By Horacio Marquez
Contributing Editor

Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) with Warren Buffett at the helm has one of the greatest financial combinations investors have ever seen. The shares of the once-wheezing textile-maker-turned-investment-vehicle doubled over the past 10 years while the broad Standard &Poor’s 500 Index returned only 18% during the same period. In the process, Buffett became the richest man on the planet, with a net worth of about $62 billion, Forbes magazine reported back in March.

Since then, however, Berkshire Hathaway’s shares have plunged 23% – the “Class A” shares closed Friday at $116,650 each, down from their 52-week high of $151,650 (the “Class B” shares represent 1/30th of the Class A shares). And Berkshire Hathaway recently reported a slight drop in its year-to-year earnings due to some weaknesses in its operating businesses, as well as some market losses in long-term derivative positions that ultimately will almost surely be very profitable.

But the long-term track record of Buffett is indisputable.  His fame is such that many make a living of playing the “WWWBN Game” – “What Will Warren Buy Next.”

Some analysts argue that Buffett has lost his magic touch. We dismiss this out of hand.  His most-recent decisions to add into railroads, to buy shares in leading steelmaker Posco Ltd. (NYSE ADR: PKX) and 19 other South Korean companies, buying the leading Israeli industrial company and taking profits in his China holdings just before that market lost half its value all were brilliant moves and will more than compensate for any mistakes he made in timing the U.S. dollar’s weakness the year before or more recently in taking some mark-to-market losses in credit default swaps, where he eventually should end up making very good money.

More recently, Buffett’s Berkshire has added – either directly or indirectly – holdings in such companies as Kraft Foods Inc. (NYSE: KFT), making it the foodmaker’s biggest shareholder, and GlaxoSmithKline PLC (NYSE ADR: GSK), Europe’s largest drugmaker. Berkshire also was involved in a buyout deal for chewing gum icon Wm. Wrigley Jr. Company (NYSE: WWY).

And we’ll be filing periodic updates on some of his other, more-recent moves.

The bottom line: Under Buffett, Berkshire Hathaway is a like an astute and disciplined kid in a candy store.

It’s very clear that Buffett’s investment philosophy – capitalizing on value situations in companies that enjoy strong, sustainable competitive advantages in secular growth markets, and that will perform very well over the long term – has worked much more often than not.  And most of the “mistakes” that some analysts point to are actually linked overwhelmingly to short-term market movements that could easily reverse.

For instance, let’s take a look at Berkshire’s second-quarter earnings and the performance in its “troubled” insurance businesses.

For the second quarter, Berkshire’s net income declined 8% to $2.88 billion. Operating earnings declined 10% to $2.27 billion. The per-share operating earnings of $1,465 on the Class A shares actually topped Wall Street’s estimate of $1,370.

Berkshire typically derives about half of its revenue and profits from its insurance businesses. Its underwriting profit came in at $360 million, a drop of about 43%, and Berkshire said it anticipates that price competition in most of its insurance markets will reduce underwriting profits for the rest of the year.

However, Berkshire was able to post an increase in its insurance investment income to $884 million, up 3% from the $862 million reported in the year-ago quarter. That’s something that rival American International Group (NYSE: AIG) was unable to accomplish.

Berkshire Hathaway’s operating profit from its non-insurance businesses advanced 4%, reaching $1.086 billion.

Some observers contend that Buffett has become too distracted with too much ukulele-playing at Berkshire Hathaway’s investor gatherings and catching the public eye with trips to China, shown live on financial cable channel CNBC. Buffet is now also intent on saving the United States from “itself” and the mountain of debt it has amassed, which is the reason for his participation (and stellar performance) in the financial documentary “I.O.U.S.A..”

 And yet some argue that Buffett’s advancing age (77) brings the uncertainties of succession to the forefront and that Berkshire Hathaway, with a huge pile of cash and its massive size, is too big to find enough profitable opportunities.  Think again.

The evidence is very clear that when it comes to selecting the right companies for the long haul – the process developed by Buffett and his longtime partner in managing Berkshire, Charles T. Munger (84) – is solidly in place, until proven different, rather than the opposite.  And while succession is a valid question, the list of capable individuals to carry on with this process inside this organization is long. And the Berkshire portfolio is very sound. 

In terms of the decline in Berkshire’s share price, most of it can be attributed to the general slowdown of the U.S. economy.

