Berkshire Hathaway: Stop Obsessing Over Warren Buffett's Stock Picks

Summary

• Berkshire Hathaway was a net seller of equities in 2020, and there is no overarching theme to the stock trades that were done.
• This marks another step in the evolution of Berkshire from investment-focused to operations-focused.
• The stock portfolio is still an important source of cash and capital growth for Berkshire but should not be used in isolation to evaluate the company.
• Berkshire will probably grow in line with the overall economy, but EPS can grow faster due to a smart buyback policy.

Less Oracle, More Operator

It's been entertaining to see media reaction to Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) 13-F filing and annual report this year. Commentators like to attribute more significance to Berkshire's stock trades than they actually deserve. For example, one story suggested that the purchase of Chevron (CVX) made it clear that "Buffett was bullish on the energy sector" yet could not explain why he sold Suncor (SU). There are similar stories about how Buffett soured on banks yet he added to Bank of America (BAC) even as he trimmed total allocation to the sector. The most entertaining commentary was the speculation around Berkshire's short-term 0.25% allocation to Barrick Gold (GOLD) and if Buffett had changed his long held views on the metal. The 13-F is not even a complete picture anymore, as the annual report shows an increased allocation to foreign stocks like BYD (OTCPK:BYDDY) back in the top 15 after its 25-bagger gain. Itochu (OTCPK:ITOCY) also made the top 15 as the largest of five Japanese trading companies in which Berkshire built a position last year.

Anyone looking for macro views, sector allocations, or individual stock picks was probably left disappointed or convinced Buffett had lost his focus. CNBC Contributor Josh Brown put it well in this video where he states, "I think the Berkshire 13-F is probably less worth paying attention to than maybe ever before in my lifetime."

Reviews of the annual letter also reflected disappointment that Buffett not only didn't comment on last year's trades, but also was quiet about the pandemic, social issues, and politics. I wonder if the author has ever read a Berkshire annual report, as these topics are rarely addressed. These critiques seem to miss the point that Berkshire Hathaway is continuing its evolution from Warren Buffett's investment fund into an enduring operating company.

Berkshire's stock portfolio is still a major cash cow for the company due to the dividends it generates, but will be less of a growth driver by design going forward. If there is any theme to the trades done in 2020, it is sector diversification to make the portfolio look more like the overall market. Also, the Japanese trading companies, Chevron, and Verizon (VZ) pay generally higher and safer dividends than the banks and airlines that were sold. While the timing of some of these trades after the pandemic lows was not optimal, Buffett appears to be setting the stage for his successors to focus less on the equity portfolio and more on the operating companies.

Follow The Money

Berkshire's shifting priorities can best be seen in the overall investment flows in 2020. The cash flow statement shows that Berkshire was a net seller of $8.6 billion of equities in 2020, selling $38.8 billion and buying $30.2 billion. This compares to a net buy of $4.3 billion in 2019 and $24.4 billion in 2018.

Although Buffett stated in his annual letter this year that he is happy owning a non-controlling portion of a business, Berkshire's main inorganic investment in 2020 reflects the direction the company seems to be moving - expanding the operating businesses through bolt-on acquisitions. In this case, Berkshire Hathaway Energy purchased natural gas pipeline and storage facilities and an interest in a NGL export terminal from Dominion Energy (D). Berkshire has already paid out $2.5 billion in cash and assumed $6.9 billion of debt associated with these assets. This portion of the deal closed on 11/1/2020. Remaining assets which still require regulatory approval to transfer will close this year for another $1.3 billion cash payment.

Cove Point Terminal (Source: Dominion Energy)

Despite Buffett's statement in the letter that "Bonds are not the place to be these days", Berkshire increased its fixed income holdings by $1.7 billion in 2020. This comes from an increase in foreign government bonds, offset by a decline in corporate bond holdings.

Source: Berkshire Hathaway Annual Report

I don't want to read too much into this move. It's conceivable that Berkshire simply wants to avoid negative interest rates on overseas cash and shifted some cash equivalents into slightly longer maturities. (50% of Berkshire's bond holdings have a maturity of one year or less and another 40% matures in 1 - 5 years.)

