I recently wrote this piece plaining the difference (as I saw it) between core holdings and "accent pieces." An "accent piece" I argued, like a striking piece of art or furniture, is something with interesting potential for large gains but which you don't want to build your whole future around.
In the case of stocks, it may be a small or mid cap, a stock with significant and imperfectly defined risks, or a stock in which you broadly see potential but lack the context for ideal understanding. For an "accent piece" in your portfolio, you would buy only a fraction of the amount you might put into a core holding - perhaps less than 1% against as much as 5-7% in a core holding.
This was how I felt about Ross Stores (NASDAQ:ROST), for example, which I bought in the low 60s within a point of the low in 2014. I surrendered it by writing a call which took me out a year and a few days later for a long term gain of roughly 65%. I left another 10% gain on the table, but that's okay. I loved Ross at the price I bought it for, but much less so after the runup.
The trouble with making Ross a core holding long term was that I don't trust my background knowledge about retail. I rarely step inside a store. My one regret was that I didn't buy it in more size, but I thought that I would have a chance to average up if proved right. It went up so fast with only slight corrections that I never got the chance. That's okay. It did its job. It was an accent piece.
At this point I am looking closely at two recent Berkshire buys - Axalta (NYSE:AXTA) and Phillips 66 (NYSE:PSX). Axalta is a mid cap (6 billion market cap) company in a niche market with several competitors. Phillips 66 is a much larger company (42 billion market cap) with risks I understand pretty well but feel imperfectly able to handicap. If I grow to understand them better while holding a small position, I would consider either as a core portfolio holding, but more likely PSX, which is larger and with which I already have some context and clearer view of the risks.
Whose Buy Were These Two Stocks?
This is a very interesting question. Some observers have argued from the size of the purchases that the buyer was Ted Wechsler or Todd Combs (especially in the case of Axalta), others that it was Buffett himself. I have another candidate: Meryl Witmer. One of the other three may have actually been the person who pulled the trigger, but I suspect that Witmer was the individual who provided the bullet. Maybe the right way to think about this is that Warren, Ted, and Todd listened to Witmer's opinions and knew her well enough to pay them very serious attention. If I am right, it provides a very interesting insight into the inner workings of Berkshire (NYSE:BRK.A)(NYSE:BRK.B) itself.
Meryl Witmer, a General Partner of Eagle Capital Partners, has been a participant in the annual Barron's Roundtable since 1999. She often (not always) brushes aside questions on prospects for the market as a whole, but when it comes to her stock selections she is in my view the most interesting of the gathering of savants, and she probably provides the most consistently profitable ideas. She mainly likes small, obscure, and somewhat oddball companies, but her insights are very fundamental and not oddball in the slightest.
Witmer has a particular interest and insight into industrials. This fits my own investment interest, so I naturally examine her suggestions with avid interest. Industrials are never trendy, and they trade within a band from cheap, misunderstood, and underloved to fairly priced, less misunderstood, and moderately loved - my kind of stock. If you look at their end markets, you can get a reasonable sense of their risks and prospects. (When I look at tech, social media, or contemporary retail and service models - Millennial territory - I have no idea how to handicap risks and returns.)
A second fact of note is that Buffett himself has discovered industrials in recent years. He used to love companies like Coca-Cola (NYSE:KO) which operate almost without fixed capital. The downside to this is that with a little shift in consumer preference, competitors without capital or any particular "know-how" can easily cut into Coke's market.
The beauty of industrials is the very factor Buffett used to avoid, perhaps best explained by considering his purchase of Burlington Northern Santa Fe. Burlington has an almost visible moat - tracks, engines, cars, land - and it requires enormous amounts of annual expenditure on upkeep. But this may be OK, Buffett has discovered, as long as you get solid and predictable returns on that capital. After all, nobody is going to build a parallel railroad.
I believe that this is the kind of thinking behind the Axalta and Phillips 66 purchases - with a little push from Meryl Witmer. Both Axalta and PSX are recent recommendations from her short list for the Barron's Roundtable, with Axalta reiterated forcefully and in detail this year. Both have origins as units ditched by larger companies, PSX by Conoco (NYSE:COP) (then called Conoco Phillips), and Axalta by DuPont. Companies like this, frequently mispriced and misunderstood, are happy hunting ground for astute analysts.
Oh, and one more thing, as that TV detective used to say: Meryl Witmer is a great admirer of Buffett, a feeling which must be mutual as she became a member of the Berkshire board and several important board committees in March of 2013. Already having a good view of Witmer and her track record as I knew it, I found my positive view of her greatly deepened when validated by Buffett. How many value investors has Buffett pulled out of all the babies in the world to adopt onto his board? You got it. One.
Meryl Witmer's Case For Axalta
The Barron's lead presenting the Axalta case was that it might gain 60% within a year or two. Here's how Witmer got to that number - a price of 40 from the current 25.
Axalta makes specialty paints for vehicles and machinery. The biggest chunk of its earnings derive from the refinish after-market, which consists of auto body shops. This is the highest margin part of its business, and the thousands of well-established relationships are its best defense against competition.