While such key Berkshire holdings as American Express Co. (NYSE: AXP), Wells Fargo & Co. (NYSE: WFC) and its insurance units are temporarily suffering in different degrees from the real estate crisis and global credit downturns, these conditions will eventually abate and reverse strongly. And since stock prices have, in many cases, been pushed down much more than was warranted, this reversal could be very strong, indeed.

This is a high-quality investment portfolio. Once it contained the very best companies in the U.S. market – such flagship brand names as The Coca-Cola Co. (NYSE: KO). But Buffett has changed with the times, recognizing the powerful opportunities that globalization has brought – and will continue to bring for decades to come. In addition to the afore-mentioned move into Korea, Berkshire is engineering forays into such promising – but undervalued – markets as Germany.

Against this current market backdrop, cash is clearly king. Berkshire’s ready access to investment capital, and the shortage of investing liquidity are ready made for Buffett to exercise his well-known stock-picking prowess – creating still greater profit opportunities for Berkshire Hathaway down the road.

Our conclusion: The short-term weakness in the U.S. economy – which is reflected in the weakness of Berkshire’s stock price – makes Berkshire a bargain itself right now. And with Buffett at the helm, Berkshire will continue to be one of the most-profitable investments you’ll be able to find anywhere in the world.

But this is not a short-term play – or a stock for trading. It’s a long-term core holding – indeed, one of the best you’ll find. Therefore, I would buy Berkshire Hathaway in incremental stages on any weakness between now and the end of the year, as market conditions improve and tax-loss-selling on U.S. stocks abates.

ACTION TO TAKE: BUY shares of Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), making your purchases in incremental stages between now and the end of this year.

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a brand-new Money Morning feature that so far has covered such companies as Cisco Systems Inc. (Nasdaq: CS), ABB Ltd (NYSE ADR: ABB), Cummins Inc. (NYSE: CMI), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), and General Electric Co. (NYSE: GE). Over the next several Mondays here in Money Morning, we'll be reviewing Chesapeake Energy Corp. (CHK), and will take a look back at some of our previously featured stocks.]

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By Horacio Marquez
Contributing Editor

What investor wouldn’t want to own General Electric Co. (NYSE: GE)?

After all:

• With a market value of $300 billion, it’s the biggest industrial company in America.
• It owns one of the original “Big Three” television broadcasting networks in NBC – though it also operates the successful “informative portal” MSNBC in conjunction with high-tech heavyweight Microsoft Corp. (MSFT).
• Of the 12 firms that were part of the original Dow Jones Industrial Average, this is the only one that remains.
• It strives to be either first or second in every business it operates.
• It’s one of the very few major industrial companies in the world to enjoy a AAA debt rating – an achievement made all the more remarkable by the fact that it operates a massive financial-services business.
• It’s a major player in the fast-growing emerging markets of Eastern Europe, Latin America and Asia – and it’s been a market force in China for more than a decade.
• And it raises its dividend almost every year.

Unfortunately, all hasn’t been well in GE-Land for some time. Chief Executive Officer Jeffrey R. Immelt, a longtime insider who took over the top job in 2001, hasn’t been able to achieve the growth or consistency that legendary predecessor John F. “Neutron Jack” Welch seemed able to maintain so effortlessly during his 20-year stewardship of GE (1981-2001). Nor does he enjoy the Wall Street adoration that Welch always seemed to command.

Immelt hasn’t been able to achieve the predictable consistency that was a hallmark of Welch’s days at GE’s helm.

Even so, when GE reported its first quarter results on April 11 – and badly missed analysts’ estimates – it was a shocker to Wall Street. Nobody I know remembers the last time that GE missed earnings. The stock sold off sharply and nothing the company has done since then has been enough to restore confidence in the U.S. industrial heavyweight.

But this isn’t a cause for concern. Indeed, this actually represents a rare buying opportunity. Let me explain …

GE is managed with a very strong discipline and it is this discipline that leads us to point out that buying GE on weakness is an excellent idea.  The company’s portfolio of businesses is run with a set of very strict criteria destined to maximize shareholder value. And those guidelines are “static:” They evolve to stay ahead of the rapidly changing global marketplace.

Indeed, in late July, GE announced a reorganization that pares its six main business lines into four business units to take advantage of the world’s most enduring and promising long-term growth trends. Those new units consist of:

• GE Technology Infrastructure, led by Vice Chairman John Rice, which includes healthcare, aviation, transportation and enterprise solutions.
• GE Infrastructure, headed by John Krenicki, which will include energy, oil & gas and water.
• GE Capital, led by Vice Chairman Mike Neal, which brings together all of the company’s financial-services businesses, including commercial finance, GE Money, the corporate treasury, and the industry verticals.
• and NBC Universal, headed by Jeff Zucker, which will remain unchanged.

