By Bill Bergman, Senior Stock Analyst at Morningstar.
When we relaunched Ultimate Stock-Pickers last year, we made a point of including a few insurance companies 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. They also tend to be a bit more long-term oriented than fund managers, investing their portfolios according to the time horizons and payout profiles inherent in their companies’ product lines. Fixed income tends to dominate the investment portfolios of most insurance companies, as the asset class provides a steady stream of cash flows and (in most markets) less risk than equities. That said, there will always be room for stock holdings, which provide the potential for capital appreciation.
Of the four insurance firms in our Investment Manager Roster– Berkshire Hathaway (BRK.A/BRK.B), Markel (MKL), Alleghany (Y), and Fairfax Financial, Berkshire Hathaway is probably the best known, owing to the legendary status that Warren Buffett and Charlie Munger have with investors. Buffett has been involved in Berkshire’s investment portfolio for much of the last 40 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 Berkshire has had finding investments that not only meet the needs of the business, but allow Buffett and Munger to demonstrate their investing acumen. Insurers are, ultimately, only as good as the promises they make (and keep), with the capital they collect and maintain (through their investment portfolios) playing a leading role in their ability to meet those promises.
It should also be noted that changes in the holdings of Berkshire’s stock portfolio are not always an indication that Buffett or Munger have made the decision to buy, sell or hold a particular security. Louis Simpson, for example, has overseen the investment portfolio at GEICO, Berkshire’s auto insurance subsidiary, for more than 30 years. He is not required to run investment decisions by either Buffett or Munger. That said, Simpson’s management style is not all that different from Buffett’s, researching the companies he invests in extensively, taking large positions in firms he considers to be attractively valued, and running concentrated portfolios where just a handful of stocks can make up a significant portion of the total portfolio.
Berkshire’s top-10 holdings should be viewed for what they are: a short list of the highest-conviction holdings of some of the best investors in the business. What’s interesting to note is that Coca-Cola (KO) has held the top spot in Berkshire’s portfolio for much of the last 20 years. Looking back at 1995, when the insurance operations at Berkshire contributed about 80% of the firm’s operating earnings (versus closer to 70% during 2009), common stock investments accounted for an eye-opening 90% of Berkshire’s total investment portfolio. Within what was a $22 billion stock portfolio back then, the seven largest holdings made up nearly 90% of the total market value of the portfolio, with Coke alone accounting for one third.
Since that time, Coke’s common stock value (including dividends) has risen 265%, which (while a little less than half the return enjoyed by investors in Berkshire Hathaway during the same period) has allowed the soft drink firm to remain Berkshire’s largest holding coming into 2010. Taken collectively, the top-10 stock holdings at the end of last year accounted for 87% of the insurer’s $58 billion equity portfolio. Four consumer names–Coke, Procter & Gamble (PG), Kraft Foods (KFT), and Wal-Mart (WMT) –in this list of top-10 holdings made up 39% of Berkshire’s total equity portfolio, and two financial services firms– Wells Fargo (WFC) and American Express (AXP) –accounted for 26%. Looking at all 41 stocks in the portfolio, consumer goods and services accounted for 41% of the total value of the holdings at the end of 2009, with financials contributing another 34%. And this was all before Berkshire completed its purchase of Burlington Northern (BNI) early last month, which effectively removes that top-10 holding from the insurer’s stock portfolio this year.
Parsing through Berkshire’s Trading Activity
Berkshire significantly pared back positions in two energy firms– ConocoPhillips (COP) and ExxonMobil (XOM) –and trimmed away at top 10 holdings Procter & Gamble and Johnson & Johnson. The rest of the selling in the portfolio was focused on Moody’s (MCO), WellPoint (WLP), UnitedHealth Group (UNH), Ingersoll-Rand (IR), Norfolk Southern (NSC), Union Pacific (UNP), CarMax (KMX), Gannett (GCI) and SunTrust Banks (STI). In Buffet’s Annual Letter to Shareholders released this past weekend, the Oracle of Omaha noted that the sales the firm did during the second half of the year were intended to raise cash for the Burlington Northern transaction (which is similar to what Berkshire did earlier in 2009 when it was raising funds for its Dow Jones and Swiss Re investments).
