building a similar advantage as they upgrade networks around the country. With so many choices for the consumer, and DirecTV's equipment subsidies and marketing spending coming in around $800 for each customer acquired (which easily takes upward of 18 months for the firm to recoup), the road ahead looks far more challenging.
General Dynamics (GD) - 4 Star
While also well outside of his core competency, General Dynamics is a far more attractive name on a valuation basis than some of the other stocks that Todd Combs has been snatching up this year. Dogged by concerns about drastic cuts in defense spending (in the aftermath of the debt ceiling debate and resolution), the shares dropped close to 25% during the third quarter, with Combs picking up more than 3 million shares (which were worth around $175 million at the end of September). While the shares have rebounded more than 10% since then, Morningstar analyst Neal Dihora continues to find some value in them. In his view, General Dynamics' products form the backbone of U.S. defense superiority. While this makes the firm extremely vulnerable to future cuts in defense spending, he believes that General Dynamics' entrenched product range, robust aerospace business, and focused acquisitions should allow the company to produce returns on invested capital well above its cost of capital for years to come.
Dollar General (DG) - 1 Star
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 (FDO), 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 continue to wonder what Todd Combs is thinking with this investment, which runs well outside of his core competency. After picking up more than 1 million shares in the second quarter, Combs added 3 million more shares in the third quarter, with Berkshire's stake in Dollar General being worth close to $170 million at the end of September.
MasterCard (MA) - 3 Star
With Todd Combs going all in on Visa during the third quarter, we were surprised that he was not adding to Berkshire's stake in MasterCard, which was worth around $125 million at the end of the period. With MasterCard currently trading at 104% of the fair value estimate ascribed to the shares by Morningstar analyst Michael Kon (versus Visa, which is trading at 84% of Kon's current fair value estimate for that firm), it could be that the shares never got quite as attractive to Combs as Visa's did during the third quarter. Perhaps his margin of safety for MasterCard, which operates the world's second-largest credit card network, is also a bit larger than the one he has in place for Visa. That said, Combs does have a decent position in MasterCard, which was his second-largest holding at Castle Point Capital Management at the end of the third quarter of last year (just before he started to unwind his fund in anticipation of taking his new job at Berkshire). No doubt he likes the fact that MasterCard's scale and switching costs for issuers, merchants, and cardholders garner it a fairly wide economic moat, and that just like Visa, it will benefit from the growth that is expected to come from electronic payments longer term.
Verisk Analytics (VRSK) - 2 Star
Unlike the other new additions to Berkshire's portfolio this year, Verisk does not really qualify as a purchase. The company is basically 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 that 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 rather than an outright purchase of Verisk that led to the holding showing up in Berkshire's portfolio. We think that this arrangement also explains the error in Berkshire's initial 13F filing for the third quarter, which showed the insurer holding twice the number of shares it held in Verisk at the end of the second quarter. We believe that Berkshire counted the shares it received in early October (as the remaining Class B shares converted to Class A common stock) toward its holding at the end of September--an error that has subsequently been corrected by the insurer.
While this was one of the busier quarters we've seen in a long time for Berkshire from a buying perspective, we would be remiss if we didn't note one other major stock purchase during the quarter--Berkshire's own common stock. As you may recall, in late September the insurer announced a share-repurchase program aimed at buying back Berkshire's Class A and B shares at prices no higher than a 10% premium to the firm's current book value per share (which stood at $96,876 per Class A share, or $65 per Class B share, at the end of the third quarter). While Buffett was vague about how much cash he would spend buying back Berkshire's stock, he did note that repurchases would not be made if they reduced the firm's consolidated cash balance below $20 billion. Given how close Berkshire's stock was trading to the upper threshold of Buffett's targeted buying range, and the fact that the shares ran up quickly the day that the buyback plan was announced, we weren't expecting much repurchase activity during the third quarter. As it turns out, Berkshire repurchased just $18 million of its own shares (15 Class A shares and 227,669 Class B shares) during the waning days of the September quarter--a far from meaningful amount (at less than 0.025% total combined shares outstanding). That said, it is interesting to see Buffett use his reputation as an investor to put a floor under Berkshire's stock price at a time when concerns about global financial markets were impacting the value of just about every financial services stock in our coverage universe.
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Disclosure: Greggory Warren own shares in the following securities mentioned above: Procter & Gamble, 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.