IVV - Why SPY Investors Might Want To Reallocate Into Berkshire Hathaway

2023-12-18 02:19:04 ET

Summary

• Peter Lynch warns against "diworsification" in portfolios, adding low-quality or overvalued investments without diversification benefits.
• The S&P 500 index appears diworsified, favoring overvalued tech stocks and lacking allocation to defensive sectors.
• Investors should consider reallocating to Berkshire Hathaway, which has a well-managed, diversified portfolio and is more reasonably valued than the S&P 500.

"Know what you own, and know why you own it"

- Peter Lynch

Peter Lynch warns investors against what he calls "diworsification" which can result from adding investments to a portfolio in a way that they make the risk/reward balance worse, instead of better. This can happen when adding lower quality investments, or overvalued investments, to a portfolio without adding much in the form of diversification benefits.

We believe the S&P 500 index ( SPY )( IVV ) increasingly looks like a diworsified portfolio, as it increasingly favors the overvalued technology sector and gives a very small allocation to more defensive sectors like utilities ( XLU ) and real estate ( VNQ ). If investors are looking to invest in SPY and IVV simply because they want to invest in the stock market in a simple diversified way, they might want to consider equal-weight alternatives like the Invesco S&P 500 Equal Weight ETF ( RSP ). Another option is reallocating some funds to an extremely well-managed, diversified, conservative, and with a history of taking advantage by making investments when markets crash. We are talking about Berkshire Hathaway ( BRK.A )( BRK.B ), which has assembled a great portfolio of public and private businesses, has significant available liquidity to invest if markets crash, has access to negative cost leverage in the form of insurance "float", and we believe is currently more reasonably valued than the S&P 500 index. For these reasons, we believe index investors should consider some reallocation to Berkshire Hathaway.

Less Exposure to "Bubble" Stocks

The relationship between the market cap-weighted S&P500 index and its equal weight version shows some level of mean reversion. With the market cap weighted version tending to be above the historical mean of their ratio during times of excessive optimism like before the global financial crisis, during the post Covid bubble, and recently in the last few months. We believe that once the excessive optimism about the "Magnificent Seven" companies moderates, the ratio will probably return closer to the historical average.

This group of companies is responsible for most of the S&P 500 index ( SP500 ) gains this year, and is trading with very high forward price/earnings ratios. The list includes Apple ( AAPL ), Microsoft ( MSFT ), Amazon ( AMZN ), NVIDIA ( NVDA ), Alphabet ( GOOGL ), Meta ( META ), and Tesla ( TSLA ). There is no denying that as a group their valuation appears extremely demanding, even though some would argue it is easier to make the case of overvaluation for some of them. For example, NVIDIA and Microsoft have seen their valuations shoot up from investor excitement towards AI, while this has so far had relatively little impact on their financial performance.

Sector Allocations

The S&P 500 has a high concentration in technology companies at the moment, with a close to 29% allocation. It is actually probably higher, as some tech companies actually get classified as "Communication Services".

Meanwhile, the equal weight version of the index has industrials as its top weighted sector, with an allocation of roughly 15%. It certainly looks a lot more balanced compared to the market cap weighted version. For example, utilities have an allocation of more than twice of that given in the market cap weighted version.

Admittedly, Berkshire Hathaway's investment portfolio is even more concentrated, with roughly half of its US portfolio invested in Apple. While this does not look great, especially with credible analysts estimating fair value at around $160 per share, while shares are trading close to $200. Mitigating this issue is the fact that part of the portfolio is invested internationally. For example, we know Buffett has made huge investments in Japan. More importantly, the investment portfolio represents a fraction of the total assets the company owns. Its investments are in large part financed by insurance "float".

The most recent quarterly report included a table with a summary of cash and investments held in their insurance businesses as of September 30, 2023. As can be seen, in addition to the equity securities, Berkshire Hathaway has very significant amounts of cash, cash equivalents, and US Treasuries, as well as other fixed maturity securities. This already reduces the allocation of Apple to about a third of this total, and we have not even considered the rest of the assets like the BNSF railroad, Berkshire Hathaway Energy, and other various manufacturing, service, and retailing businesses that they privately own. In total, Berkshire Hathaway owns more than one trillion dollars in assets, making Apple only about 15% of the total portfolio.