Capex also remains a significant investing cash use. Berkshire spent $13 billion on capex in 2020. This was down from $16 billion in 2019 but understandable in light if the pandemic. The final section of Buffett's letter this year, "A Berkshire Number That May Surprise You", demonstrates the growing importance of capital investment to the company. Berkshire now has the highest amount of property, plant, and equipment in the US by book value at $154 billion. This is a necessary outcome of Berkshire's size, which makes it difficult to find low-capital, high margin businesses:

Our leadership in fixed-asset ownership, I should add, does not, in itself, signal an investment triumph. The best results occur at companies that require minimal assets to conduct high-margin businesses – and offer goods or services that will expand their sales volume with only minor needs for additional capital. We, in fact, own a few of these exceptional businesses, but they are relatively small and, at best, grow slowly.

Asset-heavy companies, however, can be good investments. Indeed, we are delighted with our two giants – BNSF and BHE: In 2011, Berkshire’s first full year of BNSF ownership, the two companies had combined earnings of $4.2 billion. In 2020, a tough year for many businesses, the pair earned $8.3 billion.

Source: Warren Buffett, Berkshire Hathaway 2020 annual letter

Berkshire's investment cash flows in 2020 clearly show a priority toward building up the company's main operating businesses which make up three of the four "Family Jewels" referred to in Buffett's letter.

The Family Jewels

Buffett's "Family Jewels" discussion in the annual letter marks a welcome focus on the four businesses that make up "most" of Berkshire's value: Insurance, BNSF railroad, Berkshire Hathaway Energy, and the stock investment in Apple (AAPL). That's not to say that Berkshire's numerous fully owned Manufacturing, Service, and Retail companies or its non-Apple equities are on the chopping block anytime soon. Nevertheless, there is no longer a mention of a "forever" holding period, as the sales of bank and airline stocks showed. Additionally, Berkshire sold most of its fully owned media investments to Lee Enterprises (LEE) as the decline in the newspaper business became terminal.

The three main operating businesses each benefit from being a part of Berkshire. The insurance business benefits from the strength of Berkshire's overall balance sheet, allowing it to invest float in equities rather than primarily fixed income as most insurance companies do. The railroad and utility company each issue bonds not backed by the parent company but they still benefit from the option to retain cash and not dividend it back to Berkshire unlike most public companies in their industry. Berkshire Hathaway Energy has retained all its earnings to make massive investments in grid infrastructure in the western US. They also invest heavily in renewable energy generation which has allowed the utility to have a negative effective tax rate, reaching -40.7% in 2020.

The stock portfolio is still important, of course, as shown by the inclusion of Berkshire's $120 billion, 5.4% stake in Apple. Berkshire has earned nearly a 4-bagger return in just over 4 years with Apple. Critics can say that it was one of Berkshire's few home run investments in the past decade, but it atoned for many smaller mistakes over that period. The small trimming of the Apple position in 2020 helped Berkshire to still report a $6.2 billion realized gain on stock sales despite selling airlines and banks too early in the recovery.

The Apple position also illustrates one of Buffett's favorite topics. Berkshire's ownership percentage in Apple has grown despite the partial sale thanks to Apple's share buybacks. This brings us to the topic of buybacks at Berkshire itself, which impressed me with their aggressiveness in the back half of 2020, and could be a driver of share price growth going forward.

The Power Of Buybacks

Berkshire spent $24.7 billion on buybacks in 2020, which amounts to around 5% of market cap. The buybacks continued into 2021. While Buffett was not as aggressive at the lows of the March 2020 COVID crash, the caution was forgivable due to the uncertainty around the impacts of the pandemic. The continued buying at around $225 per B share in December 2020 was encouraging. Several years ago, Berkshire loosened its buyback threshold from 1.2 times book value to "below Berkshire’s intrinsic value, conservatively determined". Nevertheless, book value at the end of 2020 was $192.91 per B share equivalent. That means the December 2020 average buyback price was still under Berkshire's former buyback ceiling price of 1.2 x $192.21 = $231.49. It will be interesting to see the February buyback numbers since Berkshire has been trading higher than this level during the month.

