Investors seeking better-than-average returns typically have to take on greater-than-average risk. A company that can outpace the S&P 500 with less downside in the case of a market downturn is a rare find.

In his 2023 letter to Berkshire Hathaway (BRK.A) (BRK.B) shareholders, Warren Buffett identified one company that has better prospects than the average American corporation. He also said it operates with less risk of losing capital, which should provide significant downside protection.

Buffett’s track record of outperforming the S&P 500 since founding his first investment partnership in 1956 is quite astounding. The average compound annual return of Berkshire Hathaway stock since Buffett took control of the business in 1965 are nearly double the index. So, when Buffett says he believes a stock can do better than average, investors listen.

The one stock Buffett thinks should do better than average
Berkshire Hathaway’s investment portfolio is valued around $318 billion.

In his most letter to shareholders, Buffett identified several stocks in the portfolio that he plans to hold indefinitely. He first calls out Berkshire’s investments in American Express (AXP) and Coca-Cola (KO), two investments he hasn’t added to since the mid-90s. Still, the two have grown so much in that time that they represent two of the four largest equity positions in Berkshire’s portfolio.

American Express has benefited from the shift to digital payments like credit cards. As the issuer and network operator for its credit cards, Amex guarantees control over the economics of the payment ecosystem. That’s a strong position to be in, ensuring it controls its own destiny. Recent efforts to expand its payments network internationally, increase lending, and attract younger consumers, have paid off in strong operating results.

Coca-Cola is one of the best known brands in the world. The strength of its brand and its global scale give it a considerable competitive advantage, or moat, as Buffett likes to call it. Coke’s brand strength allowed it to raise prices and protect margins amid the staggering inflation of the last few years (both domestically and abroad).

While Buffett considers both Coke and Amex wonderful businesses, they don’t earn the spot as Buffett’s top pick to outperform the average American corporation.

Over the last few years Buffett’s been accumulating a massive stake in Occidental Petroleum (OXY). In his letter to shareholders he said he likes Occidental’s domestic oil and gas holdings as well as its carbon-capture initiatives. He praised CEO Vicki Hollub, who has taken steps to aggressively increase Occidental’s portfolio of properties.

Buffett has consistently added to Berkshire’s position in Occidental whenever its price drops below $60 per share. The stock has grown to account for 4.5% of Berkshire’s equity portfolio, even more if you include the preferred shares Buffett acquired in 2019. Weakening oil prices have led it to trade below that level recently, though, and Buffett hasn’t added any shares since June.

But Occidental isn’t Buffett’s top pick for a single stock that should outperform the market average with less downside either.

The stock Buffett notes should perform better than average is Berkshire Hathaway itself. The combination of its equity positions and wholly owned companies gives it much more potential than any single business on its own. “With our present mix of businesses, Berkshire should do a bit better than the average American corporation and, more important, should also operate with materially less risk of permanent loss of capital,” Buffett wrote to shareholders.

Buffett’s betting big
Buffett isn’t just saying Berkshire should perform better than average, he’s backing it up with cold hard cash. Practically 99% of his wealth is tied to Berkshire Hathaway’s performance. In his letter to shareholders he notes his family is also heavily invested in Berkshire, including his sister Bertie and her three daughters.

Not only has he put his own wealth into the future of Berkshire Hathaway, he’s also consistently redeployed Berkshire’s own cash to buy back shares of the stock. Since the board of directors updated the company’s share repurchase authorization in 2018 to allow Buffett to buy back shares whenever he felt they were undervalued, he’s rarely missed an opportunity to do so.

That said, Buffett did slow repurchase activity considerably in the second quarter, eschewing purchases altogether in June. That’s not necessarily a sign that Buffett feels the shares are overvalued at this point. Buffett may want to keep a giant pile of cash for a potential acquisition or to provide more flexibility for his eventual successor. (He just turned 94.) As of the end of the second quarter, Berkshire had $277 billion in cash and equivalents.

That cash offers considerable downside protection for investors. If the stock market tumbles, Buffett is well positioned to take advantage of the opportunity to buy stocks or entire companies trading below their intrinsic value.

It’s hard to consider Berkshire shares overvalued, even if it does trade for a relatively high price-to-book value (one of Buffett’s preferred valuation measures). But Buffett has deleveraged Berkshire recently, holding enough cash to cover its insurance business reserves. Meanwhile, Berkshire’s operating earnings from its wholly owned businesses totaled $42.1 billion over the past four quarters. That’s remarkable growth from the $27.6 billion the company produced in 2021.

At its current valuation, Berkshire Hathaway trades for just 23.75 times its trailing operating income. That doesn’t include investment gains, which have been substantial. If you strip out the $318 billion equity portfolio, the company is priced at 16.3 times operating earnings. And that includes a massive cash position that Buffett could invest when he finds a suitable opportunity. At that price, it’s no wonder he feels Berkshire has a great chance to outperform over the long run.

— Adam Levy

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Source: The Motley Fool