Warren Buffett's Pension Strategy?

Noah Buhayar of Bloomberg reports, Buffett Adds Stocks in Pension Handoff to Lieutenants:
Billionaire Warren Buffett is betting that his deputy investment managers can find value hiding in a corner of Berkshire Hathaway Inc. (BRK/A): its $10.4 billion in pension assets.

Todd Combs, 42, and Ted Weschler, 52, have been building stock portfolios with funds they oversee for defined-benefit plans at Berkshire subsidiaries, including railroad Burlington Northern Santa Fe. The strategy saves Buffett’s company fees it would pay to outside asset managers and could reduce the need for contributions to the pensions.
“For his whole career, Buffett has been extremely choosy about who he will allow to manage Berkshire’s money,” said James Armstrong, president at Henry H. Armstrong Associates, which oversees about $400 million, including shares in the Omaha, Nebraska-based company. “Now he’s got two young guys who have a lot of energy and some capacity, and I think it makes perfect sense” that he selected them for pension investments rather than “some big bank.”

BNSF liquidated hundreds of holdings backing obligations to retirees as Berkshire took control of investments for a $1.9 billion defined-benefit plan in 2012, two years after Buffett bought the railroad, U.S. Department of Labor filings show. Since then, the fund made concentrated stock bets in companies favored by Combs and Weschler.

Holdings of DirecTV (DTV) and DaVita HealthCare Partners Inc. (DVA), for instance, were each valued at more than $300 million at yesterday’s share prices, based on assets listed in regulatory filings in May. Stock picks in the plan used to be a fraction of that size, separate filings show.
Pension Plans

Changes occurred at plans of other Berkshire units, including FlightSafety International Inc., which trains pilots. A $281 million fund tied to the unit sold holdings last year in Johnson & Johnson (JNJ) and Procter & Gamble Co. (PG) -- both Buffett picks -- and added stock in Viacom Inc. (VIAB) and oil refiner Phillips 66. Berkshire’s Acme Brick Co. and cowboy-boot maker Justin Brands Inc. also eliminated holdings in P&G and J&J.

Reallocating pension assets is one way Buffett, 83, can assign more funds to Weschler and Combs without liquidating some of his own long-held investments. Berkshire’s stock portfolio, valued at $103.3 billion as of June 30, includes stakes of more than $10 billion in Wells Fargo & Co., Coca-Cola Co., International Business Machines Corp. and American Express Co. (AXP)

The amount of funds the deputies oversee more than doubled to about $5 billion each, the billionaire wrote in March. Combs and Weschler were each hired in the past three years.

A review of pensions at subsidiaries with combined assets of about $5 billion shows that Berkshire tends to target fewer than a dozen stocks for each plan and has smaller-than-average investments in bonds. Buffett didn’t respond to a message seeking comment.
Acme’s Trust

The trust for Acme’s pension held 83 percent of its $116 million portfolio in nine equities at the end of 2012, and less than 4 percent in corporate and government bonds, filings show. That compares with 50 percent in stocks and 37 percent in debt for similar-sized U.S. private pension plans, according to a forthcoming study from Towers Watson & Co.

While some of Berkshire’s pension funds are overseen by outside managers, the investments have been shifting toward equities. More than half the assets were in stocks at the end of last year compared with 36 percent at the end of 2009, according to regulatory filings. Assets climbed about 76 percent in that period, as Buffett bought more businesses and markets rose.

Many pension funds avoid concentrations in single stocks to limit risk. Buffett became the world’s fourth-richest person in part through targeted bets made with funds from insurance subsidiaries. He has called bonds among the “most dangerous” of assets, saying near-record-low interest rates aren’t enough to compensate investors for inflation risk.
Washington Post

After joining the board of Washington Post Co. in 1974, Buffett advised his friend and the company’s then-chief executive officer, Katharine Graham, to abandon Morgan Guaranty as the company’s pension asset manager. By switching to investors that shared his approach, returns would probably be better without taking on too much risk, Buffett wrote in a memo published by Fortune magazine.

Graham took the advice, and the results stand out. At a time when the average corporate pension plan in the U.S. is underfunded, the Washington Post’s ended 2012 about $600 million overfunded. Berkshire’s total obligation to pension holders was $14.1 billion, meaning that the plans had an average funding level of about 75 percent.
Berkshire’s Outlook

Some picks by Combs and Weschler have turned out well. The Phillips 66 (PSX) shares that FlightSafety’s plan bought last year almost doubled in value, according to filings. Justin Brands’ investment in General Motors Co. (GM) in 2012 had climbed more than 70 percent through yesterday based on the cost of shares reported in its annual filing to the Labor Department.

“These are the kinds of bets he’s believed in all along,” Jeremy Gold, an independent pension actuary and economist, said of Buffett. “He believes that these insights provide returns and cost savings above and beyond the returns for risk taken in more highly diversified, externally managed portfolios.”

Buffett’s picks have led to some losses. Before Weschler and Combs took over, at least five Berkshire pension plans bought bonds tied to Energy Future Holdings Corp. Buffett apologized for the wager in a 2012 letter to investors after the securities plunged in value.

