How To Create A Powerhouse Portfolio Like Buffett's

Joseph Hogue's picture

Monday, March 7, 2016 - 7:30am

by Joseph Hogue

Warren Buffett's 2015 Letter to Shareholders is out and all investors are talking about is the Oracle's losing bet in IBM (NYSE: IBM) and his warning of widespread earnings manipulation in the market. 

While both of these may be interesting and important topics, most investors have completely missed one of the most important ideas in the letter. In fact, this one idea contributed to 85% of Berkshire Hathaway's (NYSE: BRK-B) increase in net worth and it did it with just five investments.

Buffett talk just briefly about his Powerhouse Five portfolio this year on page four of the letter. These are the five most profitable non-insurance businesses owned by Berkshire Hathaway and has been a focus of the legendary investor for nearly two decades. 

The group is a critical component of the Berkshire portfolio and accounted for 85% of the 2015 increase in Berkshire's net worth. The $13.1 billion earned by just five companies represented a 5.2% gain over the year before and well above the 12.5% loss the Berkshire portfolio suffered in market value during the period.

How To Create Your Own Powerhouse Portfolio
Buffett doesn't talk at length about his Powerhouse Portfolio and has only started building it since the 1999 controlling stake in MidAmerican Energy. Within the group is a utilities holding company, the BNSF railway, an Israeli tool-making company, a specialty-chemicals company and an industrial equipment manufacturer. 

The fundamentals that tie those companies together are those at the heart of Buffett's investing style and your clues to building your own Powerhouse Portfolio.

1. Cash is king in the Buffett portfolio and a company that can grow operational cash flow is more likely to return it to shareholders. While cash flow from operations is just one part of overall cash flow, it's the cash-generating power of the business.

2. Buffett's decades of experience have given him an eye for great leadership and it's what he looks at most critically when investing in a company. It's less quantifiable than the other fundamentals but look for management decisions and how strategic decisions have guided the company.

3. Buffett likes to invest in global leaders within their industries, large-cap companies that can use their financial power and position to drive efficiency and higher market share. Even in the few that don't have a large international presence like BNSF Railways, the companies tend to dominate their geographic range.

Ultimately, investing is about taking a share of profits so Buffett looks for companies that are more profitable than their competitors. Of the profitability measures, I like the operating margin the most because it shows management's ability to make money after operational expenses but before financial leverage and tax effects.

Three Stocks In My Powerhouse Portfolio
Allergan plc (NYSE: AGN) is one of the largest specialty pharma manufacturers and its planned merger with Pfizer (NYSE: PFE) will create a $302 billion behemoth in the space. Management has proven itself extremely adept at maneuvering in the acquisition-led industry, filling its drug pipeline for the right price while avoiding costly deals. Selling the generics unit to Teva Pharmaceutical (NYSE: TEVA) makes the Pfizer deal possible and focuses the company on a less price-sensitive side of the market. The company has an operating margin of 14%, well above the industry's 7% median, and cash flow has grown at a 77% annualized pace over the last three years. Shares trade for just 18.6 times trailing earnings, well below the industry's average multiple of 27.0 times earnings.

Analog Devices (Nasdaq: ADI) is a leader in signal processing chips for the industrial and automotive markets and one of the largest analog chip makers in the world. Management made the decision years ago to sell low-margin product lines and focus on high-performance chips. The higher profitability has helped the company set a goal of distributing 80% of its free cash flow to shareholders through dividends and buybacks. Analog Devices posts a very strong 31% operating margin and operational cash flow growth of 3.6% annually over the last three years. Shares trade for just 17.1 times trailing earnings, well below the five-year average of 20.7 times and below the industry's average multiple of 29.1 times earnings.

As both a content creator and a distributor, Walt Disney (NYSE: DIS) has a huge amount of pricing power relative to competitors in the media space. Management under CEO Bob Iger has put together the best content creation assets in the industry with Pixar, Marvel and Lucasfilm. Media networks including ESPN, ABC and Disney offer best-in-class distribution for the content. The company sports an operating margin of 26% against an industry median of 7% and has increased operational cash flow by 11% annually over the last three years. Shares trade for just 17.3 times trailing earnings, below the five-year average of 19.3 times and below the industry's average multiple of 22.2 times earnings.   

Risks To Consider: While Buffett's Powerhouse Portfolio contributes a big chunk of overall earnings, he knows that a diversified portfolio across many investments is necessary to protect against company-specific risks.

Action To Take: Put together your own Powerhouse Portfolio of focus stocks to take a position in the market leaders that will drive your overall return.

P.S. We're locking in a paycheck of $15,100 for every $100,000 we invest... and our dividends keep growing... sometimes overtaking our original stock price. Invest like this and it just might change the way you think about investing forever.

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.