Rising Interest Rates to Test Berkshire Outperformance, Buffett Legacy

NEW YORK ( TheStreet) -- Some of the most followed Wall Street commentators fear an era of rising interest rates will dent the legacy of this generation's best investors. For Warren Buffett, however, rising interest rates could trump fears he has expressed that Berkshire Hathaway ( BRK.B) will underperform rising markets in coming years.

When Berkshire Hathaway commenced its May 4 annual shareholder meeting, Buffett had a lot to celebrate given the conglomerate's rise to new record share price highs and a strong first quarter earnings report due to growth from the firm's operating subsidiaries. At the meeting, however, Buffett and his longtime lieutenant Charlie Munger repeatedly expressed an expectation of underperformance by Berkshire relative to the S&P 500 Index. They even invited Doug Kass of Seabreeze Partners to make the case for betting against Berkshire's shares.

But behind a dog and pony show of pessimism and a tempering of expectations at Buffett's capitalist Woodstock, Berkshire could actually be poised for its finest hour.

Understanding how such a scenario may play out could be far more productive for investors in current markets, as stock strategists and economists parse Ben Bernanke's words for when the Federal Reserve may "taper" an $85 billion monthly bond purchase program and boost the federal funds rate from its current range of zero to 0.25%.

Buffett has spent the years between dot-com bust, the credit crisis and a recent stock market surge transforming Berkshire Hathaway into to a set of businesses that may become increasingly insulated from market trends, especially in a gradually rising rate environment.

For instance, Berkshire may see higher than average compounded returns from its burgeoning energy, railroads and industrial operating subsidiaries, if rising interest rates do, in fact, chip away at stock market valuations and bond prices. Those businesses could also provide cash flow to support the firm's outperforming stock portfolio, acquisitions and a recent penchant to make large loans at rates well above the market.

Expectations of a long-term rise in interest rates are beginning to confound some of the this generation's top investors and have even propelled the so called "Bond King," Bill Gross of Pacific Investment Management Company, into a bout of soul-searching.

Gross, a manager of the famed Pimco Total Return Bond Fund, in April questioned his performance and the 20-year to 30-year returns posted by other widely acclaimed investors such as Buffett, George Soros of Soros Management, Ray Dalio of Bridgewater Management, Leon Cooperman of Omega Advisors and Howard Marks of Oaktree Management ( OAK).

Did this a generation of investing "kings," "vigilantes" and "oracles" simply benefit from an unprecedented moderation in interest rates from the early 1980s to current levels, Gross wondered?

While rising interest rates present challenges to bond investors like Gross, the carry trades between assets used by hedge fund managers such as Dalio and Soros and even value-oriented stock pickers such as Cooperman, there's reason to believe Buffett and Berkshire may be insulated from such headwinds.

In fact, Buffett may have quietly prepared Berkshire for a rate rise in recent years, according to Berkshire investor Bill Smead, chief investment officer of Smead Capital.

Smead points to a 1999 speech Buffett made in Sun Valley, Idaho and an October 2008 op/ed he published in the New York Times as indicative of the "Oracle's" thinking.

In 1999, Buffett warned investors at the Sun Valley conference that earnings growth in Corporate America would have to accelerate sharply over the next decade and interest rates would have to fall precipitously for stocks to move above from their tech-bubble highs.

Interest rates did fall sharply and corporate earnings benefitted from both the fat years of the housing boom and the cost-cutting executed in the wake of the crisis. However, since Buffett's speech the S&P 500 has only posted a total return of about 55% when counting dividends reinvested to the index, according to Bloomberg data.

Berkshire's Class A shares have more than tripled from $54,500 to a current share price of $171,550 over the same period.

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), Coca-Cola ( KO), Wells Fargo ( WFC) and IBM ( IBM).

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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