Similar Performance

The last ten years have been a close race in terms of total performance between Berkshire Hathaway and the S&P 500 index. Currently, SPY is a little bit ahead, but as we'll see below, it appears the valuation for Berkshire is a lot more reasonable than that of the S&P500 index.

Negative Cost Leverage

One advantage that Berkshire Hathaway has is its negative cost leverage. This is the result of being able to use insurance float to finance investment. At the end of September 2023, Float was approximately $167 billion. Berkshire Hathaway has proven a very astute underwriter, and despite the occasional losses, on average it has usually managed to turn a profit from its insurance businesses. For instance, in the first nine months of 2022, it had an underwriting loss of almost $1.5 billion, but in the first nine months of 2023, it is showing an underwriting profit of close to $2.3 billion. This means it is basically able to finance its entire Apple investment at a negative cost!

Management Fee

Index fund providers like BlackRock ( BLK ) and Vanguard like to boast about their low management fees. While it is true that the gross expense ratio on assets under management is quite low, it is not nothing. For example, SPY currently has a gross expense ratio of 9.45 bps or .0945%. As for the RSP ETF, its total expense ratio is even higher, at 0.20%.

Meanwhile, last we heard, Buffett's salary was only about $100,000 per year. While it might have gone up since then, it is still likely much lower than the close to $950 million the company would have to pay Buffett if he charged a similar fee on AUM.

ESG

One area where we find both Berkshire Hathaway and the S&P 500 index lacking is in their efforts to improve social and environmental sustainability. Morningstar gives Berkshire a 3 out of 5 grade regarding its ESG rating. Also, while Berkshire Hathaway Energy has been an investor in wind and solar energy, in general the company continues making very significant fossil fuel investments.

The S&P 500 index does not have good ESG characteristics either, with SPY currently having around 9.9% in assets with fossil fuels involvement. A large percentage of companies in the index perform testing in animals, and sadly it has a meaningful percentage of assets in companies making or selling controversial weapons. As Morningstar mildly puts it, this index might not appeal to sustainability-conscious investors.

Valuation

The SPY ETF is currently trading with a price/earnings ratio of around 23.5x, and a forward price/earnings ratio of about 21x.

The equal weight version of the S&P 500 index looks somewhat cheaper, with a price/earnings ratio of around 16x, and a forward price/earnings ratio of less than 15x.

Perhaps a better valuation metric for the S&P 500 index is the Shiller PE Ratio , which averages the inflation-adjusted earnings of the past ten years to calculate the Schiller price/earnings ratio. As can be seen below, the index has rarely been this expensive. It is currently trading at close to 2x its median value.

Meanwhile, Berkshire Hathaway is trading at close to its price/book average of the last two decades. Buffett has made comments noting that book value is a relevant measure for Berkshire Hathaway, even if it tends to understate its intrinsic value.

Similarly, Seeking Alpha currently assigns a 'C' grade to its valuation, while Morningstar pegs its fair value at $400 per B share, meaning they see shares as more than 10% undervalued.

Risks

While Berkshire Hathaway is a conglomerate with significant diversification and a history of good risk management, it is still just one company. Still, we believe investors should consider the option of reallocating some percentage of their SPY holdings into Berkshire Hathaway, as it appears more reasonably valued at the moment. The company also has an advantage over the index, in that it has significant available liquidity to deploy into new investment opportunities in the event of a market crash.

Conclusion

Berkshire Hathaway has delivered a similar performance to the S&P 500 index in the last ten years. However, we find the valuation considerably more reasonable than that of the index. For this reason, we believe investors should consider the possibility of reallocating a portion of their index ETFs into Berkshire Hathaway. As such, we are maintaining our 'Sell' opinion on SPY and initiating Berkshire Hathaway with a 'Buy' rating.

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