In the sweeping reorganization, GE’s Commercial Finance, GE Money, GE Industrial and GE Healthcare were folded into new, expanded business segments. Immelt has said GE will consider selling portions of GE Money, which provides banking and credit services.

Under Immelt, the Fairfield, Conn.-based GE has been slimming down and refocusing in an effort to create a less-cyclical company. It’s already ridded itself of business units that weren’t driving profitability. Last year, GE offloaded its underperforming plastics business, selling it to a Saudi Arabian company for $11.6 billion. Back in May, GE announced plans to spin off or sell its century-old home appliance business. When it found no serious takers, it announced in July that it would spin off the entire business unit.

These are the right moves to make, and show that GE is going to focus on such broad global trends as infrastructure development. For infrastructure alone there’s an estimated $40 trillion worth of projects that need to be done around the world.

Commercial finance also will be important. To that end, GE recently announced the formation of a new joint venture with an Abu Dhabi government investment company that will bring a badly needed $4 billion worth of outside capital into the commercial finance business, which has been weakened by the financial crisis.

The deal with the Mubadala Development Co. also will launch or broaden several other ventures with the Persian Gulf sovereign wealth fund, which expects to become one of the top 10 institutional investors in GE. That, too, is a good move, as it connects GE with one of the key emerging sources of worldwide capital – sovereign funds – while also creating a relationship with a leading player in one of the world’s top growing markets – the Middle East.

The themes that define GE’s business portfolio underscore the company’s commitment to establishing sustainable competitive advantages in high-growth, high-margin markets.

For example, its infrastructure businesses are enjoying very fast rates of growth, thanks to industrialization and urbanization in the emerging markets and the weak U.S. dollar.  This business, which supplies and later maintains highly differentiated, high-margin products where the company commands market leadership – or is at least a very close second: Jet engines for military jets and commercial airliners, turbines for electric power plants, and elements for wind generation. They are delivering more than half of the industrial unit revenue and enjoy strong double-digit growth.

GE is poised to enjoy very fast rates of growth in the years to come as its business line-up potential starts kicking in, as we are already seeing in the infrastructure business.

The recent earnings miss was mainly due to real estate deals that could not close because of the financial freeze-up in the global credit markets, last-minute charge-offs in GE’s finance business, and some weakness in the company’s U.S. industrial results.  This temporary situation has subsequently seen some consistent improvement as banks take losses and recapitalize, and as the stimulative measures of both the U.S. Federal Reserve and the U.S. government provide the anticipated boosts to the U.S. economy. In this sense, the U.S. economy should re-accelerate in the year’s second half, lifting the performances of the financial, media and industrial businesses in this country.

GE, with its typical discipline, will continue to divest slower-growing business units, using the realized capital to invest in faster-growing businesses. As this business plan evolves and the U.S. economic growth accelerates, the company should clearly outperform the much-lowered expectations that Wall Street analysts established to following the company’s earnings miss.

It is time to buy GE with a medium to long term, while enjoying a 4.16% dividend yield that is superior to 10-year U.S. Treasury bonds.

Here’s one other thing to consider: GE has a long history of boosting its dividend payout in the fourth quarter. So buy now and watch as the yield on your original purchase price escalates year after year after year.

If you are hesitant to endure market volatility, just dollar-cost average over a few weeks as you buy into this top U.S. company.

Action to Take: BUY shares of General Electric Co. (NYSE: GE), and capitalize on its rebirth as a U.S. industrial powerhouse, perhaps using the dollar-cost-averaging technique to smooth out market volatility as you build your position in this stock.

[Editor’s Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a brand-new Money Morning feature that so far has covered such companies as Cisco Systems Inc. (CS), ABB Ltd (ADR: ABB), Cummins Inc. (CMI), Chevron Corp. (CVX), and Valero Energy Corp. (VLO). Our analysis of Berkshire Hathaway Inc. (BRK.A, BRK.B), the investment vehicle run by famed investing guru Warren Buffett, is now planned for next Monday’s issue of Money Morning. ]

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By Horacio Marquez
Contributing Editor

Valero Energy Corp. (NYSE: VLO), the largest independent refiner in the U.S. market, is a well-known and avidly traded name. Despite being a member of the super hot energy sector, Valero has seen its stock price collapse from its 52-week high of $75.75 to Friday’s close at $34.72 (a 54% decline). The 52-week low is $29.70, and the Wall Street analyst community remains very negative on the shares of the San Antonio-based company – even though it beat analysts admittedly reduced expectations for both revenue and earning.

