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Berkshire Hathaway chairman Warren Buffett. (RICK WILKING/REUTERS)
Berkshire Hathaway chairman Warren Buffett. (RICK WILKING/REUTERS)

strategy lab

Better than index funds: Buy a conglomerate’s stock Add to ...

Norman Rothery is the value investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Staking out a bold position in the stock market is anathema to most Canadian fund managers. While a few mavericks are willing to load up on stocks they really believe in, the majority are too timid to deviate significantly from the market.

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Problem is, many actively managed, high-fee mutual funds look too much like the index and are doomed to trail the market once fees are taken into account. It’s a sorry state of affairs that explains why sharp investors are turning to index funds in droves. They try to outperform the high-fee funds by buying the market as cheaply as possible.

While low-cost indexing has much to recommend it, investors can do away with annual fees entirely by buying stocks directly.

Stock picking comes with its own benefits and drawbacks. It allows investors to be very selective, but it can lead to overly concentrated portfolios. After all, it takes time to research each stock. Buying hundreds of them, like the big index funds do, isn’t practical or cost-effective.

But conglomerates represent an easy way to boost diversification because they typically own a collection of businesses, which makes them act sort of like mini-mutual funds. A few of them even come with their own stock portfolios.

For instance, Leucadia National Corp., Loews Corp. and, increasingly, Fairfax Financial Holdings Ltd. are worthy of attention. It’s also hard not to mention Berkshire Hathaway Inc., which owns a huge number of businesses and has become one of the largest companies in the United States.

The firm’s success is largely attributable to famed investor Warren Buffett, who runs the company from a small office in Omaha, Neb.

Mr. Buffett started buying Berkshire Hathaway in the 1960s, when it was an ailing textile concern, and subsequently funnelled the firm’s excess cash into more promising businesses. He has been particularly keen on insurance companies because they generate money that can be invested in the stock market.

By the end of 2013 Berkshire Hathaway held dozens of stocks in its portfolio including Wells Fargo, Coca-Cola, American Express, IBM and Wal-Mart.

It also directly owns a slew of other businesses. It controls a large utility called MidAmerican, the BNSF Railway, Marmon Group and many others. Some of them happen to be conglomerates in their own right. For instance, Marmon Group consists of approximately 160 businesses that operate in a variety of sectors.

Add it all up, and Berkshire Hathaway owns more businesses than many specialty index funds do.

Even better, Berkshire Hathaway’s stock is trading at a discount to the market. It can be had for 1.4 times book value and 16.2 times earnings. That’s cheap compared with the S&P 500, which trades at 2.7 times book value and 17.9 times earnings, according to Bloomberg.

It also looks reasonably priced based on its own history. Berkshire Hathaway traded for more than 1.7 times book value before the crash of 2008 and it could reach similar levels again.

Either way you look at it, you don’t have to pay a huge premium for Mr. Buffett’s hand-picked selection of businesses.

On the downside, the famed investor is getting on in years, which means the end of his run is closer than most people would like. But a succession plan is in place and the firm is willing to buy back its own stock when it trades for less than 1.2 times book value, which puts a bit of a floor under its shares.

Owning Berkshire Hathaway comes with some risks that admittedly wouldn’t be present if all of its businesses traded as separate companies. The firm is stronger than the sum of its parts in many ways, but a single bad bet could conceivably bring the whole thing down.

Nonetheless, Berkshire Hathaway represents an interesting option for cost-conscious investors who want to pick up a diversified collection of businesses in one handy package.

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