Berkshire Hathaway: Top Picks from a Legend

During tumultuous times in the market, many people look toward those investors who have successfully navigated the choppy waters in the past to provide guidance on how to profit from today's dislocations. Who else has better taken advantage of these types of markets over the course of his lifetime than Berkshire Hathaway CEO Warren Buffett? Thus, it seems reasonable to scan Berkshire's holdings to ferret out some of the best ideas from the firm's equity portfolio.

I should note, however, that Buffett has repeatedly said that the stocks that may be appropriate for Berkshire may not be appropriate for other investors. Part of the reason for this is Berkshire has become so large that Buffett and his colleague Lou Simpson can only look at a handful of the world's largest companies, where they can deploy large amounts of capital. Many individuals, on the other hand, have a much greater universe of stocks from which they can choose, including smaller stocks with potentially much better growth potential. Another reason why some of the stocks that Berkshire owns could potentially not be appropriate for other investors is that Berkshire has a much different time horizon than many other investors. For example, Berkshire has a stated objective of holding forever, which in an insurance company structure with many long-tail liabilities, makes intuitive sense. It also means that Berkshire can patiently wait longer than other investors for a business' prospects to improve, and it also can benefit from the effects of compounding longer than other investors.

Even with these caveats, it still seems reasonable to attentively listen to Buffett's advice or watch his moves to gain insights into stocks and markets. Buffett has a better temperament for investing than just about anyone, and his vast sums of accumulated investing knowledge give him insights and an edge that others could only hope to replicate.

Given our coverage universe of more than 2,000 stocks at Morningstar, we are in a unique position to not just watch what Berkshire does on a quarter-by-quarter basis, but to also offer commentary on what we think are the most attractively valued businesses of Berkshire's portfolio at any given time. Presently we believe that 13 stocks from Berkshire's portfolio look very interesting, and, as such, these stocks are rated 5 stars by our analysts*.

Best Ideas
The 13 we like best are: American Express, Bank of America, General Electric, Home Depot, Lowe's Companies, Moody's, Sanofi-Aventis, US Bancorp, USG Corporation, United Parcel Service, United Health Group, Wellpoint, and Wesco Financial.

Here are some sneak peeks into the Analyst Reports on five of these companies: Analyst Michael Kon's recently wrote about American Express' competitive strengths, stating "American Express operates the most successful closed-loop credit card network in the United States and many other profitable card businesses around the world. Although the Amex card isn't yet as widely accepted as Visa or MasterCard the firm has evolved from a niche player into a global payments giant. Thanks to its closed-loop network, Amex essentially owns the entire value chain and, as a result, retains the full economic value that's being created by the card scheme. Unlike Visa and MasterCard, Amex can issue its own cards and doesn't have to rely on merchant acquirers to process transactions. We think that another important advantage of this business model is that servicing cardholders and merchants as opposed to large financial institutions provides Amex with pricing power."

Daniel Holland commented on General Electric's latest joint venture, writing "General Electric announced that it has entered into an $8 billion joint venture with Abu Dhabi-based Mubadala Development Company with each company committing $4 billion in equity to the enterprise. The partnership will have a heavy focus on commercial finance within the Middle East and Africa, areas that should continue to experience strong growth over the next three to five years. Both firms will also commit additional capital in order to develop renewable infrastructure and expand its use within the region. This venture plays particularly well into GE's sweet spot of commercial origination and infrastructure equipment and more importantly gives it an opportunity to develop a presence in emerging markets with a proven partner."

Damien Conover recently provided his initial take on Sanofi-Aventis' second-quarter results: "Sanofi-Aventis reported second-quarter results that were in line with our expectations; we don't expect to make any changes to our fair value estimate. Excluding fluctuations in foreign exchange rates, total sales grew 5% year over year, led by robust growth in long-acting insulin Lantus. Strength across many of Sanofi's drugs offset generic competition to cancer drug Eloxatin. On the cost side, Sanofi continues to make positive strides, as shown by the 2% decline in selling and administrative expenses versus the prior-year period. We expect further cost reductions as the company completes its restructuring initiative."

