5 Bargains in Berkshire's Portfolio

Last week, Berkshire Hathaway (BRK.A)/(BRK.B) released its second-quarter 13-F. Morningstar’s resident Berkshire specialist, Gregg Warren, noted that the behemoth was a net seller of equities during the quarter. True, Berkshire picked up shares of Barrick Gold (GOLD) and bumped up its stakes in Liberty SiriusXM (LSXMA), Store Capital (STOR), Kroger (KR), and Suncor Energy (SU).

However, each of these pickups accounts for less than 1% of Berkshire’s portfolio, reminds Warren.

As for sales, Warren Buffett revealed during Berkshire’s virtual annual meeting that the team had sold its entire airline stake in April. Moreover, Berkshire jettisoned its stake in Goldman Sachs (GS) and trimmed its overall exposure to financials stocks during the quarter.

Given the market’s exceptional bounceback during the second quarter, bargains are less bountiful than they were three months ago. That said, here’s a look at a handful of stocks in Berkshire Hathaway’s portfolio that are undervalued by our standards.

Kraft Heinz Company (KHC)
Morningstar Rating (as of Aug.

18, 2020): 4 stars
Morningstar Economic Moat Rating: None

“Five years have passed since the marriage between Kraft and Heinz. Although the initial motivation of the tie-up was enhanced profitability (which ultimately impaired its competition position), we believe the firm is charting a new course following the appointment of CEO Miguel Patricio in 2019.

Patricio has yet to make his strategic agenda public, but we don’t believe that implies Kraft Heinz has pushed pause on efforts to steady its ship.

“We still expect the strategic playbook to be anchored in pursuing sustainable efficiencies versus blindly rooting out costs as the company elevates brand spending (marketing and product innovation) and enhances its capabilities (category management and e-commerce). We continue to expect marketing, research, and development to expand to more than 5% of sales in the aggregate over our 10-year forecast versus less than 5% the past few years.

“Packaged food players as well as grocery stores have suggested that consumers have increasingly sought out trusted brands (like those in Kraft Heinz’s mix) since the onset of the pandemic, in line with the boost in household penetration and repeat purchase rates that Kraft Heinz has experienced. However, we expect the recent pace of gains prompted by COVID-19 stock-up trips will slow over the next several quarters as consumers work through their pantries and resort to away-from-home food consumption as social distancing mandates are eased.

“We don’t expect Kraft Heinz to merely ride these tailwinds.

Rather, we view this environment as an opportunity to pick up the pace on the change that has just gotten underway at the organization. We’ve been encouraged by Kraft Heinz’s renewed commitment to enhance its service levels with retail customers–relationships that had been tarnished under prior leadership. This aim has gained heightened importance against the current backdrop, evidenced by the decision to focus manufacturing assets on the company’s highest-turning stock-keeping units and even to enlist the help of co-manufacturers (despite the higher cost).

We view this as prudent.”

–Erin Lash, director

General Motors (GM)
Morningstar Rating (as of Aug.

18, 2020): 5 stars
Morningstar Economic Moat Rating: None

“We think General Motors’ car models are of the best quality and design in decades. The company is already a leader in truck models, so a competitive lineup in all segments, combined with a much smaller cost base, says to us that GM is starting to realize the scale to match its size. The head of Consumer Reports‘ automotive testing even said Toyota and Honda could learn from the Chevrolet Malibu.

Tariff risk is a concern but seems to be abating compared with a couple of years ago.

“We think GM’s earnings potential is excellent once it can reopen its plants, which are shut down owing to the coronavirus outbreak, because the company finally has a healthy North American unit and a nearly mature finance arm with GM Financial. Moving hourly workers’ retiree healthcare to a separate fund and closing plants have drastically lowered GM North America’s break-even point to U.S. industry sales of about 10 million-11 million vehicles, assuming 18%-19% share. We expect further scale to come from GM moving its production to more global platforms and eventually onto vehicle sets over the next few years for even more flexibility and scale.

Exiting most U.S. sedan segments also helps.

“GM makes products that consumers are willing to pay more for than in the past. It no longer has to overproduce in an attempt to cover high labor costs and then dump cars into rental fleets (which hurts residual values). GM now operates in a demand-pull model where it can produce only to meet demand and is structured to do no worse than break even at the bottom of an economic cycle when plants can be open.

The result is higher profits than under old GM despite lower U.S. share.

“We also like GM embracing the opportunity of ride-sharing and ride-hailing and selling Opel/Vauxhall. We think actions such as buying Cruise Automation, along with GM’s connectivity and data-gathering via OnStar, position the company well for this new era. Cruise intends to offer autonomous ride-hailing with its Origin vehicle but needs more time to ensure safety and quality of service.

GM is also investing £20 billion in battery electric vehicles for 2020-25 and believes in an all-electric future, though not soon.”

–David Whiston, strategist

Liberty Global (LBTYA)
Morningstar Rating (as of Aug.

18, 2020): 4 stars
Morningstar Economic Moat Rating: Narrow

“Liberty Global is essentially an investment holding company that consists of five major assets: U.K. cable company Virgin Media, which plans to merge with wireless carrier O2, leaving Liberty with a 50% stake in the combined firm; a 60% stake in Telenet, the largest cable company and a wireless carrier in Belgium; a 50% stake in VodafoneZiggo, the largest cable company and a wireless carrier in the Netherlands; full ownership of the largest cable company in Switzerland; and around £8 billion in cash and other investments. Given that the cash sitting at the holding company accounts for more than half the firm’s total market cap and that only a very small amount of debt resides at the holding company level, future capital allocation will play a very large role in determining Liberty Global’s value.

