Warren Buffett is one of the most respected investors on Wall Street. That’s partly because he has amassed a personal fortune of $140 billion, but also because Berkshire Hathaway(NYSE: BRK.A)(NYSE: BRK.B) has grown at a phenomenal pace under his leadership.
The company’s Class A shares have returned 20% annually since Buffett took over in 1965. S&P500(SNPINDEX: ^GSPC) returns approximately 10% annually. Berkshire’s outperformance comes down to wise capital allocation decisions, and Buffett deserves much of the credit.
He has orchestrated dozens of smart takeovers, made many wise investments and bought back company shares in a way that has undoubtedly created shareholder value. But two recent capital allocation decisions are worth examining. In the June quarter, Buffett sold 389 million shares Apple(NASDAQ: AAPL) and he bought $345 million worth of his favorite stocks.
Here’s what investors need to know.
Berkshire first took a stake in Apple in the first quarter of 2016, and in the fourth quarter of 2017 it became the largest position in the company’s portfolio. Many investors were initially surprised because Warren Buffett had avoided technology stocks for most of his career. But he has praised Apple CEO Tim Cook on several occasions for his extraordinary management, and Buffett recently said the iPhone “might be the greatest product of all time.”
Apple is still Berkshire’s largest holding and Buffett doesn’t expect that to change this year. But his decision to sell 49% of the position in the June quarter raises questions, especially as he had already reduced the position by 13% in the March quarter. Why would Buffett sell so many Apple shares if he clearly admires the company?
Earlier this year, Buffett was asked that question at Berkshire’s annual meeting, and he attributed the decision to a likely increase in the corporate tax rate in the future. The US federal government has run a historic budget deficit in recent years, and Buffett believes that at some point higher taxes will be used to remedy the situation. In that scenario, Berkshire would pay more taxes on its earnings, and GAAP earnings include investment gains.
In other words, Buffett sold Apple stock this year so that Berkshire won’t have to pay a higher tax rate on investment gains in the future. That makes sense, but it raises another question: why focus on Apple? If corporate taxes rise, Berkshire would owe the federal government a large portion of its investment gains on each share. Why is Buffett Selling Apple So Aggressively? The logical answer is appreciation.
Apple is a wonderful company with enviable brand authority and a strong presence in many markets, including its position as the largest smartphone manufacturer in the US. However, Wall Street expects its profits to rise 8.6% annually over the next three years, making his company’s current valuation of 34.4 times earnings look expensive. These figures give a PEG ratio of 4, a significant premium to the three-year average of 2.7.
Berkshire Hathaway changed its stock buyback program in 2018 to allow Warren Buffett to buy back shares when he believes they are discounted compared to their intrinsic value. Buffett spent $345 million on stock buybacks in the June quarter, bringing the total to $2.6 billion this year and nearly $78 billion since 2018.
Consistent share buybacks indicate that Berkshire stock is regularly undervalued in Buffett’s estimation. It also suggests that Berkshire is his favorite stock. As my colleague Sean Williams explains, Buffett could have bought each of the 379 companies in the S&P 500 with $78 billion. Alternatively, he could have bought shares in the other 121 companies. Instead, he spent the money on buybacks.
What sets Berkshire apart is the breadth of its insurance operations, coupled with the prudent investment decisions of Buffett and his students, Todd Combs and Ted Weschler. To explain this further, Berkshire is the global leader in insurance floats – a term referring to premiums collected by the company that have not yet been paid out in the form of claims. Moreover, according to Buffett, Berkshire paid “less than nothing” to increase its float thanks to disciplined underwriting.
He once defined float as “funds that are not ours, but that we can still deploy, whether in bonds, stocks or cash equivalents such as US government bonds.” That’s why Buffett loves the insurance industry. With disciplined underwriting, it generates large sums of investable capital, and Buffett has used those funds to create substantial value for shareholders.
Berkshire’s book value per share — a good proxy for changes in intrinsic value — rose 194% over the 10-year period ending in the June quarter. The S&P 500 returned 179% over the same interval. That tells me that Buffett and his students have invested Berkshire stock very effectively.
Wall Street expects Berkshire’s operating profits (which exclude investment gains and losses) to rise 17% annually through 2027. That consensus estimate makes the current valuation of 23.3 times operating profits seem reasonable. Patient investors should feel confident buying a small position in Berkshire today, especially since Buffett is likely to buy back shares this quarter.
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Trevor Jennevine has no positions in any of the stocks mentioned. The Motley Fool holds positions in and recommends Apple and Berkshire Hathaway. The Motley Fool has a disclosure policy.
Warren Buffett Just Bought $345 Million of His Favorite Stocks (Hint: Not Apple) was originally published by The Motley Fool
