Warren Buffett Shows Investors What Not To Do

by: Efficient Alpha

Warren Buffett's Berkshire Hathaway (BRK-A) holds two-thirds of its equity portfolio in just four companies. While that kind of conviction for four names may seem like a call to mimic the bet in your own portfolio, you may want to think twice about following the Oracle of Omaha into these four stocks. Whether your goal is to beat the market or just beat your own return requirement, there are better opportunities in combining a broad market fund with investments in smaller companies.

I doubt that Buffett or his $284 billion Berkshire empire will worry about it but the principal investments held by the company have underperformed the general market significantly over the past year. The SPDR S&P500 (NYSEARCA:SPY) has posted a total return of 20% over the past twelve months, including a 1.7% cash return. This compares against an average return of just 16% for the four holdings that make up 66% of Berkshire's holdings. The overall return on the four stocks masks a huge variation in returns, but that's not the real problem.

The real problem with the selection of the four companies is that the portfolio offers all the risk of an overweight position with little growth. While two of the stocks did extremely well over the last year, all four are giant large-cap companies and offer less potential for growth than smaller options.

The Oracle does it again

The company's $11.4 billion investment in American Express (NYSE:AXP) paid off big time with a total return of 34% over the last year, including a 1.3% cash return. The investment represents 12.7% of Berkshire Hathaway's total portfolio. The shares trade for 18.3 times trailing earnings, just over the industry average of 17.5 times earnings. Free cash flow almost doubled last year to $4.4 billion from $2.4 billion in the year before with only a marginal drop of $136 million in capital expenditures.

Bloomberg reported earlier this month that Time Inc (NYSE:TWX) may be in talks to buy the publishing arm of American Express. Disposing of the unit would be a positive move for Amex, which really has no business being a publisher in the first place. The company lumps publishing results in with its Enterprise Growth Group and other operations for a catch-all segment called Corporate & Other so it is difficult to get an idea of profitability. The company booked $1.66 billion in "other" revenue in 2012, just over 5% of the $31.6 billion in total revenue.

I like American Express, especially if it can get rid of its publishing unit, but prefer Consumer Portfolio Services (NASDAQ:CPSS) for exposure to the credit market. The $131 billion California-based company purchases and services auto loans, mostly as a source of alternate credit to buyers with poor credit ratings. Earnings are expected to almost double this year and next on strong auto sales and a rebounding jobs market.

Wells Fargo (NYSE:WFC), the largest holding in Berkshire's portfolio at $19.5 billion, also had a stellar year with a total return of 27% including a 2.8% cash return. Despite the strong price return, the bank still trades under the industry average of 14.3 times earnings with an 11.4 times earnings multiple.

I recently argued that Wells Fargo would lag performance in other banking names for the rest of the year. Relative to other banks, Wells is much more focused on consumer and residential growth. This focus has helped the bank outperform during the housing recovery but now may hold the lender back as rates rise. Chief Financial Officer Tim Sloan disappointed investors recently saying that the bank would post around $80 billion in originations this quarter, well under the $100 billion trend over the last eight quarters.

Investors looking for exposure to banking may want to consider smaller regional players like Valley National Bancorp (NYSE:VLY). The $2 billion New York and New Jersey lender offers a 6.5% dividend and a return on equity of 9.4% with a portfolio diversified across retail and commercial.

No one wins them all

Not every investment has been a runaway success for Buffett and his company. In its second quarter results, Berkshire Hathaway reported an unrealized loss in its equity investments of $135 million over the last twelve months.

The $13.1 billion investment in International Business Machines (NYSE:IBM), 14.6% of the company's total portfolio, helped to drive a large portion of that loss. IBM is down 5% over the last year including a 1.8% cash return. The company's price multiple of 13.6 times trailing earnings is below the industry average of 16.1 times but still well above its own five-year average of 12.5 times earnings. Free cash flow fell $234 million last year to $15.5 billion on top of $26 million less capital expenditures.

The company is selling off unprofitable business lines in the face of a slowdown in corporate spending on technology. Synnex Corporation (NYSE:SNX) has agreed to buy its customer-care outsourcing business for just over $500 million. The divestiture follows the sale of its retail store systems unit to Toshiba Tec Corporation. Through the sale of businesses with lower margins, management has set a goal of $20 per share in earnings by 2015. That would represent an increase of 31% off of the $15.25 in earnings posted last year.

For technology exposure, I think MKS Instruments (NASDAQ:MKSI) offers a better upside than IBM. The $1.4 billion company offers process improvement instruments and controls in the advanced manufacturing space. While manufacturing is not experiencing the rebirth that many predicted, regional economic developers are still supporting the push for advanced manufacturing. Earnings are estimated to more than double next year and the company has 40% of its market cap in cash.

While shares of Coca Cola (NYSE:KO) have gained over the past year, they have underperformed the broader market significantly. The stock posted a total return of 5%, including a 2.8% cash return. Berkshire Hathaway holds an investment of $15.5 billion, 17.3% of its total portfolio, in the soft-drink company. The poor performance may continue as earnings catch up to a lofty stock price. The shares trade for 20.4 times trailing estimates, just over the 19.7 times industry average and well over the company's five-year average of 17.6 times trailing earnings. Free cash flow increased $1.3 billion last year to $7.8 billion though it was supported by drop of $140 million in capital expenditures.

The large beverage makers could lose market share to smaller upstarts like SodaStream International (NASDAQ:SODA) and its do-it-yourself soda machines. Not only are machine sales increasing but they provide a growing and recurring source of revenue through drink mix sales. Sales increased 50% last year to $436 million and are expected 30% higher this year.

Growth and a market fund

While the four companies in Berkshire's portfolio will probably provide stable growth over the long-term, I think the company has its portfolio weighting reversed. Holding two-thirds of your equity investments in just four names is a good bet to underperform the market. These companies are extremely large so they do not benefit from the growth or flexibility of small-cap companies but they still bear significant company-specific risk so they do not offer the kind of diversification your portfolio needs.

A smarter allocation would be to hold two-thirds of your portfolio in a market fund like the SPDR S&P500 and the rest in a selection of strong small-cap companies. This provides the diversification of a market portfolio with better opportunity for growth.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.