Berkshire Puts Money Back to Work in Equities
With Buffett's lieutenants hitting the ground running, will a more collaborative process among Berkshire's newest investment managers prompt a rethinking of long-standing holdings?
By Greggory Warren, CFA | Senior Stock Analyst
When we relaunched the Ultimate Stock-Pickers concept a little more than three years ago, we made a point of including a few insurance companies in our list of top managers because, unlike their peers in the mutual fund business, the portfolio managers at insurance companies tend not to be impacted by investor redemptions during weak market environments. They're also a bit more long-term oriented than most mutual fund managers, investing their portfolios according to the time horizon and payout profiles associated with the products underwritten by their firms rather than the vagaries of the equity markets. While fixed income tends to dominate the average insurance company's investment portfolio, with the asset class providing a steady stream of cash flows necessary for duration matching, some insurers choose to hold a larger position in stocks, which have historically generated superior long-term returns compared with some of the other investment options available to them.
Of the four insurance firms in our Investment Management Roster-- Berkshire Hathaway (BRK.A) / (BRK.B), Markel (MKL), Alleghany (Y) and Fairfax Financial (FRFHF)--Berkshire is probably the best known, owing to the cult-like status that Warren Buffett and Charlie Munger have with investors. Buffett has been involved in Berkshire's investment portfolio for more than forty years, while Munger has been contributing to investment decisions at the firm for nearly as long. This type of longevity is rare among asset managers, and speaks to the success that Berkshire has had finding investments that not only meet the needs of its business, but that allow Buffett and Munger to demonstrate their investing acumen. While the long and successful tenure of Berkshire's portfolio managers has been a competitive advantage for the firm for the last several decades, the insurer is in the midst of a changing of the guards.
Changing of the Guard at Berkshire
According to the succession planning process that Buffett announced in his 2005 annual letter to Berkshire's shareholders, the firm expects his three main jobs--chairman, chief executive officer, and chief investment officer--to likely be handled by one chairman, one CEO, and three or more external hires (reporting directly to the CEO) that would manage the investment portfolio, once Buffett retired. Berkshire had to start getting serious about filling the investment manager roles at the firm after Lou Simpson announced he was retiring from his position running GEICO's investment portfolio in 2010. Simpson oversaw the investment portfolio at Berkshire's auto insurance subsidiary for more than 30 years, and at the time he announced his retirement in the third quarter of 2010 was managing around $4 billion for the insurer.
Given their years of experience working together, Simpson was not required to run investment decisions by either Buffett or Munger, and had a management style that was similar to theirs--researching the companies he invested in extensively, taking large positions in firms he considered attractively valued, and running fairly concentrated stock portfolios. So it was a little surprising to see Buffett's first pick (announced in October 2010) be a little-known hedge fund manager named Todd Combs, who ran a fairly concentrated fund at Castle Point Capital Management dedicated almost entirely to the stocks of financial services firms. While he has been busy over the last 15 months buying and selling securities, only two of his top 10 holdings at Castle Point-- U.S. Bancorp (USB), which was already in Berkshire's portfolio when Combs started working for Buffett and Munger, and MasterCard (MA)--have shown up in the insurer's stock holdings.
Despite ongoing speculation that other top 10 holdings from Castle Point--like Western Union (WU), Starwood Hotels & Resorts (HOT), and State Street (STT)--might eventually work their way into Berkshire's portfolio, Combs has been content to put money to work in other financial services names, like Visa (V) and Torchmark (TMK), as well as some non-financials, like Dollar General (DG), CVS Caremark (CVS), General Dynamics (GD), and Intel (INTC). At least we are willing to ascribe these transactions to Combs, since Buffett's second investment manager hire, Ted Weschler, was not officially announced until mid-September of last year (and most of the transactions mentioned above took place during the third quarter of 2011).
That said, there was also a fairly large purchase of DIRECTV (DTV), which was Weschler's single-largest holding at Peninsula Capital Advisors, during the third quarter, so it is quite possible that he had his hand in several of the purchases we are ascribing to Combs. What we do know with a bit more certainty is that Weschler was the likely buyer of shares of DaVita (DVA) and Liberty Media (LMCA), both of which were top five holdings in his fund. And we can also assume that both Combs and Weschler are going to maintain stock positions similar in size to what Lou Simpson had run over the years, with typical holdings running in the $200 million-$300 million range (compared with Buffett's own stock picks, which tend to be significantly larger in size), and perhaps a few positions increasing in size beyond that level if the two lieutenants are fortunate enough to find stocks they feel confident enough in holding to build out concentrated stakes.