The risk for pension holders from Buffett’s strategy should be minimal, said Richard Shea, a partner at Covington & Burling LLP who is chairman of the law firm’s employee-benefits and executive-compensation practice.
Cash Pile

Most corporate defined-benefit plans are required to insure obligations through the Pension Benefit Guaranty Corp., he said. Companies also are responsible for addressing shortfalls. Buffett’s firm had $35.7 billion in cash at the end of June.

“If you had to pick an employer to be behind the trust, Berkshire is not such a bad one to have,” said Shea.

That’s a view shared by Patrick Hiatte, who retired in 2009 to a farm in Missouri after working more than three decades in communications at BNSF. Payments from the plan account for about 40 percent of annual income for him and his wife.

“As long as that direct deposit keeps coming once a month, I have every confidence in the plan’s managers,” he said. Berkshire is “a good solid group of companies. The more I read, and the more I learn about it, the better I feel.”
Indeed, if I had to pick someone to manage my defined-benefit or defined-contribution plan, Warren Buffett and his team at Berkshire would be high on my list (Berkshire is just one of many top funds I track every quarter).

What does the article say about Buffett's strategy for managing the defined-benefit plans Bershire inherited through acquisitions? First and most important, there is no talk of switching people out of defined-benefit to defined-contribution plans. Buffett plans to honor those commitments (Interestingly, I've tracked a lot of activity on my blog from Omaha, Nebraska over the last few years. Could it be the Oracle of Omaha?).

Second, fees matter a lot and Buffett isn't going to waste his time farming out the bulk of these pension assets to outside managers using useless investment consultants when he has the expertise to manage them in-house There is no mention of allocating money to hedge funds or private equity funds either. Again, fees matter a lot to Buffett and so does liquidity and performance. He is handily winning on a wager he made in 2008 with Protégé Partners, a fund of hedge funds manager, betting the S&P500 would beat a group of hedge fund managers selected by Protégé.

Third, Buffett and his team are not just great stock pickers, they also know how to engage in more sophisticated derivatives strategies. Buffett might have called derivatives "financial weapons of mass destruction," but the truth is Berkshire made a killing on the same long-term option strategy that allowed HOOPP to gain 17% in 2012.

Fourth, and hardly surprising, Buffett is not bullish on bonds given the current near record low interest rates. In this regard, he joins pensions that are massively betting on a rise in interest rates. This is understandable given that Buffett made his fortune picking great companies and he prefers stocks over bonds in the long-run. He thinks market timing is a loser's proposition and many long-term investors (like Doug Pearce at bcIMC) agree with him.

Keep in mind, however, that Buffett enjoyed the greatest bull market in stocks and never managed money during a prolonged debt deflation cycle (doubt he will ever see one in his lifetime). Also, the Fed's quantitative easing (QE) policy has been a boon for risk assets and I'm seeing a lot of activity in the stock market reminiscent of the 1999 liquidity melt-up in tech stocks. Momentum chasers trading high-beta stocks are loving it but be careful as the market's darkest days might be ahead.

Finally, many of you don't know but my favorite activity is tracking stocks. Apart from analyzing the core holdings of top funds every quarter, I literally spend long hours every day looking at different stocks from different industries and analyzing their charts. I now have a list of over 1,000 stocks and ETFs which are grouped in various industries and love bouncing ideas off of my friend, Frederic Lecoq, a former portfolio manager at PSP Investments who has converted from a pure fundamental investor to a successful technical trader. He loves what he's doing and doesn't miss the headaches and politics at big pension funds.

Leave you with these interesting tidbits. One of the best stocks Buffett bought in the Berkshire portfolio after the crisis was McKesson Corporation (MCK). Just check out the five-year chart. Buffett also bought, sold and re-bought Conoco Phillips (COP), another one of his top-performing stocks in the last five years. He still holds Conoco Phillips but not McKesson. You can check out Berkshire Hathaway's latest holdings here (he got a beating on IBM!). You won't hear about this on CNBC because they do a lousy job covering the holdings of top money managers (typically you'll hear of stocks they want to dump on unsuspecting retail investors).

And who is my favorite stock picker over the last few years? I'd have to go with Bruce Berkowitz of Fairholme Funds, another great deep value investor. According to the Fund's latest letter, his average rolling 5-year return was 68.56% versus 16.84% for the S&P 500. He bought American International Group (AIG) way before others piled in and made a killing for himself and investors who stuck with him during the drawdown. He's also long Bank of America (BAC), one of Buffett's top picks. Berkowitz recently announced he is opening up his hedge fund to institutional investors and I would jump on that opportunity if the fees are reasonable. 

Retail investors that don't have access to top hedge funds should read this article on hedge fund returns in an ETF wrapper. It turns out the Global X Top Guru Holdings Index ETF (GURU) has been doing a great job trouncing the S&P 500 and most other hedge funds. This ETF picks the best ideas from funds that do not trade often and wraps them in one portfolio. The annual management charge is 0.75 per cent compared to the “two and 20” hedge funds charge and it beats the hell out of closet indexers raping you on fees for mediocre performance (GURU is far from perfect but still very interesting).

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Below, the Oracle of Omaha explains why stocks still offer the best investment opportunities compared to cash or long-term bonds. I agree but you better have the right "gurus" picking your stocks. And if asset bubbles pop and debt deflation creeps into the system, all bets are off. Pensions ill-prepared for a rough landing, praying for an alternatives miracle and massively betting on rising rates will feel the pain.