There were also a handful of purchases made during the quarter, with Berkshire nearly doubling its stake in Iron Mountain (IRM), the dominant player in the document management industry, and more than doubling its position in Republic Services (RSG), the nation’s second-largest waste removal company behind Waste Management (WM), and a firm that we had highlighted late last year. Berkshire also added to existing positions in Wells Fargo and Wal-Mart, and made a meaningful addition to Becton Dickinson (BDX), which the insurer began buying in the second quarter of last year and which has been a top idea of Morningstar analyst Alex Morozov for quite some time now.
Taking a Deeper Look at Berkshire’s Biggest Bets
Of the top-10 holdings in Berkshire’s stock portfolio at the end of 2009, our analysts have placed wide moat ratings on five of these companies, and narrow moats on the rest. By way of contrast, Morningstar stock analysts have given wide moat ratings to only about 10% of our entire universe of more than 1,700 companies, with about half of our stock coverage receiving narrow moat ratings. It’s also interesting to note how many of the firms in Berkshire’s top-10 holdings are still trading at 4- and 5-Star prices, even after the big run up in the markets last year. Believing that these 10 stocks deserve more consideration, we collected some commentary from our analysts reflecting their current thinking on these high-conviction holdings in Berkshire’s portfolio.
There hasn’t been a meaningful change in the number of shares Berkshire holds in Coke in well over a decade and yet it remains the top holding by market value in the insurer’s stock portfolio. Morningstar analyst Phil Gorham sees the company facing a dichotomy of prospects between emerging and developed markets, with the former offering the potential for strong growth as per capita income (and consumption) increases and the latter creating challenges as consumer tastes shift away from carbonated soft drinks. Having struggled to maintain positive relationships with key bottlers like Coca-Cola Enterprises (CCE), it was interesting to see Coke agree to buy CCE’s North American bottling operations this past week (a transaction Phil believes may have been prompted by PepsiCo’s (PEP) move to consolidate its own North American bottlers last year). Given all the flack Buffett gave Kraft during its pursuit of Cadbury (CBY) this past year, we were curious to see what he might say about this deal in his annual letter to shareholders, but it looks like we may have to wait for Buffett to weigh in on this transaction.
Wells Fargo (WFC)
Berkshire owns about the same dollar amount of Wells Fargo it did at the end of 2008, with the largely unchanged value a product of a modestly weaker stock price and an increased number of shares. Our analyst Jaime Peters thinks Wells Fargo is well-positioned after it took advantage of the credit crisis to expand its national footprint through the acquisition of Wachovia. With the merger on track and Wells Fargo starting to achieve some revenue synergies on top of the cost savings it was expecting from the deal, the acquisition is looking better every day. Jaime expects Wells Fargo to see a strong rebound in earnings during 2010 and believes that a dividend increase will likely occur before the year is out.
Burlington Northern (BNI)
This was perhaps the most exciting story in the Berkshire portfolio this past year, in part because the stock is now off the market. Berkshire increased its stake in Burlington Northern early in 2009, and then made a bid for the entire business in November of last year (with the deal closing in early February 2010). While the move prompted the selling of both Union Pacific and Norfolk Southern from the portfolio, Berkshire will not be lacking for exposure to the railroad industry. Morningstar analyst Keith Schoonmaker believes Burlington Northern is well-positioned to thrive as a wholly-owned subsidiary in the Berkshire community.
American Express (AXP)
American Express was the top performing stock among Berkshire’s top-10 holdings last year, with its share price doubling during 2009 (albeit only after taking a drubbing during the collapse of the financial markets in 2007-2008). Our analyst Michael Kon believes American Express’s credit quality is on the mend, as losses on bad loans have been declining steadily since last April. While this should allow the firm to once again focus on growth, he expects it will be difficult for American Express to see a return to pre-recession spending volumes until cardholders start using their cards more frequently than they are currently. That said, the trend of replacing cash and checks with electronic payments should provide the firm with a tailwind in the years ahead.
Proctor & Gamble (PG)
While Proctor & Gamble’s shares rallied with the markets last year, Berkshire was selling the stock in the fourth quarter of 2009. Given that Berkshire was gathering liquidity for the Burlington Northern transaction, and the insurer had been trimming positions in both Proctor & Gamble and Johnson & Johnson (JNJ) prior to the bear market to help fund other investment opportunities, we’re not going to read too much into this move. Morningstar analyst Lauren DeSanto believes that, despite a very challenging 2009, P&G remains focused on driving profitable market share growth in its categories. She expects new CEO Robert McDonald, who assumed the helm midway through last year, to continue to stress execution with retailers and customers, guiding P&G to operate like a smaller, more nimble company. Lauren thinks these initiatives, which augment increased brand investments and an improved new product pipeline, leave P&G well positioned coming into 2010.
