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Berkshire Hathaway's 5-Star Stocks

How to profit by combining Morningstar's and Berkshire's best investment ideas.

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In addition to its just-released shareholder letter,  Berkshire Hathaway (BRK.B) also recently released its latest Form 13-F, which disclosed the investment conglomerate's stock holdings as of Dec. 31, 2006. Both Warren Buffett--perhaps the greatest investor of our time--as well as Lou Simpson, his colleague at Berkshire's wholly owned auto insurer GEICO, manage Berkshire's equity portfolio, and I think comparing a cross-section of their picks with Morningstar's research can potentially uncover some very attractive investment ideas. To begin profiting from some of these picks and to receive my most recent analyses, be sure to sign up for my e-mail alerts.

In my view, just because Berkshire owns a stock doesn't necessarily mean that the price is still attractive enough for you to consider purchasing it. In fact, Buffett actually said in last year's Berkshire Hathaway annual shareholders' letter, "Expect no miracles from our equity portfolio. Though we own major interests in a number of strong, highly profitable businesses, they are not selling at anything like bargain prices." He went on to say, "The likelihood is that their per-share earnings, in aggregate, will grow 6-8% per year over the decade and that their stock prices will more or less match that growth." While it is certainly possible that Buffett is being somewhat conservative in his assessment, and that for many investors 6-8% annual growth over 10 years would be welcome, I'd like to think that investors can do better by cherry-picking from Berkshire's portfolio, rather than simply replicating it. Before taking a look at what we at Morningstar think are the most compelling ideas from Berkshire's portfolio, I'll recap the conglomerate's most recent transactions.

New Additions
In its recent filing, Berkshire disclosed three new positions:  Ingersoll-Rand Company (IR),  United Healthcare (UNH), and  US Bancorp (USB). It should be noted that Berkshire had been accumulating its stake in US Bancorp since early 2006 but had been granted permission to delay the filing of this position over the last couple of quarters. Berkshire also modestly boosted its stake in  Wells Fargo (WFC) and USG (USG).

Presently, our analysts believe that each of these stocks (with the exception of USG, which at this time we don't rate) is fairly valued, as each holds a 3-star rating. This means that our analysts believe the stock price will only grow by the company's cost of capital over the next year. Even though Morningstar doesn't rate USG at this juncture, as I wrote in an article last month, I remain cautiously optimistic on this investment, given that the company is well-positioned as the low-cost provider in the wallboard manufacturing industry after having emerged from bankruptcy in mid-2006.

Eliminations and Reductions
Berkshire also sold some stocks last quarter, eliminating its position in  Sealed Air (SEE) and  Target (TGT). I was a bit surprised by the decision to jettison the Target shares, given that Berkshire owns positions in similar public mass-market retailers  Wal-Mart (WMT) and  Costco (COST), not to mention its wholly owned subsidiary Nebraska Furniture Mart. However, it should be noted that Berkshire's buying and selling of Target seemed to coincide with my colleague Joseph Beaulieu's recommendation of the shares, given that it was rated 5 stars by Morningstar in February 2006, and is rated 3 stars (fairly valued) now. Berkshire's position in  Outback Steakhouse (OSI) was also liquidated, since the firm was acquired by a group of private equity funds last quarter.

As I had expected, Berkshire continued to divest its  Ameriprise (AMP) shares, selling 11 million shares during the quarter--almost 60% of its position. Given that my colleague Dafina Dunmore continues to believe that fierce competition in the retail brokerage industry will make it difficult for Ameriprise to generate above-average returns on capital in the coming years, I suspect Berkshire will continue divesting its Ameriprise stake during 2007. Berkshire also sold some of its position in  Comcast (CMCSA), whose shares have had a terrific run, climbing by more than 63% last year. Morningstar's Mike Hodel also currently believes Comcast is fairly valued, with a 3-star rating on the shares. Giving even further credence to this recommendation, I noted in a recent article that several other investment managers began selling some of their Comcast shares in mid-2006. Finally, Berkshire also reduced its investment in both specialty retailer  Pier 1 (PIR) and tax-advisor  H&R Block (HRB). Over the last few years, Pier 1 has struggled with several merchandising missteps, and our analyst John Gabriel thinks there is still a lot of work to be done. According to our H&R Block analyst Kristan Rowland, despite the moat-worthy characteristics of H&R Block's tax advice business, its subprime mortgage business will continue to weigh on near-term results.

Five-Star Stocks
Only six of Berkshire's 39 stocks boast a 5-star rating, which I think gives further credence to Buffett's statement that many of Berkshire's equity investments are "not selling at anything like bargain prices." That said,  American Express (AXP),  Johnson & Johnson (JNJ),  United Parcel Service (UPS), Wal-Mart,  Western Union (WU), and  White Mountains Insurance (WTM) still boast 5 stars, which means that our analysts think that this subset of Berkshire's portfolio, if bought now, still offers the potential to earn attractive long-term returns. I checked in with the analyst for each of these companies to get a brief take on the investment thesis for each firm.

My colleague Ryan Batchelor said of American Express, "This firm has by far the best business model out of any of the card-based businesses in our coverage universe. Given that the firm is now a pure play card firm, it's poised to take advantage of the long-term secular trend of consumer payments moving away from cash and checks more toward card-based and other forms of electronic payments. Although all card firms share in this secular growth trend, American Express' superior business model has the best economics--most revenue per dollar spent on its cards--and the best demographics--highest spending per cardholder--which allows for a virtuous cycle of merchants wanting to accept Amex cards to capture high spenders and high spenders wanting Amex cards for the industry-leading rewards that the firm is able to offer, given its financial strength."