Whatever internal metric Buffett is now using to set buyback levels, Berkshire has earning power of around $20-$25 billion per year operating income before any investment gains which will fluctuate from year to year but be positive over time. That means the ceiling price for buybacks should go up at least $10 per B share each year as retained earnings increase book value by that amount. We can also see from Berkshire's $27 billion of free cash flow in 2020 that buybacks can continue at close to the same rate as last year without decreasing Berkshire's still massive $135 billion cash pile or requiring any new debt issuance. The cash pile still remains available for opportunistic new investments if they become available.

As an investor who would probably reinvest any dividend back into Berkshire shares, I am equally satisfied with a buyback yield that exceeds the average S&P dividend yield. Buffet has said Price/Book levels are less relevant to Berkshire's intrinsic value than in prior years, but buybacks have still been below 1.2 times book. After trading at unusually low P/B in 2020, Berkshire is now trading closer to average P/B levels. If this premium keeps going up, we may not see the 5% buyback yield we saw in 2020, but Buffett's willingness to do buybacks in line with his prior statements was encouraging.

Source: Seeking Alpha BRK.B Charting Page

Valuation

There are many good sum-of-the-parts valuation articles on Berkshire Hathaway on Seeking Alpha. My last detailed one where I explain my methodology was published in November 2019. I have updated this model using the same methodology with 2020 results. One can argue that the model is conservative since 2020 earnings are lower from the pandemic than what we can expect going forward.

The resulting B share value of $268.64 is around 8% higher than the market price on 3/2/2021.

Another simple way to value the company is based on multiples of book value. Buffett has moved away from book value, but only because it is too conservative as Berkshire becomes more of an operating company. Unlike the stock portfolio, the operating assets do not get marked up as their economic value increases. Therefore, a multiple at least in the middle of the historical range, such as 1.4 is appropriate. Based on 2020 ending book value of $192.21 per B share, fair value would be 1.4 x $192.21 = $269.09, similar to my sum-of-the-parts valuation.

While these values are only 8% above current market value, I have stated above that book value should increase about $10 per B share annually from retained operating earnings. That is before any capital gains on the investment portfolio. Continued buybacks would further boost book value per share.

Conclusion

Buffett's discussion of the "Family Jewels" is helping set the expectations for the next generation of Berkshire leadership. The insurance, railroad, and utilities will be the main drivers of Berkshire's value going forward. The stock portfolio will remain a significant cash cow, but the moves made in 2020 suggest that Buffett now views it as another steady contributor rather than the primary source of performance. Berkshire's smart buyback program will also be a source of EPS growth.

This year's annual meeting Q&A participants of Warren Buffett, Charlie Munger, and operations vice-chairmen Ajit Jain and Greg Abel further reinforce the transition to an operating company. Investment managers Todd Combs and Ted Weschler will be on the sidelines. Over time, I hope investors shift focus to Berkshire's operating "jewels" and stop obsessing over stock trades in the 13-F.

Berkshire Hathaway looks about 8% undervalued based on 2020 earnings. Post-pandemic recovery in railroads, manufacturing, service, and retail should be a tailwind for the company in 2021. Berkshire's smart share buyback program will also increase EPS. That makes Berkshire a buy at these levels.

Analyst’s 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.

Comments

[six]

BRK is NOT evolving into an operating company... it is evolving into ah operating company and a stock portfolio and HUGE pile of cash earning 0ish%.

[User 49655511]

@six

luckily 2-10 spreads are rising

[locum2]

It appears that BRK changed it’s strategy. They’re making lots of trades chasing the market. A few years ago they invested in XOM, then two quarters later they had sold their position.

[Bryant24]

@locum2 the oil market tanked and the XOM investment changed. It was smart to get out when they did. The strategy really hasn’t changed, the vast majority of the portfolio is concentrated with long term positions. There are more trades now because you have three managers investing three separate portfolios. Buffett has only ever said his favorite holding period is forever, he’s never said it was his only holding period, he does change his mind sometimes, you won’t last in investing if you can’t do that.

[economonoc]

@Gary Gambino Nice article, and a good perspective. Thanks.

