Editor's Choice

The One Stock You Should Own

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When building the core of any portfolio, it is essential to have a diverse collection of great businesses run by superior management. While the list of Top 10 Stocks seeks to achieve those objectives with a collection of fantastic companies to own for the long term, the ninth company on the list can achieve this goal all by itself. That company is Berkshire Hathaway (NYSE: BRK-A) or (NYSE: BRK-B).

Better than a mutual fund

Warren Buffett and Charlie Munger have created a conglomerate that is an ideal alternative to any mutual fund; Berkshire owns a diverse collection of companies in manufacturing, insurance, supply chain, energy, retail, railroad, and a number of other industries. Motley Fool contributor Rich Smith recently published an excellent article with visual illustration of the components of Berkshire's business that really helps newcomers understand the scope of Berkshire's operations. Many investors don't realize just how large some of these business units are; eight of Berkshire's businesses would qualify for the Fortune 500 if they were standalone companies! In addition to the portfolio of fantastic businesses owned by Berkshire, the company also boasts a portfolio with significant investments in world-class companies like fellow top 10 stocks Coca-Cola (NYSE: KO), American Express (NYSE: AXP), Wells Fargo (NYSE: WFC), and IBM

While this diverse collection of investments may look a lot like a mutual fund on the surface, there are several reasons that Berkshire has had much better performance than mutual funds over time:

  • The management team is unparalleled. While this obviously starts with Buffett and Munger, the more important names to think about for a long term investment today are the talented managers of Berkshire's business units; Ajit Jain, Greg Abel, Todd Combs, and their peers are poised to continue Berkshire's success going forward. 
  • Berkshire embodies the long-term buy and hold philosophy. While the company's quarterly filing of its changes to its investment portfolio are well-publicized, the fact of the matter is that Berkshire sticks to Buffet's famous mantra in his 1998 letter to shareholders: "In fact, when we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever." One of many real examples of this is See's Candy, a business that has been owned by Berkshire for 40 years. In contrast, mutual funds constantly turn over their investments based on short-term motivations.
  • The businesses generate synergies. While mutual funds are collections of unconnected companies, Berkshire leverages the differing business models of its companies to make the sum greater than the parts. For example, Berkshire's insurance businesses have minimal capital requirements and generated a float of $70 billion as of last year. This is a perfect compliment to a capital-intensive business such as Burlington Northern Santa Fe, which plans to increase its capital spending to $4.1 billion in 2013. Berkshire's ability to leverage its float in its other businesses is a powerful advantage.
  • The businesses operate in well-established industries. Berkshire's holdings may appear "boring" to investors craving multi-bagger returns, but there's no doubt that these businesses can generate consistent profits. As Buffett has demonstrated for decades, this strategy minimizes the downside risk of questionable business models that may not last, or the potential to overpay for growth. 
  • Management's interests are aligned with shareholders. This is obvious from reading the commentary in Buffett's annual letter to shareholders, including the pride that Buffett takes in the fact that Berkshire's corporate office includes just 23 other employees and only one floor of a building. This too is in sharp contrast to most corporate cultures.
  • There is a sense of accountability. Every Berkshire annual report starts with a comparison of Berkshire's performance compared to the S&P 500. While Berkshire's book value has doubled the performance of the S&P over the long term, management takes full responsibility when the results are not good and provides an honest and plain English discussion of what went wrong. As recently noted in the Wall Street Journal, two thirds of mutual funds failed to beat the S&P 500 last year; that fact is far less clear in reading each fund's documentation. It is also less than clear to many investors that not only did their investment not beat the overall market, but that poor performance had no bearing on the fund extracting fees of 1%, 2%, or more from the investor. 

In combination, Berkshire's strategy and culture have led to powerful results. Even as the company has matured and its growth has slowed, it has continued to beat the market over the past decade:  

<img src="http://media.ycharts.com/charts/c31be5e399fb2fcbd85d911a6caa6bf9.png" />

BRK.B Total Return Price data by YCharts

It is not a coincidence that Berkshire's large investments in other corporations have outperformed the index as well. Buffett is famously quoted as saying “If you gave me $100 billion and said, ‘Take away the soft-drink leadership of Coca-Cola in the world,' I’d give it back to you and say it can’t be done.” This is precisely the moat that Buffett looks for in making investments in world-class companies and has earned Coca-Cola the title of "world's most valuable brand." What does this mean for investors? Low risk combined with solid growth opportunities in emerging markets, an expanding brand portfolio, and innovations like the Coca-Cola Freestyle machine will continue to form a market beating combination going forward. 

What is particularly impressive about the chart above is that Berkshire's largest positions in financial institutions, American Express and Wells Fargo, survived the financial crisis and have managed to beat the S&P 500 over the past decade. American Express and Wells Fargo are perhaps the simplest case study for how Berkshire's mentality differs (in a good way) from that of many on Wall Street. After surviving a difficult decade for the financial industry, American Express continues expansion beyond credit cards and into mobile, savings accounts, and more. With a forward price to earnings ratio of just 11 and a TTM free cash flow yield of 20%, there is every indication that there is more upside ahead based on the current share price.

Similarly, Wells Fargo's recovery has been stronger than many of its peers. While the company has restored its dividend and has experienced a recovery in share price, Wells Fargo also remains a compelling holding for Berkshire and individual investors given its current valuation. Wells Fargo boasts a forward P/E ratio of less than 9 and a PEG of right around 1, which is a sizable discount to the pricing commanded by other companies with similar market capitalizations.

In the case of each of Berkshire's large investments, the companies were selected based on a thorough understanding of the business and risks facing both the companies and the greater industry. When the financial crisis caused the downfall of a number of well-known institutions that took too many risks, American Express and Wells Fargo survived and in fact exited the crisis even stronger. Meanwhile, Berkshire's management did not panic when the share prices of each company briefly collapsed; instead, the company held shares in both companies through the short-term noise while many panicked.

Buffett has put a floor on Berkshire's share price

In addition to all of the reasons noted above that Berkshire is a superior way to gain diversity in a portfolio, management has added another. The company recently established a share repurchase program, which was subsequently updated to be triggered once the share price falls to 1.2x the company's book value. This "floor" provides significant downside protection to investors, while also further expressing management's confidence in the health of the company. For reference, 1.2x book value based on the most recently available information translates into a share price of around $89. This makes the recent 52-week high around $99 per share a very reasonable price in terms of current valuation, and a compelling buy considering all of the reasons that the company continues to succeed.

Berkshire is a Top 10 stock

In total, the reasons to invest in Berkshire Hathaway discussed above are a unique combination that can't be found in any other single company. The diverse, well-run businesses are massively successful, and there's no reason to doubt that Berkshire's historical trend of market beating returns with below average risk will continue for the foreseeable future. While the pace of this market out-performance won't be as great as the early days of Berkshire's historic rise, there should still be a place for this type of risk/reward profile in any portfolio. For this reason, Berkshire joins a stellar group of companies in the top 10 stocks:

  1. Apple
  2. Diageo
  3. Coca-Cola
  4. Chipotle Mexican Grill
  5. Costco Wholesale
  6. 3D Systems
  7. Canadian National Railway
  8. National Oilwell Varco
  9. Berkshire Hathaway
    One more stock to go! 

BrewCrewFool owns shares of American Express, Berkshire Hathaway, and Coca-Cola. The Motley Fool recommends American Express, Berkshire Hathaway, Coca-Cola, and Wells Fargo. The Motley Fool owns shares of Berkshire Hathaway and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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