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Rising Interest Rates to Test Berkshire Outperformance, Buffett Legacy

So if Buffett was worried that the earnings growth of publicly traded companies and a drop in interest rates would do little for stock market valuations in the new millennium, what was his strategy?

Given Berkshire's ever bigger acquisitions, including BNSF, Heinz, MidAmerican Energy, NV Energy, Lubrizol, Marmon Holdings and Iscar Metalworking, it seems clear that the goal was to buy companies at the right price and benefit from their compound growth over the long-term.

In fact, Buffett's Sun Valley speech came just a few days before Berkshire's acquisition of MidAmerican Energy, the firm's biggest at the time.

"When [Buffett] did that talk, he looked around and said I have to get our performance away from the performance of public equity markets," Smead says of the Sun Valley conference.

Consider the impact of Berkshire's oft-criticized acquisition strategy if interest rates rise with a recovering U.S. economy.

Buying Burlington Northern Santa Fe at a premium price in 2009 may have put Berkshire's book value growth and stock performance closer to the S&P 500 index in recent years, but compound returns on the future earnings and cash flow of the railroad from Berkshire's purchase price of $26 billion may outperform broader indexes in coming years.

The scenario may already be playing out.

After five years of a rising correlation between Berkshire's stock performance and the S&P 500 to an almost perfect alignment by early 2012, the company's performance has begun to diverge from the broader market.

Berkshire's beta, which peaked at a near-perfect correlation of .97 in February of 2012, has fallen to .91, according to Bloomberg data.

Then comes Berkshire's second big move, a now famous "bet on America" article published amid the meltdown of Wall Street in October 2008. "I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds," Buffett wrote.

While Buffett was speaking about his personal investments in the op/ed, Berkshire Hathaway has increased its stock portfolio to over $90 billion and built leading stakes in strong performers such as American Express (AXP - Get Report), Coca-Cola (KO - Get Report), Wells Fargo (WFC - Get Report) and IBM (IBM - Get Report).

Berkshire has also been investing in fixed income, but only through above market buyout loans to the likes of 3G Capital, Coty (COTY) and Mars and emergency cash to Goldman Sachs (GS), General Electric (GE) and Bank of America (BAC).

Through the crisis years, Berkshire and its operating subsidiaries haven't been content to let their bank accounts swell with cash as companies such as Apple (AAPL), Google (GOOG) and Microsoft (MSFT) have. Instead, the firm has been devoting ever rising amounts of cash to capital expenditure, whether it is alternative energy projects for MidAmerican, infrastructure for BNSF of capex at Marmon.

So what would Berkshire's outperformance and a lowering in its correlation with overall markets mean?

For one, it would be yet another victory lap for Buffett's Graham and Dodd-inspired investing style, as the performance of some peers trails off in a new investing environment.

The ordinary investor might also do well to forget about the short-term obsessions of market watchers and try to position for longer-term opportunities, as Buffett may have done in Sun Valley in 1999.

The big question for Berkshire's performance, after all, doesn't center on interest rates. It instead revolves around whether Buffett and Munger can continue to uncover ample high-return investments given Berkshire's ever-growing size, as Berkshire-chosen bear Doug Kass pointed out in May.

-- Written by Antoine Gara in New York

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