According to Warren Buffett, these are stocks that could outperform the S&P 500 with less risk

By | March 31, 2024

One of the basic principles of investing is that to earn better than average returns, an investment typically requires higher than average risk. But sometimes you come across an investment that could beat a broad index like the S&P500 without a high level of risk.

In his most recent letter to shareholders, Warren Buffett suggests Berkshire Hathaway (NYSE: BRK.A) (NYSE: BRK.B) is one of those investments. Buffett may be a bit biased: Nearly all of his $135 billion net worth is invested in the company, where he is CEO. But his reasoning is correct and the stock looks attractive.

This is why Buffett thinks his company’s stock can perform better with less risk.

A close-up of Warren Buffett.

Image source: The Motley Fool.

“Slightly better” than the average American company

Since Buffett took control of Berkshire Hathaway in 1965, the stock has beaten the S&P 500. Compound annual gains through 2023 were 19.8%, versus 10.2% for the broader index. But Buffett says the days of market-wrecking returns are behind him.

While he says he expects Berkshire to do “a little better than the average American company,” he cautions that expecting “anything more than ‘something better’ is wishful thinking.”

Buffett has built a portfolio of partially or entirely proprietary companies for Berkshire Hathaway, and the selection is impressive. He mentions old holding companies Coca-Cola And American Express as well as Berkshire’s growing interest in Western petroleum like some of the major companies it owns part of.

The company also owns a leading insurance business and a core railroad business, which generated $37 billion in operating revenues last year.

The biggest investment interest is his position in Apple, which is worth about $155 billion. That position was largely built with a significant investment between 2016 and 2018. Despite a recent stock sale, Buffett’s commitment to Apple cannot be questioned. It is more than 40% of Berkshire’s stock ownership.

“After 59 years of accumulation, the company now owns a portion or 100% of several companies that, on a weighted basis, have slightly better prospects than those of most major U.S. companies,” Buffett wrote to shareholders in February.

But it’s not just that it owns a portfolio of strong companies, it’s also well positioned to avoid financial ruin thanks to another prudent investment from Buffett.

The huge protective policy on Berkshire’s balance sheet

In recent years, Berkshire Hathaway has seen its cash and equivalents assets rise to $168 billion. For the most part, this is invested in government bonds with a short term.

Buffett said this amount could be excessive: “Your company also has a position in cash and U.S. Treasury securities that is far greater than what conventional wisdom deems necessary.” He says this cash position is “similar to an insurance policy on a fortress-like building thought to be fireproof.” Still, he would prefer to be overly conservative with Berkshire’s and its investors’ money.

The large cash position could protect this position if the US slides into recession. On the other hand, a large pile of money is a hindrance to investment returns. The good news for Berkshire investors is that this barrier is mitigated by current interest rates: the company earns more than 5% interest annually on its government bonds.

But that pace won’t last forever. Federal Reserve Chairman Jerome Powell reiterated the Fed’s expectation to cut rates in 2024 following the most recent meeting of the Federal Open Market Committee (FOMC). As Berkshire continues to produce tens of billions in free cash flow, Buffett will soon have to find a better investment for his growing cash pile.

That won’t be easy. He notes that as the company has grown, it has become harder to find an investment that can really make a difference. One of his favorite ways to deploy cash recently was through Berkshire Hathaway’s robust stock buyback program.

That investment has paid off well and, given Berkshire’s current share price, may continue to work.

Does Berkshire belong in your portfolio?

As Buffett notes, Berkshire is not in a position to generate returns that will beat the overall S&P 500 by 9.5 percentage points per year, as has been the case in the past. But it offers very attractive prospects for risk-adjusted returns.

The cash position is more than sufficient to protect the railway and insurance activities in the event of an economic downturn. With cash to spare, Berkshire could find an investment opportunity in the event of a market downturn.

Meanwhile, its existing broad investment portfolio ensures that it can fully participate in US economic growth. Overall, the range of partially or wholly owned companies means the business is well diversified when a single company faces challenges.

The stock, meanwhile, trades at an attractive valuation: just 23.7 times last year’s operating profit, not including potential gains from the equity portfolio. As such, it seems undervalued when you factor in the likelihood that Buffett’s “slightly better” than average stock picks will outperform over the long term.

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American Express is an advertising partner of The Ascent, a Motley Fool company. Adam Levy has positions at Apple. The Motley Fool holds positions in and recommends Apple and Berkshire Hathaway. The Motley Fool recommends Occidental Petroleum. The Motley Fool has a disclosure policy.

The first stock that Warren Buffett thinks could outperform the S&P 500 with less risk was originally published by The Motley Fool

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