[Winnertakesall]

Trust me I don't, I've outperformed him for 22 years running.

[User 49655511]

Just a few more weeks of what has happened for the last two weeks and we can all start howling about how BRK has beaten the S&P 500 for the last 10 years. Mainly to throw it in the faces of so many people on here (who just read it some place else).

[rope789]

The title of the article is disingenuous.

Sure - over time, BRK has become more of an "operating company."

But the market value of the securities portfolio is roughly 50% of the company's market cap.

So - it isn't like the "stock picks" don't matter: they matter A LOT.

Yes - Apple was an absolute home run - that investment is arguably the single most impactful investment decision ever made, by anyone - - measured in sheer "total dollars added." Apple alone accounts for roughly 20% of BRK's total market cap.

But "investment process" should not be predicated on the hope of picking a few huge winners.

Batting average matters (or, if you are a baseball purist, on base percentage matters).

Buffett's batting average has fallen precipitously over the past decade:

1. Airlines
2. Kraft Heinz
3. Wells Fargo
4. Precision Castparts

Buffett is the best investor in history. Period.

But capital allocation and stock selection DO matter a lot.

Ted and Todd may be "on the sidelines" at the upcoming meeting, but their impact at BRK is very significant, and as Buffett ages, Ted and Todd will really be the drivers of the most important role at BRK: Capital allocation - the investment and deployment of the free cash flow generated by the company.

Abel is the likely best bet to be CEO, but he's an operating guy, as is Jain.

Investors need not "obsess" over BRK's stock selections, but they most DEFINITELY matter a LOT.

[Gregg Rosenberg]

@rope789 Batting average matters much less than position sizing. Buffett for 60 years has advocated making a few concentrated bets rather than diversifying and making a huge bet on one's best idea. By far, the most important thing is to get that right. The batting average can be .100 but you've got to put most of your capital in the .100 and lose very little on small positions in the other .900.

Buffett, of course, has done much better than that. In the last 12 years, he's made $80B+ profits twice, once on BNSF and once on Apple. That's all he has to do. The losses have all been small, so it doesn't really matter what the batting average is.

[rope789]

@Gregg Rosenberg

BOTH are important.

Let's keep it real.

BRK / Buffett, running a concentrated strategy, had outstanding returns on the publicly-traded segment of the business for decades.

But that segment of the business has struggled in relative terms, and more recently, in absolute terms, over the past 10-15 years, which is a pretty long stretch even for the most patient, long-term investors.

In a concentrated strategy, ALL the positions matter.

Sizing does matter, but you can't just say "the losses have been small, so batting average doesn't matter."

Total return is what matters the most.

What is troubling is that, INCLUDING a huge, and hugely successful bet on Apple, the performance of the publicly-traded securities has not been good for 10-15 years.

Most shareholders don't care HOW the returns were made; they care WHAT the returns were.

Returns have struggled, and stock selection matters, especially when the public securities portfolio is half the market cap. We don't have to "obsess" over stock selection, but whatever the process is the leads to security selection, it matters.

[locum2]

@rope789, don’t forget IBM and XOM.

[jcesilver]

What value do you think there should be for the $138 billion in cash?

[Gary Gambino]

@jcesilver the cash offsets the insurance float liability, so I simply leave both out of the valuation calculation. I do count the interest income as well as the underwriting income and value that at a peer multiple to other insurance companies.
Having said that, some portion of the cash has "option" value in that it is available to be immediately put to work if Warren finds a suitable investment. Based on the track record of recent years, I don't count that in the base case. You may consider that upside if you like.

[dave9923]

@Gary Gambino As you described, one way to think about Berkshire's cash is as being offset by the insurance float liability. However, since Berkshire is continually writing new policies, that insurance float will never truly have to be paid back (it is paid back with new premiums, and those liabilities are paid back with newer premiums, etc.). Therefore, I think you have to include the cash in Berkshire's value estimate.