Additional Insight on Combs and Weschler
We also picked up a few additional tidbits of information about the two managers over the course of the weekend that we spent in Omaha earlier this month attending the Berkshire Hathaway annual meeting. During the question-and-answer session that Buffett and Munger hold each year, there was a question this year about the salaries for the two managers that Berkshire had hired (with the assumption being that the firm would have a tough time attracting talent without a competitive pay package). In his response, Buffett noted that each manager was being paid a base salary of $1 million, and that each would be eligible to receive bonuses equivalent to 10% of the amount by which their portfolio beat the S&P 500 index on a three-year rolling basis. He also noted that Combs was already doing well in this regard, based on the stock picks he had made during 2011.
Buffett went on to highlight the fact that each manager gets paid 80% of their bonus based on the performance of their own portfolio, and that 20% of the payout is based on the performance of the other manager's investments. While the bonus mix might change up a bit if Berkshire ends up hiring additional managers, it does speak to Buffett's desire to establish a more collaborative process among the investment managers that he has lined up to assume the responsibilities of his role as chief investment officer at the firm once he does finally leave the scene. That said, it will make our task of discerning who is buying and selling securities at the firm a bit more difficult to navigate, given that both men could be buying up stakes in the same firms, which we feel was likely the case with DIRECTV over the last three quarters.
We also learned over the course of the weekend in Omaha (through conversations with people familiar with the two managers) that Combs is an investor more in the mold of Charlie Munger, while Weschler evokes a bit more of Warren Buffett's investing style. So it came as no real surprise to us to learn recently that Buffett had Weschler working on a non-portfolio-management-related deal with Ally Financial, aimed at buying its Residential Capital mortgage unit, in which Berkshire holds unsecured debt, before the auto lending firm put its home lending division into bankruptcy. While the negotiations came to naught, it does speak volumes about the extent to which Buffett is willing to use his investment managers to fulfill his role as chief investment officer.
Buffett also clarified the size of the portfolios that Combs and Weschler were managing, noting during the question and answer session at the annual meeting that each manager was working with a bank of $1.75 billion at the end of last year, and that they were both given another $1 billion to work with at the end of the first quarter of 2012, bringing the total amount that these two investment managers were working with to $5.5 billion (exclusive of any gains/losses on capital that had already been put to work). What their full responsibilities end up being, though, and how much flexibility they ultimately have with the large legacy positions that Berkshire maintains in names like Coke (KO) , Wells Fargo (WFC), and American Express (AXP), remains to be seen, in our view.
Berkshire Hathaway's Top 10 Stock Holdings (as of 03/31/12)Star Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) % of Stock Portfolio Coca-Cola (KO) 2 Wide 75.08 1.03 Low $169,526 19.7 Wells Fargo (WFC) 4 Narrow 31.45 0.77 Medium $167,096 17.9 IBM (IBM) 2 Wide 197.86 1.09 Low $228,228 17.8 Amrcn Exprss (AXP) 3 Wide 55.66 1.03 High $64,060 11.6 P&G (PG) 4 Wide 63.96 0.85 Low $175,257 6.5 Kraft (KFT) 4 Narrow 38.35 0.87 Medium $67,994 3.9 Wal-Mart (WMT) 3 Wide 61.71 1.01 Low $209,856 3.8 CncoPhllps (COP) 3 Narrow 51.2 0.88 Medium $64,745 2.9 US Bncrp (USB) 3 Narrow 30.66 0.93 Medium $58,076 2.9 J&J (JNJ) 4 Wide 63.56 0.83 Low $174,559 2.5 Stock Price and Morningstar Rating data as of 05-17-12. Figures do not include foreign investments that are held abroad, such as BYD Corporation, Tesco PLC, and POSCO.