Recently commenting on J&J, our analyst Heather Brilliant said, "While Johnson & Johnson has encountered some challenges in its pharmaceutical business, we're confident it can emerge unscathed thanks to a solid research pipeline, diverse revenue base, and exceptional cash flow generation....The firm has reported more than 70 years of sales growth and churns out free cash flow reaching almost 20% of sales. This excellent cash generation has enabled the company to grow its dividend for the past 44 years, a trend we expect to continue."

Morningstar analyst Peter Smith remarked on United Parcel Service, "Of the four major package delivery companies, UPS generates the best returns and strongest free cash flow. Growth opportunities abound, especially internationally, and returns are improving. We also expect management to use the firm's under-levered balance sheet in the near future for an acquisition or large share repurchases to drive shareholder value."

In a recent report on Wal-Mart, my colleague Joseph Beaulieu said, "At its most successful, Wal-Mart has used its leverage over suppliers and its operational savvy to drive strong returns on invested capital, so I'm glad to see signs that it is returning to those core strategies. In recent quarters, gross margins have continued to increase as a result of higher initial markups and fewer markdowns on general merchandise. Inventories are growing much more slowly than revenue, and this trend should continue to boost gross margins while reducing working capital requirements--two things that help drive returns on investment."

My colleague Brett Horn commented on Western Union, "Western Union has a dominant position in a highly scalable business, processing approximately five times the transactions of its closest competitor, but it still has only 17% market share. This leaves the company with plenty of room to grow as the industry consolidates, and it is using its cost advantages to price out smaller competitors. Western Union also benefits from solid secular growth, as rising immigrant populations are driving increases in money transfer volumes."

I have long viewed White Mountains as one of the best managed insurers I follow. As I stated in one of my recent Analyst Reports, "Making acquisitions is a key competency that fulfills a rare dual role at White Mountains: business expansion and wealth creation. Over the past few years, the firm entered life insurance by acquiring Symetra, boosted its casualty portfolio by buying Sierra, and expanded its property reinsurance business by acquiring Sirius and Tryg-Baltica. By patiently and opportunistically seeking motivated sellers, management acquired each firm for less than book value--and arguably below fair value. White Mountains profits by awaiting opportunities, and we think investors should do likewise with its shares."

I will also note that five out of these six firms boast a wide moat rating by Morningstar, while the other is rated a narrow moat. In other words, our analysts believe that each of these companies possesses a sustainable competitive advantage, which should help keep returns consistently above each firm's cost of capital.

The Full Portfolio
Here is the complete breakdown of Berkshire's portfolio, ranked from the largest position to the smallest. I will also note that Berkshire owns some international stocks, but since the conglomerate owns the local shares and not the U.S. traded ADRs, it doesn't have to disclose them. As such, I've excluded them from this article.

To receive my next analysis of Berkshire's portfolio, as well as commentary on the holdings of other legendary investment managers, please sign up for my alerts. Not only will you receive e-mails that include my most recent analyses and model portfolio, but more importantly, you can also start profiting from the ideas of some of the best investment minds around.

 The Berkshire Hathaway Portfolio
Stock Morningstar
% of Holdings
Coca-Cola (KO) 17.9%
American Express (AXP) 17.1%
Wells Fargo (WFC) 13.5%
Procter & Gamble (PG) 12.0%
Moody's (MCO) 6.2%
Wesco Financial (WSC) 4.9%
Anheuser-Busch (BUD) 3.3%
Johnson & Johnson (JNJ) 3.0%
ConocoPhillips (COP) 2.4%
Washington Post (WPO) 2.4%
White Mountains (WTM) 1.8%
USG (USG) Not Rated 1.7%
Wal-Mart (WMT) 1.7%
US Bancorp (USB) 1.6%
M&T Bank (MTB) 1.5%
Amer Standard (ASD) 0.9%
Ameriprise (AMP) 0.8%
Nike (NKE) 0.7%
Comcast (CMCSA) 0.6%
Tyco (TYC) 0.6%
General Electric (GE) 0.5%
Costco (COST) 0.5%
SunTrust Banks (STI) 0.5%
First Data (FDC) 0.5%
Iron Mountain (IRM) 0.5%
Western Union (WU) 0.4%
Lowe's (LOW) 0.4%
Gannett (GCI) 0.4%
Torchmark (TMK) 0.3%
Home Depot (HD) 0.3%
UPS  (UPS) 0.2%
H&R Block (HRB) 0.2%
Petrochina (PTR) 0.2%
Servicemaster (SVM) 0.1%
UnitedHealth (UNH) 0.1%
Ingersoll-Rand (IR) <0.1%
Sanofi-Aventis (SNY) <0.1%
Comdisco (CDCO) Not Rated <0.1%
Pier 1 Imports (PIR) <0.1%
Holdings as of 12-31-06
Morningstar data as of 02-28-07

Thanks to Justin Shapiro for his assistance analyzing Berkshire's 13-F filing.

Justin Fuller has a position in the following securities mentioned above: AXP, PG, HD, WU, GE. Find out about Morningstar’s editorial policies.