The PE ratio currently stated for backward-looking earnings doesn't make Axalta look impressively cheap, but the forward looking earnings of about a dollar, and about two dollars another year out improve the picture. More important, however, is that if you add back depreciation and amortization and then subtract the much smaller capex expenditures - a favorite piece of simple Buffett arithmetic - you get almost another buck of cash flow. Axalta starts to look cheap enough at 40 and very cheap at 25.
Even if the economy gets worse and the market gets a bad case of the hiccups, you could expect to be OK holding a solid company at those prices. Asked in an interview on CNBC what her goals were with a typical investment, Witmer said, oh, maybe 60% in a couple of years, a double if you get lucky, or if it turns out to be less, say, 30%, that's OK, and if you got it a little wrong probably breaking even. Most investors would be happy with that range of outcomes.
I also like the review Witmer made of the competition, including PPG, which is substantial and not to be dismissed, but a probability to be folded into your calculation. She did not omit the risks. Considering them, it's an accent piece for now, possible a core holding after I have seen how it feels as part of my portfolio.
And a funny aside from the Barron's piece. Axalta was dumped by DuPont and taken private by the management in place with the help of Carlyle group, which sacked twelve of seventeen major executives while expanding its plants. Carlyle then put Axalta back into the market as an IPO in 2014, doubling what it had paid DuPont. Berkshire bought a secondary placement from Carlyle in April of 2015, 20 million shares at $28 per share (up about 33% from the initial offering), giving him 8.7% of the company. If you buy now, you get it about 10% cheaper than Berkshire did. Dan Loeb, for those who follow him, also recently bought about a $60 million position in Axalta.
Joel Greenblatt, of "magic formula" fame, wrote a book entitled You Can Be A Stock Market Genius (you can't, of course, but people like Witmer can) chronicling a series of cases where he argued that the thing to buy was the apparent garbage the parent company was dumping. Witmer and Mario Gabelli (whom she has described elsewhere as one of her heroes) had a wonderfully acid exchange about the dunces at DuPont along with Oscar Schafer, who has also touted Axalta. Buy whatever DuPont sells, they agreed.
Meryl Witmer's Case For Phillips 66
Phillips 66 was spun off from Conoco Phillips in 2012. The oil folks at Conoco probably outdid the folks at DuPont, knowing as everybody knows that the real business is pulling oil out of the ground and selling it - no more distraction from our core business from those damn refineries. Good move good timing: not! I wonder how many integrated oil company execs are now thanking the market god for not succumbing to the tremendous pressure at that time to do what Conoco did. Where are all you folks that wanted to break up Exxon?
Nobody wanted Phillips 66, of course. It started trading at 37, is about 80 today. Witmer bought the initial offering. Buffett initially swapped his shares for the Phillips chemical business. Then he started buying it again in the second half of last year, this time in significant size. Reporting a large purchase in January, he had reached ownership of 13.7% of the company. It would be fun to have a transcript of every discussion of PSX that went on among the very smart folks at Berkshire.
Oil refiners have one problem: in the large context they don't control their own destiny. They are completely hostage to the "crack spread," the difference in price between their raw material and their products. I got to be familiar with this as an owner of Valero (NYSE:VLO) as far back as 1984. I remember it well because the damnable "crack spread" did counterintuitive things that wrecked an otherwise good idea. My second time around I did better with Valero.
Refiners are always cheap for sort of the same reason mortgage passthroughs are always cheap. Think of the way people with mortgages refi when rates go down, cutting down your potential capital gain, and hang on when rates go up, increasing your duration and inflicting maximum capital loss. It's sort of like that with refiners, or can seem so. Some people are arguing that the present may be one such moment in which lower oil prices are about to stop helping and as more capacity comes on line to drive down gasoline prices and squeeze profits. The key takeaway is that refiners are hostage to a couple of commodity markets - not one but two - with their profits carved out of the middle. On the other hand, their valuation may compensate you for this.
There is a bit of a positive kicker for PSX, however. A significant and growing part of their business is in higher value products such as plastics, which are less hostage to market conditions beyond the company's control. Witmer also cited, in her 2013 recommendation, the fact that an export installation about to be built was on land bought in 1940 (she asked management a specific question eliciting this fact) - probably carried on the books, she joked, at a couple of thousand dollars. Hidden value, in other words.
Since it was spun off from Conoco Phillips in May of 2012, PSX has bought back roughly 15% of its shares - a corporate behavior which Buffett likes (and I do too). Its dividend yield is 2.8%, with regular increases. Selling around 80 with TTM earnings of 7.73, it trades at a PE multiple of just over 10. Earnings should grow, but the annual rate of growth will be lumpy because of the unpredictability of the crack spread.
My only reason for not leaping to make PSX a large core holding is - you got it, that "crack spread" problem. I need to see it play out during a couple of years of turbulence while owning just enough to keep my attention keen.
Its lots of fun to think about what must go on among the smart folks at Berkshire. I have to think that the flow of ideas probably went from Witmer to Warren, Ted, and Todd. She would have bought the full position for her own portfolios before mentioning it to Barron's, you can be pretty sure of that. As for me, I don't have a position in either company yet. As is often the case, I have used this SA article to help crystallize my thoughts. I will likely be buying modest positions next week, hoping the market obliges with a down day.
Disclosure: I am/we are long BRK.B.
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.