Despite some buying and selling activity among roughly half of Berkshire's top 10 stock holdings during the first quarter, the list looks pretty much like it did at the end of last year. Wells Fargo continues to be Buffett's "go to" stock, with Berkshire picking up another 10.6 million shares of the bank's common stock during the first quarter. After touting Wells Fargo in his annual review to shareholders last year as a major holding that could see a meaningful increase in its dividend, Buffett continues to put his money where his mouth is, snatching up 51.7 million shares of the bank in the last year alone. And since the start of 2009, Buffett has added 104.1 million shares of Wells Fargo (equivalent to 36% of its holdings in the bank at the end of 2008) to its investment portfolio.
The only other top 10 holdings in Berkshire's stock portfolio that saw buying activity during the quarter were Wal-Mart (WMT) and International Business Machines (IBM). In Wal-Mart's case, Buffett was actually buying shares before news broke last month that the firm's largest foreign subsidiary, Wal-Mart de Mexico, had been accused of years of widespread bribery in that country. We had recently speculated that Wal-Mart was one of only a few names we could envision Buffett buying, after he commented in the wake of the annual meeting that Berkshire had purchased two stocks (already in Berkshire's portfolio) in the days before and after the meeting. The question remains, though, as to whether or not Buffett added to the 7.7 million shares Berkshire picked up during the first quarter when the stock took a turn for the worse at the end of April. With the retail giant accounting for less than 4% of Berkshire's total stock holdings at the end of the first quarter, we wouldn't be surprised if Buffett did step up and purchase more shares of Wal-Mart during the current quarter.
With regard to IBM, Buffett continues to add to the stake that Berkshire started building in the first quarter of 2011, with the half million shares that the firm picked up during the first quarter of 2012 bringing Berkshire's stake close to 64.4 million shares at the end of the most recent period. For those that may not recall, Buffett first announced to the world in November of last year that he'd purchased 63.9 million shares of the technology giant during the first (4.5 million), second (20.3 million), third (32.5 million), and fourth (6.6 million) quarters of 2011. Berkshire was able to amass such a large stake in IBM without the market catching on, because Buffett took full advantage of an obscure rule (in Section 13-F of the Securities Exchange Act of 1934) that has historically allowed him to withhold purchases or sales from his quarterly filing with the SEC until he is good and ready to disclose them. With Berkshire once again invoking this rule in their first-quarter 2012 filing, it is anybody's guess what Buffett, Combs, and/or Weschler were up to during the quarter that they did not yet want to disclose to the public.
Looking more closely at the selling activity among the top 10 holdings, Buffett sold another 9.0 million shares of Kraft Foods (KFT) during the first quarter, with Berkshire selling 27.2 million shares of the packaged-foods giant overall during the last four calendar quarters. After initially purchasing 132.4 million shares of Kraft in the fourth quarter of 2007, Buffett has been a net seller of the stock. While some of the initial selling activity in Kraft during the first quarter of 2010 has been attributed to Berkshire's purchase of Burlington Northern--with the insurer also paring back stakes in top-10 holdings like Procter & Gamble (PG) and Johnson & Johnson (JNJ) to raise capital for the deal--all of the subsequent sales can be tied directly to the packaged food giant's purchase of Cadbury (which was announced in January 2010). Never completely warming up to the acquisition, Buffett (despite insisting time and time again that Berkshire is invested in Kraft for the long haul) has viewed Kraft more as source of cash than anything else over the last two-plus years.
The same could be said more recently for Procter & Gamble, of which Buffett sold 3.5 million shares during the first quarter of 2012. In an interview on CNBC following Berkshire's annual meeting earlier this month, Buffett was less than supportive of P&G's business model of selling higher-end products in a difficult economy, noting that the firm does "not have the pricing flexibility with some items that they thought they had." When asked if he was selling, his response was "I'll just say that we've been a long-term holder," and then went on to point out that that sounded "a little weasely." Anyway you look at it, a less-than-resounding statement of support for what has been a long-term holding for Berkshire (with most of the shares coming to the firm in 2005 after P&G bought Gillette, which Buffett had first bought for Berkshire in 1989). At 6.5% of the reported stock portfolio, 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.