The $64 million question (*) is this: Is it time to buy? During the past year, I have watched as many ventured into this stock for a trade – only to get clobbered.  The key factor in determining Valero’s profitability – and its stock price – is the refining profit margin, known as the "crack spread" in industry parlance.  This is the difference between the cost of oil purchased by Valero and the price it can get for the distillates it obtains by refining the 3.1 million barrels of crude oil that it processes daily.

Recently, the overall industry crack spread has been narrowing. In fact, it has been for some time as governments around the world and gasoline companies actually try to hold down the pain motorists feel at the gas pumps.

The "perfect storm" that hit Valero this year had several catalysts:

• First, we watched as the price of crude oil soared exponentially, the result of rocketing global demand overseas and a lack of effort in both the United States and other countries to increase production.
• Second, demand for distillates in the United States waned as the U.S. economy slowed down and distillate prices soared trying to catch up with crude prices.  This made it very difficult for the increases in the price of gasoline to be able to keep up with increases in the price of oil, compressing Valero’s crack spreads from last year.

That was the bad news.

The good news is that crack spreads in the second quarter have increased from the first quarter of this year.  Also, since Valero’s refineries can process the cheaper "heavy sour" crude oil, the company has a sustainable competitive advantage over other refiners, giving its refineries staying power through rough times like these.  For very-long-term holders, this is when you buy stocks such as this one; since the weaker rivals often disappear (the rivals either eventually get shut down, get sold off – or both), and the strong players emerge as the victors.

In the refinery sector, that strong player – and eventual victor – is Valero. But we are not there yet, and the lack of expansion in refining capacity in the U.S. market over the past decade has established a definite floor under crack spreads, meaning there’s only so low they can go.

The U.S. government expects crack spreads to improve moving forward, but those spreads remain well below where they were in last year’s second quarter. That’s good because it means there’s room for improvement – in both the margins and the share prices.

Another plus is that as oil prices have been dropping precipitously recently from the high of almost  $150 per barrel, crack spreads have been increasing.  And the drop in prices of natural gas, which is an input to Valero’s refining process, has also declined, further adding to margins.

The bullish argument, then, is this: The drop in oil prices, and sequentially expanding margins (from quarter to quarter, as opposed to year over year), will combine with the low valuation in Valero’s stock price (the current Price/Earnings Radio is 6.76, while the Forward P/E is 11.22) to boost the company’s share price, which appears to have bottomed of late.

This bullish case could very well be accurate; unfortunately, it’s still too difficult to call. And here’s why:

• The U.S. economy isn’t going into a recession. That means U.S. demand for petroleum products won’t abate as much as analysts expected, and may actually soon begin to escalate anew (even if it’s somewhat reduced because of energy-reduction initiatives).
• Emerging-market demand will continue to escalate as incomes rise and more consumers buy cars. The respite there also is likely to be a temporary manifestation: They have curbed gasoline demand subsidies because of the inflationary impact of high crude prices and food prices; as crude prices are abating, demand is likely to reaccelerate.
• Evidence about the resilience of emerging markets has been abundant of late. There was Cisco System Inc.  (CSCO), which reported stronger-than-expected sales and profits last week, thanks largely to strong performance in Mexico, Russia and Asia – and especially China. There was the comment by Jeffrey R. Immelt, chief executive officer for industrial giant General Electric Co. (GE), who talked of the undiminished strength in the emerging markets – with a specific reference to the Asian infrastructure boom. And there’s the launch of the $2,500 car – the Nano – in India by Tata Motors Ltd. (TTM), a domestic carmaker with global aspirations.

It’s worth noting, too, that most of these markets outside the United States, which are currently slowing, have plenty of room to cut interest rates. And some will be able to do so, should the prices of commodities and other goods continue to decline.

Unfortunately for our evaluation of Valero, in addition to the ongoing gyrations in oil prices there’s substantial uncertainty being created in Washington, largely because of the ongoing political battle that’s focused on the lifting of the ban on drilling in offshore U.S. waters. The mere possibility of this ban being lifted has added much downside pressure to oil prices by motivating profit-taking by the speculators who had previously been betting that long-term prices were destined to head higher.