I remember at one of the shareholder meetings, Warren said that if someone offered to convert his insurance float into equity with the caveat that he had to never be in the insurance business again, he wouldn't do it. That means, if the float is say $130 Billion today, if someone offered him $130 Billion in cash, and in exchange Warren had to totally hand over his entire insurance operation (including the premiums and liabilities), he wouldn't do it. Basically, he wouldn't sell his insurance operation for the float value. In my mind, that means that he values the insurance operation higher than the Float value. Another clue of this is that he lists it as his #1 crown Jewel. Given this, you are likely undercounting the value of Berkshire's insurance operation in your value estimate.

[Gary Gambino]

@dave9923 what you described in the first paragraph is the textbook definition of a Ponzi scheme. It works fine until the growth stops, then there is some call on the funds that is too big to meet.  
***Berkshire’s insurance operations are definitely NOT that. ***
SOME amount of Berkshire’s cash is there to pay for unexpected big insurance losses. Warren said many years ago that he wanted at least $20 billion set aside for that purpose. If you asked him today, he would probably give a higher number.

Of course Warren wouldn’t sell the insurance business for just the amount of the float. The insurance business earns steady underwriting profits, and the excess cash earns interest. I accounted for both in my valuation. They also support the ability to invest in the equity portfolio which, although it is on a separate line in my valuation, is part of the insurance business.

[economonoc]

I'm in favor of buybacks below intrinsic value, as at present. But mathematically, buybacks at prices above book value per share actually reduce book value. For each dollar spent on buybacks, $1 of book value goes out and $(book/price) comes in. Buybacks at prices above book value per share and less than intrinsic value per share increase Intrinsic value per share and decrease book value per share.

[connjoltrane]

@economonoc unlike most companies, Berkshire hasn't and won't do that.

[economonoc]

@connjoltrane If you mean that Berkshire won't buy back its shares at prices above intrinsic value per share, then I agree. They are buying back at prices above book value though of course.

[connjoltrane]

@economonoc Book value isn't a good measure of intrinsic value. WB has said that many times.

[j. hughes]

Great to see someone who knows exactly what he is investing in and not squawking for a dividend.
Don't disagree with @Gary Kime's comment either.

[Clauser1960]

Excellent analysis! Congrats to the author!

[Money 29]

Berkshire Hathaway will make money each year no matter what stock Buffett buys. Some years more and some years less, but Berkshire is a money making machine. Berkshire will be around and making money for many years to come no matter who is running the company. Buffett understands that slow and steady wins the race.

[rwolfe]

Very informed article. Thank you. I have been a Berkshire investor for quite a few years and have been rewarded very well. I believe one of the things that many people do not take into account is the value of all the bolts on companies that have been purchased. It would be very difficult to put a value
on all of them. Way too many. Look at all the companies that are wholly owned by BHE. there must be 15 to 20. We really don't know how much money is filtered up too Berkshire, so, I expect most of them if not all have retained earnings. I doubt that the prices of the stocks (A and B) reflect that value. I expect most of them just keep growing, getting bigger and bigger. If you have any insight on this please me know

[Gary Gambino]

@rwolfe Berkshire owns 91% of BHE. The way the accounting works for that is everything on BHE's books is consolidated onto Berkshire's balance sheet, The 9% Berkshire doesn't own is then subtracted at the bottom of Berkshire's balance sheet as Noncontrolling Interests.
So, there are no "hidden" retained earnings not accounted for, but the retained earnings at BHE will grow its earnings power over time as they are reinvested in the business.

[zarock]

@Gary Gambino
Out of curiosity, any idea why they own only 91% of BHE, and not 100%?

[economonoc]

@zarock Forbes says 
"Walter Scott Jr, lifelong friend of Warren Buffett, owes the bulk of his fortune to Berkshire Hathaway Energy, Buffett's massive utilities subsidiary.
In 2000, Scott and Buffett partnered to buy utility MidAmerican Energy, later renamed Berkshire Hathaway Energy, for $2 billion.
Scott still owns about 9% of Berkshire Hathaway Energy and serves on its board. He is also a director of Berkshire Hathaway.
He began his career at construction giant Peter Kiewit in his native Omaha, Nebraska, rising to the rank of CEO in 1979."
Here again regrettably, journalists have conflated Buffett with Berkshire, but you get the idea.