First-Quarter Purchases Made by Berkshire's ManagersStar Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) Shares Purchased (millions) Wal-Mart (WMT) 3 Wide 61.71 1.01 Low $209,856 7.7 Wells Fargo (WFC) 4 Narrow 31.45 0.77 Medium $167,096 10.6 DaVita (DVA) 3 Narrow 81.40 0.95 Medium $7,652 3.3 General Mtrs (GM) 5 None 21.62 0.45 High $33,854 10 DIRECTV (DTV) 2 Narrow 46.08 1.21 Medium $30,182 2.7 Lib Intrctv (LINTA) NA NA 17.12 NA NA $9,564 1.3 IBM (IBM) 2 Wide 197.86 1.09 Low $228,228 0.5 Bank NY Mlln (BK) 4 Wide 20.40 0.58 High $24,331 3.8 Viacom B (VIAB) 3 Narrow 46.72 0.93 Medium $24,660 1.6 Stock Price and Morningstar Rating data as of 05-17-12.
As for the non-Buffett moves made during the quarter, we saw Berkshire pick up another 2.7 million shares of DIRECTV, which at $1.1 billion at the end of the first quarter accounted for less than 2% of Berkshire's reported $75.3 billion stock portfolio. We continue to ascribe this position, as well as DaVita (which increased in size by 3.3 million shares) and Liberty Media (where Berkshire picked up another 1.3 million shares), to Ted Weschler, as these three firms were top-five holdings in his fund at Peninsula Capital Advisors. We also believe that Weschler was behind this quarter's new money purchase of Viacom (VIAB), which fits in more nicely with his bent toward media and communications names. It's anybody's guess who was behind the 10-million-share investment in General Motors (GM), which doesn't really fit in with Weschler's background, or Todd Combs', who has had more of a penchant toward financial services names.
That said, we think the ramping up of Berkshire's position in Bank of New York Mellon (BK), which increased in size by 3.8 million shares, was a Combs move, as was the sale of 860,000 shares of Dollar General which had been one of his first additions to the portfolio during the second quarter of last year. While we're not sure if Combs or Weschler initiated the stake in Intel during the third quarter of 2011, Berkshire sold off around one quarter of its stake during the quarter, which makes sense to us given that the stock is up some 50% from its lows in mid- to late August 2011. As for the remaining transactions, they looked to be more housecleaning related than anything else, with Berkshire moving 1.5 million shares of Comdisco (CDCO) and 1.2 million shares of Verisk Analytics (VRSK) off the books during the first quarter. There were also very minor shares changes in the share levels of U.S. Bancorp and Ingersoll-Rand (IR) during the period.
First-Quarter Eliminations Made by Berkshire's ManagersStar Rating Moat Size Current Price ($) Price/Fair Value Fair Value Uncertainty Market Cap ($mil) Shares Eliminated (millions) Kraft (KFT) 4 Narrow 38.35 0.87 Medium $67,994 -9 P&G (PG) 4 Wide 63.96 0.85 Low $175,257 -3.5 Intel (INTC) 3 Wide 26.20 0.9 Medium $131,812 -3.8 Verisk (VRSK) 1 Wide 47.93 1.5 Medium $7,960 -1.2 Dollar Gnrl (DG) 1 None 46.01 2.09 Medium $15,571 -0.9 Cmdsco (CDCO) NA NA 5.15 NA NA $21 -1.5 Ingrsll-Rnd (IR) 3 None 40.67 0.97 Very High $12,149 - US Bncrp (USB) 3 Narrow 30.66 0.93 Medium $58,076 - Stock Price and Morningstar Rating data as of 05-17-12.
Even with all of these changes, the top 10 holdings at Berkshire continue to account for close to 90% of the total stock holdings at the firm. With Buffett firmly in control of these positions, and Combs' and Weschler's portfolios currently accounting for less than 8% of Berkshire's total stock holdings, it is unlikely that their actions will have a significant impact on the performance of the portfolio in the near to medium term. What remains to be seen is whether the collaborative process that Buffett is attempting to nurture prompts him top look more closely at long-standing positions like Washington Post (WPO) and Moody's (MCO), or even Coke or American Express, where there has been no buying or selling activity in years, and reallocate capital to make way for the next generation of investors at Berkshire Hathaway.
Disclosure: Greggory Warren owns shares in the following securities mentioned above: Procter & Gamble, Kraft Foods, Johnson & Johnson, 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.
The Morningstar Ultimate Stock-Pickers Team does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.