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Buffett, a Defense of the Oracle of Omaha

Don't count him out yet. An analysis of his strategy and holdings shows his slump is probably just a blip.

It may be too early to count out the Oracle of Omaha.

Some journalists and investors, perhaps suffering from Schadenfreude, have argued that Warren Buffett, chairman and chief executive officer of

Berkshire Hathaway


, might be nearing the


of his long track record of phenomenal performance.

They point to


that have fallen more than stock-market benchmarks, as well as a huge derivative book that is sustaining billions of dollars in market-to-market losses during the worst financial crisis in 75 years.

Buffett, who became the world's richest man about a year ago and has since slipped to second place behind Bill Gates, has beaten the U.S. benchmark S&P 500 Index 37 times from 1965 to 2007, according to data published in Berkshire Hathaway's 2007 letter to shareholders. Investors of Berkshire, a holding company weighed heavily toward insurance holdings including GEICO, had an average annual gain of 21.1% during that time, twice as much as the S&P 500's 10.3% advance.

Buffett hasn't fallen into ruts. The few cases of underperformance are aberrations that have quickly reversed course. In 1999, Berkshire trailed the S&P 500 by 20.5 percentage points. A year later, the company's stock beat the benchmark by 15.6 percentage points. The average outperformance following an underperforming year is 19.4 percentage points.

Although Berkshire has large stakes in publicly traded companies, much of its success comes from investments in private firms. Berkshire has private portfolio companies involved in industries such as home furnishing, athletic wear, candy, jewelry and electrical components, to list a few. Those investments follow Buffett's criteria for investing: solid management with a wide "moat," meaning an easily defensible position in the industry.

None of the private portfolio companies is sexy, which is a reason for their success. It is unlikely that any of them will crash and burn because of excessive leverage or an out-of-control derivatives book.

Beyond investments in retailers and public companies, Berkshire's biggest holdings are in the insurance industry. In 2007, Berkshire posted $3.37 billion in pretax profits from underwriting at insurers, which include



General Re


National Indemnity


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There are no indications from Buffett that any of Berkshire Hathaway's portfolio companies have significant exposure to the toxic assets that have been weakening the competition. This is due to Buffett's ability to identify businesses that are sustainable and worthy of the Berkshire Hathaway seal of approval.

Still, Buffett has made substantial derivative investments, which may be a surprise to some. While "derivative" has become a buzzword that makes many stomachs turn, Buffett's exposure is far tamer than any of the books that have been sinking investment firms throughout 2008.

Seventy-three percent of Berkshire's $9.25 billion derivative book comes in the form of European "put" contracts written by Berkshire Hathaway at the market price for the S&P 500 and three foreign markets with a weighted average remaining life of about 13 1/2 years. Since these are European option contracts, meaning they can only be exercised at expiration, Berkshire Hathaway will only lose money if the index's value at expiration falls below the level it was when the contract was written.

The remainder of the derivative book is in credit default swaps. However, the main hit on the derivative book comes from market-to-market accounting, which forces Berkshire to write down the put contracts to the current fair value, even though Buffett has said he has no plans to sell the contracts before expiration. Those losses will most likely reverse themselves in the coming years as the market rises and credit markets improve.

Buffett has been active in the financial crisis, and injected capital into an ailing bank with more favorable terms than the U.S. government has. In September, he bought $5 billion worth of preferred stock in

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report

along with warrants to purchase an additional $5 billion in common stock at a strike price of $115 a share. The preferred stock carries a hefty 10% annual dividend, which will bring in $500 million every year for Berkshire Hathaway, more than the zero percent the government will be yielding on its injected capital.

Criticism of Berkshire's public holdings may be justified with the benefit of hindsight. Some fault Buffett for missing out on a profitable exit from


(KO) - Get Coca-Cola Company Report

at its peak of $86.13 in 1998. Clairvoyance is a lofty expectation even for an oracle.

Buffett has described himself as a long-term investor. Quick exits should not be expected and could even be regarded as a violation of his mandate. Investors ought to realize that Berkshire's portfolio will change little from year to year. Especially for holdings like Coca-Cola, in which Berkshire holds more than 8%, any exit would be very difficult due to the sheer size of the investment.

The composition of Buffett's current publicly traded


, or what was available as of Sept. 30, seems ideal under normal market conditions. It provides for the benefits of diversification with a mix of blue-chip companies in wide-ranging industries.

When the holdings are compared to Ratings data, a positive picture emerges. While the current universe of rated stocks has only 9% listed as "buy," Buffett's portfolio comprises 19.4% "buy"-rated stocks. All of those shares outperformed the S&P 500 by double digits in 2008.

Stocks in the portfolio with a "hold" rating account for the vast majority. Sixty-seven percent of the Berkshire portfolio has a "hold" rating from Ratings. A "hold" rating means a stock will probably perform in line with the market. Forty-four percent of stocks rated by Ratings are "hold." The average outperformance of the "hold"-rated securities of Berkshire Hathaway was 6.4 percentage points in 2008.

Buffett holds some stocks rated "sell" by Ratings. They comprise 13.8% of the portfolio. Of the stocks rated by Ratings, 47.25% are rated "sell." In all, Buffett's holdings as of Sept. 30, if equally weighted, beat the S&P 500 by 5.4 percentage points in 2008. Ratings' model can be described as "safety first." Neither the model nor Buffett like excessive risk, volatility or debt, and those aversions fare well in a recession.

Much of Berkshire's performance is dependent on Buffett's actions after the crash in October. Until the results are available for that time period later this month, we are left to speculate on the possibilities. No investment manager can promise gains, but Buffett is more consistent and honest than most. Just because he isn't ringing up a positive return doesn't mean he has lost his edge.

Prior to joining Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level II CFA candidate.