Hence, while Valero’s beaten-down shares appear very appetizing right now, and while the shares seem well positioned for a near-term speculative trade, there’s still too much uncertainty to call this an actual "Buy" for investors. Unless we see much-lower oil prices, which would rekindle gasoline demand in the U.S. market and expand Valero’s margins, the upside, if any, in Valero’s stock will remain very limited.  So I cannot recommend to buy Valero here.  However, since Valero’s stock has come down dramatically, and the company still is profitable (they are still profitable, show mildly expanding sequential margins, and management is committed to support the stock with buybacks), neither do I see a compelling reason to call it "Sell" here. So I will stick with a tenuous "Hold" until we can at least start resolving the uncertainties surrounding oil prices and the U.S. economy.

Action to Take: HOLD Valero shares as we await a bit more certainty in both the oil sector and the U.S. economy.

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a brand-new Money Morning feature that so far has covered such companies as Cisco Systems Inc. (CS), ABB Ltd (ADR: ABB), Cummins Inc. (CMI), and Chevron Corp. (CVX). Next week, Marquez will write about Berkshire Hathaway Inc. (BRK.A, BRK.B), the investment vehicle run by famed investing guru Warren Buffett. ]

(*) It was once the "$64,000 question," but inflation has done its work all too well.

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By Horacio Marquez
Contributing Editor

As the old Wall Street adage says, nobody ever got poor by taking profits.

And Potash Corp. (NYSE: POT), the world’s largest fertilizer company, is a living case study as to why that’s true.

The Saskatoon, Canada-based Potash posted stellar results for the second quarter.  Gross margins and earnings tripled to 68% and $905 million, respectively, from the same quarter last year on the back of huge gains in the prices of potash, phosphate and nitrogen, which in the past 12 months increased more than 160%, 130% and 55%, respectively. And the company raised its earnings outlook by about 30% for the year.

This stellar financial performance came on the back of increased global demand for grains, which drove grain prices to record highs and caused the head of the United Nation’s World Food Programme to warn that soaring food prices are causing a “silent tsunami” of hunger to sweep the globe.

But despite posting superb profits that handily beat earnings estimates and raising outlook, the stock sold off, together with the rest of the sector.  That’s partly because commodity prices have dropped back, causing related stocks to do the same. The stock-price decline, in the case of Potash, also has a company-specific negative component: Workers are threatening to strike at three mines that account for roughly 30% of Potash’s output. Without question, a strike could negatively affect Potash’s output – even as it raises the price of potash globally, helping the company’s rivals in the near-term.

However, the afore-mentioned sell-off in commodities has been driven by several important factors:

• Short-term momentum players and some institutional investors have moved away from the so-called “ethanol trade,” since electoral uncertainties raise probability that next year’s ethanol subsidies might be reduced or scrapped altogether.  This worry also has affected Archer Daniels Midland Co. (ADM), a prime beneficiary.
• The U.S. dollar has been climbing against both the Japanese yen and the European euro, especially now that Europe has started to slow, a victim of its appreciated currency tight monetary policy. Some emerging economies also tightened their monetary policies to curb inflation. In this environment, commodities as hedge for inflation have lost some appeal, at least for the moment.
• This slowdown and demand destruction, in part because of higher prices, have also induced oil prices to decline, and that, in turn, has helped reduce overall inflationary pressures – reducing the need for investors to hedge energy with grains and other agricultural commodities.
• Summer in the United States has not seen extreme temperatures nor hurricanes, so this year’s crop has only been mildly affected by floods, unlike last year’s weather-induced crop losses. Benevolent weather has also helped lower the price of oil.

On the positive side, emerging-market urbanization, and the accompanying consumer boom (all driven by strong growth in real incomes) is alive and well and will continue unabated for the long-term.  So, at some point, Potash and its competitors will become a compelling long-term “Buy.” But the uncertainty regarding the U.S. ethanol subsidies, which originally helped fuel the demand for fertilizer, is too difficult to call at this point.

With most investors having captured massive profits in these stocks and with a high probability of seeing next years’ capital gains taxes increased, there is a strong incentive to take profits now.

Therefore, I would lock in profits and wait for an opportunity to get back into this stock closer to the year-end. You’ll want a bit more clarity about the prospects for continued ethanol subsidies and lower prices to get back into this stellar company and its main peers in the sector.  And stay tuned for news on the Potash strike.

Action to Take: SELL Potash shares right now, and look to buy back in later this year when the outlook is clearer.

[Editor’s Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a brand-new Money Morning feature that so far has covered Cisco Systems Inc. (CS), ABB Ltd (ADR: ABB), Cummins Inc. (CMI), and Chevron Corp. (CVX). We continue to appreciate all the readers who are writing to us, suggesting stocks they’d like to see analyzed.]

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