Author: Rocco Huang
Covestor model: Tortoise and the Hare
Disclosure: Long ACN
According to Berkshire’s most recent 10-Q, the investment powerhouse was on a stock buying spree during the third quarter.
We are not sure whether it was Mr. Buffett himself or the newly hired Todd Combs (formerly with Castle Point Capital Management LLC) who was calling the shots, but spending nearly $7 billion in a quarter was highly unusual. Last time they did it was the 4Q of 2008.
The billion dollar question: What did they buy?
Let’s first take stock of what we know and what we don’t know based on public information.
In Berkshire’s 10-Q, the company separates its equity investment portfolio into three categories. We know that almost all of the $7 billion was spent on equity securities belonging to a category named “Commercial, Industrial, and Other”. The other two categories are “Banks, Insurance, and Finance” (e.g., Wells Fargo, American Express) and “Consumer Products” (e.g. Coca-Cola, Procter & Gamble).
We don’t know the names of the newly purchased securities. Berkshire discloses its individual security holdings in the 13(f) reports every quarter. The next 13(f) is expected to come out in mid November. However, the company is allowed (and has done so in the past) to seek for so-called “Confidential Treatment” (CT) from the SEC if it is able to convince SEC that the immediate disclosure of its positions will impede competition, cause increased volatility in the market place, or is against public interest in any other ways. If Berkshire indeed is seeking (and is granted) CT delayed disclosure for the next 13(f) , we may have to wait several months before we know what exactly the company had bought in 3Q.
However, we can always do some educated guesses based on what we know about Mr. Buffett’s track record and revealed preference.
We know that he doesn’t like to overpay. We also know that he prefers businesses with dominant competitive positions (preferably natural monopolies). When he has to choose between cheapness and competitiveness, he leans toward buying the best businesses at a fair price, and away from buying second-rate businesses at a fire-sale price.
Searching in the industrial sector with Mr. Buffett’s preference in mind, the best candidate I can come up with is either United Parcel Service (UPS), which Berkshire already has a small stake in, or FedEx Corporation (FDX).
Mr. Buffett considered the acquisition of Burlington Northern Railroad a bet on the U.S. economic future. Recently, he has expressed optimistic views about the economy, citing strong traffic in the railroad business he owns. It is not surprising that either UPS or FDX will be another leveraged contrarian bet on the global economy.
Thanks to economies of scale, the duopoly of UPS and FedEx in the global express delivery business is a done deal. Few investors now considers the rise of a third competitor as a distinct possibility. What bulls and bears are debating is simply whether the global economy is entering an extended period of slow growth and trade. Similar to railroads, package delivery businesses have high operating leverage due to high fixed costs of their physical networks. Any up- or downturn of the economy can translate into large swing in profitability and valuation.
There is no doubt that in the short term their businesses are going to experience some tough time. UPS and FedEx had reported slowdown in international traffic and lowered sales guidance recently, and I trust that their CEOs know more than everyone of us does about their own operations. The question is whether this is just a cyclical downturn or a new normal.
We know that Mr. Buffett doesn’t care much about cyclical ups and downs. So long as a business does well averaged over a business cycle (e.g. 10 years), losing money in 1-2 years is not going to bother him much. If he indeed had raised his stake in UPS or had started buying FedEx in 3Q, it would be an unequivocal statement that he didn’t believe in an oncoming “lost decade” for the global economy.
An outright takeover of UPS or FedEx is not an immediate possibility, given that it will take some time before Berkshire finishes digesting the debts brought on in the Burlington acquisition. In 3-5 years, however, we never know. After all, Berkshire was with Burlington Northern Railroad for a while as a minority shareholder before taking the whole company over. Both UPS and FedEx are still spending billions of dollars each year in capital expenditures to build out their global networks. As a subsidiary of Berkshire, strong free cash flow generated by Berkshire’s other more mature subsidiaries can be used to fund these expenditures in a very tax-efficient manner.
If Berkshire was buying manufacturers, then I am guessing it’s diesel engine leader Cummins Inc. (CMI) and industrial conglomerate Ingersol-Rand (IR). Berkshire already owns shares in IR.
Some money managers are guessing it’s smaller players (i.e., below $5 billion in market cap) such as Kennametal Inc (KMT). I believe that they are not the most likely candidates. We know that Berkshire prefers to run a focused portfolio, and therefore I doubt that the average position size of the $7 billion spent in 3Q was less than $1 billion. As Berkshire has to disclose any >5% positions, and as we haven’t seen any recently, I am betting that what they bought in 3Q were relatively large companies with +$20 billion market cap.
Certainly, the “Commerce, Industrial and Other” category includes not just traditional industrial manufacturers, but also commercial and professional services providers. We can probably rule out any IT service companies such as Accenture plc (ACN) no matter how cheap or how dominant they are, because we know that Mr. Buffett prefers businesses that he can understand and that he expect to remain more or less the same 20 years from now. He doesn’t like his investment to be tied to technological changes.
Other likely candidates include garbage collectors such as Waste Management (WM) and Republic Services, or payroll service providers such as Automatic Data Processing (ADP) and Paychex (PAYX). We know that Mr. Buffett loves subscription-based businesses that collect fees well before services are provided. In this respect, garbage collectors are not unlike newspapers, and they are here to stay as we are not going to digitalize garbage any time soon.
Finally, there certainly a possibility that Berkshire increased its stake in MasterCard Inc (MA) significantly. Broadly speaking, MasterCard Inc can be considered a financial-related support service company, and not a “financial company”. Therefore, it will not be considered completely inappropriate to place MA in the “Commercial, Industrial and Other” category. However,I doubt that Berkshire plays such a game with words.
If Berkshire did adopt such a definition, then likely candidates would include financial technology providers such as Fiserve (FISV) and Fidelity National Info Services (FIS), tax preparer H&R Block (HRB), financial information providers such as Dun & Bradstreet (DNB) and Verisk Analytics (VRSK), which Berkshire already owns.
