Prudent Diversification? Not This Crazy Old Man in Omaha (His Initials are W.B.)

Warren Buffett has been graciously doling out great free advice for decades. From “It’s far better to buy a wonderful company a fair price than a fair company at a wonderful price” to his vivid recasting of the old buy low/sell high mantra into “Be fearful when others are greedy and greedy only when others are fearful” the Berkshire Hathaway (BRK.B) chairman is a valuable resource for DIY-investors.

Up to a point that is. One of the key components of Buffett’s investment strategy flies in the face of standard portfolio theory. The man who runs a widely diversified conglomerate, doesn’t diversify within his stock portfolio. At the end of the third quarter nearly 70% of Berkshire Hathaway’s $75 billion stock portfolio was invested in four stocks: Coca-Cola (KO), Wells Fargo (WFC), IBM (IBM) and American Express (AXP).

KO Chart

KO data by YCharts

For a bit of perspective, the Vanguard Total Stock Market index fund -- the go to core stock holding for individual investors -- also has $75 billion in assets, with the four largest holdings accounting for about 10% of the portfolio.

Buffett’s hyper concentration has a definite “don’t try this at home” element to it. Putting more than two-thirds of your 401(k) into four stocks would qualify as a bit of retirement Russian Roulette. But at the same time, there’s still plenty to glean from understanding Buffett’s stake in his Big Four.

For starters, in a world where the average U.S. large cap mutual fund stock manager turns over his portfolio nearly 80% a year, Buffett is investing, not trading. Coca-Cola, Wells Fargo and American Express have been in the portfolio for more than two decades.. Only IBM is a newbie, making its first appearance in the portfolio in 2011. As he explained in Berkshire’s 2011 annual report: “We view these (four) holdings as partnership interests in wonderful businesses, not as marketable securities to be bought or sold based on their near-term prospects.”

Buffett has a high level of confidence in what he’s getting. Back in the 1996 annual report he riffed on his yen for “The Inevitables,” big dominant companies -- typically global leaders -- with the infrastructure to continue to deliver. “Obviously many companies in high-tech businesses or embryonic industries will grow much faster in percentage terms than will The Inevitables. But I would rather be certain of a good result than hopeful of a great one, ” he wrote. Three of Buffett’s Big Four rank in the top 25 of Interbrand’s annual ranking of global brands. Coca-Cola tops the list, IBM is #3 and AmEx # 24. (Wells Fargo isn’t so global, but it runs a hell of a bank.)

The good result Buffett wants is sustainable profit growth that pays off for Berkshire Hathaway shareholders both short-term and long-term. The short-term payoff is the dividend payouts churned out by the Big Four. Buffett calculated that Berkshire’s dividend haul from the Big Four in 2011 would have been more than $860 million if IBM had been owned for the entire calendar year. (The position was started in the first quarter of 2011.)

As hefty as that dividend payout sounds, it’s actually only a fraction of Berkshire’s share of total earnings for the Big Four, which Buffett estimated to be $3.3 billion in 2011. “Over time, though, the undistributed earnings of these companies that are attributable to our ownership are of huge importance to us. That’s because they will be used in a variety of ways to increase future earnings and dividends of the investee. They may also be devoted to stock repurchases, which will increase our share of the company’s future earnings.”

Buffett surmised that a decade out Berkshire’s share of Big Four earnings could reach $7 billion, of which $2 billion would be doled out in a dividend. That 130%+ pickup in the dividend is no greater than what three of the Big Four have managed to generate over the past 10 years. (Wells Fargo, which pared back its dividend during the financial crisis, is the one miss.)

KO Dividend Chart

KO Dividend data by YCharts

And clearly there’s plenty of room to keep the dividend boosts coming.

KO Payout Ratio TTM Chart

KO Payout Ratio TTM data by YCharts

While it’s clear Buffett has plenty of love for his Big Four that doesn’t mean he’s buying all four today. Only the Wells Fargo and IBM positions have been added to in 2012. Berkshire Hathaway hasn’t invested a fresh penny in Coca-Cola since 1994, and its stake in American Express hasn’t been added to since 2000.

It’s also telling that Buffett isn’t using Berkshire’s ample cash to significantly boost these-or any other-positions. At the end of the third quarter, Berkshire Hathaway had nearly $48 billion in cash and short-term investments, up from $37 billion at the end of 2011. He’s always said he likes to keep $20 billion or so on hand; that leaves nearly another $30 billion he’s choosing not to spend. That’s a pretty telling commentary on what Buffett thinks of current valuations -- for stocks and direct investment.

The current YCharts rating for all four stocks is Neutral. For a deeper dive into why Buffett is so comfortable with his Big Four, continue reading our series in coming days:

Buffett’s Big Four: Coca-Cola

Buffett’s Big Four: Wells Fargo

Buffett’s Big Four: IBM

Buffett’s Big Four: American Express

Carla Fried is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.



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