Berkshire Hathaway's Beating the Market, But Its Biggest Holdings Aren't. What Gives?
Over the course of the past few years, Warren Buffett's Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) has measurably outperformed the S&P 500 (SNPINDEX: ^GSPC). That's not exactly news, of course. The Oracle of Omaha's stock picks have beaten the broad market in most years since the company was taken over by Buffett back in 1965. Buffett's value-oriented regimen works!
For the past couple of years, however, something curious has happened. Berkshire stock is still beating the market. But the company's very biggest holdings, like Apple (NASDAQ: AAPL), Bank of America (NYSE: BAC), American Express (NYSE: AXP), and Coca-Cola (NYSE: KO), are at best merely keeping up with the S&P 500, or at worst severely lagging it.
What gives?
Dividends explain part of the difference -- but only a small part. The dividends Berkshire's collected from the stocks it's holding still don't come close to fully explaining why the fund is doing so well when the stocks it's holding aren't. The remainder of the difference is rooted in something else well worth understanding, since it has implications for all investors, particularly for investors that like to borrow the occasional stock pick from Buffett.
Something doesn't add up for Berkshire Hathaway
Anyone reading this likely already knows that while Berkshire holds about four dozen different stocks, it's not a particularly well-diversified fund. Its three biggest positions account for around 60% of Berkshire's entire stock portfolio. The next biggest three -- Coca-Cola, Chevron (NYSE: CVX), and Occidental Petroleum (NYSE: OXY) -- make up another 16% of the fund's picks. Just for good measure, we'll point out that Kraft Heinz (NASDAQ: KHC) is its seventh-biggest position. At a mere 3% of the value of all of Berkshire Hathaway's stocks, however, it's far from being a high-impact holding. All told, these seven stocks account for more than 80% of the total value of the fund's positions in publicly traded companies. If Berkshire Hathaway is going to rise or fall, it's seemingly going to happen because of these tickers.
And yet for the past one-year and two-year timeframes, six out of seven of these tickers have underperformed the S&P 500, while Berkshire shares have outperformed the S&P 500.
| % of Portfolio | 4-Year Chg. | 3-Year Chg. | 2-Year Chg. | 1-Year Chg. |
|---|---|---|---|---|---|
Berkshire Hathaway |
| 137% | 62% | 18% | 36% |
S&P 500 |
| 114% | 32% | 15% | 31% |
Apple | 43% | 188% | 47% | 4% | 12% |
Bank of America | 10% | 70% | (6%) | (18%) | 30% |
American Express | 9% | 187% | 57% | 16% | 36% |
Coca-Cola | 7% | 44% | 18% | (1%) | 0% |
Chevron | 5% | 173% | 51% | (4%) | 0% |
Occidental Petroleum | 4% | 489% | 127% | 7% | 9% |
Kraft Heinz | 3% | 58% | (10%) | (7%) | (6%) |
Data source: TradeStation
How is this possible? If it's not coming from Berkshire's biggest stock positions, where's all of this value coming from?
It's an often-forgotten detail about Berkshire Hathaway, but it's not a mutual fund. It's a conglomerate that just so happens to use much of its idle cash to hold stocks of publicly traded companies. The conglomerate itself owns over 60 privately held companies, including familiar ones like GEICO Auto Insurance, Pilot Travel Centers, railroad company BNSF, Dairy Queen, Duracell, flooring company Shaw, and Clayton Homes, just to name a few. These are sound businesses as well. And arguably far more so than Berkshire's individual stock holdings, these privately owned businesses are geared first and foremost to generate cash for the parent company. Depending on the year, all of Berkshire's holdings combined generate between $40 billion and $50 billion worth of operating cash flow per year.
To put this figure in perspective, Berkshire Hathaway's current market cap stands around $900 billion, less than half of which is made up of the sum value of all the stocks it holds. These stocks couldn't even come close to producing the bulk of this operating cash flow. Most of Berkshire's cash generation (which carried it to a record hoard of $167.6 billion as of the end of last year) comes from its privately held businesses.
How to be like Buffett when he's not buying new stocks
The problem for investors is obvious: Outside of owning a stake in Berkshire, you can't invest in any of Berkshire Hathaway's privately owned entities like Duracell batteries, GEICO, or See's Candies -- they're not publicly traded. For investors who wholeheartedly believe in doing things exactly the way Warren Buffett does them, this presents a clear challenge.
There are some similar alternatives, however, for investors willing to venture off the beaten path.
You've likely heard the term "private equity," perhaps without fully knowing what it means. It's not complicated. Just as the name suggests, private equity firms supply promising up-and-coming companies with capital, usually in the form of a loan, but sometimes in exchange for an equity stake in a company. Ordinary investors can't make such deals. But ordinary investors can buy shares of private equity firms, plugging into the premise of owning budding businesses that aren't publicly traded.
Blackstone (NYSE: BX) is one of these private equity firms, and it's a good one. Share prices are up nearly 50% for the past year, and higher to the tune of 250% for the past five.
Driving these gains is its underlying portfolio of client/customer companies. It's currently funding 126 different outfits, including Ancestry.com, Emerson Climate Technologies, dating app Bumble, and Hello Sunshine (a media business launched by actress Reese Witherspoon). None of these are companies you can directly invest in on your own.
Publicly traded private equity firms aren't your only means of plugging into otherwise-uninvestable companies, however. A category of organizations called business development companies (or BDCs) can do the job too. Take Prospect Capital (NASDAQ: PSEC) as an example. In many ways, it functions like a private equity firm by virtue of providing capital to mid-sized companies that may not qualify for conventional loans but also aren't ready to go public just yet. All told, Prospect is working with over 100 different companies including Shutterfly, Staples, Credit.com, and playground equipment maker PlayPower.
The key difference between Prospect and Blackstone is that Prospect Capital is mostly built from the ground up to generate dividend income from its loans rather than drive capital appreciation. Prospect is currently yielding an impressive 13.2%.
Take the hint from Berkshire
Blackstone and Prospect Capital obviously aren't the only private equity (or business development company) outfits out there. Indeed, there may be far more of these private investment and BDC options to choose from than you ever might have imagined. And they're all increasingly worth a look, particularly given how the overall stock market continues to inch toward uncomfortably high valuations. As was noted, not even Buffett is nibbling here, and he's never been one to shy away from a worthy investment just because he might have to pay a bit of a premium for it. Maybe you shouldn't be nibbling on conventional stocks either.
Private companies, however, are a compelling alternative to ordinary stocks. And not just right now. If the market's current volatility and persistently rich valuations become the new norm, perhaps more investors should be taking bigger, more serious looks at these truly alternative ways of putting your money to work.
This might help drive the point home: Capital markets data company Preqin suggests the current private credit market is worth on the order of $1.5 trillion right now, but by 2027 could be worth $2.2 trillion. In a similar vein, market research outfit Technavio predicts the worldwide private equity market will be about 50% bigger in 2027 than it is now.
To this end, maybe Buffett is onto something, recognizing that conventional stocks just aren't promising enough given their current prices. He seems to be pretty content with -- and doing pretty well with -- Berkshire's privately owned businesses.
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Bank of America is an advertising partner of The Ascent, a Motley Fool company. American Express is an advertising partner of The Ascent, a Motley Fool company. James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Bank of America, Berkshire Hathaway, Blackstone, and Chevron. The Motley Fool recommends Kraft Heinz and Occidental Petroleum. The Motley Fool has a disclosure policy.
Berkshire Hathaway's Beating the Market, But Its Biggest Holdings Aren't. What Gives? was originally published by The Motley Fool