Kraft Foods (KFT)
While Kraft is a relatively new addition to the portfolio, with Berkshire starting to build a stake in the packaged foods giant in 2007, it has been far from boring. Our analyst Erin Swanson thinks Kraft’s recent acquisition of Cadbury makes sense from a strategic perspective, but the integration of the global confectionery firm is not without risk. Beyond melding disparate corporate cultures, Cadbury’s public dismissal of Kraft’s business model and management team over the past several months increases the challenges of integration. The good news for Berkshire, though, is that Kraft consummated the deal without overly diluting its own shareholders (one of several points of contention Warren Buffett had with some of the moves Kraft was making in an attempt to get the deal done). Better yet, Erin believes that fourth-quarter and full-year results, which were aided by ongoing investments in product innovation and marketing support, have positioned Kraft to continue producing solid cash flows for shareholders.
Berkshire was buying more of this stock than it was any of its other top 10 holdings during 2009, nearly doubling the number of shares in the Wal-Mart portfolio. Morningstar analyst Joel Bloomer believes the firm, with $400 billion-plus in annual revenue, not only dominates the U.S. retail landscape but is also growing quickly internationally. Wal-Mart has been redirecting capital spending from the U.S. to faster growing parts of the world, like Latin America and China. The firm’s fiscal 2010 results benefitted from this commitment to international growth, which more than offset consumer trade down and mild deflation in the U.S. With the international segment contributing 25% of Wal-Mart’s total revenue, Joel anticipates more of the same over the next few years.
Wesco Financial (WSC)
Wesco is the majority-owned affiliate of Berkshire Hathaway headed by Buffet’s long-time partner Charlie Munger. The firm has developed significant reinsurance operations, but also folds in Berkshire-like operating subsidiaries such as furniture rental and steel servicing businesses. We think Wesco has garnered a narrow moat largely through the financial strength of its insurance operations, which is derived from a high level of capital, underwriting ability, and investment success. Given how well its investment portfolio has performed in recent years, the firm’s financial strength has only improved on a relative basis, further cementing its market position. Wesco’s respect in the marketplace and its position in the Berkshire umbrella help attract quality reinsurance business at good prices.
Conoco Phillips (COP)
Oops. We’re all human and this looks like it could be Berkshire’s biggest error in recent memory. Buffett acknowledged as much in his letter to shareholders last year, when he apologized for the poor timing involved in building a stake in this firm (which occurred just as oil and gas prices started to collapse in the second half of 2008). Berkshire has spent the last year and a half unwinding this position, and even started selling a big chunk of its stake in ExxonMobil during the fourth quarter (which the insurer only started building in the third quarter of last year). Bad or unlucky timing wasn’t unique to Berkshire regarding ConocoPhillips in recent years, as our analyst Allen Good notes the firm has made aggressive capital investments itself (including acquisitions) at inflated prices in recent years. He believes that while ConocoPhillips is leveraged to natural gas production and refining in the U.S.–and, as such, dependent on a recovery in natural gas prices and refining margins–management is taking steps to improve returns even if a recovery does not transpire. The company is also in the process of divesting $10 billion of underperforming and non-strategic assets, with the proceeds going towards debt reduction.
Johnson & Johnson (JNJ)
Rounding out the top-10 holdings is the only stock on the list currently trading at a 5-Star price. Berkshire’s stake in Johnson & Johnson has ebbed and flowed over the years, with the company likely trimming its stake in the fourth quarter of last year to help raise funds for its purchase of Burlington Northern. Morningstar analyst Damien Conover likes the firm’s reliable, and significant, long-term growth prospects. Having already gone though a majority of its own patent expirations, Johnson & Johnson is not being as severely impacted by the patent expiration shock currently affecting the rest of the pharmaceutical industry. With the company in the midst of launching four new potentially blockbuster drugs, and the firm maintaining brand and quality leadership in medical devices and consumer products, Damien feels that Johnson & Johnson is well-positioned for long-term growth.