Keith Schoonmaker wrote of United Parcel Services' second-quarter earnings, "United Parcel Service's margins were again compromised by a tremendous increase in fuel cost and lower demand for premium shipping offerings. In all segments UPS improved revenue via price increases, thereby producing a 6.7% increase in quarterly revenue despite flat overall volume. However, pricing power proved insufficient to preserve operating margins, which slipped to 11.2% from 14.5%. Earnings dropped from $1.04 per diluted share to $0.85, year over year. Given the prices we see at the gas pump and continuing softness in other sectors, we're not surprised by UPS' report of lower margins. However, since our projections for growth and margins during 2008 are slightly more pessimistic than the results UPS is realizing, we are not changing our fair value estimate at this time."

Last month, Matt Coffina wrote about Wellpoint's earnings: "WellPoint's second-quarter earnings showed signs of improvement from the first quarter. Although we've slightly lowered our earnings expectations for 2008, we're raising our fair value estimate after reconsidering some very conservative long-run cost assumptions. We continue to believe WellPoint's shares are a bargain. Earnings per share for the quarter were $1.44, up 6.7% from the second quarter of 2007. Operating revenue was up 3.1% year over year. While membership in the individual and small-group market declined, which we attribute to the weak economy, the company continued to steal market share among large national employers. Overall nonrisk membership increased 6.2% from the previous year, while risk-based membership fell 3.3%."

The Full Portfolio
I've included the full Berkshire portfolio below along with Morningstar's proprietary star ratings for each stock as of Aug. 20, 2008. I'll note that I didn't include ConocoPhillips as it's unclear what Berkshire is doing with this position based on recent regulatory filings. I'll also note that this list does not include some of Berkshire's international positions, as the firm doesn't have the same disclosure requirements internationally as it does domestically.

The Berkshire Hathaway Portfolio
American Express Co. AXP
Bank of America Corp. BAC
General Electric Co. GE
Home Depot Inc. HD
Lowe's Companies Inc. LOW
Moody's MCO
Sanofi Aventis SNY
US Bancorp USB
USG Corporation USG
United Parcel Service Inc. UPS
United Health Group Inc. UNH
Wellpoint Inc. WLP
Wesco Finl Corp. WSC
Carmax Inc. KMX
Coca Cola KO
Comcast Corp CMCSA
GlaxoSmithKline GSK
Ingersoll-Rd Company LTD. IR
Iron Mountain Inc. IRM
Johnson & Johnson JNJ
Kraft Foods Inc. KFT
M & T Bank Corporation MTB
NRG Energy, Inc. NRG
Norfolk Southern Corp. NSC
Sun Trusts Bank Inc. STI
Wells Fargo & Co. Del WFC
Posco PKX
Anheuser Busch Cos. Inc. BUD
Burlington Northern Santa Fe IRM
Costco Wholesale Corp. COST
Nike Inc. NKE
Procter & Gamble Co. PG
Torchmark Corp. TMK
Union Pacific Corp. UNP
Wal-Mart Stores, Inc. WMT
Washington Post Co. WPO
Gannett Inc. HD
Comdisco Holding Co. CDCO	Not Rated
Tesco PLC TESO	Not Rated
Wabco Holdings Inc. WBC	Not Rated
Berkshire Hathaway holdings as of 6-30-08. Star ratings as of 8-20-08.

*The Morningstar Rating for Stocks is calculated by comparing a stock's current market price with Morningstar's estimate of the stock's fair value. Our rating system also includes an uncertainty adjustment, so that it's more difficult for a company to earn a 5-star rating the more uncertain we are of our fair value estimate.

Under our system, 3-star stocks are those that should offer a "fair return," one that adequately compensates for the riskiness of the stock. Three-star stocks should offer investors a return that's roughly comparable to the stock's cost of equity. (The cost of equity is often called a "required return" because it represents the return an investor requires for taking on the risk of owning the stock.)

Five-star stocks, of course, should offer an investor a return that's well above the company's cost of equity. Conversely, low-rated stocks have significantly lower expected returns.

The Morningstar Rating for Stocks also includes a small buffer around the cutoff between each rating, to reduce the number of rating changes produced by random market "noise." If a £50 stock moves up and down by 25p each day over a few days, the buffer will prevent the star rating from changing each day based on this insignificant change.