[Bryant24]

I think this is a good article, the only thing I would slightly disagree with is that Berkshire was a net seller of equities. If you include the buybacks they were a net buyer by about $17 billion. I guess it's just depends on how you view the buybacks, but in my mind they looked at all the available investments and determined that Berkshire was the best value out there. I also think one of the big reasons that Berkshire has moved away from using book value as a proxy for valuation is due to the buybacks. If you buyback stock at over book value your book value decreases, but in Buffett's and Munger's view they are actually increasing the intrinsic value of the company with the buybacks. The more buybacks you do the more you are distorting book the book value vs. intrinsic value. I think they went away from the book value metric a couple of years ago in anticipation of the large buybacks that we're seeing today.

[thomasdewitt]

The investment theme you can read out of his recent buys is that almost everything is currently too expensive. His hurdle rate is 10%, if he does not find it he waits. Hard to swallow for people who want to get rich quickly.

[John McCoy]

@thomasdewitt His recent investments into VZ and CVX aren’t really investments, they are simply a parking place for cash that pay strong dividends, nothing more. Just a superior option over being in cash or bonds.

[Gregg Rosenberg]

@John McCoy That is my guess as well. He's earning near zero in short term bonds and decided instead to put some into a 4-5'ish percent dividend in which he's unlikely to lose principle. I sort of suspect the recent pharma purchases were similar. He really doesn't know what to do with the cash that's earning nothing and is trying to find places to get some return with minimal risk to principle.

[jasonjones]

You are right on target. Buffett has a different investment access than retail investors and different goals. Has a constant flow of insurance premiums. He can negotiate better prices.

[Gary Kime]

Great article Gary! I get a kick out of all the nay sayers that say that WB has lost it. Whitney Tilsen says it best when he explains that BRK is not a stock for those wanting to get rich but for those that want to stay rich.

With bonds where they are, I can’t think of a better replacement in my portfolio for a class I want to return 8 to 10 percent fairly consistently. He’s still as sharp as he’s ever been and he’s the most patient investor one could hope for.

These last ten years have been foolish and have lead to difficult times for someone as disciplined as Buffett! But the funny thing is he’s so patient that eventually he’s going to win big again and his shareholders have done just fine as he waits.

As young investors trash him and jump on the Cathie Wood train, all the old people already understand that those trends will come and go! However, it’s only a lesson that stocks with you once you’ve been burned!

Charlie and Warren are doing just fine!

[Bryant24]

@Gary Kime I don't think it's really been that difficult, they've performed very well over the last ten years. The S&P has done a little better but you can't really control the whims of the market. IF you look at 10 years ago at the end of 2010 Berkshire had operating earnings of around $12 billion and a stock portfolio worth $60 billion. So they have roughly doubled the operating earnings over the last 10 years and the stock portfolio has grown from $60 to $280 billion so over 4.5 times. They've also increased the cash and cash equivalents over that time period and decreased the number of shares outstanding by a meaningful %. Berkshire is set up to be a compound growth machine, as long as they don't do anything really stupid it would be hard for Berkshire not to do well over time. People love to pick on their mistakes but they do a good job of minimizing the damage of any mistakes and the grand slam homeruns like Apple tend to far outweigh the mistakes.

[locum2]

@Gary Kime, yes the two billionaires are doing fine. Any investor for the past 10 years, not so much.

[John McCoy]

The story at Berkshire going forward will be massive investments in operating companies (BNSF, BHE, etc), and I believe it's a great story. The one stock that Mr. Buffett is buying that everyone should pay attention to is BRK-A/B.

[Sophos]

Guy has more money than he profitably knows what to do with it

[Buyandhold 2012]

I never obsess over Warren Buffett's stock picks.

I just like to know which stocks are in Berkshire Hathaway's portfolio.

Then I keep them on my watch list.

[Dew Mew]

@Buyandhold 2012 and wondering why he sold: MCD, DIS, HD, LOW, NKE, WMT, COST, MTB, JPM, PG, JNJ, CPB, PEP, KMX, CMCSA, DE, CVS, FISV, HSY, HCA, LMT, MSFT, STI, TIF, UNH etc etc