“Virgin Media is Liberty’s most important operating asset. It is the only major cable company in the United Kingdom, connecting about 15 million homes and businesses, or a bit less than 60% of the country.

The U.K. telecom market is unique thanks to the presence of Sky and an aggressive regulatory wholesale regime that provides low-cost access to the network of BT, the legacy phone company. Virgin has struggled to gain market share comparable to that seen among cable companies in the United States and elsewhere in Europe, despite holding the same network advantages that those peers enjoy. Virgin is expanding the reach of its networks, but revenue growth has been disappointing.

The decision to merge with O2 will create the second integrated wireless and fixed-line player in the U.K., which should benefit Virgin’s strategic position. Regulatory approval of the deal could come with conditions that make it less attractive, however.

“Adding wireless in the U.K. addresses Liberty’s most pressing strategic concern. The firm must now turn its attention to its cash balance.

Management has lamented the disconnect between Liberty’s share price and the private-market values of its assets, but share repurchase plans remain fairly modest, suggesting management anticipates finding new investment opportunities in the relatively near future.”

–Mike Hodel, director

Suncor Energy (SU)
Morningstar Rating (as of Aug.

18, 2020): 4 stars
Morningstar Economic Moat Rating: None

“Suncor Energy is one of Canada’s leading integrated energy companies, focusing on crude-oil production, refining and upgrading operations, and the marketing of petroleum products. Upstream operations are primarily focused on the development and production of the Athabasca oil sands and are supplemented with conventional crude oil that provides Suncor with access to higher world pricing. Suncor’s integrated operations help to mitigate market volatility and capture refined-product pricing for the company’s crude production.

However, high sustaining capital requirements result in unfavorable cost structures when compared with peers.

“Like peers, Suncor faces an uphill struggle coping with lower oil prices on its upstream operations. Depressed realized prices have stalled the growth potential of Suncor’s additional oil sands assets, as proposed expansion projects still require high levels of capital spending. Unlike Canadian peers, Suncor’s downstream business provides a hedge for lower oil prices and excels when differentials widen.

“In the current environment, leverage remains reasonable and is attributed to Suncor’s integrated operations.

The company’s future oil sands projects could drive significant growth in a better oil price environment, but these projects aren’t economical until solvent technology is implemented and oil prices recover, limiting their upside. Suncor is at an upstream disadvantage to peers, which are proceeding with solvent-assisted technology in the next phase of growth projects. However, we think the market is too narrowly focused on the threat of increasing heavy oil differentials and the current low oil price environment and is ignoring the company’s integrated operations.

Suncor’s downstream business provides stable cash flows when oil prices are low or differentials widen and hedges against the company’s upstream production. The company continues to generate stable operating cash flow, and now we see upside to our fair value estimate at current levels. Even after the dividend cut, the stock offers investors a 3.5% dividend yield.”

–Joe Gemino, senior analyst

Biogen (BIIB)
Morningstar Rating (as of Aug.

18, 2020): 4 stars
Morningstar Economic Moat Rating: Wide

“We think Biogen’s specialty-market-focused drug portfolio and novel, neurology-focused pipeline create a wide economic moat.

“Biogen’s strategy has its roots in the 2003 merger of Biogen (multiple sclerosis drug Avonex) and Idec (cancer drug Rituxan). Rituxan’s market penetration is high, and patents in the U.S. (where Biogen derives its profit share from Roche) expired in 2018, leading to biosimilar approvals in late 2019. While this pressures Biogen’s profit share, subcutaneous Rituxan as well as novel antibody Gazyva will allow for extended oncology revenue.

“In MS, Avonex and longer-acting Plegridy generate £2 billion in annual sales and remain the leading MS interferon drugs.

Biogen also acquired full rights to MS antibody Tysabri (more than £1.5 billion in annual sales) from partner Elan. Oral MS drug Tecfidera (£4 billion annually) had a strong launch and continues to show solid safety and efficacy data. While a recent patent ruling validates formulation patents through 2028 in the U.S., the ability of Biogen’s new oral drug Vumerity to improve gastrointestinal tolerability should only partly offset headwinds from increased competition in the MS market.

While pricing power and demand for Biogen’s injectable MS portfolio are eroding in the face of new competition, Biogen receives substantial royalties on the biggest new competitor, Roche’s Ocrevus, which helps offset pressure on older MS drugs.

“Outside of MS, Biogen has strong human genetic validation for its neurology pipeline. Spinal muscular atrophy drug Spinraza (partnered with Ionis) is a £2 billion franchise, although competition from Novartis (gene therapy Zolgensma approved in May 2019) and Roche (oral drug risdiplam) could begin to erode Spinraza sales. Aducanumab has the largest potential and could launch as the first disease-modifying Alzheimer’s therapy by late 2020.

While there is significant uncertainty surrounding the potential approval of aducanumab, we think the market also underestimates Biogen’s remaining pipeline, which includes a continuing partnership with Ionis and drug candidates to treat conditions including stroke, Parkinson’s, pain, and ALS.”

–Karen Andersen, strategist

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