1 Stock That Could Outperform the S&P 500 With Less Risk, According to Warren Buffett

One of the basic tenets 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-based index like the S&P 500 without a high level of risk.

In his most recent letter to shareholders, Warren Buffett suggests Berkshire Hathaway (BRK.A 0.77%) (BRK.B 0.86%) is one of those investments. Buffett might be a bit biased — practically all of his $135 billion net worth is invested in the company, where he is the chief executive officer. But his reasoning is sound, and the stock looks attractive.

Here’s why Buffett thinks his company’s stock can outperform with less risk.

A close up of Warren Buffett.

Image source: The Motley Fool.

“Slightly better” than the average American corporation

Since Buffett took control of Berkshire Hathaway in 1965, the stock has trounced the S&P 500. Its compound annual gain through 2023 was 19.8% versus 10.2% for the broader index. But Buffett says those days of market-trouncing returns are behind it.

While he says he expects Berkshire to do “a bit better than the average American corporation,” he warns that expecting “anything beyond ‘slightly better,’ though, is wishful thinking.”

Buffett has built a portfolio of partly and wholly owned businesses for Berkshire Hathaway, and the roster is impressive. He calls out longtime holdings Coca-Cola and American Express as well as Berkshire’s growing stake in Occidental Petroleum as some of the great companies it owns a piece of.

It also owns a leading insurance business and a railroad among its core operations, which produced $37 billion in operating earnings last year.

The biggest investment holding is its position in Apple, which is worth about $155 billion. That position was largely built with a sizable investment between 2016 and 2018. Despite a recent share sale, Buffett’s commitment to Apple can’t be questioned. It’s over 40% of Berkshire’s stock holdings.

“After 59 years of assemblage, the company now owns either a portion or 100% of various businesses that, on a weighted basis, have somewhat better prospects than exist at most large American companies,” Buffett wrote to shareholders in February.

But it’s not just that it owns a portfolio of strong businesses, it’s also well positioned to avoid financial ruin thanks to one other prudent investment by Buffett.

The enormous protection policy sitting on Berkshire’s balance sheet

Over the last few years, Berkshire Hathaway has seen its cash and equivalents holdings balloon to $168 billion. For the most part, that is invested in short-term Treasury bills.

Buffett said that this amount could be excessive: “Your company also holds a cash and U.S. Treasury bill position far in excess of what conventional wisdom deems necessary.” He says this cash position is “akin to an insurance policy on a fortress-like building thought to be fireproof.” Still, he would rather be overly conservative with the money of Berkshire and its investors.

The big cash position can protect it if the U.S. slides into a recession. On the other hand, a big pile of cash is a drag on investment returns. The good news for Berkshire investors is that this drag is mitigated by current interest rates: The company is receiving more than 5% annual interest on its Treasuries.

But that rate won’t last forever. Federal Reserve Chairman Jerome Powell reiterated the Fed’s expectation to lower interest rates in 2024 after the most recent Federal Open Market Committee (FOMC) meeting. Considering Berkshire continues to produce tens of billions in free cash flow, Buffett will need to find a better investment for his growing cash pile before long.

That won’t be easy. He notes that as the company has gotten bigger, finding an investment that can truly move the needle becomes more difficult. One of his favorite ways to deploy cash recently has been through Berkshire Hathaway’s robust share repurchase program.

That investment has worked out well, and given Berkshire’s current share price, it can keep working.

Does Berkshire belong in your portfolio?

As Buffett notes, Berkshire isn’t in a position to produce returns that will beat the overall S&P 500 by 9.5 percentage points per year as it has in the past. But it offers a very attractive outlook for risk-adjusted returns.

Its cash position is more than ample to protect its railroad and insurance businesses in the case of an economic downturn. With cash to spare, Berkshire could find an investment opportunity in the case of a market downturn.

Meanwhile, its existing broad investment portfolio ensures that it can fully participate in U.S. economic growth. Overall, the range of partly and wholly owned businesses means the company is well diversified should a single business face challenges.

The stock, meanwhile, trades at an attractive valuation: just 23.7 times last year’s operating earnings, which doesn’t include the potential gains from its equity portfolio. As such, it appears undervalued when you include the likelihood of Buffett’s “slightly better” than average stock picks to outperform over the long run.

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

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